July 22, 1999
by Warren Gump (TMFGump)
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Looking just at share prices over the first six months of the year, you might think that the pharmaceutical companies need to develop a therapy for falling stock prices. While the overall market enjoyed fat gains, these stocks actually lost some of their value. The S&P Pharmaceutical Composite Index, which tracks the drug companies in the S&P 500, saw 2% of its value evaporate during the first half of 1999, while the overall S&P 500 increased 12%.
Eli Lilly -17%
Pfizer - 13%
The drug sector has generally been considered one of the premier areas for growth investors to place their money. Through massive investments in research and development, these companies have created a phenomenal track record of introducing new products and regularly increasing both revenues and profits. After decades of such performance, growth investors have been more than willing to pay above-market P/E ratios for the great names in the industry like Merck (Nasdaq: MRK), Pfizer (NYSE: PFE), Abbott Laboratories (NYSE: ABT), Bristol Myers Squibb (NYSE: BMY), Eli Lilly (NYSE: LLY), and Schering-Plough (NYSE: SGP).
Over the past few years, growth investors have raised their expectations for satisfactory growth. While consistent 8%-15% earnings growth used to be the hallmark of a superb growth firm, the emergence of technology and other hyper-growth industries has raised the bar. After watching companies like Microsoft (Nasdaq: MSFT) and Cisco Systems (Nasdaq: CSCO) average earnings increases of more than 30% per year over a decade, many people view earnings growth of less than 15%-20% as boring and mundane. Companies not meeting this higher threshold have been left withering in obscurity as market darlings continue to be bid higher.
Compounding this problem for traditional growth stocks is the emergence of Internet stocks as the growth vehicle of choice. Why wait five or more years for a traditional growth stock to double when buying an Internet name -- virtually any Internet name -- seems to result in a double in a month or less? This amazing performance of upstart companies has resulted in tremendous amounts of money being redeployed out of drug stocks into faster-growing sectors. While this trend could continue, a stumble by some of these companies would likely cause investors to once again appreciate the benefit of steady, consistent earnings growth provided by drug companies over long periods of time.
The shift away from drug stocks can't be blamed entirely on the emergence of faster-growing alternatives. Disappointments from the industry's fastest growers have played their part in dampening investor enthusiasm. Pfizer and Warner-Lambert (NYSE: WLA) have been two of the hottest drug stocks over the past couple of years because of strong new product introductions. While investors had been conditioned to expect only good news from these companies, some bad news recently came forth. Excitement over the introduction of Pfizer's impotency drug Viagra was well documented last year. Although the product got off to a fast start, sales have recently softened. Because of this slowdown, the company cautioned that Q2 earnings growth would likely be less than 10%. (Expectations for full-year earnings growth remain above 20%.)
Over at Warner-Lambert, once promising diabetes drug Rezulin was eclipsed by new competition that has less severe side effects. Due to serious liver problems in some patients, Rezulin has been relegated to being a second-line treatment against the disease, which will likely result in lower sales in upcoming quarters. Instead of being a billion-dollar plus drug, Rezulin will probably only have modest future sales. Strong results from Lipitor, a cholesterol-reducing drug jointly marketed by Pfizer and Warner-Lambert, should help keep the company humming with 29% earnings growth for the year, but the fact that Rezulin will not buoy future revenue sent many investors looking for other opportunities.
Merck, the largest U.S.-based pharmaceutical firm, is also facing company-specific problems. Investors are concerned about the loss of patent protection on major drugs with nearly $5 billion in annual sales. Next year, the company loses protection on high blood pressure drug Vasotec and ulcer treatment Pepcid. The following year, Mevacor, a cholesterol fighter, and high blood pressure drug Prinivil could also face generic competition. Merck believes recently introduced drugs like painkiller Vioxx, osteoporosis treatment Fosamax, and asthma treatment Singulair will offset reduced revenues from the drugs losing their patent protection.
Compounding concern about issues at individual companies, the Clinton administration has cast a pall over the industry by proposing that Medicare help pay for prescription drug benefits. Although common sense suggests this additional coverage would be good for drug companies by expanding the number of patients who could afford treatments, the reality is that many people fear this proposal could be the precursor to some type of governmental price controls. If that were to be the case, drug companies would face margin pressures as prices contract. Given the business model of drug companies, however, some of the margin reduction could be offset by lower research and development spending.
Not all drug sectors were weak in the first half of the year. Some of the biotechnology companies with major new products, like Biogen (Nasdaq: BGEN) and Immunex (Nasdaq: IMNX), scored big during the first half of the year. Strong sales from Biogen's Multiple Sclerosis drug Avonex, as well as high hopes for compounds in the company's research pipeline, drove the stock up 55%. New interest in Immunex, sparked by terrific sales for its arthritis drug Enbrel, caused the stock price to double between December and June. The many years and hundreds of millions of dollars invested in biotech research appear finally to be reaping some substantial rewards. Pharmaceutical companies should benefit from the biotechnology revolution, as most of them incorporate the technology in their research and development programs.
The downturn in traditional pharmaceutical company stocks probably doesn't signal the end to their status as premier companies for growth investors. Their long, well-documented track record of providing substantial earnings growth will likely continue as new discoveries open up new market opportunities. Investors will invariably face temporary bumps in the road caused by diffuse issues like political bickering or research disappointments, but the aging population and increased sophistication of medical research bodes well for the future. Long-term investors are usually provided a tremendous buying opportunity when such a high quality sector falls out of favor.
-- Talk About: Merck Pfizer Abbott Bristol Myers Eli Lilly Schering-Plough Warner Lambert Immunex Biogen
-- Learning About Warner-Lambert -- 7/16/99
-- Acquisitive Abbott Labs -- 07/09/99
-- Biogen Earnings Soar -- 07/09/99
-- Abbott to Acquire Alza -- 06/22/99
-- Biotech Big Boy Biogen -- 06/18/99
-- Pfizer Flops on Fatal Fed Restriction -- 06/10/99
-- Pfizer Warns About Trovan -- 05/27/99
-- Merck Wins FDA Approval -- 03/16/99
-- Biogen Daily Double -- 03/15/99
-- Biotech Brouhaha -- 02/02/99
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