NEW YORK (Money magazine) -
In the future, successful drug companies will have to come up with innovative cures for complex, hard-to-treat conditions like cancer -- without letting their research-and-development spending get out of hand.
If there's one thing investors have to learn, it's that the drug industry isn't a safe bet for all seasons. It goes through its booms and busts like every other sector. Right now, it's in a particularly rough patch--and will likely be stuck there for the next five or six years.
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| | Company | | Price | | P/E | | Yield | | Abbott Laboratories | $36.60 | 17.8 | 2.7% | | AstraZeneca | 35.14 | 19.1 | 2.2 | | Bristol-Myers Squibb | 22.60 | 14.8 | 5.0 | | Eli Lilly | 57.82 | 22.7 | 2.3 | | Johnson & Johnson | 53.06 | 23.4 | 1.5 | | Merck | 54.90 | 17.5 | 2.6 | | Novartis | 35.83 | 19.1 | 1.5 | | Pfizer | 29.40 | 18.5 | 2.0 | | Schering-Plough | 18.68 | 13.2 | 3.6 | | Wyeth | 37.60 | 16.9 | 2.4 |
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* Data as of Feb. 18 | Source: Thomson/Baseline |
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Seven to 10 years from now, there is a beacon of hope: That's when the burgeoning science of genomics--which is unlocking the secrets of human genes--could pay off, unleashing the next big wave of drugs. Yet it's crucial for investors to realize that not all drugmakers will survive to see that genomics-inspired boom.
Because the years ahead will be tough, there is likely to be a divergence between those firms that adapt themselves and their business models to new opportunities and those that stick to the old ways and get left behind. Here are four key factors that companies will have to focus on to survive.
REAL INNOVATION. Rather than peddling me-too blockbusters for already well-treated conditions, pharmaceutical companies that want to survive will have to come up with cures for tough conditions like cancer. Because they target smaller patient groups, cancer treatments may never turn into multibillion-dollar sellers like Lipitor. But there'll be an upside: The FDA will approve these drugs faster because they address unmet needs among the growing numbers of cancer patients. And since there are fewer competitors in these areas, the manufacturers will be able to charge higher prices. (Two major companies that have developed promising cancer drugs: AstraZeneca and Novartis.)
NEW CLASSES OF DRUGS. To address conditions for which ordinary drugs have not proved effective, drugmakers will have to add biological (or large molecule) treatments to their arsenals. Such medications are more targeted than traditional pills and are likely to play a key role in the fight against cancer and rheumatoid arthritis. A likely winner here is Eli Lilly, which has built up its expertise in biological cures for conditions like diabetes.
STRATEGIC PARTNERSHIPS WITH BIOTECHS. To stay competitive, companies need to leverage their sales forces and prestige to strike advantageous deals with biotechs (like Pfizer) or have the ready cash to buy them out (like Johnson & Johnson).
EXTENDING BLOCKBUSTERS. Finally, companies that survive will be the ones that are able to milk existing blockbusters effectively, for as long as possible, until the next wave of big drugs hits the market. For instance: Pfizer got a boost recently when its antidepressant Zoloft was approved for social anxiety disorder as well, extending its use to new patients.
Of course, some of the strengths and weaknesses of the companies are already priced into their stocks. So the top companies are not necessarily buys at their current prices; some weaker companies might actually be better short-term investments because they are possible takeover targets for the European pharmas eager to expand in the U.S.
Overall, investors will have to get used to much tamer returns. Bernstein's Evans sees the group as a whole increasing earnings by only 8 percent over the next 10 years--about 40 percent below Wall Street's consensus estimates. The solid dividends these stocks pay will continue to make them attractive. But the huge premiums to the market as a whole that they sported in the past will almost certainly vanish.
While some companies are clearly better positioned for the changing climate, investors also have to pay careful attention to valuation. And some lagging companies may be attractive as buyout candidates. Here are profiles of the largest U.S. drugmakers and two rising European stars.
ABBOTT LABORATORIES. Investors are expecting a lot from Abbott (ABT: Research, Estimates). Its new antibody Humira, which treats rheumatoid arthritis, could turn into a blockbuster. In addition, Abbott makes hospital products like anesthesia injections, has a strong AIDS franchise and is building up its arsenal of cancer drugs. The road ahead might be rockier than some investors think: Abbott recently abandoned a clinical trial on a new prostate cancer treatment. Nevertheless, at a relatively low P/E ratio of 18, and with a dividend yield of nearly 3 percent, Abbott looks like a solid bet.
ASTRAZENECA. Although generic competition could soon start biting into sales of its blockbuster heartburn treatment Prilosec, British-based AstraZeneca (AZN: Research, Estimates) has a range of strong new products. Top of the list: the new statin Crestor, which could win FDA approval this year. Iressa, a lung cancer drug, could also be approved soon. AstraZeneca's long-term pipeline is considered one of the best around.
BRISTOL-MYERS SQUIBB. A lot has gone wrong at Bristol (BMY: Research, Estimates). Key drugs have come off patent, the company has had trouble finding new drugs to replace them, and it has restated its earnings for 2000 through 2002. Still, some expect Bristol to be a surprise winner this year. Its expertise in the crucial field of cancer research makes it a strong candidate to be bought out by a European pharma moving into the U.S. Its stock is cheap (the P/E is 15) and it pays a 5 percent yield.
ELI LILLY. While other companies are struggling to find new drugs, Lilly (LLY: Research, Estimates) is in a league of its own. The company, which spends nearly 20 percent of its revenue on R&D (vs. the industry's 12 percent to 15 percent average), is getting ready to release as many as seven promising products by the end of 2004, including drugs for impotence and depression. The only problem: a P/E of 23 makes the stock risky at this level.
PFIZER. Its impressive lineup boasts 10 blockbusters, including cholesterol-fighter Lipitor and anti-impotence pill Viagra. Buying out Pharmacia will provide Pfizer with short-term cost savings and bolster its presence in the crucial arthritis and cancer arenas. Don't expect Pfizer (PFE: Research, Estimates) to keep up its 27 percent earnings growth, but it could still pull off 10 percent or so. That makes it a reasonable buy at its P/E of 18.
JOHNSON & JOHNSON. With its diverse range of consumer products, medical devices and drugs, J&J (JNJ: Research, Estimates) is virtually a health-care mutual fund. While its broad revenue base gives stability to its earnings, J&J faces stiff competition from Amgen and Abbott Laboratories in crucial areas like rheumatoid arthritis. J&J will always be a blue-chip choice, but there are cheaper buys in the sector right now.
MERCK. Historically one of the most innovative pharmas, Merck (MRK: Research, Estimates) is counting on its recently approved cholesterol drug, Zetia, to pick up the slack when its current cholesterol fighter, Zocor, goes off patent in December 2005. The company plans to spin off Medco Health, its pharmacy benefits manager, sometime this year. That should satisfy concerns about potential conflicts of interest, but it'll make it harder for Merck to sustain its earnings growth rate: Medco's profits grew much faster than those of Merck's drug business.
NOVARTIS. Approved in 2001, cancer drug Gleevec established Swiss pharma Novartis (NVS: Research, Estimates) as one of the most innovative companies in the sector. A pain-relief drug for arthritis is expected to hit the market in 2003. Novartis looks set to become a larger player in the lucrative U.S. market, making this a good time for investors to take a stake in the company.
SCHERING-PLOUGH. The company took a huge blow when Claritin went off patent. Claritin continues to make money through over-the-counter sales, and prescription drug Clarinex is winning new clients. Plus, Schering (SGP: Research, Estimates) splits proceeds from Zetia with Merck. Still, many analysts fear that the company's long-term pipeline is weak. Investors looking for a beaten-down value play might find Bristol more compelling.
WYETH. Wyeth has a top-selling antidepressant, Effexor; thrives in areas that the other pharmas don't have much expertise in, such as vaccines; and boasts a range of tie-ins with biotechs, including Amgen. After its sharp slide in 2002, Wyeth's stock (WYE: Research, Estimates) looks set for a strong rebound this year. In the long term, however, it still needs to find a way to cope with the slowing sales growth of its hormone replacement therapy franchise, which has been hit by recent safety concerns.
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