007 Secret Weapons of Drug Firms

After 14 books and 21 movies of being beaten and bruised--but staying alive, secret agent James Bond isn't just lucky; he's good. No matter how dire his circumstance, Bond's cunning intellect, charm, and use of gadgetry allow him to escape death and complete his mission. In other words, Bond has certain enduring qualities that are impossible for his foes to replicate or disarm and that lead to his success time after time. But what can James Bond teach us about stock investing?

Simply put, all firms hit rough patches at some point, but great firms hold competitive advantages that always pull them through. Just like Bond, firms that make good long-term investments are at their best when their backs are against the wall. Do your stocks have what it takes to succeed in the long run? Today we put several specialty pharmaceutical firms to the test.

An Introduction to Specialty Pharmaceuticals
Specialty pharmaceutical firms are more marketers than researchers, relying on acquisitions to fill their drug pipelines. The few drugs that are developed internally are usually not new compounds, but rather reformulations of existing drugs that offer less frequent dosing or better safety profiles. By far, the most prized asset of each of these firms is their salesforce, which blankets physicians and adds value to their products.

However, stuck in between big resourceful drug companies and innovative biotechnology firms, not all specialty pharmaceuticals compete effectively. At last count, the top-10 big drug firms controlled more than 68% of all pharmaceutical sales representatives in the United States. In addition, biotech firms are constantly breaking ground on new treatments that replace existing therapies. As a result, we think only the specialty pharmaceutical firms that utilize their salesforce most efficiently will endure this competition and succeed in the long run.

Before we determine which firms make the cut, we've identified seven secret weapons used by specialty pharmaceuticals to increase salesforce efficiency and create lasting competitive advantages.

Seven Secret Weapons: For Your Eyes Only
Specialization
Firms that stick to a single therapeutic market can sell their entire product lines to a small, targeted group of doctors, making their salesforces highly efficient. For instance,  Endo Pharmaceuticals (ENDP) markets drugs exclusively for pain. With all of its products treating the same condition, the firm keeps its salesforce small and markets only to physicians who see the highest volume of pain-related cases, such as surgeons. On the opposite end, firms that sell a huge variety of unrelated products miss out on the benefits of specialization. Take  Valeant Pharmaceuticals International , maker of everything from beta blockers for heart failure to skin treatments for overexposure to the sun. Valeant must market its products separately to cardiologists, dermatologists, and many other physician groups, which requires a larger salesforce that's more costly than its worth.

Blockbusters
Blockbuster drugs pull in more than $1 billion in annual sales and usually target a highly prevalent condition. As drugs are prescribed by doctors and not patients, blockbusters that serve large patient populations require virtually the same selling effort as smaller market drugs and are extremely profitable. For instance,  Shire  markets its attention-deficit hyperactivity disorder (ADHD) drug Adderall XR to pediatricians and child and adolescent psychiatrists. While ADHD affects roughly 8% of all U.S. children, Shire's sales efforts are fixed by the limited number of specialist physicians.

Orphan Drugs
An orphan drug serves an unmet need for a small patient population and in return receives seven years of exclusivity before competing products can reach the market. Because the drug does not face direct competition and the need is high, little selling effort is required. For instance, Shire markets the new orphan drug Elaprase for a rare genetic condition named Hunter Syndrome. With a pre-established queue of patients already seeking treatment at launch, Shire quickly penetrated the market with little salesforce presence.

Royalty Streams
Smaller pharmaceutical companies often focus on early-stage research and outlicense their later-stage projects, which require more expensive clinical trials, to firms with greater resources. In return, the smaller firm is rewarded with royalties on all future sales of the product. For instance, in its early stages,  Sepracor  licensed the compound that became allergy medication Claritin to  Schering-Plough . As a result of its earlier efforts, Sepracor collects virtually cost-free royalties on drug sales and can use the cash to strengthen its other operations.

Inlicensed Drugs
Under the right situation, a company can also benefit from taking the reverse of the above transaction and inlicensing a drug from an outside firm. Although it will need to make royalty payments, the firm can add value by acquiring drugs in its pre-existing specialty.  Medicis Pharmaceuticals  already sells products to plastic surgeons, mainly its dermal filler Restylane. Recently, Medicis agreed to inlicense Reloxin, a Botox-like product, and to pay royalties on future sales. As Medicis already has a salesforce in place to target plastic surgeons, the added cost to market Reloxin will be relatively low, and value should be created.

Patient Demand
Instead of marketing only to physicians, some firms also use direct-to-consumer advertising to raise awareness for their products. Firms hope this type of promotion will cause patients to seek out treatment during their next trip to the doctor, making life easier for the salesforce. For instance, Sepracor uses advertising for its sleep aid Lunesta to build patient demand, which in turn can cause more doctors to become interested in the product.

Market Choice
Below is a chart showing a small sample of widely found medical conditions and their prevalence in the U.S. In addition, we've included the number of active physicians in the U.S. in each specialty group that treats the corresponding condition. Which market would you rather compete in? All else being equal, we think firms that target the markets with the highest number of patients per physician will make the most of each sales call. For instance, a single visit to a dermatologist for a psoriasis drug may result in prescriptions to more than 500 patients.

Patients per Physician by Disease Market
	U.S. Prevalence (million)		Physician Group	# Active in U.S.*	Patients per Physician
Psoriasis	5.84		Dermatology	10,957	533
Congestive Heart Failure	4.80		Cardiology	21,875	219
Inflammatory Bowel Disease	1.40		Gastroenterology	12,089	116
Age-related Macular Degeneration	1.75		Ophthalmology	18,054	97
Diaper Rash	1.00		Pediatrics	56,519	18
* Physician data from the American Medical Association

Tying It Together with the Salesforce Efficiency Ratio
Although we've identified certain firms that use one or more of the secret weapons, the salesforce efficiency ratio (SER) helps us tie everything together to rank the firms and recognize competitive advantages. We calculate the SER by dividing a firm's total sales (in millions) by the average number of sales reps employed during the year. For instance, if an SER equals one, each representative pulls in an average of $1 million in sales; the higher the SER, the more efficient the salesforce. As you will see, just because a firm is larger and sells more products doesn't necessarily mean its salesforce is more efficient.

With competition from both big pharmaceutical companies and biotech firms, the SER indicates which specialty pharmaceutical firms may have carved a niche that will allow them to succeed in the long run. While an SER does not always correspond to our economic moat rating, which takes a wide view of many factors in the competitive landscape, we think it says a good deal about a firm's competitive position.

Salesforce Efficiency Ratio (SER) and Firm Rank
Company	Morningstar Rating	2006 Sales ($ millions)	Average # of Reps	Salesforce Efficiency Ratio (SER)		Economic Moat Rating
Endo Pharma Hldgs (ENDP)		910	480	1.896		Narrow
King Pharma		1,989	1,050	1.894		Narrow
Elan		560	319	1.755		None
Allergan		3,063	1,750	1.750		Wide
Shire		1,797	1,158	1.552		Narrow
Axcan Pharma		292	194	1.505		Narrow
Forest Labs		3,442	2,839	1.121		Narrow
Sepracor		1,197	1,675	0.715		None
Valeant Pharma Intl		907	1,531	0.592		None

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Consider Buying
Valeant Pharmaceuticals International 
Business Risk: Average
Economic Moat: None
Price/Fair Value Ratio: 0.76
While we singled out Valeant for its inefficient salesforce, we think the firm should become more specialized in the near future and that the shares remain a bargain at a 5-star price. With its back against the wall, Valeant recently shed its preclinical research programs and instead plans to focus on its late-stage pipeline, which includes Phase III epilepsy drug candidate Retigabine. Valeant already sells several drugs for neurological disorders, such as Tasmar and Zelapar for Parkinson's disease, and if Retigabine is approved, the firm can use the same salesforce channels. In addition, we think Valeant will pursue acquisitions to strengthen its existing positions in dermatology and infectious disease. Both actions should increase the firm's salesforce efficiency ratio.  Click here for our full Analyst Report.

Consider Selling
Shire 
Business Risk: Average
Economic Moat: Narrow
Price/Fair Value Ratio: 1.89
Shire remains one of the most efficient specialty pharmaceutical firms we cover, but we think the market fully reflects this value and that new challenges are ahead. Shire is set to lose the bulk of its Adderall XR sales when generic competitors enter the market by early 2009. In 2006, the drug accounted for roughly 45% of Shire's total sales and we think it will be difficult for the firm to make up for this lost revenue. In addition, the firm's royalty income, which contributes big profits, should decline over the next five years. Both events may negatively impact the firm's salesforce efficiency ratio.  Click here for our full Analyst Report.