Drug Stocks That Are on the Mend
By Amy Tsao
Owning pharmaceutical stocks was a losing strategy the past two years as the sector declined 20% amid a recovering stock market. But lately, hope is budding among investors that 2004 will be different. "What we've been talking about here is whether 2004 will look like 1994," says Anne Underhill, health-care analyst and portfolio manager at Baring Asset Management, referring to the year then-President Bill Clinton proposed a national health-care plan. The plan pressured drug stocks for months, but when it was blocked in the second half of 1994, the sector began a rally that lasted through 1998.
Unlike that surge, strength this time around won't be equal among all players as patent expirations and pipeline productivity vary by company, Underhill says. She wouldn't make a "buy the sector" recommendation by any means.
Others agree: Pick carefully. "I don't believe we're going to have some kind of golden age," says Mehta Partners analyst Shaojing Tong. "Some companies will not be able to deliver enough products to fill the gap" created by sales lost as a result of patent expirations. (Tong's firm owns several drug companies in its funds.)
Still, with valuations depressed, many pros and analysts say select pharmaceutical stocks are compelling enough for a fresh look. Many are expected to have improved earnings comparisons, new products, and progress to show with treatments in late-stage trials in 2004. By the second half of next year, an election year, drug stocks could have a strong run -- especially if a Medicare drug benefit finally passes and industry-friendly Republicans end up continuing to dominate both houses in Congress, as analysts expect.
The steadiest bet may be Pfizer (PFE ), which next year should still see some cost savings from its acquisition of Pharmacia in April, 2003. Its valuation is low, at about 16 times next year's earnings-per-share projection of $2.10.
"It could make a safe play," says Liu-Er Chen, Evergreen Healthcare Fund's portolio manager. He believes that the stock could come close to $40, if many of the projects in its pipeline work out. Sales of a recently approved drug for congestive heart failure could ramp up in 2004. Medications for neuropathic pain and epilepsy, smoker's cough, cholesterol, and hypertension are expected to be launched next year or soon thereafter. Underhill agrees, figuring that investors have overreacted to Pfizer's potential patent expirations and are "not giving them any credit for products coming." (Underhill owns Pfizer personally, and her firm owns Pfizer and Lilly shares.)
PATENT LIFE LEFT.
Interestingly, the strongest-performing drug outfits next year may not have great pipelines. Some will bank on the strength of existing drugs. To Chen, Abbott (ABT ) is trading inexpensively, at about $44, and the spinning out of its hospital-products division should boost future valuations. Abbott also recently launched Humira, a competitor to Amgen's (AMGN ) rheumatoid arthritis Enbrel. He predicts that Abbott likely will be the No. 1 performing drug stock in the next year -- especially if Humira proves a hit.
Wyeth's (WYE ) lack of patent expirations is an appealing factor that could outweigh its lackluster pipeline and ongoing worries over the potential impact of diet-drug lawsuits. Its patents are home free until 2008. And while few new drugs are lined up, it has plenty of opportunity to build its existing lineup. Tong expects Wyeth stock, now at about $39, to rise to the mid-$50s next year as "the top and bottom lines recover dramatically when they solve manufacturing issues for vaccines and for Enbrel." (Amgen and Wyeth co-promote Enbrel.) Another plus: The pain of hormone-replacement therapy's sales decline would have subsided by 2004.
Johnson & Johnson (JNJ ), says Chen, has become "such an unpopular stock" in the past year because of manufacturing issues and competitive pressures. At $51 and change, it's off 7% year-to-date even though each part of J&J's diversified business is doing "quite well," says Chen. He believes it may be hurt after Boston Scientific (BSX ) releases a competing drug-coated coronary stent device later this year. On the upside, the two concerns should have the fast-growing market to themselves for some time.
Not all pharmaceutical stocks are poised to do well. Underhill says Merck's valuation is attractive, but another earnings downgrade may be inevitable. "There are more pressures on the existing product lines than even they have admitted to so far." Sales of its biggest drug, Zocor, fell on expiring patents outside the U.S., Merck said during its Oct. 22 earnings call. It also warns that fourth-quarter product revenues will be lower than expected as it starts a new wholesaler program that will help control stockpiling ahead of annual price increases.
Many are hoping that Merck, which in recent weeks announced its first-ever layoffs and stopped development of a late-stage drug for depression, will consider making bigger acquisitions to grow (see BW Online, 11/13/03, "Merck's Downer Keeps Deepening"). Meantime, the stock, which trades at $45, "probably won't move above $50 for the next three to four years," says Tong, "and it could break $40 on the downside."
To Rob Junkin, portfolio manager at John Hancock Advisors, shares in outfits like Merck, Schering-Plough (SGP ), and Bristol-Myers (BMY ) are cheap, but their peers have fewer problems and are trading just a touch higher. While Eli Lilly (LLY ) has the strongest pipeline, at 24 times next year's earnings, it looks pricey, Junkin says. Valuations on Pfizer and Wyeth -- players that don't have nearly the issues of some of their peers -- are trading at just above the industry average p-e ratio of about 15, he says. (Junkin says his firm owns several stocks in the pharmaceutical sector.)
Though fundamentals aren't stellar, some relief for Big Pharma seems on the horizon. For investors willing to brave some political uncertainty, select shares should indeed find higher ground next year.
Tsao covers the markets for BusinessWeek Online and writes for the Street Wise column
Edited by Beth Belton