Drug stocks’ slide a tough pill to swallow

Aspiring presidents can be the Typhoid Marys of pharmaceutical stock prices, and this year could be an especially sickly season for drug companies, according to analysts.

Medicare and other health-care proposals are always talking points, but drug companies are the likely whipping boys of this campaign.

Forget that 1999 fourth-quarter profits over the year before were up about 12% at Merck & Co. Inc. and Johnson & Johnson Co., while Bristol Myers Squibb Co. was up 16%, Eli Lilly & Co. 20% and Pfizer Inc. was higher by 34%. Candidates are playing off of public fears about genetically engineered food and medicine as well as concerns about the high cost of prescription drugs.

Drug companies are easy targets, notes Beth Cariello, a pharmaceutical analyst with Deutsche Banc Alex. Brown in Baltimore. “Whether or not anything happens in health care reform,” she says, “this whole Medicare discussion is going to be front and center, in your face, every day.”

“Drugs are intimately related to all sorts of health programs: managed care, government, private industry, third-party insurance, you name it. For the drug industry, the best thing is the status quo. The less government the better,” says Herman Saftlas, senior pharmaceutical analyst at S&P Equity Group.

What concerns pharmaceutical companies, and their investors, is the prospect of price controls on drugs.

“Government-mandated price controls don’t take into account the risky nature of pharmaceutical research and development,” says Jeff Trewhitt, spokesman for the Pharmaceutical Research and Manufacturers of America, the industry’s principal trade association.

Over the past 15 years, members of Pharma, as the trade group is known, have increased research and development spending from $4 billion to $24 billion. “But with government price controls, there’s no give and take,” says Mr. Trewhitt. “The growing cost of research is not calculated into the equation, and investors know that.”

Mr. Saftlas contends it’s no accident that U.S. drug research is so well-funded compared with other countries. U.S. pharmaceutical houses have a much greater chance of making a buck on their discoveries.

“Among the major nations,” he explains, “it’s the freest drug industry in the world, no question.”

As a result, drug prices are 30% to 100% higher than those in many price-regulated countries, according to the National Center for Policy Analysis.

Drug company profit margins reflect the difference.

Pfizer has boasted an average 19.3% net profit margin over the past five years, while all large pharmaceutical companies have averaged 15.9%.

In contrast, the average profit margin for all S&P 500 firms has been 5.9% over the same time period.

Not surprisingly, drug company stocks on an industry basis are priced at a premium. The industry’s price-to-earnings ratio is 35 compared to 30.9 for the S&P 500.

Moreover, U.S. drug prices have been rising 15% or more annually, well ahead of inflation, according to several surveys.

This has brought calls for Medicare reform and heavy criticism of the drug companies. In the midst of such political heat, some drug stock prices dropped 20% to 30% last year.

The industry and investors fear having to deal with either a state-by-state jumble of price-controlled drugs or a multistate effort to cap prices.

Already, 16 states subsidize low-income drug purchases for the elderly and others are debating even wider programs in which states would band together to force lower drug prices.

Despite a short swing upward in January — a bit over 5%, according to the S&P index of major pharmaceuticals — stock prices have yet to recover from an industrywide fall last year of more than 18%.

Mr. Saftlas expects pharmaceutical houses that are most reliant on Medicare — for instance those with big blood-pressure product lines — to be hardest hit in 2000. These include most of the biggest: Bristol-Myers, Merck, Pfizer and Warner-Lambert.

In the current presidential campaign, Republican candidates have been low-key about Medicare drug coverage. Texas Gov. George W. Bush has said only that the elderly should have access to health plans that cover prescription drugs.

Arizona Sen. John McCain has proposed federal block grants to states to help subsidize the cost of drugs for the low-income elderly.

other side plans more

The Democrats, however, have proposed more far-reaching changes.

Bill Bradley wants to expand health insurance coverage to 95% of Americans through federal subsidies for families with incomes below $50,000.

The money could be used to buy conventional private insurance or insurance through the Federal Employees Health Benefits Program, which is noted for discount pricing and a wide variety of available plans.

Mr. Bradley has also endorsed adding drug coverage to Medicare, particularly for high-cost pharmaceuticals.

Vice President Al Gore has less sweeping goals, though he has endorsed the Clinton administration proposal to add prescription-drug benefits to Medicare. President Clinton himself has also proposed other health care measures, including extending insurance to cover the so-called working poor.

In mid-January, the drug giants changed course on Medicare drug coverage.

Recently, top executives of Merck, Amgen Inc., Johnson & Johnson and Pharma met with congressional and administration leaders to talk peace.

Alan Holmer, Pharma president, said that the industry is committed to drug coverage for seniors and would consider a separate agreement with the White House and Congress on that issue — though the big drug companies had pushed for broader Medicare reform.

Amgen chairman Gordon M. Binder bluntly notes, “If very important people in America say bad things about the industry, that’s harmful to us.”

Leonard Yaffe, the pharmaceutical analyst at Banc of America Securities, says adding drug benefits to Medicare could be a neutral or even slight positive to drug-company bottom lines, an opinion he admits is a minority one among analysts.

“Everyone now agrees that the Medicare drug benefit will be passed and implemented in 2001,” says Mr. Yaffe. “And, it’s our belief that it will be administered by pharmacy benefit plan managers, so there wouldn’t be price controls.”

This means, he says, that while the drug companies would likely be required to sell their drugs at a discounted price, they would also be selling more units. “If you net out those two,” he says, “we think it ends at about neutral.”

Does this mean today’s depressed drug stock prices are a buying opportunity? Many analysts expect more pharma-bashing as the campaign wears on. But Mr. Yaffe expects drug stocks to outperform the general market and to beat the S&P 500 this year.

He was negative on the sector throughout 1999, until he announced a bullish “overweight” rating last November, which still remains.

Meanwhile, Zack’s Investment Research, which tallies an average of the investment recommendations by brokerages, reports the following: American Home Products, moderate buy; Bristol-Myers Squibb, moderate buy; Pharmacia & Upjohn, hold; Merck, moderate buy; Pfizer, moderate buy; Warner Lambert, moderate buy.

“The big pharmaceuticals will hold their own, but I don’t think they’re going to be stellar performers this year,” Mr. Saftlas says.