Generics Are Catching Up with Big Pharma

Pharmaceutical stocks are often thought of as big, safe, defensive names. With the market as turbulent as ever, we thought it would be a great time to catch up with Jason Napodano, CFA, our senior pharmaceutical analyst.

Jason, as always, thanks for being here.

You bet Mark, thanks for having me.

So we are mid-way through the second quarter. What’s the story with big pharma?

Well, I’d say a whole lot of ebb and flow. Most of the stocks are stuck in sideways trends and have been for the past several years. If you look at three-year charts of some of the biggest names in the industry, including J&J (JNJ), Abbott Labs (ABT), Glaxo (GSK), Eli Lilly (LLY), Bristol (BMY), Wyeth (WYE) and Sanofi-Aventis (SNY), they are virtual overlays of each other.

With the exception of Abbott Labs, one of our only buy-rated names in the group, all of the above stocks are down between 5% and 20% over the past three years. Others, such as Pfizer (PFE), are down even more. Only Merck (MRK) and Abbott have positive three-year charts, and Merck’s stock is down 35% year-to-date, so I wouldn’t necessarily say the stock is out-performing.

Jason, why does big-pharma seem to be stuck in this rut?

It’s pretty simple Mark, revenue growth has slowed due to patent expirations. And, for many of the names I spoke about above, it’s only going to get worse. Last year the industry saw almost $13 billion in lost sales due to loss of exclusivity on blockbuster drugs. That figure should stay about even in 2008, and peak in 2012 when some of the world’s biggest drugs like Pfizer’s Lipitor and Viagra, Bristol and Sanofi’s Plavix, and Merck’s Singular all lose exclusivity.

That makes it difficult for big pharma names to grow their top-line when they could lose as much as $2-3 billion in sales in one year from a key drug going off-patent. In 2005, the industry-wide average top-line growth was 8%. It should slow to 5% in 2008. By 2010, that figure could decline to only 4% year-over-year growth for the industry-wide average. Unless these companies develop some significant new blockbusters, 2012 may show no growth in overall total branded pharmaceutical product sales.

What are some of these companies doing to combat the patent issue?

Well, speaking on an industry-wide basis, most are cutting costs and buying back shares to maintain earnings growth. I’ve been saying for awhile now that big pharma is no longer a growth industry. It’s a mature industry with slowing top-lines and tough new competition from small biotech firms. Brian [Marckx, another Zacks big pharma analyst] and I have been analyzing historical and projected income statements for the largest players in the sector, and we found some interesting trends:

Firstly, product gross margins [PGM] have been extremely stable. The industry-wide average hasn’t changed much since 2005 (77.8%). In 2006 it was 78.0%. Last year the industry-wide average was 77.9%. Brian and I forecast 77.8% for 2008, and then steady at 77.9% through 2012. That means the days of driving earnings growth by improvements in manufacturing scale are over. It also means that price becomes more important. PGMs are what they are, and thanks to small contract manufacturing organizations [CMOs], small biotech can compete with big pharma on price. In fact, most profitable biotech firms have higher PGMs than the industry’s largest players.

Another interesting trend we discovered is that the myth of lower R&D spending is just that – a myth. R&D as a percentage of revenues has been pretty stable at around 16.5% to 17.0% since the boom days of the late 1990s. For both big pharma and biotech, this level of spending on R&D should remain stable through 2012. Pharma companies are spending as much on new product development now as they ever did.

So, if gross margins are stable, and they are still spending about the same level on R&D, where’s all this cost cutting coming from?

It’s coming from Sales, General and Administrative [SG&A], Mark. The industry-wide average SG&A spend earlier in the decade was over 33%. In 2005, it dropped below 32% for the first time since we’ve been tracking the data. Last year (2007) it was only 30.2%. We forecast 29.6% for 2008. By 2012, the industry-wide average is expected to decline to 27.6%.

Many of the industry’s largest players are adding as much as 3-4% year-over-year growth to their bottom-line just by cutting SG&A. As a result, industry-wide pre-tax margins are expanding – from below 30% earlier in the decade, to 32% in 2006, to 33% this year, to potentially as high as 35% by 2012.

Sounds like a textbook definition of a mature industry. You know what I wonder, Jason? Are these guys hurting themselves by cutting costs too much? It would seem to be a slippery-slope.

Mark, you hit the nail right on the head. Ultimately, R&D is the most important figure to track. You never want to invest in a pharmaceutical company that is cutting R&D costs just to make its numbers. R&D is the lifeblood. But it’s getting to the point where big pharma can no longer compete with the innovation and novel discovery platforms being developed by small biotech.

However, it takes a heck of a lot of advertising and promotion to ramp a pharmaceutical product up to blockbuster sales levels. As a pharmaceutical company, you don’t want to lose sight of the fact that you are as much as giant marketing firm as you are a drug discovery firm. This is where big pharma still has an edge. Get yourself too thin and it could come back to bite you in the end.

Jason Napodano, CFA is a senior analyst covering both traditional drug companies and biotechnology firms for Zacks Equity Research.