By Aravind Adiga

(MONEY Magazine) – For years we've heard that the pharmaceutical sector is the closest we have come to a sure thing in the world of investing. We practically know the arguments by heart. America is aging: We need more drugs to fight arthritis and lower our cholesterol levels, and treating disease with medicine is far more cost-effective than surgery and other procedures. Scientific advances are accelerating: Breakthroughs in genomics and biotechnology are paving the way for new billion-dollar drugs. People don't worry about prices when their health is at stake: The big drugmakers boast astounding profit levels--gross margins of 80%, operating margins of 35%. Drug stocks are recessionproof: Boosted by year after year of 15% earnings growth, drug stocks have beaten the S&P 500 by nearly 100% over the past decade. And with analysts projecting an average 13% annual profit growth for big pharma (as the industry is known on Wall Street), drug stocks look like a solid bet for uncertain times.

A compelling story--but wrong. In fact, the case for pharma is far more tenuous today than investors believe. The drug giants have been profoundly less innovative through the 1990s than they appeared to be. They posted their amazing growth numbers thanks to only a handful of drugs that addressed a surprisingly narrow range of conditions; they copied one another's drugs while ignoring many promising avenues of research; they merged with one another and slashed costs, sometimes unwisely, to prop up earnings.

And now the very factors that helped the sector thrive in the '90s have become liabilities. By all measures, 2002 was an awful year for pharma stocks. The sector, a defensive play expected to hold up relatively well in a market downturn, fell 22%, matching the S&P 500. The primary culprit: Big drugs like Claritin came off patent and saw sales plummet as generic versions hit the market. Meanwhile, few new drugs are coming along to replace them or the dozens of other blockbusters that are facing patent expiration. Add in several scandals over product safety and growing anger from consumers and policymakers over rising drug prices, and all at once, the drug companies are facing an avalanche of serious challenges.

Does this mean that drug stocks are dead? Hardly. But it does mean that they are no longer surefire money machines. Investors will have to be much more careful about which pharma stocks they own. All of the companies, to one degree or another, have become overly reliant on a way of doing business that simply cannot last. Some are already trying to adjust their model, while others are still working mainly to extend their winning ways without preparing for a very different future. Successful investors will be those who pick out the few first-tier players from the second-tier also-rans.

THE FLAWS IN THE MODEL So where did big pharma go wrong? As is often the case, the industry's troubles today find their roots in the successes of yesterday. The pharma boom was built on a wave of research done in the 1970s and 1980s that produced several important new classes of drugs, including statins, which lower the levels of cholesterol in the blood; proton pump inhibitors, which reduce gastric acid that causes stomach ulcers; and selective serotonin reuptake inhibitors (SSRIs), which alter brain chemistry to fight depression. By the mid-1990s these discoveries led to a host of blockbusters like Lipitor, the anticholesterol drug; Prozac, the antidepressant; and Prilosec, the heartburn pill.

These medicines were, indeed, remarkable breakthroughs--and saved or improved the lives of millions of people. But they proved so lucrative that they became the model--the only model--that the industry relied on. The business imperative for drug companies became to focus on blockbuster drugs and do everything possible to squeeze every bit of profit out of them. In fact, after the first wave of breakthroughs, the big money was mostly in imitation, not innovation. Each time a company came up with a blockbuster, its peers rushed to piggyback on its success with a similar pill. The "me-too" drugs, while offering modest improvements, were not fundamentally different. But they offered a low-risk way to cash in on a hot market.

You can see how this pattern played out by looking at statins, which lower cholesterol by cutting back its production by the liver. The first entrant in the U.S. market, in 1987, was Merck's Mevacor. Over the next decade, as Mevacor proved to be an astounding moneymaker, a slew of others rushed in: Novartis with Lescol, Warner-Lambert (now Pfizer) with Lipitor, Bristol-Myers Squibb with Pravachol and Bayer with Baycol. Merck itself added Zocor. Some of these drugs were more powerful than others, yet all of them belonged to the same class of drugs, and none represented a fundamentally new way of limiting cholesterol. Statins are now the top revenue grossers at Merck, Pfizer and Bristol, responsible for close to $20 billion in annual sales. Lipitor alone roped in revenue of nearly $8 billion in 2002.

It was an addictive formula: Offer a simple variation on an existing medicine, turn it over to the marketing machine and watch the money roll in. Indeed, marketing, as much as science, was responsible for creating the blockbuster phenomenon. The average large drug company spends 12% to 15% of its revenue on research and development, but 30% to 35% on sales, marketing and administrative activities. Many pharmaceutical giants boast sales forces that run into the thousands.

Drug marketing got a big boost in 1997, when the Food and Drug Administration relaxed its advertising rules, making it feasible for companies to pitch prescription medications directly to consumers. According to the General Accounting Office, from 1997 through 2001, direct-to-consumer advertising increased 145% to nearly $3 billion annually. The payoff was enormous. Today some 8.5 million consumers a year ask for a drug after seeing it advertised on television. "Direct-to-consumer marketing created the blockbuster drug," says Liu-Er Chen, manager of the Evergreen Health Care fund. Doctors were targeted even more intensively: In 2000, for instance, drug companies gave nearly $8 billion in free samples to doctors, according to the Kaiser Family Foundation. The result was that patients asked for more brand-name drugs, doctors began prescribing more brand-name drugs and sales took off.

THE UNINTENDED SIDE EFFECTS But like any addiction, the me-too strategy was ultimately bad for pharma's health. For one thing, it led the drug companies to concentrate on a relatively small set of medical conditions. In fact, only six areas formed the foundation of the drug boom: certain cardiovascular problems (especially hypertension and high cholesterol); inflammation (arthritis); gastrointestinal diseases (ulcers); diabetes; infectious diseases (like respiratory infections); and certain central nervous system conditions (depression and anxiety).

Meanwhile, despite spending large sums on research and development, the industry was making little headway against many other diseases. Big pharma has put out very few blockbusters for cancer, Alzheimer's or Parkinson's disease. In some cases, this was because the diseases are so hard to treat. Anticancer drugs, for example, have often been effective only on small populations and have sometimes produced toxic side effects. In other cases, though, the drugmakers were reluctant to devote resources to diseases that affected relatively few people. As the industry focused on common complaints like high cholesterol, esoteric conditions got less attention. According to the Tufts Center for the Study of Drug Development, between 1998 and 2001, biotech firms accounted for 65% of research spending on "orphan drugs"--medicines developed for rare conditions that affect fewer than 200,000 people. The big pharmaceutical companies accounted for only 28% of that spending.

The focus on blockbusters also led the major drug companies to make some questionable strategic decisions. For example, starting in the 1970s the fledgling field of "large molecule" research promised to come up with antibody-based treatments that would be better targeted cures for conditions like cancer. But medicines based on large molecules were difficult to manufacture and had to be administered by injection rather than via simple-to-swallow pills. Would they ever become blockbusters? Many big pharmaceuticals were skeptical and cut back on their large-molecule research efforts, largely ceding the field to biotech companies. That's why some of the most exciting cancer products have come out of biotechs like Genentech (see "What About Biotech?" on page 108).

In the end, the me-too strategy left many companies precariously reliant on a handful of potent pills. Three drugs, for instance, accounted for about half of Eli Lilly's sales last year. Even a widely diversified firm like Pfizer, which makes hundreds of drugs and consumer products, got almost 25% of its 2002 sales from Lipitor. And as important as they have been to sales, blockbusters have accounted for an even greater portion of the companies' earnings growth rates. And those growth rates, in turn, were largely responsible for the lofty price/earnings ratios that drug stocks commanded.

The downside of this dependency became apparent when bestsellers started to come off patent and quickly lost sales to cheaper generic versions. "The market didn't fully digest the profitability of these drugs," says Tom Wald, manager of Invesco Health Sciences fund. Take Eli Lilly, which lost protection on Prozac in August 2001. Partly as a result, its net income, after growing more than 20% in 1999 and 2000, turned negative: -8% in 2001 and -4% in 2002. For the sector as a whole, earnings were up just 1% in 2002 vs. 5% for the S&P 500.

The trend will only get worse over the next few years (see the timeline on page 106). According to research firm Datamonitor, of the 52 blockbuster drugs on the market in 2001, there are 42 that will go off patent by 2007. In 2001 those 42 drugs accounted for an astonishing $82 billion in sales--a huge gap to fill.

THE NEW-DRUG DROUGHT, PART 1 This wouldn't be a crisis, of course, if the drug companies were coming up with blockbusters to replace the aging warhorses. In fact, though, fewer new drugs are hitting the market each year (see the chart at right on page 103). Back in 1996 the FDA approved 53 new drugs. In 2002 it approved just 17.

Why aren't the pharmas simply putting out new me-toos to replace the drugs going off patent? One reason is a change in attitude in Washington. "The FDA has become more cautious in approving me-toos," says Invesco's Wald. Observers attribute the shift to a series of highly publicized cases in which recently approved drugs produced dangerous side effects. In August 2001, for instance, Bayer took Baycol off the market after it was linked to deaths in several patients worldwide.

At the least, the FDA wants to see that any new drugs with potential side effects have clear advantages over current treatments. Take the case of Bristol's drug for congestive heart failure, Vanlev, which had been touted as a potential blockbuster. In March 2002, a study showed that Vanlev was only marginally more effective than a drug already on the market. Bristol shares fell 15% in one day. Why did investors punish the stock so harshly? They knew what was coming. In July an FDA panel recommended the rejection of Vanlev. Now Bristol has to conduct further expensive testing before Vanlev stands a chance of being approved.

Even when big pharma gets its drugs through the FDA, it is paying for its choice to focus on relatively few conditions. Many new drugs are entering crowded fields where the only way to succeed is to take business away from rivals. This year, for instance, AstraZeneca could win approval for a new, potentially more effective statin, Crestor. Its arrival may be bad news for the other statins: Lipitor, Zocor, Lescol and Pravachol.

What's true of larger markets like statins is also true of the smaller markets. Pfizer's Viagra has grown into a $1.7 billion drug. Now that domination could be threatened. This year Lilly and ICOS are set to launch a new impotence cure, Cialis, and in Europe GlaxoSmithKline and Bayer will together launch their own anti-impotence drug. In the field of rheumatoid arthritis, Johnson & Johnson's Remicade already vies with Amgen's Enbrel; Abbott Laboratories is about to enter the fray with Humira, its new antibody treatment. Biotechs like Genentech look set to follow soon.

THE NEW-DRUG DROUGHT, PART 2 Having tackled the six big disease categories, pharma's biggest untapped opportunity is in addressing degenerative diseases like Alzheimer's that affect Americans as they get older. The trouble: Degenerative diseases are incredibly hard to treat. "The easy things have been done with the methods that we had," admits Paul Herrling, head of corporate research at Swiss pharma giant Novartis.

One problem is that researchers still don't know what causes most chronic or degenerative diseases like Alzheimer's. Nor do they know exactly how to measure a drug's efficacy for these conditions. (It's easy to check whether a person's cholesterol level has risen or fallen; to know for sure that a drug is slowing a person's mental decay is considerably more complicated.) That's one reason drug companies are having to do more trials on more patients. From the mid-1980s to the mid-1990s, the number of clinical trials conducted for each medication almost doubled, from 36 to 60; the number of patients enrolled in the average trial almost tripled, to 3,521. It now costs $802 million to bring a drug to market, according to the Tufts Center. In 1991 that figure was just $231 million. Put another way, it now takes 12 to 15 years to come up with a new drug; in the 1980s it took only 7.2 years.

The complicated nature of degenerative disease is not the sole reason for rising R&D expenses and lengthier gestation periods for new drugs. Many observers claim that big pharma is making too many mistakes. "Consistent operational excellence has been lacking," contends David Blumberg of Accenture's pharmaceutical and medical products group. He argues that information gathered from early trials is not always used efficiently, so that "go/no go" decisions can be made early on, avoiding expensive disappointments later.

Finally, there's the question of whether drug companies have simply gotten too big to conduct research effectively. Giants like Pfizer boast about the size of their R&D labs, but "it's not clear that mere size creates more innovation," Accenture's Blumberg notes. "Many are afraid of the converse." (GlaxoSmith Kline, for one, has tried to address the problem by splitting its R&D labs into discrete units.) Whatever the reason, all those R&D dollars haven't been producing big breakthroughs. And renewing the culture of innovation will be no simple task. "These are aircraft carriers," says Neil Sweig, a pharma analyst at Fulcrum Global Partners. "They do not turn around that quickly."

MAKING THE BEST OF IT Faced with a shortage of promising new medications--something drug industry executives have seen coming for several years--big pharma has embraced a variety of stall tactics. The goal: to keep the business looking healthy (and share prices up), while waiting for a new wave of blockbusters to emerge. This has been a driving force behind the remarkable wave of big deals that swept through the industry: Pfizer acquiring Warner-Lambert for $90 billion in 2000, then paying $60 billion for Pharmacia this year. Johnson & Johnson buying out Alza for $10.5 billion in 2001. With each deal, sales forces and administrative functions are combined, slashing billions in costs--and fueling rising earnings.

But cost cutting is never a substitute for growth. And after each merger, the company needs to find that much more revenue to hit its financial targets. After absorbing Pharmacia, for instance, Pfizer will have some $48 billion in revenue. To expand sales at 10% annually--the rate it would probably need to achieve the 16% profit growth that analysts expect--the company will have to add close to $5 billion each year to its top line. A daunting task, to be sure.

Some observers also feel that companies took cost cutting too far. "The pharma companies began starving manufacturing of capital, and some of them ended up with Third World manufacturing environments," says Sanford Bernstein's pharma analyst, Richard Evans. He cites the push for savings as a key reason some drugmakers have been running into trouble with the FDA over the quality of their manufacturing plants. In May 2002, for instance, Schering-Plough agreed to pay $500 million as part of a settlement after the FDA found significant violations of regulations related to quality assurance, equipment, laboratories, packaging and labeling at four facilities in New Jersey and Puerto Rico.

Another stall tactic: trying to extend the life of existing patents to delay the onslaught of generics. If a company sues a generic manufacturer, claiming patent infringement, it automatically receives a 30-month patent extension while the case is under review. In fact, the law is so lenient that pharma companies can receive multiple 30-month extensions by filing sequential claims against generic manufacturers. In March 1998, Apotex filed an application to make a generic version of Paxil, GlaxoSmithKline's blockbuster antidepressant. Glaxo's response was to sue Apotex in June 1998, winning a 30-month extension that lasted until November 2000. However, Glaxo also listed nine additional patents on Paxil and brought suit against Apotex four more times between 1998 and 2001. Each of the four suits has won Glaxo another 30-month extension. This particular approach has begun to generate resentment among consumer groups and state governments, who claim that some drugmakers are extending their control on blockbusters by filing additional patents that have nothing to do with the key chemical compounds that make the drug work. In November 2000, for example, Bristol, soon to lose patent protection on its anti-anxiety drug BuSpar, sued generic manufacturer Mylan Laboratories for infringing on its patents. A group of states' attorneys and consumers sued Bristol in turn, alleging that it acted illegally to lock generic competitors out of the BuSpar market by filing frivolous secondary patents. Earlier this year, while admitting no wrongdoing, Bristol settled the case for $535 million. Even the Republican administration, traditionally pharma-friendly, doesn't seem to be on their side on this issue: President Bush recently proposed limiting a pharmaceutical to a single 30-month extension on a patent.

Drugmakers also face pressure from insurers on prices. Aetna, the second-largest insurer, has said that with Claritin now sold over the counter, it will no longer cover non-sedating antihistamines like Aventis' Allegra and Pfizer's Zyrtec unless doctors make a special request. California's WellPoint Health Networks has been lobbying the FDA to move antihistamines like Allegra, Zyrtec and Clarinex from prescription to over-the-counter status. What would that do? When Claritin moved over the counter last year, prices for a month's supply fell from $80 or so to about $30. While it's not clear how successful insurers will be in their effort to contain prices, their new militancy does not bode well for the profit margins of big pharma.

And there could be more trouble ahead: the Federal Government's proposal to add a prescription-drug benefit to Medicare could theoretically expand drug sales in the short term. But as Paul Heldman of the Schwab Washington Research Group warns, "The government is an unreliable partner." He thinks it likely that the cost of the drug benefit will goad the government to start cutting payments to insurers--who would then squeeze drug companies. "In the long run," Heldman argues, "it's a net negative."

SORTING OUT THE STOCKS 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. 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 (see "Stocks to Watch" on page 104). 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.

And 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% over the next 10 years--about 40% 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.