Is the picture brightening for Big Pharma at last? On Feb. 8, Herman Saftlas, S&P's Pharmaceuticals analyst, upgraded his fundamental outlook for the industry group to positive from neutral, citing new signs of life in big U.S. pharmaceuticals.
What's behind his improved outlook? Saftlas says that despite generic erosion on patent-expiring drugs, S&P expects industry profits to rise modestly this year, helped by improved new-product flow, increased drug purchases arising from the implementation of the new Medicare drug benefit, and cost streamlining. Litigation issues are looking better, he notes, and many pharmas also offer what S&P sees as attractive p-e ratios and dividend yields.
The S&P Pharmaceutical subindustry index, which consists of 25 large, mid-, and small-cap companies, has been under the weather for some time. During 2005, this index fell 5.5%, vs. a 3.8% advance for the S&P Composite 1500. In addition, this group posted a five-year compound annual price change of -7.0%, vs. a five-year gain of 1.5% for the S&P 1500. Thus far in 2006, this sub-industry index gained 2.6%, while the broader market rose 1.9%.
PATENT PRESSURE. As can be seen in the chart below, the rolling 12-month relative price performance for this group has exceeded that for the overall market and is beginning to recover, in S&P's view. As a reminder, the jagged blue line represents the subindustry index's rolling 52-week price performance as compared with the 52-week performance for the S&P 1500. Any point above 100 indicates market outperformance over the prior year, while points below 100 indicate market underperformance. The red line is a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the sub-industry index's 14-year mean relative strength.
Saftlas still sees challenges for the big drugmakers. He notes that branded drugs generating an estimated $45 billion in sales in 2005 have lost or are expected to lose patent protection over the next three years. However, S&P believes much of the shortfall should be compensated by new drugs. During 2005, the FDA approved 19 new molecular entities (NMEs), and 10 novel biologicals. Saftlas expects over 25 NMEs to be approved in 2006.
Despite near-term uncertainties over pricing and patent expirations, S&P thinks pharmaceuticals remains one of the healthiest and widest-margin U.S. industries. Saftlas sees longer-term prospects enhanced by demographic growth in the elderly (accounting for about 33% of industry sales), and by new therapeutic products from discoveries in genomics and biotechnology. In S&P's view, merger cost economies and synergies should also bolster profits at many companies.
GENERIC BONANZA. Prospects for the generic/specialty pharmaceutical segment remain favorable, according to Saftlas. S&P sees a large number of blockbuster drugs losing patent protection over the next few years, providing significant opportunities for this sector. Saftlas also thinks the new Medicare drug plan will be especially beneficial for generic companies. He favors companies with rich generic pipelines, especially with first-to-file generics with the potential for 180 days of marketing exclusivity, and competence in litigating complex patent issues.
So there you have it. From both a fundamental and momentum standpoint, S&P believes the investment outlook for the S&P Pharmaceutical group is favorable over the coming 12 months. Among the Big Pharma outfits he follows, Saftlas' top picks include Johnson & Johnson (JNJ) and Eli Lilly (LLY), both of which are ranked 5 STARS (strong buy).
Source: Standard & Poor's
Industry Momentum List Update
For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of February 10, 2006.