Pfizer Fb
Source: Pfizer. 

You may not realize it, but there's something pretty substantial going on with the Big Pharma sector, which is comprised of giants like Pfizer (NYSE: PFE), GlaxoSmithKline (NYSE: GSK), and Merck (NYSE: MRK).

Something big is happening
In many instances, over the last month, couple of months, or even a year, short interest in Big Pharma stocks has been on a substantial decline. Short interest measures the number of shares held by short sellers on a month-to-month basis.

Short shares are nothing more than bets placed by traders that a stock is going to decline in value. If a stock drops, short sellers makes money. If a stock rises, they'll be sitting on a loss. What makes short selling riskier than standard buying and selling is that short-selling profits are capped at 100% (a stock can't drop below $0), but losses are technically limitless, because a stock can go up as high as traders take it. But that hasn't stopped traders over the past year from placing some substantial bets against Big Pharma.

However, as you can see below (I've excluded Pfizer from the chart because its huge drop in short interest would make the rest of these moves look like straight lines), two of Big Pharma's heavy hitters have witnessed a substantial decline in short interest -- or, in Merck's case, witnessed the biggest decline in month-over-month short interest in quite some time.

MRK Short Interest Chart

MRK Short Interest data by YCharts.

Why this change is occurring
What's really going on in the Big Pharma sector that's prompting short sellers to pack up their bags and leave? I believe it's actually a confluence of factors.

For starters, Big Pharma is, for the most part, over its patent cliff hump. This isn't to say that we're not going to see blockbuster drugs get eaten alive by generic competition in the coming years. Pfizer's Lyrica, a $5 billion drug, will face generic competition by December 2018, while GlaxoSmithKline's COPD and asthma therapy Advair, which lost patent protection years ago, is widely expected to see half of its $6 billion in sales evaporate by the end of the decade.

Overall, though, we're well past the worst of the patent expirations for a majority of Big Pharma -- and it's been coming through on their bottom line. Pfizer announced in the second quarter that it had delivered its third quarter in a row of operational sales growth, even with the loss of exclusivity on pain therapy Celebrex. Likewise, Merck's 10.5% year-over-year revenue decline looked ugly on the surface, but once currency fluctuations and divestments/acquisitions were removed, Merck actually grew its top line on an apples-to-apples basis. In sum, short sellers have realized Big Pharma's top line really isn't in as bad a shape as they thought.  

But there's more.

Ibrance

Source: Pifizer.

In addition, Big Pharma pipelines have actually delivered, either organically or through an earnings-accretive acquisition.

One of the biggest issues with the patent cliff is that it left Big Pharma companies scrambling to find a way to replace the lost revenue from blockbuster therapies. Although many Big Pharma stocks have very deep pipelines, the chances of them concurrently delivering new therapies to market that could absorb the impact of generic competition was minimal. However, a few years past the peak of the patent cliff we're beginning to see Big Pharma stocks deliver new therapies with blockbuster potential, as well as cushion their top and bottom lines with acquisitions.

Pfizer, for instance, had its metastatic breast cancer therapy Ibrance approved months ahead of schedule in February. The PALOMA-1 study that led to its approval showed a near doubling in progression-free survival and a better than four-month increase in median overall survival. With a half-dozen possible label expansion opportunities (if not more), Ibrance could grow into a $3 billion per year drug for Pfizer.

Breo Ellipta Gsk

Source: GlaxoSmithKline.

GlaxoSmithKline has had no trouble gaining approval for its vast array of next-generation respiratory therapies, Breo Ellipta, Anoro Ellipta, Arnuity Ellipta, and Incruse Ellipta. Breo, the first of its therapies to be approved, is finally beginning to take off after improved coverage by insurers, and following a major educational push of primary care physicians by Glaxo's marketing department. Together, these respiratory products are expected to be the cornerstone of Glaxo's bid to generate $9.5 billion per year from the sale of new products by 2020.

Merck also has a potential big hitter in its pipeline with Keytruda, a cancer immunotherapy that has multi-billion-dollar potential as both a monotherapy and combo therapy. First approved as a treatment for advanced cases of melanoma, Keytruda is on track to make its mark in non-small cell lung cancer, an indication that has seen relatively minimal survival advances over the past decade. 

Transformative acquisitions are another key component. Pfizer's purchase of Hospira will nicely augment its established products portfolio and lead to cost synergies that boost its bottom line. Glaxo's asset swap with Novartis put around $9 billion in its pocket, which is great news if GlaxoSmithKline is on the hunt for an earnings accretive deal or collaboration. And Merck gobbled up Idenix Pharmaceuticals in order to augment and expand its hepatitis C franchise. These transactions (and the potential for more deals) give Big Pharma stocks new pathways to grow their top and bottom lines, and they've clearly caused short-sellers to panic.

PFE Short Interest Chart

PFE Short Interest data by YCharts.

Are Big Pharma stocks now worth buying?
With things seeming to turn around for some of Big Pharma's biggest names, you might be wondering if it's time to buy some, or all, of these names. While it's certainly good news to see pessimism from short sellers abating, I'm not exactly breaking out the champagne for Big Pharma just yet.

One thing to keep in mind is that short covering can push a stock higher, since a short seller needs to buy stock to cancel out a short position. Presumably with short interest on the decline, we've already witnessed a move higher in the share price of some of these names, meaning they may not be as attractive of a deal as you might think.

Secondly, growth for many Big Pharma companies is still quite tempered. Low-single-digit growth has been the norm for many large drug developers dealing with recurring patent loss woes, and it's likely the turnarounds being effected at Pfizer, Merck, and Glaxo are all going to take a few more years to really pay dividends for shareholders-even if they're attractively valued as the following chart of their current P/E ratios demonstrates: 

PFE PE Ratio (Forward) Chart

PFE P/E Ratio (Forward) data by YCharts.

In other words, investors should understand that an investing in Big Pharma could take years to pay dividends. While that's not necessarily a bad thing, it means investors with only long-term horizons should consider investing in these companies.

Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

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