It's a time to be picky when it comes to drug and biotech stocks, but there are still good buys to be had. So say Herman Saftlas, Standard & Poor's investment officer, and Frank DiLorenzo, a S&P analyst. Saftlas covers pharmaceutical companies, DiLorenzo biotech.
Among the problems facing these stocks: a number of popular drugs are coming off patent and some companies have stock prices that remain high relative to those of their peers. Thus, S&P is recommending investors underweight drugs and biotech in their current portfolios, the analysts report.
Saftlas does like Johnson & Johnson and Pfizer, and DiLorenzo's favorites include Cephalon and IDEC Pharmaceuticals. And while a government program for prescription drugs could put price pressure on the pharmas, Saftlas thinks they could make up for it in volume, thanks to the possibility of a corresponding increase in sales.
The S&P analysts made these points during a chat on May 28 presented by BusinessWeek Online and Standard & Poor's on America Online. Edited excerpts follow. A complete transcript is available on AOL at keyword: BW Talk.
Q: Before we dig into the drug and biotech areas, any comments on the broader market? It sank again today.
Herman Saftlas: The market continues to fall. The economic recovery has been sluggish, and investors are more or less sitting on the sidelines for the moment, not really participating in the market. Consumer spending may not be as strong as expected.
Q: We have held Merck for 15 years -- what do you see as its price in a year?
HS: In a year, it's very difficult to call what can happen. Merck has certainly been languishing under pressures of major patent expirations, plus new products have not really come out in a while.
There was another negative development: a delay with Arcoxia, their second-generation Cox-2 treatment for arthritis and pain. They recalled their filing for that drug. That has affected them. The company still expects to have double-digit growth in their pharmaceutical division in 2003, but that's from a relatively depressed 2002 level.
Q: Do you see any near-term catalyst at all that could drive Merck?
HS: As one of the largest drugmakers in the world, they do have a pipeline of many experimental products. The two most significant ones are Zetia [for cholesterol] and Substance P [for depression].
Q: How good is Biogen (BGEN)?
Frank DiLorenzo: Well, we just upgraded it to accumulate from hold, because, this past Thursday, an FDA panel recommended approval for Amevive, to treat psoriasis. It's the first biotech drug to be approved in this area, so Biogen will have first-mover advantage. We think it could be a very big market, and feel that Amevive's sales could reach $500 million annually by 2005 or 2006.
Their main drug is Avonex. It has $1 billion in sales. The problem there is that a competitive drug, Rebif, came into the market a couple of months ago. But on balance...based on Amevive and the pipeline, we feel that at the current level, the stock is undervalued. We feel it's worth close to $60 per share.
Q: What are Eli Lilly's (LLY) prospects with Prozac now off patent?
HS: With Prozac now pretty much gone, they're highly reliant on the success of the new drugs in the pipeline, and there have been some bumps in the road there. A major concern has been that the FDA is investigating some of their manufacturing facilities, and the drugs are not going to get approval until they get a clean bill of health on those plants.
We also consider the stock overly valued relative to its peers. Essentially, earnings growth going forward is dependent on the success of the new products, which contains a certain amount of uncertainty.
Q: Frank, how about the Amgen/Immunex (AMGN/IMNX) merger? Do you like this deal?
FD: I don't like the deal right now, for the following reasons: One, Amgen is doing well on its own, and there are too many questions regarding Immunex' drug Enbrel. They can only manufacture a certain amount of this drug, so peak sales are kind of capped out right now. There is a potential competitor coming into the market next year, the drug D2E7 by Abbott Labs (ABT)....
Another problem is that Enbrel is a low-margin product, whereas Amgen's are high-margin products, so you need to generate more sales to come up with the same profitability as Amgen's drugs. I would stay away from it right now, because there are too many question marks there. Amgen is a good company on its own, but with Immunex there, it raises too many questions.
Q: Johnson & Johnson (JNJ): Over the next three years, how will it perform?
HS: We like JNJ. We think it's very well diversified into prescription and nonprescription pharmaceuticals, medical devices, and consumer products. We see continued growth in the high-margin pharmaceutical and device areas. In particular, they're going to lead the market in drug-coated coronary stents. It's the highest-quality issue in that group, in terms of earnings.
Q: Frank, what's your take on Gilead Sciences (GILD)? It makes drugs that battle viruses such as HIV and hepatitis C.
FD: I have a hold on the stock. I think it's a good company, but the stock is fully valued. If you do a comparison, for example, it's trading at a significantly higher sales-to-earnings multiple when compared with its peers, and based on that, I think it's fully reflected in the price. As a result, the company will have to perform really well to justify the price....
Q: What weighting does S&P now suggest for drug and biotech stocks in a portfolio?
HS: We have an underweight position on the group.
FD: We are underweight, but there are still some names we find attractive. We think investors need to be selective.
Q: And what do you see for the future? Resurgent strength?
HS: We are waiting for the fundamentals of the pharmas to improve. By this, I mean we would need a resurgence in new-product development. We're looking for a more favorable regulatory and political environment. That's really what it boils down to -- those two things in a nutshell.
FD: The thing I would focus on is the companies that are already profitable, that don't have a lot of question marks in front of them. I would basically go for companies with FDA approvals for products or drugs and have reasonable valuation with their peers.
Q: Frank, what's your favorite biotech pick right now?
FD: My favorite is Cephalon (CEPH).... The market capitalization is low relative to the company's potential -- it has three FDA-approved products. One product is Provigil [a treatment for sleep disorders], and another is Actiq [a treatment for cancer patients with excessive pain].
Just with those two products, if everything works out with them and they continue to grow, sales could reach $1 billion annually by mid-decade.... Also, I think the management team has done a good job of either acquiring drugs or acquiring companies and then finding a way to really increase the sales of those products....
Q: Pfizer (PFE) is going to sell its over-the-counter business this summer. Will this increase its stock price? Why do you think its stock is lagging so?
HS: First of all, the divestiture of those nonpharma businesses is a continuation of a program that has been in effect for a number of years. As far as the weakness in the stock, the whole group has been very weak, and the FDA has had some questions on PFE.
A number of the products in the pipeline have been delayed. But we still like PFE as one of our top picks in the group. It should maintain strong double-digit earnings growth going forward -- with no major patent expirations on the horizon....
Q: Many in the business believe that genomics has mostly failed due to the early disappointments. Agree? And do you have any favorites in that area?
FD: I don't agree, because it's too early to say it has failed. The drug-development process takes many years. Where genomics should help is coming up with better drug targets and better drugs against those targets.
It's going to take some time -- several years. I think you'll start to see some progress over the next three or four years. Some of the names I like that we cover are Human Genome Sciences (HGSI), Millennium Pharmaceuticals (MLMN), and Myriad Genetics (MYGN)....
Q: CuraGen (CRGN), Genzyme (GENZ), and Vertex Pharmaceuticals (VRTX): Do you like any of these?
FD: If I had to rank them in attractiveness, Genzyme would be first, Vertex second, and Curagen third. I have a buy only on Genzyme. The reason for this buy is that it's a cheap stock, generates cash flow, has FDA-approved products, and still has a lot of long-term potential. We also feel that their pipeline is underappreciated....
Q: How great an impact will the political pressure for cheaper drugs and generics have on the drug sector?
HS: That is an ongoing challenge the drug industry has to deal with, particularly on the state level. States are pressuring the drug companies for reduced prices. Managed-care providers also have become tougher. And the federal government may get into the act with a Medicare drug program. However, the Medicare program may be a benefit to the industry, with increased volume more than offsetting price reductions....
Q: Can we keep you two here long enough to tell us what drug and biotech stocks S&P thinks we should be buying, or at least accumulating?
HS: In the drug area, the two stocks we mentioned before are Johnson & Johnson and Pfizer. The reasons we stated were that they offer the strongest and steadiest growth in the group and little exposure to patent expiration -- and good valuation.
FD: I'd say my two top picks are Cephalon and IDEC Pharmaceuticals (IDPH). The main things with those companies is that they have multiple FDA-approved products, very strong rates of growth in both revenues and earnings, and reasonable p-e multiples in relation to their growth rates.