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5 reasons drug stocks aren't worth what they were
Normally, Pfizer, Merck and the like are a good defense in a volatile market. Not this year. Here's why I think they should sell at lower prices.
By Jim Jubak
Just when you think drug stocks should be perking up, theyre headed back to sick bay with a bad case of the blahs.
From May 4 through June 4, for example, Pfizer (PFE, news, msgs) was down 2%, while Eli Lilly (LLY, news, msgs) was flat, and Merck (MRK, news, msgs) climbed 2%.
The performance is all the more a mystery because this market is just about tailor-made for drug stocks. In a volatile, uncertain, fear-ridden stock market, investors historically flock to the rock-solid earnings growth and dividend yields of the drug stocks.
In fact, drug stocks are behaving so contrary to history right now that I think its worth considering the possibility that history itself is broken. I dont mean in any kind of Terry Pratchett/quantum physics kind of way, mind you, but just the possibility that drug stocks are riskier than they used to be. If thats the case, then these stocks should trade at lower valuations now and going forward than they have in the past.
Skeptical? Well, lets focus on Pfizer to see how my theory tests. In my opinion, this is the best stock to own in the drug group.
Start with current valuations. Drug stocks as a whole certainly arent expensive on a historical basis. The group trades at just 18.5 times projected 2004 earnings per share. And names such as Pfizer are even cheaper. Earnings, according to Friedman, Billings, Ramsey & Co., will grow at an average annual rate of 16% a year from 2003 through 2007, but Pfizer trades at just 17 times projected 2004 earnings.
Raging buy, no? After all, historically, were getting near some pretty impressive lows: Pfizers low price-to-earnings ratio for the last five years is 16.4. Looking at history, Pfizer hasnt finished a year with a price-to earnings ratio in the teens since the 16.1 of 1994. And remember that Wall Street is projecting that Pfizer will grow earnings by 21% in 2004.
But the stock isnt a raging buy if the risk that Pfizer wont meet those projections is higher than in the past.
I think theres good reason -- actually five good reasons -- to believe that current risk at Pfizer (and for much of the rest of the drug sector, for that matter) is higher now than in the past.
Pipeline competition is more intense. Blockbuster drugs cant count on having the field to themselves for very long. Take Pfizers newest potential blockbuster drug, torcetrapib. Torcetrapib belongs to an entirely new class of drugs known as CETP inhibitors that are effective in raising HDL, the good cholesterol.
Pfizer and others believe that raising good cholesterol saves lives. Pfizer plans to use the argument when it files for approval for torcetrapib with the Food & Drug Administration when it files for approval in late 2006 or early 2007. If Pfizer wins approval for the drug and then can combine it with its existing Lipitor drug that lowers LDL or bad cholesterol, then the company will be able to extend the life of its Lipitor franchise. Plus, it can take huge chunks of market share from Mercks Zocor and AstraZeneca (AZN, news, msgs)s Crestor drugs. But competition for torcetrapib isnt far behind. Japan Tobacco has a drug, JTT-705, that also raises good cholesterol. The drug is now in Phase II trials, and Japan Tobacco is now shopping the drug to potential partners because the tobacco company doesnt have the capacity to develop the drug on its own.
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The cost of developing a drug has soared. Developing a drug from scratch now costs about $800 million. About 90% of all promising drug compounds fail at some point on the way to market. In 2003, for example, Merck dropped four drugs in development, including two in Phase 3 trials, the last step before a drug goes to the Food & Drug Administration for approval. Some Wall Street analysts had pegged these as potential blockbusters. This high attrition rate means that the few successes almost have to reach blockbuster status to make the research, development and marketing effort pay off.
Sometimes, the drug industry sounds a little too much like the blockbuster-fixated movie industry. That comparison isnt meant as a compliment. Take Pfizers bet on torcetrapib. The company has budgeted a huge $800 million just for the human tests of the drug. Thats because the company is making the high risk bet that torcetrapib could restructure the whole market for cholesterol drugs. Theres no doubt that torcetrapib raises levels of good HDL cholesterol, but theres very little clinical evidence that raising HDL offers a significant health benefit. To get Food & Drug Administration approval, Pfizer will have to do the kind of long-term studies of patient health that run up a huge bill very quickly. If the bet pays off, Pfizer will have the drug industry equivalent of Lord of the Rings. If not, think The Hulk or Van Helsing.
Demographics have become a two-edged sword for the drug companies. An aging U.S. population has meant rising drug consumption, and that has been good for drug company sales and for the prices of drug company stocks. Think how often youve heard the argument that buying drug stocks was the best way to profit from the aging of the baby boom generation. But health-care costs have now hit the point where current trends are clearly not sustainable. Costs for the largest piece of Medicare, hospitalization insurance, will exceed the programs income from taxes, gains on trust assets and consumer premiums by 2018.
Drug prices are an easy target for politicians looking to fix the system. Lets say youre a reasonably dedicated politician looking to control government spending on health care because you know the current system is in trouble. So you propose:- Limits on the number of voters who can get care under government programs.
- Limiting the amount of care each voter gets.
- Cutting the profits of drug companies.
The drug companies managed to put off the day of reckoning in the bill that passed the Medicare drug benefit. But a majority of U.S. voters are in favor of allowing the government to negotiate lower drug prices, a practice banned in the Medicare drug legislation. So its unlikely that the drug industry wont have to give up some ground -- legalizing the importation of cheaper foreign drugs and greater emphasis on generics, for example -- by 2006, when the government share of the U.S. drug market will rise to 50%. The final step could well be congressional repeal of the language that currently bans government negotiation to lower drug prices.
Dont sell; just be sure of the risk
So what does all this mean to you as an investor?
Its doesnt mean that you should go out and sell all your drug stocks and never buy another drug share.
It does mean that you should take another look at your expectations for returns from these stocks and make sure that youre prepared for more risk in these shares in the future.
Let me show you how these five risk factors play out with Pfizer.
Remember the bullish case from Friedman, Billings, Ramsey that I mentioned at the start of this piece? According to Friedman, Billings investment research, Pfizer will grow earnings per share at an annual average of 16% a year from 2003 through 2007.
Today, you can also find solid Wall Street analysts who believe that by 2007 Pfizers organic growth -- that is, growth before any future acquisitions -- will have dropped to zero.
A range of difference of opinion that big is highly unusual for a drug stock, history says, especially for an industry-leading drug stock like Pfizer. All things being equal, the greater the difference in the bull and bear cases, the riskier the stock.
You can find that increased risk in analyst estimates for 2004 and 2005 earnings, too. For 2004, the consensus estimate is $2.12 a share, or growth of 21.4%. The high estimate at $2.15 means growth of 22.9%; the low at $2.07 equals a still-very-respectable 18.3% growth. Paying the current multiple for even that worst case 18.3% growth seems reasonable.
But go out a year further, and the spread of opinions widens. (Thats typical of projections as they get further away in time, but the degree of the change in the spread is unusually large for this sector right now.) The consensus is for just 11% growth with a high of 17% and an actual decline of 2.8% at the low end. Todays multiple isnt reasonable for a stock thats looking at falling earnings per share in 2005.
These are all estimates, and each and every one of them could be wrong. Myself, I believe that the estimate of zero organic growth in 2007 is wrong and that something like 11% average annual growth for 2003-2007 is about right. If that is correct, then I still want to hold Pfizer for the long-term.
At the same time, I do have to recognize the possibility that drug stocks wont deliver this kind of steady growth is higher than it ever has been. And if that steady growth is less certain, I should pay less for it.
So if youre a long-term investor in Pfizer, I think its reasonable to hold onto the shares. But I would take a pass on adding more until the rhetoric heats up as we go into the November election. If youre a short-term investor, Id take profits here and look to get back in the fall.
In keeping with that, Im keeping Pfizer in the long-term 50 Best Stocks in the World portfolio, but Im removing the buy. Im also selling the shares in the shorter-term Jubaks Picks portfolio.
Changes to Jubak's Picks
Sell Pfizer
Im selling Pfizer (PFE, news, msgs) out of Jubaks Picks, with its 12-to-18 month time horizon. The next six months arent likely to be the most hospitable of periods for drug stocks as drug prices get a lot of attention from politicians in the run-up to Novembers election. With the increase in risk for drug stocks in general that I outlined in my June 8 column, I think its time to give Pfizer a rest and see if the fall brings an opportunity to repurchase at a lower price.
This is a short-term call. Long-term buy-and-hold investors should just hold onto their shares and ride out this period of stagnation. Im selling the position with a 14% loss since I added the stock to Jubaks Picks on Aug. 24, 2001. The last year has been much kinder; the stock has returned more than 18% over that period. (Full disclosure: I will sell my shares of Pfizer three days after this column is posted.)
New developments on past columns
50 Best Stocks in the World
Im removing Pfizer (PFE, news, msgs) from the buy list in my long-term 50 Best Stocks in the World portfolio. The shares are up 18% over the last year, and, with an unfavorable period for drug stocks approaching, I dont think this is the best time to add more shares to long-term positions. Im also removing Citigroup (C, news, msgs) and Johnson & Johnson (JNJ, news, msgs) as buys for reasons of risk of higher interest rates and recent stock appreciation, respectively.
I am, however, adding new buys on Cisco Systems (CSCO, news, msgs), Intel (INTC, news, msgs) and Southwest Airlines (LUV, news, msgs).
With the holdover buys on BP (BP, news, msgs), Charles Schwab (SCH, news, msgs), First Data (FDC, news, msgs), Exxon Mobil (XOM, news, msgs) and Microsoft (MSFT, news, msgs) (parent of MSN Money), that leaves the number of buys in the list at eight. Thats below the maximum of 10 buys allowed at one time and about right for this market, I think. Since the last annual revision of this list (and remember that I only remove and add stocks to the list once a year but change buy recommendations as market conditions warrant) on Sept. 15, 2003, the 50 Best portfolio is up 12.02% versus 8.4% for the Dow Jones industrials ($INDU), 10.61% for the Standard & Poors 500 Index ($INX) and 7.2% for the NASDAQ Composite Index ($COMPX).
10 winning stocks for a stuck-in-a rut market
On June 3, Perus Congress passed a measure to levy a 1% to 3% royalty on mining operations in the country. The rate varies with company sales. So, it looks like Southern Peru Copper (PCU, news, msgs) will wind up in the highest 3% bracket. That royalty is higher than I expected and will cost the company about $25 million a year in after-tax earnings. The news put a stop to the stock's rally of recent days, shares are up 3.9% in the last month, but it is ultimately far less important than the recovery of the copper market from fears that Chinese efforts to restrain runaway growth would lead to a collapse in demand.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: BP, Microsoft, Pfizer and Southern Peru Copper. He does not own short positions in any stock mentioned in this column.
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