Heartburn for Big Pharma's Investors


By David Shook When Merck & Co. (MRK) Chief Executive Raymond V. Gilmartin told analysts on Dec. 11 that 2002 would be "a transition year," investors instantly knew what he meant: Earnings would be lower than expected, and the venerable New Jersey drugmaker would probably slog through the year without a major product launch. Two days later, rival Bristol-Myers Squibb (BMY) made an equally deflating announcement, when it warned that it'll miss its 2002 profit targets by a long shot.

Coincidence? Hardly. "This is a wakeup call," says industry analyst Michael Krensavage of Raymond James Financial. "These drug companies aren't supposed to miss earnings targets."

Merck and Bristol-Myers aren't alone. Many of the biggest names in pharmaceuticals are under tremendous pressure. It comes from Wall Street, which expects (but isn't seeing) annual earnings growth of 20% or more from much of Big Pharma. Drug companies are supposed to be havens in a bear market. Instead, many are being squeezed by patent expirations, manufacturing setbacks, and state-government attempts to curb drug prices for Medicaid patients. Merck says it now expects no earnings growth in 2002, while Bristol expects its earnings to decline.

18 MONTHS OUT. Odd as it sounds, investors probably shouldn't panic. Many analysts see the current woes as the tail end of a down cycle. And a few drugmakers -- namely Pfizer (PFE), Pharmacia (PHA), and Forest Labs (FRX), are still flying high. Going forward, computerized analyses of the human genome and of the thousands of proteins that play a role in diseases are sure to increase the productivity of pharmaceutical companies -- and lower their risk of failure when developing new products.

In fact, advances in research-and-development methods could have drugmakers hitting their lofty earnings goals as soon as 18 months from now, many analysts believe. For 2002, however, investors may have little choice but hold onto large-cap drug stocks they already own or wait until drug stocks bottom out before buying.

How bad will things get before they improve? Analysts say the premium on drug stocks over the Standard & Poor's 500-stock index has gone from an average of 22% throughout much of the '90s to below 10% today. What premium remains exists because drugmakers' earnings have risen 12% during 2001, while average earnings for the S&P 500 have declined 27%. Sounds impressive, but analysts says the narrowed premium reflects a fundamental problem. "It's a clear indication of what patent expirations can do to a company," says Viren Mehta, president of Mehta Global Partners in New York.

SETTING SUN. Merck and Bristol are just two of many companies experiencing difficulties. Over the past three years, patent protection has expired on five Merck drugs that at one point accounted for about half of the company's sales. Bristol has lost protection on its $1.5 billion-a-year cancer drug, Taxol -- exposing it to competition from generics. In 2002, Bristol will also watch the sun set on its monopoly on Glucophage, its $2 billion-a-year diabetes drug.

Meanwhile, Eli Lilly (LLY), whose patent has expired on the $2.5 billion-a-year antidepressant Prozac, and Schering-Plough (SGP), the maker of the $3 billion antihistamine Claritin, have suffered delays in much-needed drug approvals because of manufacturing quality problems cited by federal regulators.

These setbacks have culminated in a slump for drug stocks. Merck has tumbled 10%, to $60, since its warning that it'll earn about $3.10 a share in 2002, the same as this year. Bristol has declined 6% since its profit warning, closing at $53 on Dec. 26. The company has said it will earn as little as $2.25 a share in 2002, well off Wall Street's estimate of $2.57 and below its anticipated 2001 profits of $2.41 a share. "The industry has been in denial when it comes to facing the patent-expiration problem," says Mehta, who adds that drugmakers have had years to solve these problems -- but haven't.

"NEW SCIENCE." It won't be easy for the industry to heal itself, and there's no shortage of theories on the right cure. Mehta says drug companies need to embrace genomics -- the study of genes and their role in preventing or causing disease -- as a means for improving R&D productivity. Many companies are hard at work on gene-based drug design already, while others are just getting started. "We call it waiting for the new science to replace the old," Mehta says. The coming year could mark the mid-point in a transition that should be over by 2004, many analysts believe.

Genomics can also help companies spread their risks, adds Joseph Zammit-Lucia, president of Cambridge Pharma Consultancy in Cambridge, England. "Drug companies need to do a better job of managing risk. That's one reason we're seeing lower valuations today," he says. One way to lessen risk is to spread research dollars across a greater number of projects, so that each failure becomes a less serious blow. Still, such a suggestion revives an age-old debate over whether drugmakers are smarter to concentrate on developing fewer, blockbuster drugs (those with $1 billion-plus in sales each year) or on developing a wider array of lesser drugs.

Many companies have embraced the blockbuster strategy and are either paying a penalty for it or may be about to. Schering, which derives 40% of its sales from Claritin, is counting on a second-generation antihistamine called Clarinex to take up the slack when Claritin goes off-patent in December, 2002. If Schering can't convert enoug Claritin users to Clarinex in time, it could suffer a significant drop in profits.

MORE DEALS? Another industry challenge -- at least, according to Sanford Bernstein & Co. analyst Richard Evans -- is to "persuade consumers to swallow more pills." His suggestion is to boost promotional spending on drugs such as Merck's Zocor and Pfizer's Lipitor, both of which treat high cholesterol. While direct-to-consumer marketing already is the fastest growing expenditure for drugmakers, Evans says companies aren't spending enough on it. He also thinks they need to keep throwing as much investment and legal-defense strategy as possible into protecting their blockbuster drugs from generic competition.

Big Pharma also needs to continue seeking mergers and product-development deals with biotech companies, analysts say. Mergers allow drugmakers to realize better economies of scale from their marketing and manufacturing operations, and deals with biotechs help them fatten new-product pipelines. Look no further than the recent Pfizer-Warner-Lambert and Pharmacia-Monsanto mergers.

Pfizer and Pharmacia now have the highest earnings growth rates in the industry, which explains why they have the richest market valuations in the large-cap pharma sector. Pfizer is now $41 and Pharmacia about $43 a share, and each has a price-to-earnings ratio of about 35. Even the biotech companies, which traditionally have much higher valuations than traditional drugmakers, have begun turning to mergers to strengthen their drug portfolios.

DOG-LOVER. One camp on Wall Street believes that if 2002 proves to be weak for pharmaceuticals, investors could have a buying opportunity. "The drug stocks I'm recommending right now are the dogs," says analyst Michael Krensavage, who views both Schering and Lilly as good buys. Both recently had approvals for crucial potential blockbusters delayed because federal regulators charged them with substandard manufacturing practices. Until these issues are resolved, probably sometime in 2002, both stocks could languish. Schering has declined from $58 to $36 a share this year, nearly a 40% drop, while Lilly has fallen from $91 to just over $79, a 13% slide.

Plenty of risk remains in the sector. "It's in a cyclical downcycle," Krensavage says, a problem that's exacerbated by mounting public unhappiness over what patients perceive as the high price of new drugs. "We've seen this before," says Dilip Phadnis, a pharmaceutical marketing consultant and president of Rowin Group in Maywood, N.J. "In 1993, the outlook for pharma was really bleak, with managed-care and health-care reform encroaching on drug companies."

Now, there's renewed rhetoric of government price controls. While Phadnis and other experts don't see that as an imminent threat, it's one more sign of an industry that's in some state of disarray. For investors, the bottom line is that most drug stocks will likely remain a hard pill to swallow for much of 2002. Shook covers the pharmaceutical industry and co-writes The Biotech Beat column for BusinessWeek Online in New York


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