The Amex-quoted pharmaceuticals index reached its all-time high at the end of 2000 when, in the middle of a market meltdown and with recession on the cards, investors fled high-flying tech and biotech stocks for safer ones in more defensive sectors. The pharma sector had seen 350 percent returns over the previous six years and people would continue to buy prescriptions, even during a recession.
However, between those heady days at the beginning of the millennium and the end of 2004, the pharma index actually shed around 30 percent of its value. Over the same period, Bristol-Myers Squibb, Schering-Plough and Merck all plummeted more than 60 percent, while Pfizer and Eli Lilly each dropped around 40 percentage points.
Exchange rate fluctuations weren’t entirely to blame, either; European giants Bayer, AstraZeneca and GlaxoSmithKline fared almost as badly. Johnson & Johnson, with a vast range of non-medicinal consumer products, was one of the few companies to come through relatively unscathed.
Long-term risks
So what happened? Quite a lot, actually. In the US in particular, 2002’s Greater Access to Affordable Pharmaceuticals Act and further legislation in 2003 reinforced the ability of generic competition to take on the proprietary drug companies by limiting the ability of patent holders to delay competition from generic compounds. The side effects were devastating: Medicare, as well as major insurers, began to refuse to pay prescription bills for proprietary medication if cheaper generic products were available.
‘Ten years ago the main question when pricing a compound was, How much is the insurance company going to pay?,’ says Kathleen Eppolito, president of Scientia Communications, IR consultants for the biotech and life sciences industry. ‘Now patent protection and the length of time a patent has to run before generic competition kicks in are among the major questions, because the loss of protection has a huge effect on sales.’
‘Nowadays investors have to ask what the effect of generic competition will be,’ adds Chris Garsten, an analyst at investment company 2CG. To illustrate his point, when Bayer’s antibiotic Cipro lost patent protection in the US, sales there fell by 55 percent. Industry analysts no longer ask how much Medicare or the insurance firm will pay, but rather if they will pay at all.
Put that in your pipe
So how can proprietary drug developers defend themselves? The answer is a pipeline both broad and deep, with products at various stages of development catering to different pathologies. Merck’s head of IR, Graeme Bell, observes that the hypothetical value of even a late-stage product is extremely difficult without a thorough evaluation of the product and its potential market. ‘A promising pipeline won’t necessarily appear in your share price, while the market will punish you if you have a thin pipeline,’ he explains.
This was seen when John Hussman, manager of the $1 bn Hussman Strategic Growth Fund, told investors that Merck’s disappointing 2004 (pre-Vioxx) performance was due to disappointment over perceived weakness in the company’s pipeline. Also, according to a fund manager from Deutsche Asset Management, who prefers to remain anonymous, evaluating the pipeline presents other problems – not least, the best-case assumptions usually presented by the company. Garsten agrees: ‘When you go to pharma company presentations they will, like other companies, put the most positive spin on their outlook,’ he confides. ‘For example, they’ll try to maximize their R&D pipeline while minimizing the threat from patent loss.’
Indeed, companies fight tooth and nail to defend their patents, and sanofi-aventis probably considers very well spent the legal fees that were required to delay the assault from generic drugs on its hay fever (Allegra) and high blood pressure (Plavix) compounds.
Thin pipelines and generic competition are not the only threats, though. Recently, several compounds have been withdrawn from the market, most notably Merck’s cox-2 inhibitor Vioxx. The company itself withdrew the product last September after a study showed prolonged use to increase the risk of cardiovascular failure in some patients. In December 2004 Pfizer pulled advertising on its own cox-2 inhibitor Celebrex, which had racked up sales of $2.3 bn in the first nine months of the year. The move followed a Pfizer-commissioned study that found an increased risk of cardiovascular problems in patients taking two to four times the normal dose.
Merck refutes accusations it withheld information that could have hurt Vioxx sales, or caused its recall. Even so, class actions abound and estimates suggest they could cost Merck up to $7.5 bn, if successful. The profits that currently appear on the balance sheet as retained earnings may well be wiped out by future class actions against the firm.
As Garsten observes, drug development is a costly business, but companies first to market can make huge profits. Pfizer’s anti-impotence drug Viagra raked in billions before Eli Lilly’s Cialis arrived to provide any serious competition. That said, even novice investors can see there are huge risks involved in pharma R&D, not least that a compound could fail to gain regulatory approval after phase III trials, when a huge amount of money has already been spent.
‘One company I know had a great compound that in phase III trials was already showing compelling advantages to an already marketed commercial product,’ illustrates Eppolito. ‘Then brown fat developed in rats in three-year post mortem data, and the product never reached the market.’
To circumvent such problems, companies with enormous sums of cash in their coffers often look to buy the rights to market promising compounds being developed by smaller – particularly biotech – companies. R&D is expensive and, after a funding boom in the late 1990s, a number of biotech companies are lacking cash and only too willing to pass on any eventual marketing expenses.
Bristol-Myers Squibb acquired the rights to market ImClone’s Erbitux, which gained FDA approval in mid-2004 and is already enjoying healthy sales. But the Deutsche Asset Management fund manager warns: ‘A pharma company will set its sights on a biotech company only if the latter has a compound under development that is significant enough to affect the pharma company’s profit and loss statement.’
Buying growth is nothing new. Pfizer’s former CEO William Steere has famously admitted that his company embarked on its hostile takeover of Warner-Lambert in 2000 only to get control of that company’s cholesterol-lowering blockbuster, Lipitor. Other companies combine research and marketing forces in an attempt to reduce costs. Merck and Schering-Plough have agreed to share costs and marketing expertise to promote Merck’s Vytorin, already on sale in Germany and Mexico but yet to gain FDA approval.
Defining values
‘Whether a company develops a compound or buys the rights to market one in late-stage development, it needs to ask what the market potential is,’ points out Eppolito. Even so, analysis is generally subjective, and consensus is rare. ‘Look at the HPV vaccine, which seeks to block the papillomavirus,’ says Bell. ‘Some analysts think pretty well everyone will be vaccinated, while others see no market at all.’
The differences between how companies communicate information force investors to do some sifting before they can compare one pipeline with another. ‘With pharma analysts covering up to 25 large-cap companies, IROs need to be able to walk them through their SEC filings to help them uncover the information disclosed that enables them to develop accurate models, because the original is not quite right,’ suggests Eppolito.
Gaap EPS may penalize companies with good growth prospects because research and development costs are included, but no corresponding value is assigned to the pipeline. Evaluation is still tricky, however. ‘You need to assign a value to the existing business, and add in the implied option value of its pipeline,’ suggests the Deutsche Asset Management fund manager.
This is not necessarily easy, unless the market for pipeline products can be accurately identified. Bell has a suggestion: ‘When we present new products to the market we spend time talking about their practical aspects and potential utilization both in the US and beyond the US.’
‘Evaluation is still more of an art than a science,’ concedes Eppolito. ‘As in other industries, the IRO’s role is to help investors and analysts understand the story.’
Big pharma has suffered a number of setbacks over the past three years, with tighter regulation and fiercer competition. But in the long run, the industry itself may emerge leaner and healthier.
‘I shouldn’t worry about big Pharma,’ concludes Garsten. ‘The profit margins remain among the highest of any industry. They may have to work harder now, but it’s still a very benign business to be in.’
