Opportunities And Weaknesses In The Pharmaceutical Industry
The pharmaceutical industry is entering a period of substantial change in 2009. Most of the names in the industry are facing significant patent challenges in the years to come. U.S.-based firms are facing foreign exchange headwinds, as well. Revenue growth is non-existent, and earnings growth is being driven primarily by mergers, cost-cutting and share buybacks.
Knowing that investors rarely pay-up for this type of manufactured earnings growth, we struggle to see a broad-based out-performance for the large-cap pharmaceutical sector in 2009.
Valuations, however, are attractive, with several of the largest players trading at PEs below 10x, including Pfizer (NYSE:PFE) (7x), Eli Lilly (NYSE:LLY) (8x), Merck (NYSE:MRK) (8x), Sanofi (NYSE:SNY) (7x), AstraZeneca (NYSE:AZN) (7x) and GlaxoSmithKline (NYSE:GSK) (9x) based on our fiscal 2009 estimates. Attractive valuations, along with big dividend yields, should protect investors against significant downside risk even if the economy continues to languish well into the second half of the year.
Additionally, expectations are low. Knowing that most of the companies are not expected to generate significant revenue growth, and that cost-cutting initiatives have generally out-paced guidance and financial modeling, any bit of revenue upside could lead to select out-performance at times during the year.
M&A activity remains the wildcard for investment in the sector. We have already seen three significant deals so far in 2009, with Pfizer’s $62 billion acquisition of Wyeth leading the way. Roche’s $46 billion takeover of Genentech and Merck’s $42 acquisition of Schering-Plough prove that companies are desperately seeking for ways to grow the top-line while cutting-costs all at the same time.
Big pharmaceutical names are keenly aware of their patient situations and turning to deal-making for the answer. Most of the industry’s largest players are sitting on significant cash balances, and Pfizer, Merck, and Roche all proved that capital is available for the top players. We expect more deals to come.
Buy rated names, including Bristol-Myers and Johnson & Johnson, are sitting on $10 billion and $16 billion, respectively. Given the difficult cash-raising environment during the second half of 2008, most small- to mid-sized biotech firms are eager to partner with pharmaceutical companies in 2009.
Asset prices for early-to-mid stage product candidates are very cheap, and pharmaceutical companies are now willing to look at phase I and phase II candidates in 2009 – something most managements have been hesitant to do in the past. This should create a much better environment for the biotech industry to push higher in 2009 as sentiment on smaller names is starting to turn positive.
We have three Buy-rated names within the large-cap space: Bristol-Myers (NYSE:BMY), Johnson & Johnson (NYSE:JNJ) and Abbott Laboratories (NYSE:ABT).
For growth funds, we recommend Bristol and Abbott. Bristol is expected to grow earnings by 12% CAGR through 2012. That’s tops in the industry. Growth is sustainable with a product suite heavy in attractive areas such as biologics, cancer and cardiovascular drugs. The late-stage pipeline includes two very promising candidates: apixaban and saxagliptin – both of which could be blockbusters if approved.
Growth at Abbott is being driven by blockbuster drugs such as Humira for rheumatoid arthritis and the company’s drug-eluting stent, Xience. Abbott has also been highly acquisitive over the past few years, most recently paying $175 million to pick up Ibis Biosciences, a subsidiary of Isis Pharmaceuticals, to enhance the company’s position in molecular diagnostics for infectious disease.
Our top-pick for value focused portfolios is Johnson & Johnson. The company is trading around 1X growth (PE/G) and sitting on $16 billion in cash. Much like Abbott, J&J has been highly acquisitive over the past year, most recently paying $1.1 billion to acquire medical product maker Mentor Corp. in December 2008. We expect that J&J will continue to look for acquisition targets in both pharma and medical devices throughout the year.
The big opportunity to out-perform in 2009 is to own the names that are going to be acquired. We have no crystal ball, but names that certainly look attractive and fit the model for a large pharmaceutical company to gobble them up include Biogen-Idec, Amylin Pharmaceuticals, Vertex Pharmaceuticals, Acorda Therapeutics, Osiris Therapeutics, Auxilium Pharmaceuticals, OSI Pharmaceuticals, and Elan Corp. All of these companies have what big pharma is looking for – novel compounds with potential blockbuster sales levels at reasonable valuations.
Our top-pick for biotech continues to be Biogen-Idec (NASDAQ:BIIB). Rituxan and Avonex continue to dominate the top-line, but with Tysabri expectations significantly lowered and a late-stage pipeline that boasts seven phase III candidates, we think Biogen is set to out-perform expectations in the years to come. Biogen also possess an enormous biologic manufacturing footprint – a key asset that could help attract an interested suitor during the year.
On the small-cap, or riskier front, we would point investors towards Osiris Therapeutics (NASDAQ:OSIR) with its phase III stem cell candidate, Prochymal, and Acorda Therapeutics (NASDAQ:ACOR), with its phase III multiple sclerosis candidate, Fampridine-SR.
We continue to recommend avoiding names that offer little growth or opportunity for a take-out. These include companies developing “me-too” type drugs on hanging on the hopes and prayers of an FDA approval. Now is not the time to be taking on unnecessary risk. The number of new entity approvals was 24 in 2008, up from 18 in 2007, but the number of rejections and delays was also up.
Throughout 2008 it seemed as though just about every FDA action (PDUFA) date was pushed back and delayed. In 2008 we saw our share of surprise rejections and clinical failures as well. Drug development is a risky business; the success rate on new drugs from preclinical to approval is less than 5%.
Stay away from companies that are all ideas and no assets. Above, we discussed some key measures to hang your hat on: cash, dividends, pipelines and strategic assets like biologic manufacturing. If your target company has none of these, now is probably not the best time to roll the dice.
Run from any company looking for money or looking to raise money in the next year. Interest rates on direct financing loans are going to be through the roof, and stock prices are down so big that share offerings will be painfully dilutive. Unless the company is looking to partner with large-cap pharma, expect out-of-cash small-cap biotech to remain out-of-favor.
Above we listed several names that could potentially be taken out by large-cap pharmaceuticals at some point during the year. In contrast, owning the name doing the acquiring is often a sure-fire way to see quick under-performance. Pfizer’s stock dropped by 25% shortly after announcing the Wyeth acquisition. We would be cautious on three names in particular: Sanofi, AstraZeneca and Eli Lilly, as these are the three largest players in the sector that are likely to “go shopping.”