Better Health for Drug Makers

The pharmaceutical industry has looked wan and sickly in recent years. Gone are the halcyon days of the late 1990s, when the industry effortlessly expanded revenues by 10% to 15% a year and earnings at an even brisker clip. Loss of patent protection on many important prescription drugs, coupled with a dearth of new drugs coming out of research labs, has caused drug stocks to trail badly behind the overall market for years.

But now the sector appears to be returning to life. In the second quarter of 2006, all eight of the largest U.S.-based pharmaceutical companies beat Wall Street's earnings estimates. Four of the eight companies boosted profit forecasts for the rest of the year. Over the past six months (through mid August), the Amex Pharmaceutical Index outpaced Standard Poor's 500-stock index by about four percentage points.

No, this is not a return to the go-go '90s. But then, expectations for drug stocks are modest -- they trade, on average, at 16 times this year's expected earnings. Business prospects for many of these companies are improving. Moreover, as classic defensive plays, pharma shares generally hold up well in a weakening economy because sick people take their medicine in good times and bad. Most drug makers enjoy rising profit margins, bulletproof balance sheets and strong cash flows, which should allow them to raise dividends even in a sluggish economy.

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Several factors are working in Big Pharma's favor. Tens of millions of Americans have signed up for the Medicare Part D plan, which began to stimulate drug purchases in the second quarter of this year, analysts say. Unlike companies in most industries these days, makers of branded drugs possess pricing power and are boosting pill prices by 5% or more. And don't forget demographic destiny: The ranks of seniors, by far the most prolific pill-poppers, are rising rapidly in the U.S., Europe and Japan (most major drug makers generate about half of their sales overseas).

The drug manufacturers also seem to be running their affairs with a greater sense of urgency. They're cutting operating costs, investing heavily in research and development, and scouring the world for promising new drug technologies. Pipelines of exciting new treatments for chronic illnesses, such as diabetes, cervical cancer and heart disease, are improving. The Food and Drug Administration will approve more drugs in 2006 than in 2005, marking the first yearly increase this decade, says Trevor Polischuk, co-manager of Eaton Vance Worldwide Health Science fund.

When analyzing a drug company, Kris Jenner, manager of T. Rowe Price Health Sciences, says to focus on three things: First is the growth potential of its currently marketed products. Second is the promise of new products in the pipeline. Third is a company's exposure to patent expirations; sales of branded drugs can plummet 80% to 90% within months after generic copycats hit the market.

Polischuk thinks Indianapolis-based Eli Lilly has the best growth prospects in the U.S. drug business today. Lilly spends an industry-leading 20% of sales on research and development. It has a $4-billion blockbuster in Zyprexa, the leading antipsychotic medication, and solid growth potential in recently unveiled drugs, including Cymbalta, a new antidepressant, and Cialis, a drug for erectile dysfunction.

Patent protection

Lilly is a major player in diabetes treatments, demand for which is growing strongly worldwide. Lilly co-launched Byetta last year with a biotech company, has an inhaled insulin medication in late-stage clinical trials and has filed with the FDA for approval of Arxxant, the first treatment for diabetes-induced blindness. Incredibly, Lilly has no drugs going off patent the rest of this decade.

Polischuk is also bullish on Novartis AG. He says the Swiss company's business prospects are unsurpassed by any other large drug maker. Like Lilly, Novartis has good sales growth from existing drugs, a robust drug pipeline and little exposure to patent expirations.

Novartis's megahits include Diovan, a $4-billion hypertension fighter, and Gleevec, an oncology drug that is prescribed for multiple cancer treatments (which is unusual for such drugs). In the works are Galvus, a diabetes medication, and Omnitrope, a generic growth hormone. Unlike the major U.S. drug companies, Novartis has responded to the copycat challenge by building a huge generic-drug business, represented by its $5-billion Sandoz division.

Undervalued giant

The investment case for Pfizer is different. It is more of a value play and turnaround story than an example of dynamic growth. Pfizer stock is cheap, selling at 14 times estimated 2006 earnings -- well below the price-earnings ratio of both the industry and the overall stock market -- and yields 3.6%. This is a relatively low-risk stock.

After Pfizer completes the $16.6-billion sale of its consumer-products business to Johnson Johnson, its cash hoard will top $30 billion. Based in New York City, the company annually generates $12 billion of free cash flow -- the money that's left after capital expenditures needed to maintain the business -- and still has plenty of room to trim fat from its bloated cost structure.

So expect Pfizer, under new chief executive Jeffrey Kindler, to make nice with shareholders by aggressively buying back stock and raising the dividend later this year. So, shareholders will be paid to wait while scientists search for the next Lipitor, Pfizer's $12-billion anti-cholesterol superstar.