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Strong brand names, patent protection, regulatory approvals, and economies of scale are all key factors in the development and sustainability of a competitive advantage in the drug industry.

Pharmaceutical companies have faced considerable headwinds in the last several years from generic competition, government austerity programs, and US healthcare reform. As debt woes deepen, Western Europe will continue its price cuts in generic and branded drugs and pharmaceutical product revenues will continue to be negatively impacted.

Big Pharma is not without trouble in the USA. It has been estimated that the US health care reform legislation, through the Patient Protection and Affordable Care Act (PPACA), will reduce pharmaceutical industry revenues in 2011 by approximately $400-$450 million and is expected to cost the industry more than $38 billion over 10 years (from FY 2010 to FY 2019). The legislation also mandated a Medicaid rebate increase from 15.1% to 23.1%. In 2013, the income tax deduction for prescription drugs by retirees will be eliminated, which will decrease Medicare part D reimbursements.

That PPACA will reduce 2011 revenues is not speculative as we have seen a slew of companies who have attributed reduced quarterly revenues to the legislation in their quarterly filings. In addition, the industry faces more than $250 billion in patent expirations from now until mid-decade and new product development is unlikely to fill this void.

Why on earth would we want to invest in drug companies under these conditions? We take the contrarian view that the long-term underlying business economics for the pharmaceutical sector are modestly encouraging as an aging baby-boomer generation is now well into their 60's and PPACA will greatly increase the insured population when the coverage mandates go into effect in 2014.

Surprisingly, demand for pharmaceuticals grew by ~3% in 2009, despite the aforementioned challenge and barriers to entry for new market players are formidable.

In addition, an aging population and the fast-spreading obesity epidemic will increase the demand for prescription medicines, particularly those to treat cardiovascular disease, cancer and diabetes. Finally, an expanding middle class in BRIC countries will drive future growth for innovative healthcare companies with global reach and effective emerging market penetration strategies.

Investors can find value by identifying companies with an economic moat that have taken steps to maintain the long-term viability of their competitive advantages. Regulatory approvals, scientific innovation, effective patent life management strategies for marketed products, high switching costs, strong brands, emerging market exposure in addition to a strong pipeline are all critical success factors that will determine the sustainability of competitive advantages for drug companies.

I wrote here about Abbott Laboratories (NYSE:ABT), which I believe to have a wide economic moat and to be trading at a discount to intrinsic value. Based upon its pipelines, emerging market exposure and diversification strategy, I believe that the company is positioned to sustain their competitive advantage for the long-term.

A quick screen of other drug industry stocks (NVS, MRK, ABT, JNJ, LLY) shows moderately attractive valuation and very attractive dividend yields (click to enlarge image):

All of these companies have held up well during a tough 3-5 year economic period with most achieving growth of revenues and earnings. Return on equity in the 18-27% range is an indicator of a strong franchise and a durable competitive advantage for these companies.

Further research is needed to examine the 0-5 year patent exposure, emerging-market strategy, and strength of pipeline. With forward PE and price/book ratios substantially lower than the 5-year averages, along with other indicators of attractive valuation, these stocks are a good starting point for further research for value and dividend-oriented investors.

Source: Finding Value And Defense In Big Pharma Stocks