Heard on the Street
Drug Makers'
Juggernaut
Could Weaken
By Robert Langreth and Robert McGough
12/15/98
The Wall Street Journal
Page C1
Drug-company stocks are such favorites on Wall Street that when Merck warned last week of disappointing earnings, the brief, three-day pullback in the stock was seized as a "buying opportunity" by its fans. Yesterday, the stock fought off a 126.16-point decline in the Dow Jones Industrial Average to close unchanged, at 145 9/16.
For a stock to be considered cheap when it sells for 30 times projected 1998 earnings -- and, at 35 times trailing earnings, a hefty premium to the Standard & Poor's 500's price/earnings ratio of 26 -- it must be able to produce earnings growth with the relentlessness of a machine. Predictable earnings growth is precisely why Wall Street so loves the pharmaceutical companies. Investors have remained faithful to pharmaceutical stocks even as other favored growth stocks such as Coca-Cola and Gillette have faltered.
But Merck's warning shot could be an early indication that the earnings machine at the pharmaceutical companies is starting to grind down. Some huge, blockbuster drugs are coming off patent in the next two or three years, and there isn't enough in the drug makers' pipeline that appears likely to replenish those declining sales. Managed-care companies will no doubt seize on generic alternatives to expensive drugs once the patents fall away, causing profits at drug companies to come under pressure.
Most frightening of all, stirrings of new efforts at health-care reform are being felt in Washington.
"All these drug analysts have these macro models showing earnings going to the sky," complains Charles Engelberg, an M.D. himself and rare bearish analyst at AmeriCal Securities in San Francisco. But Merck's message last week, he says, was that sales looked weaker than expected "because they've already got a lot of competition for key drugs and they will have even more when the patents expire."
What patents? Well, take a look. In 2000 and 2001, Merck loses patent protection on five major drugs, including the high-blood pressure medication Vasotec, the antacid Pepcid, the cholesterol drug Mevacor-and the biggest selling prescription drug in America, ulcer drug Prilosec, which Merck sells in a joint venture with Sweden's Astra AB.
Indeed, patent expirations in part drove last week's proposed $35 billion merger between Astra and Zeneca Group of the United Kingdom. Zeneca's blood-pressure medication Zestril loses its patent in 2001.
Schering-Plough loses its patent on Claritin starting in 2002. Johnson & Johnson's problems go beyond a weak new-drug pipeline, and include stiff competition in its medical-device business and anemic sales in consumer products. J&J earlier this month said it would take an $800 million restructuring charge and lay off 4.4% of its work force; the company says the restructuring has nothing to do with its recent slow growth.
In further depressing news, Eli Lilly's patents on its blockbuster antidepressant Prozac are being challenged in court by Barr Laboratories, which has had success in challenging other big drug companies' patents in the past. The company hopes the issue will be moot because it licensed a purified version of Prozac with a much longer patent.
At Pfizer, sales of Viagra have flagged recently, despite a great start and an extensive advertising campaign. Some analysts say the slowdown hasn't yet been reflected in the company's lofty stock, which at 111 5/8 sells for 46 times the past year's earnings. Given these prospects, "The strength of the last few years will be hard to sustain" at drug companies, says industry analyst Steven Gerber of CIBC Oppenheimer.
The continuing consolidation among managed-care insurers may finally give health-maintenance organizations enough size and clout to clamp down on doctors' use of expensive brand-name drugs, which sometimes only offer small advantages over inexpensive generic medications. Generic drugs will allow managed-care companies to "save lots and lots of money on their pharmaceutical bills when the key drugs come off patent," AmeriCal's Dr. Engelberg says.
Moreover, HMOs' recent retreat from providing Medicare coverage has helped rekindle the debate over health-care reform. Because Medicare coverage doesn't usually include prescription drugs, these elderly patients, kicked out from under the HMOs' protective umbrella, "are getting re-exposed to very aggressive drug prices," Mr. Gerber says. "Health-care reform is back from the dead, and drug pricing is center stage again" in Washington, Mr. Gerber says.
Leading the way: the National Bipartisan Commission on the Future of Medicare. The commission will likely propose changes in Medicare to Congress in the spring-and it is discussing the extension of Medicare to cover prescription drugs. Drug companies historically have worried that Medicare drug coverage could be the first step toward price controls for all prescription medications, resulting in a profit squeeze for pharmaceutical firms. In Europe such price controls are the norm.
The mere threat of Congressional action may be enough to drive down drug stocks. After all, drug stock prices plunged the last time that such a threat emergedwhen first lady Hillary Rodham Clinton spearheaded efforts to regulate health care. It is no wonder Mr. Gerber says the "psychological risk" from the possibility of reform is a great risk to drug company stock prices.
To be sure, drug companies still have their legions of fans-and even critics admit that they are great businesses. The revolution in biology that has driven drug companies' research in recent years is expected to continue to produce new drugs, and the pace may well pick up again after the patent expirations of 2000 to 2002.
Many analysts are still bullish. Mariola Haggar, of Deutsche Bank Securities, says renewed threats of health-care reform are years away, and argues that drug stocks should continue to do well because their strong sales growth makes them attractive in a low-inflation environment. "The macro environment still favors pharma stocks," she says. "Investors are willing to pay a premium for sales growth that doesn't rely on price increases."
Investors see great promise for a new class of arthritis drugs called Cox-2 inhibitors. Promising drugs include Vioxx, from Merck, and Celebrex, to be marketed by Monsanto and Pfizer. Ian Rogers, a manager at Strong Capital Management, expects an enormous market for such medications.
"To me, there are so many powerful demographic trends" favoring pharmaceuticals companies, says Ronald Elijah, manager of Robertson Stephens Value+Growth Fund. He reduced his Merck holdings earlier in the year, but viewed the recent pullback in Merck as a buying opportunity.
But Robert Torray, who bought the drug companies when they were beaten down by worries about regulation several years ago, has unloaded his last holdings this year. They are great businesses, says Mr. Torray, manager of the $1.4 billion Torray Fund. But he adds, "I don't think people who buy in at these prices will do well."
|
