By David Shook
The pharmaceutical industry has been uncharacteristically mediocre for quite a while. It plodded through its third straight year of slowing growth in 2002, posting an average year-over-year profit increase of 1%. That was depressing compared to the 15% to 20% earnings gains common in the '90s. "It hasn't been pretty," says Edward Saltzman, president of Defined Health, a Millburn (N.J.) consulting firm.
Beset by patent expirations on blockbuster drugs, Big Pharma has lost billions in revenues to generic drugmakers, which can sell cheaper versions of lucrative medicines. The American Stock Exchange Pharmaceutical Index has declined 25% over the last two years as patents ended on top sellers like the antidepressant Prozac, allergy pill Claritin, and ulcer drug Prilosec.
However, the outlook for 2003 is brighter. Earnings are expected to rise 7% on average. Thirty new drugs should hit the market, compared to 17 last year, says Viren Mehta, founder of Mehta Global Partners, a drug-industry research firm in New York. Still, investors need to be selective in this downtrodden sector. Many of the top names, including Merck (MRK ) and Bristol-Myers Squibb (BMY ), will continue to show declining sales and net income.
In this environment, ironically, outfits with the highest earnings growth don't necessarily make the best picks, some analysts argue. Instead, a combination of factors -- a company's valuation, the strength of its products compared to the competition, and the degree to which its stock price has fallen already -- may be more important. In a sector where patent expirations can erase 30% of a drug stock's value almost overnight, two companies could do better than most: Pfizer (PFE ), the world's largest drug developer, and Eli Lilly (LLY ), which is churning out new medicines faster than any rival.
Both companies have a diverse product lineup. And both stocks are down significantly from one-year highs. Even as other drugmakers introduce headline-grabbing products in 2003 that boost their stock prices, Pfizer and Lilly are likely to finish the year near the top of the pack.
Indianapolis-based Lilly has suffered as much as any drugmaker from patent expirations. Yet it has done the most to fill the gap. When its Prozac patent ran out in 2001, Lilly lost a franchise that at its peak accounted for some 35% of annual sales -- nearly $3 billion. Little wonder earnings declined 2.6% in 2002, to $2.71 billion, or $2.50 per share, on sales of $11 billion. A year earlier, Lilly had earned $2.78 billion, or $2.55 a share. And competitive pressures remain intense. Lilly has announced that its current top seller, the antipsychotic Zyprexa, will face stiff rivalry in 2003 from Bristol-Myers' new Abilify.
PUNY IN COMPARISON.
To fight back, Lilly is expected to introduce four to five drugs this year, new products that should start healing the devastating loss of the Prozac franchise. For the full year, Lilly's earnings are forecast to flat or begin rising again, with profits up as much as 3% and sales increasing up to 8%. While that still looks puny compared to the stellar earnings growth of 20% or better that Lilly enjoyed in the prior decade, it does seem to be getting its drug lineup back in order.
In November, the U.S. Food & Drug Administration granted marketing approval for Lilly's osteoporosis drug, Forteo, which could have up to $500 million a year in sales, as well as a therapy for attention deficit disorder, Strattera, which could top $1 billion in sales annually, says Herman Saftlas, analyst for Standard & Poor's.
Lilly also received an FDA "approvable" letter last fall for Cymbalta, a new depression drug that could replace a small percentage of the Prozac sales. (The letter is often a precursor to the FDA granting full marketing approval.) And Cialis, a drug for male impotence that Lilly is jointly marketing with ICOS (ICOS ), could gain approval this year and help erode Pfizer's $1.7 billion sales of Viagra.
One caveat: At $62 a share, Lilly's stock isn't cheap. It trades at a price-earnings multiple of 25 -- making it among the more expensive stocks in the sector. Still, the price is off 22% from a one-year high -- including a 4% drop on Jan. 23 on word that Bristol-Myers' Abilify could take a chunk of Zyprexa's market share. Even with that unwanted prospect, Lilly's new-product lineup gives it ample chance to surprise on the upside, argues Saftlas.
Pfizer is also well positioned for improved performance in 2003 -- but for different reasons. It's rolling out six products either discovered internally or jointly marketed with other drug developers that together could generate more than $3 billion in annual sales within a few years, the company estimates. But for now, it's relying on perennial breadwinners Lipitor, Norvasc, and Zoloft, which account for nearly half of annual revenues.
With that trio's help, New York-based Pfizer is the No. 1 drugmaker and is growing faster than any of its peers. On Jan. 22, it reported 2002 earnings of $9.1 billion, or $1.46 a share, a 20% rise from a year earlier, on $32 billion in annual sales.
Pfizer's attractiveness stems from being a value play in an industry known more for growth than value, says Richard Evans, pharmaceutical analyst for Sanford Bernstein & Co. Analyst Michael Krensavage, of investment bank Raymond James, adds that Pfizer is trading at a p-e of 19.5, slightly lower than the benchmark S&P 500-stock index. "While Pfizer's growth is slowing, we still consider it the best the drug industry offers," he says (see BW Online, 1/24/03, "The Rx for Growth: 'Discover Drugs'").
Though Pfizer has said it expects profits to rise 13% in 2003, it has a big job in the near term assimilating long-time partner, Pharmacia (PHA ), which it acquired for $55 billion in stock last year. For many investors, however, Pfizer's slowing growth and fears that it bought Pharmacia because its own internal pipeline is empty are old news. They already triggered a stock sell-off last year. Now at $30, the shares trade 25% below their year-ago price.
Notes Bob Millen, principal for The Jensen Portfolio, which holds the stock: "Pfizer's outlook is lower than it has been in recent years, but it's still a consistent growth stock, and a company with the best patent protection in the industry." He adds that "with Pharmacia, Pfizer will have 10 of the top 37 drugs in the world." Pfizer should have $11 billion in 2003 net income, or $1.80 per share, on revenues of $37 billion, an 8% rise over 2002, analysts estimate. That's before accounting for the Pharmacia acquisition, which federal regulators are expected to approve this quarter.
Pfizer and Lilly aren't the only growth stories in the drug sector, and both will certainly face challenges. But the recovery in 2003 will be soft for nearly all players. While other companies may have new drugs that have a greater impact in 2003, or a better earnings track record, they also have pricier stocks. Discerning investors know what that means.
Shook is a writer for BusinessWeek Online in New York
Edited by Beth Belton