Things look grim, but investors who can bear it could benefit.
Big pharmaceutical stocks are divisive. Some analysts think that they're trading at bargain prices and provide a great place to ride out the global economic crisis. Others think that they deserve to be cheap and might get a lot cheaper as politicians set their sights on health-care reform. To get a better feel for the sector, I talked to Damien Conover, who is a senior analyst on Morningstar's health-care team. Conover covers such names as Johnson & Johnson
Haywood Kelly: Damien, you're bullish on pharmaceutical stocks, but let's start off with the bear case. How bad could things get over the next few years?
Damien Conover: The pharmaceutical group faces some significant near-term head winds. With a major patent cliff approaching the industry in 2010, a strong bear case can be made for the stocks. Approximately $60 billion of drug sales go generic between 2010 and 2012. The lost sales magnify the importance of developing new drugs to fill the void created by the generic competition. Drug companies, however, have failed to bring the next generation of new drugs to the market. Another issue is that, after the market withdrawal of Merck's pain drug, Vioxx, the Food and Drug Administration became risk averse and has rejected many new drugs. Because of the lack of new medicines, the earnings for several pharmaceutical companies are expected to shrink in the next few years. The poor earnings outlook has caused the earnings multiples on the drug stocks to fall to historic lows.
HK: And there's the new administration in Washington.
DC: New government regulations proposed by the Obama administration could reduce the pricing power of pharmaceutical companies. The new administration supports a host of policies that will threaten drug prices: increased insurance coverage, direct price negotiation for Medicare Part D, generic biologics, drug re-importation, and comparative effectiveness programs. Of these, I'd highlight increased governmental insurance coverage in particular, which will bring a major payer to the table. Because of its massive size and authority, the government will likely demand and receive lower drug prices.
And we can't ignore the fact that the consolidation and growth of managed care have reduced the pricing power of less innovative drugs. From the 1990s through the beginning of this decade, drug companies could easily price "follow-on," or "me-too," drugs (treatments that differ little from existing drugs) at the similar or even higher prices than comparable drugs. In 2001, for example, heartburn drug Nexium was launched and replaced most of the sales from its predecessor, Prilosec, even though Prilosec was facing generic competition and Nexium offered little differentiation. It is hard to believe that in today's landscape, managed care would offer such accommodative reimbursement to a drug with little new to offer. We've already begun to see this with managed care's reluctance to provide favorable reimbursement to Prisiq, Wyeth's antidepressant drug. So far, it has generated lackluster results.
HK: You've succeeded in painting a bleak picture. Now, how much of that is priced into the stocks?
DC: Almost all of the challenges facing the industry have been factored into the stocks. The implications of new government health- care reforms have largely been blown out of proportion. The industry might lose some pricing power, but 50 million newly insured customers should counterbalance it.