The Drug Sector's Drug Problem
thestreet.com
Investor opinion on the drug sector certainly does swing from one extreme to another. When investors focus on these companies' tremendous earning power -- and their relative immunity to an economic downturn -- the stocks soar. Investors seeking a safe haven during 2000, for example, sent Merck (MRK:NYSE - news - commentary) up 41% that year, Pfizer (PFE:NYSE - news - commentary) up 46% and Eli Lilly (LLY:NYSE - news - commentary) up 44%. (All three stocks had been down in 1999 during the huge run-up in technology shares.)
But then investors flip-flop and worry about things like drugs losing patent protection, less-than-full pipelines of new drugs and sluggish sales of compounds touted as blockbusters. They worry about earnings growth, in other words.
Those are the problems behind Merck's revenue and earnings warning on June 22. The company said it was expecting second-quarter earnings of 77 cents to 79 cents a share instead of the Wall Street analyst consensus of 81 cents a share. Not much of a miss, I'll grant you, but enough apparently to make investors remember their worries about growth. And Merck's warning took down other drug company stocks with major products coming off patent. Eli Lilly fell on the perennial worries about the expiration of patent protection on Prozac, for example, and Bristol-Myers Squibb (BMY:NYSE - news - commentary), which has its own patent issues, fell as well. Year to date, the three stocks have declined 30%, 20% and 28% respectively.
Drug stocks that don't have this perceived "growth problem" stumbled as well on Merck's warning. Johnson & Johnson (JNJ:NYSE - news - commentary), which is riding a big sales recovery in its stent business, fell 2% on the week, for example. But Johnson & Johnson is still up 19% in the past three months, and as you'd expect, it trades at a huge premium to its "growth problem" peers. At recent prices, Johnson & Johnson commands a multiple of about 28 times projected 2001 earnings per share while Merck earns a more modest multiple of 22 times projected 2001 earnings.
It would seem that investors have a choice of paying up for superior growth potential -- Johnson & Johnson -- or taking a chance with a cheaper stock that has investors worried about its prospects for future growth.
But I think there's a third alternative. The drug companies with the best sales forces -- and that means Merck, Pfizer and GlaxoSmithKline (GSK:NYSE - news - commentary) -- will fill their drug pipelines by acquiring drug companies with promising drugs or drug candidates, but which don't have the sales forces to market these drugs to their full potential. That's been the pattern in the industry over the past decade; look at Pfizer's acquisition of Warner-Lambert for a high-profile example. I don't think we're finished with that wave of consolidation quite yet.
Who Benefits?
We know who's going to be doing the acquiring. But we want to own shares of the companies being acquired because those get the premium in any deal. Who's a likely target?
Schering-Plough (SGP:NYSE - news - commentary) has been linked to Merck as a possible acquisition for weeks now. But the company's continued manufacturing and management problems -- President Raul Cesan resigned Wednesday, and it was cited by the Food & Drug Administration again last week -- make that deal less likely. The FDA is holding up approval of Clarinex, Schering-Plough's successor to its allergy blockbuster Claritin, until the company gets its plants in shape. The patent on Claritin expires in 2002, and because the drug represents about 40% of Schering-Plough's profits, any uncertainty over when Clarinex will gain approval is a likely deal-breaker.
Until recently, the big drug company with the weakest sales group and the best pipeline, Novartis (NVS:NYSE - news - commentary), didn't look like a potential acquisition candidate. But that all changed on June 18 when the FDA failed to approve Zelnorm, one of the company's most promising drugs. Novartis had billed Zelnorm, a treatment for irritable bowel syndrome, as a potential $1 billion drug. The news has sent Novartis stock down from $38.04 at the close on June 15 to $34.84 on June 28.
But look at the goodies in Novartis' cupboard. There's Gleevec, a leukemia pill approved by the FDA last month. Starlix, for diabetes, went on the market in February. Zometa, for excessive blood calcium, and Xolair, for asthma, are on track for FDA approval within the year. Elidel, for skin inflammation, and Zomaril, for schizophrenia, are likely to get approval in 2002. All that and analysts are still projecting just 10% earnings growth for 2001 and 14% for 2002. Merck, with all its problems, still looks likely to produce 10% growth in 2001 and 2002. To me, Novartis looks like an underachiever that will either get its act together or wind up on the block -- either way, the stock goes up. Not a bad set of alternatives. And the stock is well worth watching over the next few weeks. |
