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The Future of Big Pharma

Things look grim, but investors who can bear it could benefit.

Haywood Kelly, 04/01/2009

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 JNJ, Merck MRK, Pfizer PFE, Abbott Laboratories ABT, and Novartis NVS. He also heads up the monthly Morningstar Healthcare Observer newsletter, which provides in-depth research on the health-care sector.

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.PAGEBREAK

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.

Further, studies from the Congressional Budget Office state that drug re-importation and comparative effectiveness programs would only save approximately 1% of drug costs over 10 years. Also, both programs would require significant upfront investments for meager long-term benefits--typically, a dead-in-the-water proposal for Congress. These programs sound good from politicians, but the result will not have a big impact on drug sales.

HK: Is there any other area where your analysis differs from the market?

DC: I think breakthrough drugs will reach the market--and relatively soon. The Vioxx withdrawal occurred in 2004 and marked the turning point when the FDA became a very risk-sensitive group. Drug development, however, takes at least three to five years. A few years ago, pharmaceutical companies were heavy with follow-on drugs that were marginally more effective with slightly more side effects than the drugs they were replacing. Ten years ago, the FDA would have approved these drugs, but today's tougher FDA has issued an unprecedented number of rejections and delays. As a result, pharmaceutical companies have shifted their focus to areas with unmet needs such as oncology, immunology, and neurology. In these areas, the FDA has shown a strong willingness to approve marginally effective drugs regardless of side effects. Because of the long drug development period, however, the change will take several years to complete.

Now, pharmaceutical companies are approaching the dawn of a new area in medicine with several new drugs on the cusp of revolutionizing the treatment of many devastating diseases. The most near-term breakthroughs appear in immunology and neurology. For example, Novartis is close to launching a new drug for Muckle Wells. Also, many firms have late-stage drugs in development for Alzheimer's disease.

The shift to more specialized diseases will likely bring relief not only to the top line of drug companies' income statements, but the bottom line as well. Drugs in unmet medical-need areas carry very strong pricing power in the tens of thousands of dollars and require much smaller salesforces than drugs in the primary-care field. I expect the new drug cycle to lessen the heavy sales and marketing expenses established in the 1990s with primary-care drugs. As a result, a higher portion of sales from specialty drugs should fall to the bottom line as less marketing is needed.

HK: At the beginning of the year, Pfizer and Wyeth agreed to a merger. Do you expect additional mergers and acquisitions in 2009?

DC: More mergers and acquisitions should occur in 2009. Even in the slowing economy, large pharmaceutical firms are generating strong cash flows that augment already robust cash balances. With venture capital and equity markets out of the picture, Big Pharma likely will fill the void of deals with many tuck-in acquisitions and cost-saving large-scale mergers. Further, even recession-resistant drug firms are cutting costs. Consolidation can lead to greater cost savings than stand- alone restructurings. The cost cuts Pfizer will make through the Wyeth merger should give the green light for other major acquisitions. Additionally, Pfizer's access to $22 billion of debt should alert the remaining Big Pharma companies that the credit markets are open to relatively safe drug companies.

HK: Talk a little about the mechanics of valuing pharmaceutical stocks at Morningstar.

DC: We value companies through a multiphase discounted-cash-flow analysis. We forecast 10 years of drug sales and expenses. The most known factors over the next 10 years are patent losses, which reduce most drug sales to close to zero within a year. Leading up to the patent loss, we project sales and associated expenses based on our expectations for market-share fluctuations. We handicap the unknown factor of new drugs by evaluating the drug company's pipelines and published clinical data. Stronger clinical data leads to a higher amount of probability-adjusted projected sales. After the forecast period, we project an intermediate valuation step where returns approach the typical GDP growth of 3%. Finally, we add a perpetuity value based on the forecasted earnings of the drug company in the final year of the intermediate step.

HK: How do you stress test your fair values?

DC: During our discounted-cash-flow analysis, we are mindful of other valuation methods to make sure we are not missing anything. Sum-of-the-parts analysis is helpful for the large, diverse firms that have many divisions. This analysis not only helps us confirm our discounted-cash-flow analysis, but also sheds light on the primary value drivers within complex companies like Abbott Laboratories. Additionally, we perform relative valuation analysis across the pharmaceutical industry with several metrics, including price/earnings, enterprise value/EBITDA, and others. The comparable analysis yields a gut check to determine how each company in the pharmaceutical industry stacks up to one another.

Beyond using different valuation techniques, we also stress test our sales assumptions for new drugs. We run bear and bull cases for any critical new drug, which helps segment a range of valuation outcomes based on different scenarios for an important drug. For most major pharmaceutical firms, the range in valuation based on one drug usually can change the valuation by up to 5% to 8%. The range helps determine the degree of uncertainty surrounding the fair value estimate.

HK: Would you recommend buying a basket of Big Pharma stocks--through an ETF, for example--or cherry-picking a few names?

DC: Picking a couple select drug companies should offer investors better rewards than an ETF. For the most part, a Big Pharma stock will likely perform in line with a pharmaceutical ETF, especially stocks like Johnson & Johnson and Pfizer. Because Big Pharma offers such a wide portfolio of drugs, stock prices tend to move in tandem with each other. However, the extra reward offered by picking a few select names should offset the risk of less diversification than provided by an ETF. The current valuations of certain pharmaceutical firms like Novartis make this particularly true. They offer strong risk-adjusted return potential.

Haywood Kelly, CFA, is vice president of equity research at Morningstar.

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