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Sector Spotlight: No Slowdown in Sickness, So Drugs Will Prove Steady Earners

Three cheers for the drugs.

In an otherwise gloomy market, most pharmaceutical companies will roll out heaping plates of double-digit earnings growth when they serve up first-quarter results, beginning next week.

The tech sector is in the dumps, dragging most of the economy with it. But recession or not, people still get sick and their doctors still prescribe drugs by the fistful. That makes the drug sector among the steadiest earnings performers. Looming in the shadows, however, is an increasingly difficult fight to stave off patent expirations for a large number of billion-dollar drugs.

"The fundamentals for the drug sector are strong," says David Saks, portfolio manager of the SG Medscience fund. "Earnings are not going to be spectacular, I expect to see growth of 10% to 11%, but that sure beats all the forecasts of doom and gloom in technology."

On average, pharmaceutical firms are expected to post 12% earnings growth in the first quarter over the same quarter last year. This compares to an 8% drop in earnings for the broader S&P 500 compared with the year-ago quarter, according to Chuck Hill, research director at Thomson Financial/First Call.

The news won't all be rosy. Schering-Plough (SGP), plagued by manufacturing problems, has already warned that first-quarter earnings will be off by as much as 15%, compared with the same quarter last year. And longer term, big drug companies face the stiffest challenge yet from generic drug makers and their supporters over the tactics used to delay the expiration of valuable drug patents. At stake is tens of billions of dollars in sales of some of the most heavily prescribed drugs on the market.

But first, a quick take on what investors can expect from first-quarter results.

Pfizer (PFE), the largest drug firm in the U.S., is expected to post earnings growth of 24% over the year-ago quarter to 31 cents per share, making it the strongest performer in the drug sector. Barbara Ryan, analyst with Deutsche Banc Alex. Brown, sees sales of Lipitor, the company's cholesterol drug, reaching $1.4 billion in the quarter, up 27% from 2000's first quarter. Ryan has a market perform rating on Pfizer and her firm hasn't done banking for the company.

Pharmacia (PHA) is expected to rack up 18.5% earnings growth from the first quarter of last year to 32 cents per share. Sales of the arthritis drug Celebrex should rise almost 23% compared with the year-ago quarter to $645 million, according to Ryan, who rates the company a buy. But sales will be down compared with the previous quarter due to increased wholesaler buying late last year before a price increase.

Wall Street is expecting American Home Products (AHP) and Eli Lilly (LLY) to post earnings growth of about 15% over the same quarter last year. American Home will be led by strong sales of drugs like its antidepressant Effexor. Sales of Zyprexa, Lilly's antipsychotic drug, should meet expectations, but a slowdown could come over the next several quarters because Pfizer is set to launch a competing drug dubbed Geodon.

Both Bristol-Myers Squibb (BMY) and Merck (MRK) should post 11% earnings gains compared with the same quarter last year, according to Wall Street expectations.

Schering-Plough will be the only major disappointment. After a February warning, Wall Street expects the drug maker to earn 36 cents per share in the first quarter, about 15% below the year-ago quarter. Sales of the allergy drug Claritin are slowing, and the company's manufacturing problems have led to shortages in several of its dermatology and inhaled respiratory drugs.

Jeffrey Chaffkin, drug analyst at UBS Warburg, says the key to getting Schering-Plough back on track is final approval for Clarinex, the company's successor drug to Claritin, which faces a loss of patent protection in December 2002. But U.S. drug regulators have delayed approval of Clarinex, partly because of the company's manufacturing problems. This spring's allergy season is already here, and approval before the fall allergy season is unlikely, he says. (Chaffkin has a buy rating on Schering, and his firm hasn't done banking for the company.)

Investors looking beyond the first quarter see a mixed bag for drug stocks in the quarters ahead. Several companies have strong pipelines of new drugs that will fuel earnings growth, while others are vulnerable to slowing sales because of looming patent expirations. When drug patents expire, generic drug makers rush in to sell their own versions, pushing prices down as much as 80%.

Drug Patent Sunsets
2000 U.S. sales (in thousands) Maker Patent expiration
Prilosec $4,653,581 Astrazeneca 2001
Zocor 2,804,063 Merck 2005
Prozac 2,670,773 Eli Lilly 2001
Glucophage 1,808,289 Bristol-Myers expired
Claritin 1,692,444 Schering-Plough 2002-2004
Pravachol 1,312,806 Bristol-Myers 2005
Taxol Semi-Syn 803,268 Bristol-Myers expired
Buspar 760,060 Bristol-Myers expired
Claritin-D 24HR 449,160 Schering-Plough 2002-2004
Claritin-D 12HR 358,788 Schering-Plough 2002-2004
Source: IMS HEALTH, TheStreet.com research. U.S. data only.

"Within the drug group, investors need to look for companies that have the deepest pipeline of new drugs and the least exposure to generic competition," says portfolio manager Saks. "Every drug company has issues, but Pfizer and Pharmacia are in the best position, while Bristol-Myers and Eli Lilly are going to come under pressure." (Saks is long Pfizer and Pharmacia and has no position in Lilly or Bristol-Myers.)

Eli Lilly is a good case study for what happens to drug makers when their best sellers go generic. The company loses patent protection for the antidepressant drug Prozac in August, and generic drug makers like Barr Laboratories are already lined up.

"This means problems for Lilly," says Richard Evans, drug analyst with Sanford Bernstein. Evans rates Lilly an underperform and his firm doesn't do investment banking.

By Evans' estimates, Lilly will report flat to negative growth starting in the third quarter of this year and extending into the second quarter of 2002 because of slumping Prozac sales. And just how bad will Prozac sales fall? Evans predicts that the drug, which reaped Lilly $2.5 billion in 2000 sales, will fall to $1.8 billion in 2001 and $500 million in 2002.

Pfizer, on the other hand, doesn't face looming patent threats and its existing menu of drugs continues to sell strongly. Better yet, the pipeline of new drugs looks golden. Geodon, a new antianxiety drug just hitting the market, has the potential to hit $1 billion in annual U.S. sales, observers say. And on April 11, Pfizer inked a marketing pact with a German pharmaceutical firm to co-market the experimental drug Spiriva, which fights chronic bronchitis and emphysema. Sales of Spiriva could also reach peak annual U.S. sales of $1 billion once the drug is approved for sale next year.

Over the years, big drug companies have resorted to all kinds of maneuvers to delay patent expiration, including expanding a drug's use into the pediatric market or filing for new patents on old drugs at the last minute. But in recent months, many of these strategies have backfired.

Last year, Bristol-Myers filed last-minute patents for Buspar, seeking to protect its $700 million antianxiety drug franchise. But generic firms like Mylan Pharmaceuticals took Bristol-Myers to court and won. And last week, a coalition of consumer groups filed a class-action lawsuit against Bristol-Myers, alleging that the drug company's Buspar tactics were illegal.

Government regulators, led by the U.S. Federal Trade Commission, are also investigating drug companies like Schering-Plough, alleging that questionable delay tactics used to stave off generic drugs are artificially inflating drug prices and harming consumers.

"Drug companies are politically susceptible these days," says Evans. "Actions taken by companies like Bristol prove to many people that existing legislation is being abused and must be changed. And when you add in the attention being given to pricing for AIDS drugs in Africa, you create a political environment that is apt to give less protection to big drug companies, not more."

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