Sector Spotlight: Congress May Hand the Pharmaceutical Industry a Downer

The pharmaceutical industry is popping a lot of its own heartburn remedies these days.

After months of political foment over high drug prices, Congress now seems intent on sticking the industry with another challenge -- letting wholesalers import low-cost drugs, a move that could force down some high U.S. drug prices.

The measure passed both the House and Senate last week, but the industry is in overdrive trying to dilute or kill it as it moves to a conference committee. And if past experience is any guide, the industry has a decent chance of success. But behind the rhetoric are a lot of supporters.

And there's a lot to support, as the latest crop of second-quarter earnings demonstrates. Industry heavy-hitters like Bristol-Myers Squibb (BMY) and Eli Lilly (LLY) again displayed an enviable ability to churn out double-digit earnings growth no matter which way the political winds are blowing.

Lots of Lobbying

And while the branded side of the industry faces huge challenges outside the political arena, such as patent expirations and generic competition, it's shown a surprising resiliency in the face of political threats in the past. The death of the Clinton health care reform effort in the early 1990s was partly due to drug industry lobbying.

That's why investors barely blanched when two surprise amendments were added to an Agricultural Department funding bill that would give pharmacists and wholesalers rights to reimport drugs originating in the U.S. in Canada and Mexico. The moves did take some sheen off the stocks, with the Amex Drug Index dropping 9% this month, but it's still 34% up a recent low in March.

And while industry officials railed about the threat of adulterated or counterfeit medications if the measure succeeds, they were positively sanguine to analysts.

"We feel pretty confident that the defects in these bills will become pretty clear," Charles Golden, Eli Lilly's finance director, told analysts last week. The bills "were passed in haste in the heat of the political season," and do "nothing to address the real need to provide a prescription drug benefit to seniors."

Plenty of Confidence

There seems to be good reason for that confidence.

Bristol-Myers, for instance, posted a 15% gain in second-quarter earnings this week, driven by surging sales of diabetes drug Glucophage and cancer drug Taxol. Eli Lilly posted a 17% earnings gain, fueled by diabetes treatments and psychosis drug Zyprexa, despite a 9% sales drop for Prozac, its top seller that faces competition from newer products like Celexa from Forest Labs(FRX).

And odds are that this performance will continue, analysts say, due to the success of new medicines, such as arthritis medicines Celebrex from Pharmacia (PHA) and Vioxx from Merck (MRK). But much depends on how well the drug industry weathers a spate of upcoming patent expirations, which will usher in competition from generic drug makers.

Bristol-Myers, for instance, faces generic competition this year to three major drugs that, combined, generated more than $1 billion in revenue in the second quarter, including Glucophage, Taxol and Buspar, an anxiety treatment. And a potential blockbuster hypertension drug called Vanlev that could have replaced some lost earnings suffered unexpected development setbacks this year, delaying its likely market approval until 2002.

"Bristol-Myers is working through a difficult period of near-term patent expirations and setbacks for its key pipeline product, Vanlev," says a recent Credit Suisse First Boston report. While second-quarter revenue grew by 7%, it would have been only 4% without these products, CSFB notes. (The firm rates the stock hold and hasn't done recent underwriting for Bristol-Myers.)

Expirations Galore

Other companies facing major patent expirations in the next two years include AstraZeneca (AZN) with Prilosec, the world's top-selling drug (expires April 2001), Merck with Mevacor for hypertension (expires June 2001) and Eli Lilly with Prozac (expires 2001).

How well these companies sustain patent expirations is usually contingent on multipronged strategies, which typically include lawsuits against generic competitors and aggressively marketing new or replacement products.

Bristol-Myers, for instance, says it hopes to have approval for Glucovance, a diabetes drug, and Vaniqa, a drug for unwanted female facial hair, in coming months. And Eli Lilly is in late-stage development of R-fluoxetine, a refined version of Prozac.

Growing Older but Not Up

Longer term, the prospects for the industry are bright, driven in part by the graying of America.

"The drug industry is going to do well," says Edward Klebanow, pharmaceutical industry analyst with Argus Research. "Anyone with any sense is going to look at demographics: People are getting older and older people use more drugs."

Furthermore, the industry is on the verge of unlocking genetic causes of diseases that have plagued mankind for millennia. While some will take decades (or forever) to solve, chances are high for some early wins. The drug industry collectively is now targeting some 400 genetic "targets" for new drugs, but as the functions of the 100,000 or so genes are discovered, some 10,000 targets will emerge, industry analysts estimate.

As with any industry, not all new products in development succeed, but failure has a way of unlocking shareholder value by another means: through mergers. While speculation about the prospect of mega-mergers has slowed in recent months since Pfizer (PFE) bought Warner-Lambert earlier this year to create the world's largest drugmaker, it's not being ruled out in an industry that has seen an 11-year spate of such marriages.

Warner-Lambert, which developed Lipitor, the top-selling cholesterol-lowering drug, succumbed to Pfizer's hostile bid after its diabetes drug Rezulin began having problems. The drug was withdrawn this year. Other major failures could prompt more mergers, analysts say.

The industry's success "is being driven by new product flow and increased utilization of medicines," says Jeff Kraws, drug industry analyst with Gruntal & Co. "As long as companies keep coming out with new drugs, it's sustainable."

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