Investors are flocking back to pharmaceuticals as a safe haven in the downturn. But the industry is struggling with patent and licensing issues. Should you join the flight to pharma? John Stepek reports.
After years of neglect, the bear market has finally convinced investors that it's time to start buying healthcare and pharmaceutical stocks again. In June, the pharmaceuticals and biotech sector was the best performing in the UK. In the US, on 15 July, the market value of healthcare stocks in the S&P 500 rose above that of financials for the first time since 1992 (though that's as much to do with financials' unpopularity as a resurgence of faith in the pharma sector).
The rush to drug stocks is no surprise. They're seen as a classic safe haven everyone has to buy drugs during good times and bad, people are getting older and need more pills and potions to keep them healthy we all know the arguments. But just how defensive is big pharma really? As BusinessWeek points out, the sector has an awful lot of problems to contend with.
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For one thing, getting products to market is a tough process. It takes an average of ten years and $1bn to get a drug to market, and a great many of them stumble along the way. Just this week, Schering-Plough and Merck took a hit when their Vytorin cholesterol treatment performed poorly in a clinical trial. On top of this, the US regulator, the Food and Drug Administration (FDA), "has become increasingly picky and cautious", reports BusinessWeek.
Then there's the fact that even once a drug gets to market, the pharma companies don't have that long to exploit it before generic manufacturers, who make cheap copies of branded drugs, are challenging their patents and eventually robbing them of their business. According to a research report from EvaluatePharma, around $122bn worth of sales will go off-patent during 2011 and 2012. That's a full 70 of the 100 current top-selling drugs, including the number one, Pfizer's Lipitor, a cholesterol drug that is worth around $12bn a year to the company. That means finding a constant stream of new products and drugs to develop easier said than done and with the authorities becoming more fussy, new drugs aren't coming through fast enough to replace the off-patent ones.
Perhaps a bigger threat lies in the US healthcare system itself. In the second quarter of this year, the number of prescriptions bought fell for the first time since the mid-1990s, reports BusinessWeek. "Polls show that because of rising healthcare costs, patients are more apt to skip doses or cut their pills than they were three years ago. And nearly one quarter of patients report not filling a prescription because of the expense."
This seems to undermine the classic defensive argument, that people need to buy drugs during a downturn just as they do in an upturn. But perhaps what it really points to is the fact that pressure for reform in the US healthcare system is reaching a critical point. Most westerners aren't used to having to choose between staying healthy or paying the heating bill. With the US presidential election just around the corner, that means politicians have to pay attention and that could be bad news for big pharma.
As Carl Mortished points out in The Times, despite the general perception that the US has a market-dominated healthcare system, the reality is that the biggest spender in the US drugs market is the government, accounting for about 45% of spending. And with America spending about £140bn a year on medicine (compared with just £11bn a year in Britain that's more than twice as much per head), that makes the US government probably the most important single drugs customer in the world. With pressure growing to cut the amount it spends on drugs, that could put a considerable dent in big pharma's sales. As Mortished puts it: "The industry needs a new business model, and in the absence of self-generated ideas, someone in the White House might just impose one."
It doesn't sound good. But there's a flipside to all of this. For one thing, regardless of the flaws in the current big-pharma business model, someone needs to discover the drugs that are going to keep us all young and healthy (or less old and less fat, at least). Given the sheer scale of resources needed to take a new drug from research lab to the market, there's no way that the big drug companies can't be involved in that.
And signs are that the big companies are already making the necessary changes. GlaxoSmithKline has just announced a partnership with a South African generic drug company (more on this below), while Swiss giant Roche is aiming to buy up the remaining shares in biotech giant Genentech that it doesn't already own. Not only does this bode well for other companies in the generic and biotech sectors, it also shows that big drug companies are well aware of the challenges they face, and are taking steps to prepare for them.
Against the backdrop of a very uncertain stockmarket, drug stocks also have two other big things going for them. For one thing, they are cheap, even accounting for all the headwinds. Jonathan Compton of Bedlam points outin Stocks to ride to flee the bear,that drug stocks are virtually discounting "Armageddon". In fact, as Guy Monson and Subitha Subramaniam of Sarasin & Partners point out, valuations in the sector "are so low that a headline-grabbing merger is surely on the cards this year".
The other big attraction is that they're not highly leveraged, and they are not going to go bust as a result of the downturn, which is a genuine fear hanging over almost any company in the finance, airline, retail or construction sectors. As broker Charles Stanley puts it, drug firms offer "high free cash generation, coupled with a commitment to progressive dividend policies", which "should ensure that investors are rewarded while the equity market comes under pressure". We look at some of the most attractive-looking big pharma stocks below.
Generic drugs
Among the companies best placed to benefit from big pharma's problems are the generic drug makers. For every one of those 70 bestselling drugs going off-patent in the next three years, there's a generic drug maker rubbing hands at the thought. These companies don't have to worry about drugs falling flat on their faces they've already been approved, after all so getting new versions past the FDA is much easier for such producers. That means the business model is far more about scale and keeping costs of manufacturing low.
It's one reason why the sector's top player, Israeli group Teva, has just revealed a $7.5bn takeover of US rival Barr. The combined group will sell more than 500 different products and have annual sales of $11bn. Teva doesn't plan to stop there. Chief executive Shlomo Yanai tells the FT: "You are going to see more moves of this kind we would like to be one of the top three companies in all our key markets."
But big drug groups aren't about to stand back and simply watch as their products are pillaged by the generics sector. In 2005, Swiss drugs giant Novartis bought German group Hexal and merged it with its Sandoz generics arm to create what is the world's second-biggest generics player. More recently, Japan's Daiichi Sankyo has announced a takeover worth up to $4.6bn for Indian generic giant Ranbaxy.
This allows big drug groups to offset some of the sting from their products going off-patent by launching cheap versions of their own drugs. On top of this, because the drugs are so much cheaper than patented brands, gaining access to generic producers is one of the best ways for big drug makers to expand into emerging markets.
As Tim van Biesen of management consultancy Bain tells the FT, "the generics drugs cabinet meets the needs of the vast majority of patients in the developing world". Hence GlaxoSmithKline's deal this week with South Africa's Aspen Pharmacare Holdings. The move will allow GSK to take Aspen's low-cost unpatented drugs, and register them in markets where they are not approved. It expects to start selling in 2010, reports Reuters.
One problem facing generics is scarcity in their own pipelines. They may have plenty of drugs coming off-patent in the next few years to copy, but if the big drug companies run out of new blockbusters, that's bad news for generics. Where are the new drugs coming from?
Biotech
This is where the biotech sector comes in. This is the headline-grabbing end of the pharma market, the one that promises cures for cancer and other great investment stories. The sector was set alight earlier this month by the news that Swiss drug group Roche is making a $43bn bid for the 45% or so of US biotech Genentech that it doesn't already own. The group, which is the biotech industry's oldest company, makes the much-hyped cancer drug Avastin.
It's by no means the first such deal in April, Japan's Takeda Pharmaceuticals paid around $9bn for Millennium Pharmaceuticals and it's unlikely to be the last. The US is the global centre of biotech research, and the weak dollar means that many companies look cheap, particularly if you're buying in Swiss francs or euros. As Ian Oliver of Ernst & Young tells Reuters: "Given the current economic environment, the valuation of a number of public biotech businesses is particularly attractive, so you may see a bubble of biotech M&A."
Dr Steve Sjuggerud of the DailyWealth email newsletter goes one further. He reckons that the Genentech deal is confirmation that biotech has embarked on its next big bull market. Ian Davis, also writing for the Daily Wealth, points out that such rallies tend to be explosive. "Since 1983, biotech stocks have exploded higher in four triple-digit rallies and one quadruple-digit rally." Of course, they've also fallen just as sharply, with the sector losing more than half its value four times over the same period.
CNBC's excitable stockpicker Jim Cramer agrees that this is a good time to get into biotech. He points out that in 1990, when the Savings & Loan crisis was putting financial stocks under similar pressure to today, "the biotechs produced spectacular results". But be warned, this is an area where you can forget all about drug stocks' defensive qualities: biotech is about as risky as it gets. Many companies rely solely on just a few or even one early-stage products, and these often end up being jam tomorrow' or no jam at all' tales, as many investors have found out to their cost.
Just this month, one prominent UK biotech, Oxford BioMedica, saw its share price slump as its potential kidney cancer drug ran into problems during a clinical trial. That's why, if you want to buy into biotech, you should be looking at a tracker or fund that gives you broad exposure to the sector, rather than individual stocks. We look at some options below.
Big pharma: drugs giants that won't give you a headache
So which big drug companies look most attractive at the moment? Well, despite recent share price rallies, both FTSE 100-listed GlaxoSmithKline (LSE:GSK) and AstraZeneca (LSE:AZN) still look cheap, on respective forward p/es of 12.4 and 10.2. GSK's Aspen deal increases its exposure to emerging markets. The group also has a sizeable consumer products unit, accounting for 15% of its total sales.
Chief executive Andrew Witty told The Daily Telegraph this week that he planned to use the strength enjoyed by GSK brands such as Ribena, Horlicks and Lucozade, in India, for example, to help promote its medicines (medicines that are only available on prescription in the UK are often sold over the counter in other countries). As Questor says in the Telegraph, "it has significantly increased its drugs pipeline over the past few years". The stock trades on a forward dividend yield of 5%.
Citigroup likes AstraZeneca after it recently won a patent victory for its schizophrenia treatment Seroquel. The decision delays any generic competition for the drug, which is worth $4bn in sales a year. The broker has a 2,550p price target on the stock, which also trades on a forward yield of 5.0. Broker Evolution Securities added that the patent win "reinforces the safe haven aspects of drug stocks in the current market".
Another big pharma stock worth a look is Swiss group Roche (Switzerland:RO), reckons Dresdner Kleinwort. Flat sales in the second quarter were down mainly to lower sales of Tamiflu (as bird flu panic dies down) and the strength of the Swiss franc against the dollar. The broker reckons that there is still "huge scope to improve penetration rates" of cancer drug Avastin "in ex-US markets." It has a price target of CHF250 on the stock, which currently trades at around CHF180 a share.
One thing to be aware of is that the group may have to raise its bid for Genentech, though the fact that it owns the majority of the shares already, and has the right to veto "any other business combination" as Cowen & Co analyst Eric Schmidt puts it, is "likely to keep any additional premium somewhat in check."
Generics
Following Teva's offer for US group Barr, Dresdner Kleinwort likes the look of German generics drug maker Stada Arzneimittel (Xetra:SAZ) as another potential target. According to Dresdner, "Teva stressed in particular the strength of Barr in Central and Eastern Europe as a key attraction for the acquisition."
Stada, the world's number seven generics drugmaker, also has a high level of exposure to Central and Eastern Europe. Applying the same sorts of multiples to Stada as paid for Barr, Dresdner comes up with a "fair value" of between €60 and €84 per share. That's a pretty wide range, but even at the bottom end it's a good way above the current share price of around e48.
Biotech
As we point out above, biotech is a very risky area. One way around this would be to buy one of the bigger biotech stocks such as Amgen (US:AMGN) or Gilead Sciences (US:GILD), which is Jim Cramer's favourite stock in the sector, reports TheStreet.com. But even these big players are at the mercy of newsflow on their drugs. Rather than trying to guess which stocks are likely to deliver on their promises, a better bet is to get broad exposure to a wide range of stocks. You could pick and choose a portfolio of your own, but that's a tall order for most retail investors; so it makes sense to buy a fund.
In the US, several exchange traded funds (ETFs) track the sector cheaply. Daily Wealth editor Dr Steve Sjuggerud suggests the SPDR S&P Biotech ETF (US:XBI), which is "full of mid-sized biotech companies with actual sales... sales a weak economy won't wreck." The fund has an expense ratio of just 0.35%. It's denominated in dollars, so there is a currency risk, but given the poor state of the British economy, sterling could well be as weak or weaker than the dollar in the coming months. Rob Fannon, also in Daily Wealth, suggests avoiding the HOLDRs Biotech ETF, which he says is "ridiculously weighted toward just four high-profile companies".
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