BOSTON (TheStreet) -- While second-quarter results at the three biggest U.S. drugmakers are expected to be strong, investors might need to take a sedative to prepare for the potential drop in revenue that will happen as patents on money-making medications expire.
, the world's largest pharmaceutical company, could fall by $6 billion annually when it loses patent protection on its blockbuster cholesterol-lowering drug Lipitor, in November. That's 8.6% of its $70 billion of annual sales.
And it may face similar patent protection losses, albeit with lesser revenue hits, when it loses patent rights for three other drugs, including Viagra, by the end of 2012.
, the second-largest drug firm, stands to lose patent rights on the allergy medicine Singulair next year, followed by its diabetes drug Januvia and then its anti-inflammatory drug Remicade.
, the third largest of the group with an $82 billion market valuation, may come out of this industry crisis looking a little better than the others, but it has its own set of challenges.
Drug life cycles are well known, so analysts say the lost revenue has been factored into the companies' performance estimates and share prices. Shares of the major drug makers, which include many more than the top three, have a three-month return of 5% and are up 13% this year, according to Morningstar.
Trevor Polischuk, a member of the management team at OrbiMed Advisors, which is the portfolio manager of the $1.2 billion
Eaton Vance Worldwide Health Sciences Fund
(ETHSX), said "the headwinds the industry is facing are very well known. The biggest is the patent cliff and that's easy to model with 100% certainty. But what's difficult to model out are the sources of upside and innovation that these companies are pursuing. There is a lot of variability."
Losing a big part of your business is a "frightening" prospect, Standard & Poor's pharmaceuticals analyst Herman Saftlas said in an interview. Blockbuster drugs are especially profitable because their development costs have been long paid-off so the revenue goes straight to earnings, he said.
"The true test is next year when sales start to erode" and then it will be seen how these companies' efforts to deal with their problems holds up, he said.
Saftlas cites research from IMS Health that predicts that the global branded drug industry stands to lose $100 billion in revenue from 2011 to 2014, or about 11% of worldwide sales in 2011 as drugs patents expire.
Here's how each company is preparing for the end of critical patents.
The No. 3 big-pharma firm,
,which reported a 50% increase in second-quarter profit Wednesday, has spent $8.5 billion in drug company acquisitions since 2010, helping it to aggressively position itself for future new drug development. Abbott now has a diverse product line of patent-protected drugs, a top-tier diagnostics business, a consumer goods business that sells nutritional products and a medical device unit that sells heart stents.
Adding to its appeal, Abbott's shares look relatively cheap given a forward price-to-earnings ratio of 10.7, versus the S&P 500's 13.7. It also has a hefty, 3.66% dividend yield and its free cash flow has grown steadily over the past five years to $8 billion last year.
The company's revenue growth is another selling point. Its three-year average annual revenue growth is 10.7%, compared to a 2.7% industry average.
Abbott's shares are up 4% in the past three months and 12% on the year.
But Polischuk says Abbott isn't his favorite pick of the big three for several reasons: it trades at a higher valuation than its big-pharma peers, its pipeline and product line is below the industry average according to his analysis, and finally, sales of its anti-inflammatory drug Humira, contributes at least 50% of its profits and its sales are slowing.
But analyst tracked by FactSet give Abbott eight "buys," five "outperforms," nine "holds" and one "sell."
is scheduled to report earnings on Aug. 2 of 59 cents a share and $17 billion of revenue. Last year it reported earnings of 62 cents, excluding some items, on revenue of $ 17.3 billion.
The company said in June that it plans to save $500 million this year and $1 billion in 2012 through dramatic cost cuts, including a $2 billion reduction in research expenses. It also said it's exploring the sale of its animal-health and nutrition units.
Pfizer said it would pass on some of the savings to shareholders by buying back shares. The company's shares are up 17% this year and 44% over the past 12 months.
is expected to report quarterly earnings of 94 cents a share on revenue of $11.8 billion on July 29. A year ago it earned 86 cents excluding merger and restructuring-related costs, on revenue of $11.3 billion.
Merck acquired Schering-Plough in 2009 to bolster its drug offerings and in May it bought Inspire Pharmaceuticals for $430 million, which will expand its pipeline of eye-disease treatments. The company said it plans to increase its research budget to $8.4 billion this year from $8.1 billion in 2010 to speed new drugs through its pipeline.
Merck doesn't face the loss of a blockbuster drug like Lipitor that Pfizer does, Polischuk said, although it faces a series of lesser challenges. But all in all, "we think they have potential new product flows that are underestimated by investors." Merck's shares are up 2.5% this year and 7% over the past 12 months.
Polischuk favors Pfizer and Merck in part because they "are very cheap" as Pfizer has a forward price-to-earnings ratio of 8.8 while Merck's is 9.4, compared to the average 13.7 for the S&P 500. He said that means investors' expectations are extremely low for these companies such that any new drugs or innovations will drive their shares much higher
They also pay big dividends. Pfizer has a projected yield of 3.98%, while Merck's is 4.2%.
Plus, Pfizer has several late-stage products in its pipeline that could begin to make up for the loss of Lipitor and has a new management team that has talked of creating value by breaking the company up, "which we would applaud," said Polischuk, who has a Ph.D. in neuropharmacology and gross human anatomy. "So they're doing a lot of things (that could result) in a potential upside surprise."
"We feel new product flow trumps all ills and creates accelerated revenue and earnings growth (which in turn) causes share prices to go up," concludes Polischuk.
Christopher Davis, a health care funds analyst at Morningstar, said big-pharma stocks are among the top holdings of many mutual funds that stick with the stocks. Some of these investors have to include the stocks to keep their portfolios diverse, while others like their huge dividends, which are very attractive in a low-interest rate environment.
But why their underperformance over the past few years ? "I think in the past five years and even over the past decade, a lot of the big pharmaceuticals have become value stocks while investors have become more growth-oriented," explains Davis.
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