Interesting commentary on pharma by Jubak on TSC:
Investors at Risk in the Drug Sector
By Jim Jubak
MSN Money Markets Editor
6/9/2004 7:38 AM EDT
URL: thestreet.com
Just when you think drug stocks should be perking up, they're headed back to sick bay with a bad case of the blahs.
From May 4 through June 4, for example, Pfizer (PFE:NYSE) was down 2%, while Eli Lilly (LLY:NYSE) was flat, and Merck (MRK:NYSE) climbed 2%.
The performance is even more mysterious because this market is just about tailor-made for drug stocks. In volatile, uncertain times, investors historically flock to the rock-solid earnings growth and dividend yields of the drug stocks.
In fact, drug stocks are behaving so contrary to history right now that I think it's worth considering the possibility that history itself is broken. I don't mean in any kind of Terry Pratchett/quantum physics kind of way; it's just odd that drug stocks seem riskier than they used to be. If that's the case, then these stocks should trade at lower valuations now and going forward than they have in the past.
Skeptical? Well, let's focus on Pfizer to test my theory. I think this is the best stock to own in the drug group.
Start with current valuations. Drug stocks, as a whole, certainly aren't expensive on a historical basis. The group trades at just 18.5 times projected 2004 earnings per share. And names such as Pfizer are even cheaper. According to Friedman Billings Ramsey, earnings will grow at an average annual rate of 16% a year from 2003 through 2007, but Pfizer trades at just 17 times projected 2004 earnings.
Raging buy, no? After all, historically, we're getting near some pretty impressive lows: Pfizer's low price-to-earnings ratio for the last five years is 16.4. Looking at history, Pfizer hasn't finished a year with a price-to earnings ratio in the teens since 1994, when it ended at 16.1. And remember that Wall Street is projecting that Pfizer will grow earnings by 21% in 2004.
But the stock isn't a raging buy if the risk that Pfizer won't meet those projections is higher than in the past.
I think there's good reason -- actually five good reasons -- to believe that current risk at Pfizer (and for much of the rest of the drug sector, for that matter) is higher now than it has been in the past.
Pipeline competition is more intense. Blockbuster drugs can't count on having the field to themselves for very long. Take Pfizer's newest potential blockbuster drug, torcetrapib. Torcetrapib belongs to an entirely new class of drugs known as CETP inhibitors that are effective in raising HDL, the good cholesterol.
Pfizer and others believe that raising good cholesterol saves lives. Pfizer plans to use the argument when it files for approval for torcetrapib with the Food and Drug Administration in late 2006 or early 2007. If Pfizer wins approval for the drug and can then combine it with its existing Lipitor drug that lowers LDL or bad cholesterol, then the company will be able to extend the life of its Lipitor franchise.
Plus, it can take huge chunks of market share from Merck's Zocor and AstraZeneca's (AZN:NYSE ADR) Crestor drugs. But competition for torcetrapib isn't far behind. Japan Tobacco has a drug, JTT-705, that also raises good cholesterol. The drug is now in phase II trials, and Japan Tobacco is now shopping the drug to potential partners because the tobacco company doesn't have the capacity to develop the drug on its own.
The cost of developing a drug has soared. Developing a drug from scratch now costs about $800 million. About 90% of all promising drug compounds fail on the way to market. In 2003, for example, Merck dropped four drugs in development, including two in phase III trials, the last step before a drug goes to the FDA for approval. Some Wall Street analysts had pegged these as potential blockbusters. This high attrition rate means that the few successes almost have to reach blockbuster status to make the research, development and marketing effort pay off.
Sometimes, the drug industry sounds a little too much like the blockbuster-fixated movie industry. That comparison isn't meant as a compliment. Take Pfizer's bet on torcetrapib. The company has budgeted $800 million just for the human tests of the drug. That's because the company is making the risky bet that torcetrapib could restructure the whole market for cholesterol drugs. There's no doubt that torcetrapib raises levels of good HDL cholesterol, but there's very little clinical evidence that raising HDL offers a significant health benefit. To get FDA approval, Pfizer will have to do the kind of long-term studies of patient health that run up a huge bill very quickly. If the bet pays off, Pfizer will have the drug industry equivalent of The Lord of the Rings. If not, think The Hulk or Van Helsing.
Demographics have become a double-edged sword for the drug companies. An aging U.S. population has meant rising drug consumption, and that has been good for drug company sales and for the prices of drug company stocks. Think how often you've heard the argument that buying drug stocks was the best way to profit from the aging of the baby boom generation. But health care costs have now hit the point where current trends are clearly not sustainable. Costs for the largest piece of Medicare, hospitalization insurance, will exceed the program's income from taxes, gains on trust assets and consumer premiums by 2018.
Drug prices are an easy target for politicians looking to "fix" the system. Let's say you're a reasonably dedicated politician looking to control government spending on health care because you know the current system is in trouble. So you propose:
Limits on the number of voters who can get care under government programs
Limiting the amount of care each voter gets
Cutting the profits of drug companies
The drug companies managed to put off the day of reckoning in the bill that passed the Medicare drug benefit. But a majority of U.S. voters are in favor of allowing the government to negotiate lower drug prices, a practice banned in the Medicare drug legislation. So it's likely that the drug industry will have to give up some ground -- legalizing the importation of "cheaper" foreign drugs and greater emphasis on generics, for example -- by 2006, when the government share of the U.S. drug market will rise to 50%. The final step could be congressional repeal of the language that currently bans government negotiation to lower drug prices.
Don't Sell; Just Be Aware of the Risk
This doesn't mean you should go out and sell all your drug stocks and never touch the sector again.
It does mean that you should take another look at your expectations for returns from these stocks and make sure that you're prepared for more risk in these shares in the future.
Let me show you how these five risk factors play out with Pfizer.
Remember the bullish case from Friedman Billings I mentioned earlier? According to Friedman Billings' investment research, Pfizer will grow earnings per share at an annual average of 16% a year from 2003 through 2007.
Today, you can also find solid Wall Street analysts who believe that by 2007 Pfizer's organic growth -- that is, growth before any future acquisitions -- will have dropped to zero.
A range of difference of opinion that big is highly unusual for a drug stock, history says, especially for an industry-leading drug stock like Pfizer. All things being equal, the greater the difference in the bull-and-bear cases, the riskier the stock.
You can find that increased risk in analyst estimates for 2004 and 2005 earnings, too. For 2004, the consensus estimate is $2.12 a share, or growth of 21.4%. The high estimate at $2.15 means growth of 22.9%; the low at $2.07 equals 18.3% growth, still very respectable. Paying the current multiple for even that worst-case 18.3% growth seems reasonable.
But go out a year further, and the spread of opinions widens. (That's typical of projections as they get further away in time, but the degree of the change in the spread is unusually large for this sector right now.) The consensus is for just 11% growth with a high of 17% and an actual decline of 2.8% at the low end. Today's multiple isn't reasonable for a stock that's looking at falling earnings per share in 2005.
These are estimates, and all of them could be wrong. I think that the estimate of zero organic growth in 2007 is wrong and that something like 11% average annual growth for 2003-2007 is about right. If that is correct, then I still want to hold Pfizer for the long term.
At the same time, I do have to recognize the possibility that drug stocks won't deliver this kind of steady growth is higher than it ever has been. And if that steady growth is less certain, I should pay less for it.
So if you're a long-term investor in Pfizer, I think it's reasonable to hold onto the shares. But I would take a pass on adding more until the rhetoric heats up as we go into the November election. If you're a short-term investor, I'd take profits here and look to get back in the fall.
Changes to Jubak's Picks
Sell Pfizer. I'm selling Pfizer out of Jubak's Picks, with its time horizon of 12 to 18 months. The next six months aren't likely to be very hospitable for drug stocks as drug prices get a lot of attention from politicians in the run-up to November's election. It's time to give Pfizer a rest and see if the fall brings an opportunity to repurchase at a lower price.
I'm selling the position with a 14% loss since I added the stock to Jubak's Picks on Aug. 24, 2001. The last year has been much kinder; the stock has returned more than 18% over that period. (Full disclosure: I will sell my shares of Pfizer on June 11.)
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Pfizer. He does not own short positions in any stock mentioned in this column. Email Jubak at jjmail@microsoft.com.
Peter |
