CREDIT SUISSE FIRST BOSTON CORPORATION
Equity Research
Americas
U.S./Health Care/Pharmaceuticals
Taking the Pulse of Pharmaceutical Stocks Volume
Acceleration Woes
Summary
The pharmaceutical stocks have retreated markedly since merger announcements
buoyed the group (off 10% since November 8 versus a 3% gain for the S&P 500).
When we round up the usual suspects-the political environment, pipeline woes,
HMO concerns-it is not our view that the land-scapes have changed meaningfully.
Instead, Y2K has gone from bust to boom, with economic fore-casts and interest
rate forecasts ratcheting upward, creating a hostile environment for "long
duration assets."
We continue to emphasize low expectation names with the possi-bility for upward
revisions as the best way to play 2000. Our top picks remain Merck, Eli Lilly,
and American Home Products (all rated Buy).
Investment Summary
Drug stock investors have faced a turbulent fourth quarter of 1999, with
catalyst flows and merger excitement setting a positive tone early in the
quarter, only to be followed immediately by a sharp downdraft. Drug investors
obtained the majority of their performance in those early days of the quarter
, with drug stocks off 13% from January 1st to September 30th, but up 17%
from September 30th to November 5th. Underperformance set in shortly after
merger announcements hit the tape, with the drug group off 10% since November
8th versus an increasing S&P 500 (up 3%).
Economic Forecasts Have Been Revised Upward
It has long been our view that the drug stocks are long duration assets, with
extreme interest rate sensitivity. Additionally, the drug stocks tend to
underperform the market when the industry is losing relative pricing power. (
The converse is also true.) When we look at the economic forecasts from our
Credit Suisse First Boston Equity Economist, Rosanne Cahn, 30-year treasury
forecasts for 2000 have risen to 6.55% in December from 5.81% in September.
Similarly, the GDP slowdown for Y2K may not materialize to the degree
originally anticipated by the market: her forecasts for average nominal GDP
growth and CPI in 2000 are now 5.1% and 2.4% (from 4.5% and 2.2% in September).
MICAP and the Power of Interest Rates
To evaluate the economy's effect on drug stock valuations, we capture each of
these effects separately. To calculate the Market-Implied Competitive
Advantage Period (MICAP) of the industry (see our July 29, 1999 piece
entitled Listening to Market Signals), we determine the years a company
earnings will exceed its cost of capital. MICAP is consequently analogous to
fixed-income duration: the value of cash flows in the distant future is very
sensitive to rate changes. For the industry, the MICAP has climbed recently,
reaching 37 years on December 10th after spending the majority of 1999 in the
low thirties.
This dramatic rise in expectations in a rising interest rate environment
shows the merger excitement, as capitalized synergies were quickly embedded
in all the stocks (i.e., if everyone had to find a merger partner, think of
the synergies generated in the industry!). As merger excitement waned, the
specter of rising rates in 2000 and accelerating economic growth began to
reset valuation metrics.
Why Inflation and the Economy Matter
Historically, changes in the price outlook have driven industry relative
valuations. Price contraction (pharmaceutical CPI relative to overall CPI)
from 1973 to 1976 and 1992 to 1994 was coincident with underperformance,
while price expansion from 1981 through 1991 was coincident with significant
outperformance. As we look to 2000, the specter of inflation has not left and
the drug industry may have political constraints on its ability to raise
prices should inflation rise. The fear of weakening relative pricing power
could take its toll on valuations.
Low Expectation Stocks With Catalysts Are Best Performers
In 1999 the market has significantly revalued the pharmaceutical industry,
with the average drug stock down 9%. Our MICAP analysis allows a separation
between changing expectations for company fundamentals and for the discount
rate. If this recent market move were due primarily to a decrease in growth
expectations, MICAPs would have contracted substantially. However, the
industry average MICAP has actually moved up, showing the significant power
of interest rates in the value of these long-duration assets.
In our Listening to Market Signals, we showed that the "low expectations"
portfolio (low MICAP) outperforms both the industry average and the high
expectations portfolio. It is important to note that the low expectations
portfolio produced positive returns in both 1992 and 1993 (6% and 11%
compared to 12% and 8% for the S&P 500), two years when the fundamentals
worsened considerably as the industry accepted significantly lower price
increases each year.
Our current low expectation portfolio includes our top picks:
Merck. With the oft-mentioned patent expiration period fast approaching, all
of Merck's major franchises have catalysts that should drive growth. The
continued success of Vioxx could be the key to upward earnings revisions in
2001 and beyond. MICAP-28 years
Eli Lilly. Although Prozac still faces challenges, its impact on Lilly's P&L
is lessening: we are currently estimating that recent launches will
contribute more sales than Prozac in 1999 and more operating profit (our
estimate) by 2000. Longer-term, Lilly's pipeline remains robust, with 10
launches scheduled through 2003. MICAP-20 years
American Home Products. We believe AHP represents the best way to play the
current merger excitement in the pharmaceutical industry, with its valuation
assigning little value to the possibility of AmericanWarner. Even if AHP is
not victorious, downside is likely capped, with fundamentals improving and
the likelihood that the company will find another partner. MICAP-25 years
Is There a Case for Drug Stocks in 2000?
Politics, patents, pipelines, rising interest rates and potential
inflationary pressure have converged to create a hostile environment that has
driven investors from the drug sector. While these factors are undeniable,
only the macroeconomic variable concerns are new. Investors' other concerns
have remained largely unchanged recently, including:
Politics. The political environment, while hostile, is not likely to produce
anything but rhetoric in 2000. With little risk of an economic event (such as
the drug industry halting price increases, as in 1991-1993), we are not
overly concerned about the influence of rhetoric on valuations (although the
State of the Union Address will likely contain derogatory statements about
the industry). It is important to note that there is some movement for action
in 2000; however, any action would be largely incremental (drug benefits for
needy seniors) and would likely table the issue. That said, stalemate
provides the perfect environment for elections-the other side cannot claim
victory and was (of course) to blame for any failings.
Patents. Over $21 billion dollars of products face patent expirations over
the next three years, raising concern that the industry growth rate will slow
meaningfully as a result. However patent expirations are well-anticipated by
management and most companies attempt to wean themselves off these products.
Additionally, many companies (with the notable exception of Merck) are not
planning to go willingly: Bristol-Myers, Eli Lilly, Schering-Plough and
AstraZeneca all have line extensions and litigation techniques in-place that
could delay generic competition. If successful, these defense strategies
could potentially delay the expiration of over $12 billion dollars of products.
Pipelines. Although there has been some concern about pipelines in the
industry (i.e., Where is the next Lipitor or Vioxx?), the industry pipeline
appears fairly robust, with over 25 major launches in both 2000 and 2001. FDA
approvals appear to have slowed, with only 27 through October versus 38-46 in
1996-'98. These statistics mask the significant "catch-up" phase for the FDA
as drugs that languished at the agency were pushed forward and nearly all
drugs now receive approval decisions within twelve months.
The major case for drug stocks is based on the continued promise of the
pipeline that should move away from this trough cycle and expand
significantly with new drug discovery techniques. For investors concerned
about the interest rate and economic backdrop, we continue to focus on low
expectation names.
N.B.: CREDIT SUISSE FIRST BOSTON CORPORATION may have, within the last three
years, served as a manager or co-manager of a public offering of securities for
or makes a primary market in issues of any or all of the companies mentioned.
Alza Aviron Byk Gulden DuPont Eisai Genentech Hoechst ICOS Procter & Gamble
Rhone Poulenc Taiho Versicor
CREDIT SUISSE FIRST BOSTON CORPORATION
Equity Research
Americas
U.S./Health Care/Pharmaceuticals
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