June 29, 1999
Medicare Reform Talk Gives Drug Stocks the
Willies
By Lawrence Strauss
It's summer again in Washington, DC, and with a presidential election a little
more than a year away, politicians of both parties are talking Medicare
"reform."
Investors, naturally, are holding on to their wallets.
The specter of adding outpatient prescription drugs to the
basic Medicare package -- a move that President Clinton
formally proposed today -- has raised fears that more federal regulation will
lead to price controls, squeezing the bottom line of pharmaceutical companies.
Those worries have contributed to a general selloff in blue-chip drug stocks.
The Dow Jones pharmaceutical group, which advanced an eye-popping 46%
last year, is off about 9% thus far in 1999, while the Standard & Poor's 500 is
up 7% during the same period. Concerns about thin product pipelines and the
market's recent rotation into cyclical stocks have also hurt these shares.
"Obviously, it depends on the details of the proposal," observes Barbara
Dreyfus, a Washington, D.C.-based health care analyst for Prudential
Securities. "What you're going to have is a Medicare drug benefit which
initially is not going to be that onerous. But eventually it could be."
Why? Pricing pressure, she says. Health maintenance organizations (HMOs)
and other purchasers of drugs will use formularies -- lists of approved drugs
often skewed toward cheaper products and generics -- and other measures to
keep a lid on costs, she says.
Under President Clinton's proposal, all
of the approximately 39 million disabled
and elderly Medicare beneficiaries
would be eligible for the drug benefit on
a voluntary basis. About two-thirds of
Medicare recipients have some kind of
supplemental insurance to help cover
prescription drug costs.
That has created plenty of uneasiness.
"People get scared about the more
drastic parts of the reform packages,
which almost never end up getting implemented," observes Michael Yellen,
portfolio manager of AIM Global Health Care Fund, whose holdings include
big-cap pharmaceutical stocks.
Also, the proposal's outcome hinges largely on the political makeup in
Washington, DC come January 2001, the earliest any significant action is likely
to occur. "It is the most political of issues," notes Ira Loss, senior vice
president of HSBC Washington Analysis in Washington.
Dreyfus sees the Republicans pushing for a drug benefit only for those who
aren't already covered. The Democrats, she predicts, will advocate "a more
broad-based universal drug program," as President Clinton's proposal
suggests.
Some analysts and fund managers, however, don't believe that the prescription
drug benefit that is ultimately enacted will really do much harm. "In the end, I
don't think it will hurt the profit margins of big-cap pharmaceutical companies,"
says Yellen.
And they think the uncertainty surrounding Medicare may already be reflected
in these stocks' prices. "The effect has been seen already," declares James
Keeney, a pharmaceutical industry analyst at ABN AMRO. "These stocks
have underperformed for three quarters. The industry could even prosper with
a [Medicare drug benefit] program."
In a report released last week, Steven Tighe and Gregory Gilbert of Merrill
Lynch argue that a Medicare drug benefit "may not be so bad." The drug
benefit issue is less sweeping than the president's massive 1993 health care
reform plan, they say, and it's likely to target only the one-third of Medicare
recipients who now have no prescription drug coverage.
They also assert that increased volume could offset price decreases, possibly
even causing a slight overall sales increase. Under their worst-case model --
assuming that all Medicare recipients could get prescriptions filled at a 40%
discount to the manufacturer's list price -- overall pharmaceutical revenues
would decline by only 6%.
Their optimistic outlook
notwithstanding, Tighe and Gilbert point
out that some companies are better
positioned if a Medicare prescription
drug benefit is adopted. With about
25% of its 1998 revenue coming from
U.S. pharmaceutical sales, Pharmacia &
Upjohn has the least domestic exposure
among the big-cap players. Eli Lilly, by
contrast, generates about 60% of its
sales from pharmaceuticals sold
domestically -- and is hence more
vulnerable to a major overhaul of the system. (Lilly has also sold off lately
because the market share of Prozac has eroded, some analysts say.)
Which drug companies are most at risk? Those that rely more on drugs that
treat chronic conditions more common among the elderly --cardiovascular
disease, for example.
Among the companies Keeney considers most vulnerable is Merck, which
generated nearly 30% of its 1998 pharmaceutical sales from cardiovascular
drugs like Vasotec. Like the rest of the group, Merck has seen its stock sell
off this year from its high of 83 3/8, set March 19. At Tuesday's close of 71
1/2, it traded at around 26 x the $2.76 per share analysts expect it to earn in
2000, according to First Call.
Likewise, Pfizer relies heavily on
cardiovascular sales, which accounted
for nearly 60% of its 1998
pharmaceutical sales. At Tuesday's
close of 104 3/4, the stock was about
30% off its 52-week high of 150 1/8,
set April 12. The shares change hands
at about 36x First Call's consensus
earnings 2000 earnings estimate of
$2.92 per share, compared with a
multiple of more than 50x 2000
estimated earnings earlier this year.
By contrast, Schering-Plough generated 10% of its 1998 pharmaceutical sales
from cardiovascular drugs, compared with 30% from Claritin, an allergy drug
whose success doesn't rely on the elderly population. Still, its potentially
limited exposure to Medicare reform hasn't helped the stock much. At
Tuesday's close of 49 11/16, the shares were 18% off their high of 60 13/16,
set April 12.
Everyone agrees on one thing: Politics being politics, don't expect this issue to
be settled quickly. But for investors in drug stocks, politics could be risky
business indeed. |
