You might think Big Pharma stocks such as Pfizer (NYSE:PFE), Eli Lilly (NYSE:LLY), and Merck (NYSE:MRK) are cheap and due for a rebound. After all, as a group, pharmaceuticals are trading on awfully low price-to-earnings multiples. A glance at the historical trading patterns shows they haven't been down so low since the mid-1990s. Chart watchers, no doubt, will tell you that drug companies are a good bet at these levels.
But Fools take note: Drug stocks ain't what they used to be. There is a good reason why drug stocks are down so low. They are riskier than ever, and it's hard to fathom how these stocks can promise the same kind of predictable earnings growth they delivered in days gone by. Higher risks mean that drug stocks could stay stuck in a holding pattern for some time.
Riskier business
Take Pfizer -- by all accounts the premier pharmaceuticals stock. It hasn't seen a forward P/E below 16 in the past five years. No surprises there: For five years running, Pfizer pumped out fairly predictable, steady annual earnings growth of about 16%. So, trading down at 16 times, it looks like a bargain.
But look around. Big changes affecting the drug industry make Pfizer a much riskier proposition these days. Skyrocketing costs, intensifying competition, and the looming specter of more government intervention mean that Pfizer shareholders have fewer reasons to feel confident about the company repeating its earnings growth of the past.
What are some of the new barriers to the upside?
For starters, there's competition, which is fiercer than drug makers have seen before. The days when Pfizer and others could launch blockbuster drugs into rival-free markets are long gone.
To get a sense of the competition, consider one of Pfizer's most promising opportunities: the market for statin drugs that remedy arterial cholesterol, a major cause of heart disease. It's huge, with more than $15 billion in sales, but the competition is downright brutal. Pfizer's Lipitor is the market gorilla. But Vytorin, a joint effort of Merck and Schering-Plough (NYSE:SGP), newly approved, is expected to grab a chunk of Lipitor sales. Both will duke it out with Crestor from AstraZeneca (NYSE:AZN).
Pfizer hopes that Torcetrapib, its new drug designed around high-density lipoprotein (HDL), or "good cholesterol," will move from phase 2 trials to win FDA approval by 2007. Of course, Torcetrapib isn't alone in the development race. Merck is developing an HDL-raising pill in the early stages of testing. Eli Lilly and Ligand have a drug in testing that flips a master switch in cells, raising HDL. Then there's Japan Tobacco, with its own version in the pipeline. It shouldn't come as a surprise that Pfizer warned its sales would be disappointing this year because of weaker demand for some of its products.
The competition doesn't end there. Generic versions of Merck and Johnson & Johnson's (NYSE:JNJ) original cholesterol-lowering drug, Mevacor -- and even a possible over-the-counter version of that product -- mean that making money off of these drugs will get even tougher as prices plummet. Across the board, drug companies are more exposed to revenue damage from patent expirations and the rising threat of generics. Bristol-Myer Squibb's (NYSE:BMY) statin drug Pravachol and Merck's Zocor are due to expire in 2006.
Then there's the cost of developing a best-selling, blockbuster drug. It's soaring. Finding a molecular compound, fine-tuning it in the lab, clearing clinical trials and FDA approval hurdles, and then marketing it to doctors and patients now starts at about a billion dollars. Pfizer has already thrown $800 million at Torcetrapib -- and that drug has yet to pass phase 3 trials. With costs going through the roof, it's tougher for Pfizer and its competitors to keep churning out enough new drugs needed to grow sales and earnings at the pace investors have come to expect.
Big Pharma also has big business and managed care companies to contend with. Large corporations are getting together to try to squeeze lower prescription drug prices from the largest drug makers. Managed care companies, big purchasers of pharmaceuticals, have gained enormous clout.
You can't ignore the political risk. More than ever before, drugs are in the political spotlight. Many U.S. voters want cheaper drugs, which means that state and federal legislators and perhaps the president will be set on laws to meet these demands but threaten the profits of Pfizer and the drug industry. Re-importation of cheaper drugs, particularly from Canada, could threaten the value of U.S. prescription drug sales, particularly if a measure currently under discussion in the Senate is passed, legalizing the currently prohibited trade. At the same time, it's not hard to imagine laws that lift restrictions on the U.S. government -- the biggest buyer of drugs -- to negotiate lower drug prices from Big Pharma.
Think twice
Let go of the notion that big pharmaceuticals are reliable producers of steady earnings growth through both good times and bad. The days are over when investing in Big Pharma was like printing money. The dependable growth that investors have come to expect from drug stocks is less dependable. Ignore those charts that say the only way is up for drug companies. Fundamental industry change, and the risk it creates, suggests that drug stocks won't get unstuck from the doldrums anytime soon.
For more Foolish coverage of the pharmaceutical industry, read:
- Discount Pharmacy, by Ben McClure
- Diagnosing Pfizer, by Roger Nusbaum
- Pfizer's Fight, by Alyce Lomax
- Will Lipitor's Certification Boost Pfizer? and Will Cholesterol Drug Pack a Punch?, by Brian Gorman
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Fool contributor Ben McClure hails from the Great White North. He doesn't own any companies mentioned here. The Motley Fool has a disclosure policy .
