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Taking Big Pharma's Pulse

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.

Q: For years we've been hearing that, with blockbusters going off patent, the companies that make generics should be good investments. That hasn't seemed to pan out. What happened?

A: The conventional generic business model is characterized by fierce competition and low margins. When a prescription drug goes off patent, usually you have a large number of companies coming into the market with their versions of it. The margins are very thin on that business. The price starts to deteriorate rapidly. Thus, we haven't seen too many new players in this market.

But some companies have excelled by developing more lucrative hard-to-copy generics, as well as by successfully challenging branded drug patents years before they are set to expire. Generic companies that are first to file with the FDA for a generic copy of a branded drug -- and that legally demonstrate that the original branded patents are invalid or not infringed by their generic versions -- are entitled to six months of marketing exclusivity. Generic companies such as Barr Pharmaceuticals (BRL

; 5 STARS; $51) have had great success using this strategy.

Another trend in the industry that's a boon to some and a bane to others is the authorized generic. A pharmaceutical company whose patent on a main drug is expiring will often team up with a generic company and give it the exclusive right to market the drug in generic form. Meanwhile, the price is kept high -- you don't have that rush of other generics coming in.

Q: Both litigation, which gets a company six months' exclusivity, and the authorized version, which gets whatever time is left on the marketing exclusivity, seem to be short-term tactics. Eventually everybody comes into the game, and prices go down. What's the long-term outlook for the generic business? Is it going to continue to be cutthroat?

A: There's no question that the generic business is going to remain very competitive. I think that's why a lot of the leading companies, including Barr and Ivax (IVX

; 5 STARS; $20), have moved more into the specialty drug area. For example, Ivax is into respiratory drugs, and Barr focuses on female health.

There are a number of specialty products that they're moving more aggressively into in order to balance the generic exposure. But I would point out that, over the next few years, generics should boom because there are a large number of drugs going off patent.

In addition, the government is expected to pump $40 billion to $50 billion into the domestic pharmaceutical market through the new Medicare drug benefit, of which a good part should be directed to low-cost generics. I would say this is a significant opportunity for the generic business, particularly for companies that have drugs with six months' exclusivity. If you can rack up three or four of those, you should have substantial cash that can be used for acquisitions or further development of your specialty products. There is life in the generic industry.

Q: With all of the patent expirations and generic competition, what's the near-term and intermediate-term outlook for Big Pharma stocks?

A: The pharmaceutical group actually has done a little better this year. In my opinion, earnings in the first quarter were good, helped by cost savings. And I think there's a lot of room in the industry to cut costs. Look at Pfizer, which is cutting back on its overall cost structure to add $4 billion in annual savings by 2008. Whatever Pfizer does, the industry follows. I think there's a lot of potential there.

There's also repatriation of foreign earnings, which can be used for R&D here in America or for an acquisition.

On the litigation front, Lilly (LLY

; 3 STARS; $57) won a key case challenging its patent for Zyprexa, an antipsychotic. That was a big deal. If they had lost that, we think the stock would have gotten a 30% haircut. So there has been some positive news, and we believe investors have rotated into defensive pharmaceutical stocks in the face of uncertain economic prospects.

Going forward, the demographics are still positive. There's life in the pipeline -- interesting products in Phase 2 and early Phase 3 clinical trials. Pfizer, of course, has this big cardiovascular drug, Lipitor/torcetrapib, which has the potential to not only lower LDL [low-density lipoprotein] but also increase HDL [high-density lipoprotein], the good cholesterol. It could be a blockbuster. And they're looking for it to offset Lipitor when that goes off patent in 2010.

I think the industry has bottomed out. I don't think it's collapsing anymore. Pharma should move in tandem with the market. I don't see it underperforming at this point, and I think selected issues can outperform.

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