Can Derivatives Cure Drug Stocks?

Finally, the profitability of pharmaceuticals is dependent on a set of legal monopolies in the form of patent protection. As the U.S. government showed when it threatened Bayer (BAY Quote) with loss of patent protection for Cipro in the anthrax episodes of 2001, those protections can be confiscated.

As an aside, has anyone ever been brought to justice for those anthrax murders?

A Bundle of Options

A third industrial parallel for the pharmaceutical industry can be found with natural resource exploration and production. Each winner has to pay for as many as 20 losers, a daunting proposition. It is a small wonder indeed why firms in this industry spend as much time as they do in wringing out the profits from their few winners and developing me-too drugs.

Viewed in option terms, an investor in a pharmaceutical firm owns two cash flow streams. The first is the existing revenue from current products, all of which have known patent expiration dates. The second is a prospective cash flow stream from a bundle of out-of-the-money calls. An out-of-the-money call has a low probability of payoff, but a very high return when it does pay off; think of the rewards for buying puts on stock indices before a market meltdown.

The discounted cash flow stream from the ongoing business can be valued reasonably well, but as both the Vioxx and Celebrex cases have shown, even the revenue from existing products can disappear overnight and be replaced by mounting legal bills from the inevitable lawsuits.

The portfolio of call options is another matter altogether. Industry analysts, like the Kremlinologists of old and the Federal Reserve watchers of today, track the ongoing progress of clinical trials and try to navigate the labyrinth of the Food and Drug Administration's approval process. The end results of these efforts are mixed, as the wide distribution of returns for the S&P Pharmaceutical index demonstrates. Investors who dream of sugarplums on whether these out-of-the-money call options will reward them often wake up to find that they've bought a pig in a poke instead.