CANADA: Drugmakers are cheap for a reason

. TORONTO, Ontario / Financial Post / July 11, 2009 By Levi Folk, Financial Post On its website, Pfizer Inc. likes to draw attention to Steve A. of New York, who suffered a heart attack at the age of 53 last year. It was a personal wake-up call, one that required a lifestyle change and regular use of the blockbuster cholesterol drug Lipitor. Pfizer, the maker of Lipitor, also depends on the drug, its top seller for more than a decade, but it faces a major problem when Lipitor comes off patent in 2011. It's a problem that is playing out across the drug industry, and there are no quick fixes for what ails these companies. Large-capitalization drug companies in the United States -- Bristol Myers Squibb Co., Eli Lilly & Co., Merck & Co., Pfizer, Schering-Plough Corp. and Wyeth -- are the forbidden fruits of finance over the past decade. Strong cash flows and high dividend yields beguiled investors into buying shares in drug companies in the belief that management would be able to restock their product pipelines before blockbuster drugs came off patent. The problems were far enough out, back in 2003, when the likes of Pfizer first appeared on the radar screens of value investors looking for companies with strong earnings growth and dividends, and low share prices. Fast forward six years and the Dow Jones U. S. pharmaceuticals index has proved to be a value trap. What was cheap is now even cheaper by one-quarter of its value since 2003. "The drug industry is between the proverbial rock and a hard place, as successful efforts to improve nearterm earnings are not being rewarded by investors, who appropriately question their persistency going into the patent cliff period," says Barbara Ryan, a health-care analyst with Deutsche Bank in New York. Merck, a competitor to Pfizer, will see roughly US$10-billion in annual sales run off patent by 2013, exposing the company to generic competition. The fact that companies are taking a "can't beat 'em, then join 'em" approach to business is a sign of desperation. Pfizer entered the generic drug industry this year, buying the rights to sell generic pills outside of its own product pipeline from drugmakers in India. A bigger story is the fact that a number of major drug companies have thrown in the towel and made major acquisitions of competitors this year: Merck announced the US$41-billion purchase of Schering-Plough in March; Pfizer spent US$62-billion acquiring Wyeth just six weeks earlier; and in Europe, Roche Holding AG spent US$45.7-billion on biotech company Genentech Inc. Before considering the economics of these mergers, let's just remember that M&A activity is not a new page in the drug company playbook. Pfizer today is the product of a US$90-billion merger with Warner-Lambert in 2000, followed by a US$60-billion acquisition of Pharmacia in 2002. Today, Pfizer has little to show for all those dollars spent. History tells us that adding scale for the sake of product development simply does not work. Mega-mergers will flatter profits at Pfizer and Merck because they will funnel idle cash into earning assets -- competitor drugs currently on patent, and whatever drips out of their competitor's product pipelines. Moreover, after several rounds of layoffs and restructuring, cost savings will lead to higher earnings in the near term, Ms. Ryan says. That factor, combined with multi-decade low valuations, might make drug companies a nearterm trading opportunity. Yet even that prospect is clouded by a potentially sweeping health-care overhaul bill that is being punted around the U. S. Congress. The entire health-care industry is now in the crosshairs of the U. S. government, which wants to bring universal health-care coverage to a nation beset with the highest per-capita health-care costs in the world. The health-care bill will not pass through Congress without taking a pound of flesh from the drug industry. Recognizing a losing battle when it sees one, in June drug companies announced they would reduce the cost of medicines for the elderly and finance part of President Barack Obama's health-care bill, to the tune of about US$80-billion. For an industry beset with major fundamental problems, drug companies are cheap for a reason. Investors looking for a near-term punt may get a sharp bounce in the pharmaceutical index as earnings rebound over the next couple of quarters. However, that bounce is unlikely to turn into a sustained rise for these companies over the next few years, due to the gravity of the situation. [rc] levi@transmissionmedia.ca © 2009 The National Post Company.