Drug Companies: Recession-Resistant, but Government-Proof?

Europe is in a state of flux -- putting it nicely -- causing market volatility and who knows what else. If you're thinking that a flight to safety is in order, I'd suggest thinking twice before making the seemingly sure bet on pharmaceutical companies.

Oh sure, people will still get sick during massive capitulation -- the usual reason drugmakers are a safe haven -- but European debt problems are likely to have a major influence on drugmakers ranging from giant Pfizer (NYSE: PFE  ) all the way down to Onyx Pharmaceuticals (Nasdaq: ONXX  ) with its one cancer drug.

When the buyer is broke
Like Canada, European countries have no problem dictating the price that drugmakers are able to charge -- health-care "rights" apparently trump capitalism. And when a government's budget is busting at the seams, there's a lot of pressure to reduce health-care costs, especially because they tend to be a greater portion of the budget than here in the U.S.

On Wednesday, Greece decided to take action and forced drugmakers to reduce drug costs by an average of 21.5%. At the top end, drugs that cost more than about $125 will have to be cut by 27%.

Greece isn't the only one tightening its purse strings; Germany announced a plan last month to lower prices, and Spain has a plan, too. Britain's NICE (National Institute for Health and Clinical Excellence) has also been a fierce negotiator with drugmakers for its national health plan, often refusing to pay for a drug until the developer lowers its price.

Not that it really matters, where the cuts occur. Because of free- trade agreements among European nations, low-priced drugs can be exported to other European Union countries, essentially decreasing revenue in countries that haven't cut prices. Drugmakers can counter the export by limiting the amount of drugs they're willing to sell based on expected need, but they risk looking like the bad guy when drug shortages arise because middlemen export the drugs anyway.

Given the high margins on drugs, pharmaceutical companies probably won't lose money by selling the drugs at reduced prices, but it certainly will cut into earnings and leave less cash available for funding research to develop new drugs.

When a dollar earned isn't
The currency changes that have strengthened the dollar as investors flee the euro are also a serious problem for many drugmakers. For instance, overseas drugmakers AstraZeneca (NYSE: AZN  ) and Novartis (NYSE: NVS  ) are hurt because they report earnings in U.S. dollars.

All the sales denominated in foreign currencies result in less revenue when they're translated into U.S. dollars. Johnson & Johnson (NYSE: JNJ  ) has already reduced its revenue guidance for the year by about $500 million because of changes in the euro between the end-of-2009 conference call and the first-quarter call. How much will changes over the past few weeks affect revenue and earnings for the rest of the year?

Some drugmakers try to deaden the pain with currency hedges, and expenses abroad, which are now cheaper in U.S. dollars, can help the bottom line a little. But it's hard for investors to know their effect until the companies report earnings.

On the flip side, GlaxoSmithKline (NYSE: GSK  ) , which reports in the British pound, and sanofi-aventis (NYSE: SNY  ) , which reports in the euro, should benefit from a stronger dollar. First-quarter U.S. sales made up 31% and 26% of revenue for the two companies, respectively.

So sell all my drug companies and go into cash?
I wouldn't say that. Drugmakers are still throwing off plenty of cash and returning a substantial portion of it to shareholders in the form of wealth-building dividends. But realize that drugmakers will struggle to grow over the coming years because of increased pressure to lower health-care costs. Until government budget woes are settled, capital appreciation may be hard to come by.

Pfizer is a Motley Fool Inside Value selection and Novartis is a Global Gains pick. Johnson & Johnson is an Income Investor recommendation and Motley Fool Options recommended buying calls on the stock. Try any of our Foolish newsletters today, free for 30 days

Fool contributor Brian Orelli, Ph.D., doesn't own shares of any company mentioned in this article. The Fool owns shares of GlaxoSmithKline and has a disclosure policy.


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