SORRY about that. I thought the link would work for all. Here's the piece:
March 18, 1999
Some Drug Companies Sing the Pipeline Blues
By Lawrence Strauss
On Wednesday, Eli Lilly said it expected a slowdown in sales of Prozac, its
fabulously successful antidepression drug that generated $2.8 billion in revenue
last year. The stock promptly lost 5 5/16, or about 5%, on the news.
The shares regained a little ground Thursday, edging up
1/16 on the day to 88 13/16 -- 8% off its 52-week high of
97 ¾ set March 5.
The selloff in Lilly stock shows how quickly things can change for some
large-cap U.S. pharmaceutical companies, their stellar earnings records and
P/E multiples notwithstanding -- and how their lofty valuations often rest on the
narrow shoulders of a few blockbuster drugs.
Last week, Barron's Online questioned whether Merck has a deep enough
product pipeline to offset a wave of impending patent expirations. (See
Weekday Trader, "Is Merck's Medicine Chest Getting Bare?," March 9.)
But while Merck may be the most vulnerable to the thin pipeline/patent
expiration scenario, other U.S. pharmaceutical companies face the same
problem to a greater or lesser degree.
In a mid-February report subtitled
"Rosy Days May Be Numbered,"
Patricia Bank, a pharmaceutical analyst
at Vector Securities International,
asserts that investors in drug stocks "are
at a point where they realize valuations
may be too high," partly because of a
pipeline slowdown. Many of these
companies, she points out, are "to some
degree, a victim of their own past
successes in that investor expectations
may be too high."
As a result, "growth rates that have been high over the last few years may be
somewhat difficult to sustain," she argues. And more ominously, from this year
until 2001, she expects there will be "a relative lull in the collective pipeline
which could cause a slowdown in revenue" -- putting more pressure on drug
companies' earnings growth.
That appears to be the main concern that affected Eli Lilly, which, after
Merck, is the drug company most widely thought to be facing a thin pipeline in
the years ahead. Even after Wednesday's selloff, its shares traded at more
than 38x consensus 1999 earnings estimates, one of the highest P/E multiples
in the drug group.
Lilly stock changed hands at around 33x consensus 2000 estimates, according
to First Call, and now trades at a small premium to the group, according to
J.P. Morgan. It's also at a healthy premium to its projected 2000 and
long-term earnings growth rate of 17%.
Thanks to an out-of-court settlement in January, Lilly is not likely to face any
generic competition for Prozac until 2003 at the earliest. But depending so
heavily on one drug -- Prozac contributed 20% of the company's revenue
growth over the last two years, according to J.P. Morgan pharmaceutical
analyst Carl Seiden -- can be dicey.
"Lilly is a great company, and it's well-managed," says Sarah Ross, an analyst
at Edward Jones, which rates Lilly a Hold. "But when you have a drug like
Prozac most likely coming off patent in 2003, that's a big risk. Somehow,
they're going to have to fill in that gap. It puts a lot of near-term pressure on
these new products coming onto the market."
Seiden notes that the premium Lilly commands relative to its peers "requires
that pretty much everything goes right from here." That's not impossible, he
says, but key drugs must deliver. Those include Prozac; Evista, an
osteoporosis drug, and Zyprexa, a drug used to treat schizophrenia (it
generated $1.4 billion in sales last year). "Lilly has a lot riding on just a few
products," notes Seiden, who rates the stock a Market Performer, ". . . and
we don't think investors are fairly compensated for the risk."
Another big player, Schering-Plough, must contend with two key patent
expirations in 2002: Claritin, an antiallergy drug with about $1.7 billion in 1998
sales, and Intron-A, used to treat cancer and hepatitis C. It generated more
than $600 million in sales last year.
The stock closed Thursday at 58 5/8, close to its 52-week high of 59 ¼,
which it hit Tuesday. It trades at about 42x 1999 earnings estimates, and at
more than 36x 2000 estimates, according to First Call. Those are some of the
highest multiples among drug stocks, nearly 10% above the group average,
based on 2000 estimates. The shares also trade at P/Es way above their
projected growth rates of 16-17%over the next few years.
No doubt, those impending patent
expirations pose a threat to
Schering-Plough's earnings growth, says
Neil Sweig, a pharmaceutical analyst
with Southeast Research Partners. At
the same time, he says, the expirations
are more than two years off, and a lot
can happen in that time -- a merger with
another drug company, for example, or
a protracted legal fight to extend patent
exclusivity.
Sweig insists the Schering-Plough's expensive valuation is justified. He points
to the company's consistent earnings growth in the 1990s, typically above the
mid-teens annually. New products slated for this year include Temodal, a
brain cancer drug.
But Michael Kagan, lead portfolio manager of the $1.8 billion closed-end
Salomon Brothers Fund, describes Schering-Plough as a "trust me story," and
says its multiple is too pricey for his investing taste. The fund does not hold the
stock, he says.
"It's more of an issue of what are they going to show us that's going to [boost
the earnings] growth," Kagan says.
A lot of investors have put a lot of money into big-cap pharmaceutical
companies this decade, as the stocks' valuations attest. And for the most part,
they've been richly rewarded.
But these companies' thinning pipelines narrow their margin for error -- and
that could make the booming 1990s an even harder act to follow.
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