Sector Analysis
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What's the prognosis for drug stocks?

Sector analysis » Drug stocks have been sickly. Time to buy?

The pharmaceutical industry is at the center of many major issues facing society -- everything from health care reform to aging baby boomers headed into retirement. Yet, their shares have taken a pounding in recent years. For some investors, that suggests tough times ahead. For others, it may mean a buying opportunity.

Why it's interesting: Once considered a relatively safe and defensive sector in which to invest, the pharmaceutical sector, sometimes nicknamed Big Pharma, is anything but quiet and predictable today. Several top-selling drugs -- Lipitor, Zyprexa and Plavix among them -- are coming off patent protection in the next couple of years. Analysts say there are few potential blockbusters in the industry's pipelines. "The next couple of years are really tough years for patent expirations, that's the (No. 1) challenge facing the industry," said Patricia Danzon, professor of health care management at the Wharton School at the University of Pennsylvania. "Linked to that are the problems with productivity in (research and development) and bringing in new products to replace the unpatented expiring products. Virtually all the large companies are facing this."

Prescription pill bottle and money

Industry issues: Just 21 new drugs were approved in the U.S. last year, the lowest number since 2007, and the approval process is a notoriously complex regulatory process. Some are cutting expenses by slashing research budgets. There is also a fair amount of mergers and acquisition activity, including large companies buying up emerging biotech players. Still others are diversifying into consumer products, focusing on generic drugs or marketing medical devices.

The industry also faces a major unknown in health care reform.

Restructuring strategies: This year Pfizer announced it would cut its research spending by about 25 percent by 2012, including closing the English laboratory that developed Viagra. It's cutting expenses as a hedge against revenue shortfalls when its $11 billion cholesterol drug, Lipitor, goes off patent. Abbott Labs recently said it would eliminate 1,900 jobs, and GlaxoSmithKline and AstraZeneca are exiting noncore businesses. "These decisions reflect the fundamental changes taking place in the industry," says John Kimberly, a management professor at the Wharton School. "It's a moment of transition for the industry; it's a fascinating time."

How to get into the market: Investors buying individual stocks have choices of large pharmaceutical companies that make and market brand-name drugs. Larger, more diversified companies may also sell consumer products. Some companies such as Teva, based in Israel, focus on generic drugs. Smaller players include emerging companies with perhaps just a single promising product in the works, and biotechnology firms.

There are also a number of health care mutual funds, although they generally are a mix of pharmaceutical companies, device makers, hospital companies and insurers. A few exchange-traded funds invest purely in pharmaceutical companies. All the options offer liquidity.

Risks: Stock prices have taken a beating over the last decade, with Pfizer, Merck, Bristol-Myers Squibb and Eli Lilly all down more than 50 percent, mainly over pipeline concerns. New drugs can take 10 years and cost $1 billion or more to get to market. Moody's has a negative outlook on the industry, citing patent expirations and insufficient late-stage pipelines, high regulatory hurdles and global health care austerity measures as reasons to worry.

Rewards: Despite the challenges, many pharmaceutical companies still deliver healthy dividends to investors -- AstraZeneca, Bristol-Myers Squibb and Eli Lilly all pay out a dividend yield above 5 percent, for example. (A dividend yield is the annual dividend divided by the stock price.) Because stock prices have dropped, price-to-earnings ratios, or P/E, are attractive, and Danzon believes pipeline challenges have been priced in. Demographic trends are firmly on the side of the sector, with the first wave of baby boomers now reaching age 65.

Trends to watch for: Merger activity could be on the rise, as pipeline-poor companies look to buy firms with promising drugs, particularly in the biotech space, Kimberly says. The recent $20 billion purchase of Genzyme, a U.S. biotech giant, by France's Sanofi-aventis is an example.

What happens with health care reform is also out there, but its effects aren't really known. An industry fear of price controls is probably unfounded, with a Republican-led House, Danzon says. Also, any negatives of health care reform will likely be countered by the influx of millions of new potential insured customers.

The Obama administration has announced plans to open a billion-dollar government drug development center this fall to help spur drug development and create medicines.

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