The Stealth Boom in Big Pharma

by: Brett Korsgaard

According to many analysts, the pharmaceutical industry is chronically ill. Patent expirations are rife in the industry, and that inevitable 'patent cliff' and the waning pipeline of future compounds looms large on the horizon. Doubts about the industry are well documented and this pessimism has certainly been reflected in the respective share prices of "Big Pharma" (a pejorative in many camps) which, over the past decade, has lost significant market cap. The chart below gives a snapshot of the industry's largest players as ranked by market cap. Cheap valuations show the extent to which the industry has lost its marquee as one of the true great industries.

Company Price PE Market Cap Dividend Yield
Johnson & Johnson (NYSE:JNJ) $63.76 15 $173 Billion 3.6%
Pfizer (NYSE:PFE) $17.86 16.6 $141 Billion 4.5%
Novartis (NYSE:NVS) $55.20 13 $133 Billion 3.6%
Glaxo Smith Kline (NYSE:GSK) $41.31 20 $105 Billion 5.0%
Merck (NYSE:MRK) $31.44 33 $96 Billion 4.9%
Sanofi-Aventis (NYSE:SNY) $34.41 14 $92 Billion 3.8%
Abbott Labs (NYSE:ABT) $49.63 15 $77 Billion 3.9%
AstraZeneca (NYSE:AZN) $45.04 7 $61 Billion 3.8%
Eli Lilly (NYSE:LLY) $35.08 8 $38 Billion 5.6%

The above chart also manifests the opportunity for investors choosing to invest in this industry now. While it may be fine and well to speculate on the share prices of companies which offer no yield on real or potential earnings, Big Pharma churns out dividends like no other large industry can. This is something that the schizophrenic biotech industry has had a difficult time mastering-- predictable cash flows and a stable, diversified list of products. Amgen (NASDAQ:AMGN) and Genentech have been best able to model themselves after the better diversified pharmaceutical firms and avoid the “one hit wonder” model that makes investing in biotech such a crap shoot.

The true value of Big Pharma’s approach no longer lies in its ability to extract wonder drugs out of compounds, rather it lies in its ability to effectively monetize its diversifed set of health care assets and create revenue streams in a disciplined and relentless fashion. Many firms now exhibit the stabilizing effect of multiple lines of business including health care oriented consumer products, medical devices or animal health products. Additionally, most of the large pharmaceutical firms have cracked the code of giving their products multiple lives- to wit, look at Pfizer’s (PFE) latest effort to recast Lipitor as a “higher value” drug than the generics. That is a tough sell in my book, yet people will buy it and physicians will prescribe it. There is no industry in the world as great at creating real or perceived demand for a product than the pharmaceutical industry. The market is discounting pharma’s ability to come up with multiple revenue streams to replace an aging product pipeline.

While all the tenacity and R&D money in the world can’t create a blockbuster drug, the ability of pharma to morph into a more flexible, less capital intensive model is a structural trend that the markets appear to be missing. It is the less stable biotech and genomic companies that are increasingly taking the great risks. Big Pharma frequently steps in to make a play or joint venture on the most promising developments to provide adult supervision and assist in pushing the potential drug through the convoluted FDA approval process, so that they can later wield their mastery at distribution and marketing. These tie-ups will likely become more pervasive as they shift the risk onto the more entrepreneurial and freewheeling biotech industry.

Perhaps the greatest factor for a potential boom may be in the rapid appearance of the middle class in emerging markets with the means (and more sophisticated healthcare plans that support pharmaceuticals) to purchase Big Pharma’s wares. Granted, the battle ground in emerging markets will be messy to be sure- the pervasiveness of counterfeit drugs and tough negotiations with non-compliant governments will see to this. The resourcefulness and discipline of Big Pharma is not to be discounted however, and they have been known to outwait a regime and find more complicit partners when the merry go round inevitably turns. Couple this with an aging demographic in the West and you have an industry that Standard & Poor's predicts will grow by 5-7% year. This is very good growth for an industry that is slated to be past its prime and far above the growth of GDP’s in the eurozone and the U.S.

Of course, Wall Street will likely become enamored with the structural growth that Big Pharma enjoys once it navigates the current complicated landscape of patent expirations. A portfolio including a basket of equities from the above matrix would be a welcome addition to most portfolios seeking to benefit from current valuations. Expect PE expansion and rising share prices to ensue when analysts put a higher price on this stable and secular growth story. In the meantime, a juicy dividend yield and an aging demographic await. Not a bad “prognosis” for patient shareholders while the “patients” (Big Pharma) slowly develop their own cure.

Disclosure: I am long PFE, JNJ.