Taking Big Pharma's Pulse

Investors may want to take a second look at major drugmakers. A rebound may be in store, says S&P industry watcher Herman Saftlas

For a number of years, drug stocks made great investments. Profits rolled in for many of the biggest names in the industry. Yet over the past five years, the group has underperformed the Standard & Poor's 500-stock index as earnings growth faltered for many outfits.

The primary culprits: patent expirations of many money-spinning drugs and a relative shortage of new blockbusters to take their place.

But Herman Saftlas, a senior investment officer who follows the industry for Standard & Poor's Equity Research Services, thinks the industry has finally bottomed out -- and he sees opportunities in selected pharma issues. Saftlas, with more than 35 years of analytical experience at S&P, has covered health-care companies for the past 20, with particular emphasis on the major-pharmaceutical, specialty-pharmaceutical, and generic-drug groups.

Joseph Lisanti, editor of S&P's weekly investing newsletter, The Outlook, recently spoke with Saftlas about current trends in the industry -- and his views on some big names in the group. Edited excerpts from their conversation follow:

Q: Give us an overview of the drug industry today.
A: We believe drug stocks underperformed in the past five years largely because of several negative fundamental trends as well as a number of company-specific issues. A spate of patent expirations affected most of the major pharmaceutical companies. Especially hard hit were Bristol-Myers Squibb (BMY; S&P investment ranking 3 STARS, hold; recent price, $25), Merck (MRK; 3 STARS; $31), and Schering-Plough (SGP; 4 STARS, buy; $19). The patent expirations took away a large chunk of their revenues.

In decades past, most major pharmaceutical companies were able to avoid this problem by stepping up R&D spending to find new drugs to replace those with expiring patents. Unfortunately, in the past few years, the drug industry's R&D engine has sputtered, and new products haven't been forthcoming. In addition, pricing has become tougher, with managed-care companies now basically controlling the market. Another major problem recently has been product blowups.

Merck's Vioxx was used successfully by millions of people for many years. Yet the drug was yanked from the market last fall in the wake of clinical studies linking it with increased cardiovascular risks. The removal of Vioxx created a major vacuum for Merck.

That was followed by adverse clinical findings for similar drugs Celebrex and Bextra from Pfizer (PFE; 3 STARS; $28). What the Food & Drug Administration did was allow Celebrex to remain on the market with a much tougher "black box" warning. But Bextra was removed. I think the product blowups shook investor confidence in the industry. When you're invested in a company and its major product isn't there anymore, it's sobering.

Q: Are drug companies going to be buying the biotechs?
A: We haven't seen it. To actually go out and acquire biotech companies with high p-e would dilute their earnings. Drugmakers are really sensitive about dilutive acquisitions, so they do deals with smaller biotech companies. Companies like Amgen (AMGN; 3 STARS; $60) and Genentech (DNA; 5 STARS, strong buy; $81) don't need the big drug companies. They can do it by themselves. But there have been deals with the smaller biotechs, many of which have interesting opportunities. I would look for more of that going forward.

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