Drug Stocks That Look Immune to Current Woes

Amid the industry's turmoil over patents and pipelines, you can still find winning stocks.
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This market is kicking the stuffing out of the stocks of the big drug companies.

On April 4,

Merck

(MRK) - Get Report

,

Bristol-Myers Squibb

(BMY) - Get Report

and

GlaxoSmithKline

(GSK) - Get Report

all hit new 52-week lows. And

Schering-Plough

(SGP)

just missed, closing above a new low that it hit intraday.

That one-day action is easy to explain, of course. Bristol-Myers warned on that day that its 2002 earnings would be as much as 46% below analyst expectations. The stock plunged 15% in the session, destroying almost $11 billion in market capitalization. And Bristol-Myers took much of the rest of the sector down with it.

But this one-day debacle is part of a longer-term downtrend that's tougher to understand. Even the stocks that didn't make the "new lows" list on April 4 have retreated significantly over the last month:

Eli Lilly

(LLY) - Get Report

is down 4%,

Pfizer

(PFE) - Get Report

down 5%, and

Abbott Laboratories

(ABT) - Get Report

down 7%. And the six-month numbers look even worse overall: Eli Lilly off 5%, Pfizer off 6%, and Merck down 20%.

Defensive Sector No More?

That longer-term downward trend is especially perplexing because uncertainty is supposed to be good for drug stocks. When world events, national economies and individual stock markets make investors nervous, investors usually flock to the dependable earning power of drug stocks, sending share prices climbing. These ol' dependables have let many conservative investors down just when they were needed most. And with uncertainty not banished from the world, many investors are now wondering if they can trust this safe haven in the future.

I believe investors can trust this sector -- or more accurately, certain members of the sector. In fact, I have selected four attractive stocks in the group, which you'll see below. But first, what exactly is going on with drug stocks?

Let's start with recent news out of Bristol-Myers. About half of the earnings shortfall is a result of charges to write down excess inventory. But it's the other half that concerns Wall Street -- and should concern all drug company investors: lower projected sales of several of the company's smaller (though still important) drugs.

Typically when a drug company announces a problem with existing drugs, it talks up its pipeline of future drugs. The silence on this front from Bristol-Myers was deafening. The company did not talk up the prospects for Aripiprazole, its schizophrenia product due near the end of 2002, or Vanlev, a heart disease drug now under review at the Food and Drug Administration. (The company has previously talked about filing two other products with the FDA this year: Atazanavir, an HIV/AIDS drug, and a new antibiotic, Garenoxicin.)

The Street Gets Spooked

The silence spooked analysts. If Bristol-Myers had good news to take the attention off the current earnings problem, it certainly would have announced it, analysts figured. Preliminary clinical results on Vanlev already showed that the drug didn't offer any particular improvement over a Merck drug already on the market. The lack of comment must have meant either that the prospects for sales of the two drugs were extremely modest or, worse, that there was something wrong with one or both of the new drugs.

That may seem like a huge jump of logic -- but it's a reasonable one in this case. Bristol-Myers overpaid, in Wall Street's opinion, to acquire DuPont's drug operations, and then ponied up big-time again for

ImClone's

(IMCL)

cancer drug. Bristol-Myers had indeed bought 20% of ImClone to get the rights to Erbitux, only to see the FDA reject ImClone's drug data on Erbitux.

And Bristol-Myers looks like it could lose a court case over its drug Buspar. The case, which initially centered on the question of whether Bristol-Myers filed a fraudulent patent, has expanded into an antitrust claim with evidence that the company paid potential competitors to stay out of the market.

Put all this together, and Wall Street believes that it's reasonable to conclude that Bristol-Myers is a desperate company with aging products set to go off patent and an almost empty pipeline. Bristol-Myers has been willing to try almost any legal tactic to defend its drug patents and has been willing to pay almost any price to acquire new drugs. But now neither the legal strategies nor the acquisitions seem able to fix the problem, and the company has run out of time. The only thing left, most of Wall Street believes, is for a larger drug company to acquire Bristol-Myers for the value of its existing drugs.

All of this would be just a Bristol-Myers story if the company's problems -- aging drugs coming off patent and less than well-stuffed pipelines -- weren't also worries across the sector.

Patently Challenged

Every major pharmaceutical maker faces patent expiration on best-selling drugs. Eli Lilly's shares have been hammered for a year over fears that generic brands would severely deplete sales of Prozac, its flagship drug. Merck faces patent expirations and generic competition on its blockbuster drugs Pepcid, Mevacor and Vasotec.

And every drug company is worried that its new-drug pipeline might not be filled with enough products to make up for the drugs going off patent. Meantime, they always worry about producing new blockbusters that will fuel the steady 10% to 15% annual earnings growth that investors have come to expect from drug stocks.

That worry is based on a troubling trend: The drug industry has been steadily increasing the amount it spends on research and development, but the increased spending hasn't resulted in a comparable increase in new products.

Merrill Lynch has tracked both numbers: the amount drug companies spend on research and the number of patents they file. (Most new patents don't lead to a marketable drug, but every marketable drug does involve one or more new patents. Thus, the number of patents is a useful indicator of the return on the industry's internal research spending.) Merrill Lynch found that spending on R&D has increased in each of the last six years, but the number of new patents filed peaked in 1999. In 2001, the industry spent almost $16 million per patent; in 1996, the cost was just $9 million. (Merck and

Pharmacia

(PHA)

had the most cost-effective and productive research efforts.

Wyeth

(WYE)

and Schering-Plough trailed the group.)

The drug industry has pursued a two-part response to this problem. First, fight as hard as possible to delay the introduction of effective generic competition to cash-cow patented drugs; and second, boost the internal research effort with outside spending, often by funding the research efforts of multiple biotechnology partners.

Unfortunately, both of these responses have shown major flaws this year.

Losing Legal Ground

It now looks, for example, that the drug companies are steadily losing legal ground in their fight against generics. The Bristol-Myers Buspar case is just one example. A coalition made up of labor unions, state governments and major retailers (such as

Wal-Mart

(WMT) - Get Report

) has succeeded in putting all aspects of the industry's resistance on the legal docket. As in the Bristol-Myers case, the last-minute filing of a patent will now be examined by the courts to see if it constitutes fraud. The courts now seem willing to hear arguments that pricing schemes and marketing payments that delay the introduction of generics may fall under the antitrust statutes. Even drug company advertising of patented drugs with generic competition seems fair game.

The courts are now willing, as the Bristol-Myers' Buspar case again demonstrates, to at least consider assessing sizable monetary damages. Prudential Securities estimates that Bristol-Myers faces damages of better than $1 billion if found guilty in the Buspar case. Prudential concluded in an April 4 research report that "drug company patent extension strategies appeared to be coming under increasing attack and that drug companies were slowly losing legal ground."

This comes just as a number of highly publicized drug-application rejections by the FDA have raised concerns about the ability of the companies' biotechnology partners to fill the pipeline.

Protein Design Labs

(PDLI) - Get Report

, for example, reported disappointing data on its psoriasis drug Zenapax; the FDA denied approval to

Sepracor

(SEPR)

for Soltara, an antiallergy drug; and independent tests of

Dendreon's

(DNDN)

Provenge prostate cancer drug turned out to be inconclusive. Suddenly, the biotech posse that was supposed to ride to the rescue can't seem to shoot straight.

What should you do about this? First, it's important to recognize that, as always, Wall Street overreacts, throwing out good stocks with the bad. The drug industry clearly is facing another wave of consolidation that will shake out or eat up the weak companies.

Four Stocks to Buy

But the strong companies are likely to emerge from this turmoil even stronger. In that group I'd put Merck, still the research champ; Pharmacia, a research powerhouse with the need to buy its way into a bigger share of the U.S. market; Pfizer, the marketing champ and the company most likely to pick off the best products from weaker companies through joint marketing ventures; and

Johnson & Johnson

(NYSE)

, the most broadly based of the major drug companies, with its consumer and medical equipment franchises.

The most intriguing story in the short term is Eli Lilly, which has the strongest near-term pipeline in the industry but a relatively unproductive research effort, according to Merrill Lynch's historical data. The major with the biggest pipeline problem, however, seems to be GlaxoSmithKline -- this is why the company shows up at the top of every list of potential buyers of Bristol-Myers.

Merck, Pharmacia, Pfizer and Johnson & Johnson seem worth holding for the long term. The stocks should do for investors what investors have always wanted drug stocks to do: provide steady reliable double-digit growth year after year. Right now these shares look reasonably priced -- even cheap in the case of Merck -- although they could move lower on more bad news from the weaker members of the sector. Dollar-cost averaging seems an appropriate strategy.

With the other drug stocks -- ranging from Eli Lilly to Wyeth to Bristol-Myers - the ride is likely to be much more volatile than drug stock investors traditionally experience. Buying on bad news, selling on the good. Buying cheaply when a takeout looks likely. Buying to anticipate a new product -- when everyone else has discounted it. Those are the strategies for the rest of the sector, I believe. They don't sound very "drug-stock-like," but I think it's time to realize that the strong and the weak stocks in this sector deserve specialized and very different investment strategies.

Jim Jubak appears Wednesdays on CNBC's "Business Center" at 6 p.m. EST. At the time of publication, he owned or controlled shares the following equities mentioned in this column: Apache, Citigroup, E*Trade Group and Intel.