Can Drugmakers Rebuild Their Haven?


By David Shook The pharmaceutical industry socked investors with a one-two-three punch in late June. Merck (MRK), Schering-Plough (SGP), and American Home Products (AHP) said they would either miss expectations on profits or fail to gain timely approvals for new drugs. Result: Merck has fallen 32% in the last year to around $65 a share, while Schering has declined 40% to near $36. AHP has fared a bit better, falling 10% to around $59.

What's wrong with this picture? Investors can usually rely on the drug companies for steady, if not stellar, returns whenever the economy goes through a weak spell. After all, people get sick and need drugs no matter what's happening with the business cycle. Not this time. Most analysts don't expect much more than sluggish growth for much of the sector -- even when the economic picture improves.

Patent expirations and a mounting number of clinical-trial setbacks have left Big Pharma with revenue shortfalls and not enough new products to make up the difference. Another threat comes from Capitol Hill, where lawmakers may well approve a Medicare prescription-drug benefit, which could force drug companies to lower their prices. Says analyst Michael Krensavage of Raymond James & Associates: "It's getting to be a much tougher environment for drug stocks."

FEW EGGS, ONE BASKET. If they're smart, the big drugmakers will take steps to restore their luster before the next downturn. Otherwise, they risk losing their appeal to investors during hard economic times. Joseph Zammit-Lucia, president of Cambridge Pharma Consultancy, offers this prescription: Drugmakers need to spread the risk among several products, rather than placing all their bets on a few blockbusters. While this strategy would increase a company's marketing costs, it would also allow more room to recover from a stumble.

"Right now, there's more dependence on a smaller number of products, and everybody expects these products to be hugely successful," Zammit-Lucia says. With half-a-dozen drugs or more in clinical trials to choose from -- rather than just one or two -- a product's failure or an unexpected delay wouldn't matter so much. Companies could lower their risks -- and investors wouldn't be so quick to react by dumping the stocks.

Another remedy for drug companies seeking to regain their status as havens: Embrace genomics. While the genomics revolution has swept across biotech, large-cap pharmaceutical companies haven't done as much to speed the process of innovation with pure, gene-based drug-development programs. It takes 10 to 14 years and as much as $500 million for pharmaceutical makers to discover a new drug and bring it to market. After that, a drug can still fail as a result of some unforeseen side effect.

GENETIC PANACEA. So far, however, no major drug company has embarked on a genomics-based drug-discovery platform that could help put more products into clinical trials. Only Merck has acquired a genomics company to help it choose the best drug candidates among the hundreds of compounds in its clinic (see BW Online, 6/21/01, "Rosetta Inpharmatics: Translating Genes into Profits?"). "I think it's going to take many companies a while before they realize they don't have the internal capabilities to move as rapidly as they can on drug development," says William Haseltine, chief executive of Human Genome Sciences (HGSI), a genomics-based drug-discovery company.

While genomics is a long-term investment, drugmakers have a nearer-term problem on their hands in Washington. Bipartisan support is growing in Congress for a Medicare drug bill that could restrain the industry's ability to set prices for new drugs. While a comprehensive drug benefit for the nation's 39 million Medicare recipients isn't likely to become law this fall, the prospects are strong that President Bush will be sent such a bill before his four-year term is up.

Rather than fight, analysts say the drugmakers should move to set the agenda -- persuading lawmakers to preserve market competition among drugmakers as part of any mechanism for setting prices. With insurance companies managing the drug benefit -- rather than handing control to the Health Care Financing Administration, the government agency that runs Medicare -- Big Pharma won't have to worry as much about shrinking profit margins.

"With private-sector entities vying on service and price to get enrollees, we'd see a competitive marketplace for a Medicare drug benefit," says Lisa Raines, senior vice-president for government relations at Genzyme Corp. (GENZ). "That would be a way of avoiding the monolithic single-payer system, in which the government has such market power that it feels politically obligated to fix prices or refuse to cover drugs on a national basis."

SLOWER GROWTH? Certainly, drug stocks are bound to bounce back eventually, along with the rest of the market. And some big pharmaceutical companies are doing just fine now. Pfizer (PFE), Pharmacia (PA), and Johnson & Johnson (JNJ) have fared well in this year's market (see BW Online, 6/27/01, "J&J's Rx for the Anxious Investor"). With these companies, clinical data on new products look strong, or their older products are less exposed to the patent-expiration problems that rivals are facing.

However, the bulk of the industry's players may need another year or more before they can reach deep enough into their pipelines for new drugs needed to stanch losses expected from patent expirations. That fact doesn't help the industry's overall growth prospects. Steve Scala, pharmaceutical analyst for S.G. Cowen, says he expects 10% growth in 2001 (the same as 2000), followed by 9% in 2002 and 2003, then 8% in 2004. Scala and others believe slowing growth is a sign that new products aren't keeping pace with patent expirations.

With each passing month, it seems another drugmaker announces disappointments in a clinical trial or a regulatory delay. And a Medicare drug benefit has the potential to erode Big Pharma's profit margins -- traditionally the highest of any industry. Clearly, the sector will have to start thinking proactively. Otherwise, when the next downturn hits, most drugmakers will be no safer for investors than they are now. Shook covers financial markets for BusinessWeek Online in New York


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