Jewish World Review Dec. 2, 2002 / 27 Kislev, 5763
James K. Glassman
Time for a drug binge?
In turbulent times, tastes typically turn to the tried and true. For instance, investors usually flee volatile stocks in favor of shares in the big drug companies, which keep churning out good profits, whatever the economic conditions. After all, people get sick during recessions, too, and, while they can put off a new car, they can't skimp on medicine.
>But this time it's different. Over the past two years, while drug sales have continued to rise, drug stocks have performed miserably - as poorly as the market as a whole and, in some cases, distinctly worse. For example, so far in 2002, the price of Pharmaceutical HOLDRS (symbol: PPH), an exchange-traded fund that comprises all the largest drug stocks and serves as an excellent barometer for the complete sector, has dropped 20 percent - after losing 15 percent in 2001.
And look at Merck!
Including Medco, its pharmaceutical-benefit business, Merck (MRK) has more revenue than any other drug company, with an impressive portfolio of medicines, led by Zocor (which fights high cholesterol), Vioxx (arthritis) and Fosamax (osteoporosis).
Merck generated more profits in 2001 than all but six U.S. companies, with higher earnings than such giants as Wal-Mart Stores (WMT), Microsoft (MSFT) and Coca-Cola (KO). Merck's sales exceeded those of AOL Time Warner (AOL), the largest U.S. largest media company, and Gannett Co. (GCI), the largest newspaper chain, combined. And Zocor alone grossed more than twice as much as all the chewing gum sold by Wrigley (WWY), the world's largest maker.
Between 1994 and 2000, Merck's stock rose powerfully and consistently - from $14 to $96 a share, all the while paying an attractive dividend. That price increase was no fluke; it was grounded in strong fundamentals. Over a decade, sales quintupled and earnings per share quadrupled. Merck's balance sheet was gorgeous (rated A++ by Value Line), and its price stability and profit predictability were among the best in the market. Merck was a very solid stock, a comfort and a joy to own.
Then, in early 2001, Merck stock began a steady and sickening slide. The price had fallen by more than half by this July before rallying to $59.03 (as of Friday's close). Even with the recent bounce, Merck is down more than 40 percent in less than two years, and it trades at a price-to-earnings (P/E) ratio of less than 19, about one-fourth lower than the market as a whole and below its annual average for each of the past eight years.
And Merck is not alone. Eli Lilly (LLY), whose top seller, Zyprexa (for schizophrenia), grossed nearly $4 billion last year, has dropped more than one-third since its late-2000 high; Bristol-Myers Squibb (BMY), maker of over-the-counter brands such as Bufferin and cancer drugs such as Paraplatin, has fallen from $73 to $26.50; and British-based GlaxoSmithKline (GSK), with $30 billion in annual sales from such drugs as Wellbutrin and Paxil, currently trades at about half its 1999 high.
So here's the dilemma: Shun drugs or embrace them?
Is the recent decline justified, or has Mister Market, that manic-depressive personification of the behavior of all investors, become far too pessimistic about an industry that is taking advantage of two undeniable trends, the aging of the population and the increase in biochemical innovation?
My own conclusion is that, while the big drug companies certainly face difficulties, their stocks should still be part of any intelligently diversified long-term portfolio. For the short term, my guess (and I stress "guess") is that prices will rebound - that is, come back to reality.
Again, look at Merck. The company's profits are expected to be off a bit this year after rising in a Beautiful Line for the past decade. But sales continue to increase, the company maintains an impressive balance sheet, and it's producing $9 billion in cash flow annually, with only about $3 billion of that going to new capital expenditures and the rest to stock buybacks (total shares are down from 2.5 billion to 2.2 billion since 1993) and dividends (Merck yields a hefty 2.5 percent).
Over the past two years, six of Merck's drugs have gone "off-patent" - that is, lost intellectual-property protections against generic competitors - but the company has other promising ones (for cholesterol, pain, depression and HIV) set to debut in the next three years. In addition, on Thursday, researchers announced positive early test results for a Merck vaccine to combat cervical cancer.
Value Line projects that the company's earnings, cash flow and dividends will grow an average of between 8 percent and 9 percent annually for the next five years -- not spectacular, but above the U.S. average. Yet, by any conventional measure, Merck is cheap.
Still, there's no doubt that Merck has been struggling lately, and, as George Rho, Value Line's analyst wrote recently, "We're not confident that its [new-drug] pipeline is sufficient to generate better-than-average . . . share-price gains over the three-to-five-year haul." In other words, the risks may justify the low valuation.
But what about Pfizer (PFE), almost certainly the best of all the drug companies?
Pfizer makes Lipitor (cholesterol), Norvasc (hypertension), Zoloft (depression), Viagra (impotence) and eight other drugs that each gross more than $1 billion a year. But, despite impressive profits (up 15 percent so far in 2002) - and an estimate by Value Line of 17 percent annual growth through 2007 -- Pfizer stock has dropped by one-fourth over the past 12 months and now trades at a P/E of just 24.
That's the same as the P/E of the average company in the benchmark Standard & Poor's 500-stock index - even though Pfizer, as a fast grower, has traditionally traded at 11/2 to two times the P/E of the S&P. And, based on projected earnings for 2003, Pfizer's P/E is a mere 18, compared with 20 for the S&P. Pfizer also pays a nice dividend, which has risen from 12 cents to 57 cents in the past decade, and shareholders vote next month on an attractive merger with Pharmacia (PHA), which will make the merged firm far and away the largest maker of drugs in the world.
So what's going on? What do investors have against drug stocks?
Some companies have special problems. Bristol-Myers, for example, made a large investment, now practically worthless, in ImClone Systems (IMCL), the scandal-ridden biotech firm. Bristol has also attracted the interest of legal authorities for suspicious sales to wholesalers that gave a quick boost to revenues. Merck's Medco division, acquired a decade ago, has low margins, and a spinoff was postponed partly because of concerns about accounting. Both Lilly and Schering-Plough (SGP), whose stock has dropped by half in the past year, have had serious run-ins with Food and Drug Administration regulators.
More generally, investors worry about three political and legal threats: (1) government action to make it harder to extend patents and thus give a boost to generic drugs, (2) a drug benefit for Medicare that could get Washington into the business of setting pharmaceutical prices, and (3) huge open-ended class-action lawsuits. Pharmaceutical executives are also concerned about loosening restrictions on mail-order drugs from countries such as Canada, where government controls keep prices lower, and about attempts to limit advertising for prescription drugs.
The election of a Republican Congress eased worries a bit (and pushed up stock prices), but the political threats aren't going away. As drugs become more and more effective at treating diseases, consumers will naturally spend more on them - and politicians will be tempted to step in to hold down costs.
The industry argues that drugs are an excellent value (they represent less than 10 percent of total health care costs) and that a decent patent life is a necessary reward for the huge investment in developing a new medicine ($800 million for the average drug, according to the Pharmaceutical Researchers and Manufacturers of America). But the firms face a tough and unrelenting battle.
And if that isn't bad enough, at some companies, important patents are expiring. In an excellent survey in its Oct. 28 issue, the newsletter Dow Theory Forecasts notes that Merck's Zocor, a gold mine, begins losing patent protection in 2005; Abbott Laboratories (ABT) loses exclusivity on four of its top five drugs between now and 2005; and expirations in the past year have hit two of Bristol's five bestsellers, with the other three losing patent rights in 2004, 2006 and 2008.
In all, the newsletter calculates that drugs that generated $40 billion in sales in 2001 will lose patent protection by 2005. The good news, however, is that "the product flow is picking up, and many important new drugs are expected to hit the market over the next 12 months."
Still, the fear is that drug companies will respond to the decline in their stock prices by cutting costs, especially research and development - a $50 billion item. Sharp reductions in R&D would prove a disaster, not just for the companies but for health care around the world - since U.S. research is the engine that drives discovery of new medicines.
Pfizer, which also makes over-the-counter products such as Visine, Ben-Gay and Unisom, still spends $6 billion a year on R&D, and it remains the class of the field. It is the only large drug stock rated a "strong buy" by Raymond James & Associates, with a price target over the next 12 months of $48 a share (it closed Friday at $32.37). And, along with French-based Aventis (AVE), Pfizer is highest-rated in its sector by Value Line for timeliness (a "2" rating, just below the market's best).
Morningstar, the Chicago research firm, ranks Pfizer "A+" (tops) for profitability and "A" for financial health but gives a slight edge to Merck for growth. Dow Theory likes both companies but has a slight preference for Pfizer.
So take your pick. Or take all the big drug companies by purchasing Pharmaceutical HOLDRS. Or simply own a health-sector mutual fund like Vanguard Health Care, which, at last report, owned large chunks of Pfizer and Merck, or Putnam Health Sciences, which has a major holding in Glaxo. But don't neglect drug stocks. Over the past 35 years, the sector has produced total returns that are more than five times as great as stocks as a whole -- sometimes in the face of political threats greater than today's. Of all the major market sectors, I have always liked drugs best. There's no reason for mind-changing.
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JWR contributor James K. Glassman is the host of Tech Central Station. Comment by clicking here.
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