Monday, March 28, 2005
March 28 2005 - Financial Times
In the good old days, pharmaceutical companies traded at a significant premium to the market, which was justified by predictable earnings growth, bulletproof balance sheets, Microsoft-monopoly-like profit margins and a return on investment that was the envy of corporate America. Political and drug expiration risks were the only factors that instilled some sense of gravity. Those good old days are gone. Though some companies will be able to recover some of the lost market premium, quite a few former darlings will be left behind.
Political risk has not disappeared, but for the most part it went into a three-year hibernation until the next presidential election.
It seems that drug re-importation from Canada is an unlikely possibility at this point as pharmaceutical companies have significantly restricted shipments to Canada, thus forcing the alarmed Canadian government to devise ways to make drug purchases from Canada a very difficult, if not impossible, task for the US consumer.
Relief of some political risk should help the valuation pressures on the pharmaceutical sector. However, the much-praised consistent growth and predictable earnings will become a thing of the past for some companies, whose success was driven by a heavy reliance on just a handful of blockbuster drugs.
Although hardly alone, Pfizer is a poster child for a big pharmaceutical company’s addiction to blockbuster drugs. More than half of its sales came from 10 blockbuster drugs, and more than 21 per cent of sales arrive from a single drug: Lipitor, a $10bn-in-sales cholesterol-reducing agent. Pfizer needs to consistently discover mega-billion, blockbuster drugs to maintain its earnings growth, since a discovery of a drug with a hundred million dollars in sales will be a small drop in a Pfizer’s $52bn sales bucket.
In addition, Pfizer is facing a problem on the cholesterol front: Merck’s Zocor, another statin (a drug that lowers cholesterol) and a competitor of Lipitor, is facing patent expiration in mid-2006. Aside from Zocor’s expiration having a devastating impact on Merck’s bottom line, its rippling effect will be felt by Pfizer because insurance companies may might start pressing patients to take a generic version of Zocor that at that time will be priced at a small fraction of non-generic versions of either drug.
Blockbuster success is a double-edged sword. In this litigious society a discovery of side-effects brings an army of tort lawyers to the doorsteps of pharmaceutical companies. Merck’s Vioxx withdrawal was a good example of that, as class-action lawsuits followed a day after the withdrawal announcement. Almost by definition, blockbuster drugs’ side- effects affect a larger number of consumers, since they are widely used, thus producing a feeding frenzy of class- action lawsuits.
It is impossible to know how the Vioxx class-action lawsuits will affect Merck’s future. However, the uncertainty of the outcome definitely adds a degree of ambiguity to Merck’s financial state, constraining management decisions, possibly adding great volatility to Merck’s future earnings and squeezing margins with additional legal expenses in the meantime. The litigation risk deals another blow to the valuation multiple.
Medical device/instrument companies are likely to take over the leadership from pharmaceutical companies and inherit the premium valuation. They will reap the rewards from the baby boomers’ desire for longer and healthier lives. With few exceptions, medical device/instruments companies have a much more diversified product line. Although intellectual property is very important and a main driver of this industry’s growth, by the time the original patent expires several generations of new products have been introduced, thus patent expiration is not as significant for the medical device/instrument this industry as it is for pharmaceuticals counterparts.
Companies that provide services to the pharmaceutical industry are a good sidedoor to participate in the industry’s future prosperity without subjecting investors to the all risks. IMS Health, a provider of market intelligence to the pharmaceutical industry, comes to mind as a good side position. It has all the qualities of a pharmaceutical company: strong competitive advantage, terrific return on capital, monopoly-like profit margins, great cash flows, very reasonable valuation and good consistent growth prospects ahead, without all the aforementioned risks.
Should investors avoid pharmaceutical companies all together? Not at all. The demographic trends of ageing baby boomers will push demand for the pharmaceuticals into the stratosphere for a long time. However, investors should add another dimension to their analysis – product diversification.
Companies that have a high concentration of sales in just a few blockbuster drugs should either be avoided or have a much smaller place in the portfolio. Also, investors should temper valuation premium expectations for the overall sector as it is unlikely to return to its old levels.
Vitaliy N. Katsenelson, CFA
Copyright Financial Times 2005