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At my work, I was reading an analyst report on the healthcare sector. The conclusion is that the healthcare sector has not been a very popular area in the last decade, this after a stellar performance in the 1990s. The reasons are now clear: too many ineffective drugs at too high prices. Since the start of 2011, the mood has changed, though, with the new biotech leaders firmly in the driving seat now, helped by new findings on DNA analyses/sequencing and a decade of expensive R&D spending. Demand in emerging markets is growing as well as the occurrence of the typical Western diseases in these areas.

The pharmaceutical industry is currently facing unprecedented change.

These pressures are forcing companies to refocus on ways to increase the productivity of their R&D, and consider streamlining value chain costs, such as the money spent on sales, marketing and manufacturing. The result is an industry in which specialty and niche operators (as opposed to large volume blockbusters) are prized for their potential to reimburse investors.

Activities such as marketing are being streamlined or outsourced, although the ability to manage what remain substantial risks is retained. The exponential increase in the number of mergers and acquisitions is a result of the way pharmaceutical companies assess their business models. The industry continues to grow modestly, while adapting to changes.

Pharmaceutical companies face many challenges and uncertainties, including heightened competition from makers of generic drugs, unprecedented pressure on pricing from payers (such as insurance companies), constraints on public sector budgets and declining R&D productivity. The pressure to reorganize R&D, provide affordable price and marketing overhauls is intense.

However, there are improvements in early-stage product pipelines in the pharmaceutical industry, particularly in the fields of cancer and diabetes, which offer long-term promise. In addition, an aging population and new products are likely to create a robust future for the industry.

Lost Decade

The change in the industry over the last decade has been marked by the decline of the so called 'Big' Pharma companies. While successful in the previous century, as drugs like aspirin, penicillin, blood-pressure drugs, anti-psychotics, tranquilizers and other drugs were introduced, the need for more effective and especially safer drugs became evident. Also the demand for drugs to treat the strong rise of complex diseases like cancer, heart disease, Alzheimer's and diabetes became obvious.

As innovation success started to slow down by the 1990s, many companies turned themselves into 'marketing wizards' with more people employed in the sales and advertising parts of the company than in R&D. New 'formulations' of older drugs were relaunched with all kinds of 'improved' effects elaborated upon in ever more expensive advertising campaigns.

The backlash of this trend is still felt, as large corporations like GlaxoSmithKline (NYSE:GSK) and Pfizer (NYSE:PFE) recently had to pay huge sums to the regulators as fines for their overenthusiastic and highly deceptive efforts. However, stocks such as Merck (NYSE:MRK) and Pfizer are worthy investments which have an interesting dividend yields.

Merck

Prospects for Merck are great again as the pipeline keeps on producing valuable new medicines to compensate for the loss of patents of older drugs. Second quarter numbers show an increase in sales and profits, with net income at $ 3.23 billion or $1.05 per share (was $0.95 per share in Q2 2011). Consensus was $1.01 per share. Revenue rose by 1.3% to $12.31 billion, beating estimates of $12.15 billion. This was down 4% year-over-year, but it was mainly due to the higher USD exchange rate, according to management.

Merck's Consumer Health and Animal Health divisions also did well. New drugs are focused on new biotech molecules to treat HIV (Zolinca), osteoporosis (odanacatib), and Phase 3 drugs are in other settings for odanacatrib plus high cholesterol, insomnia and cancer treatment areas.

Singulair is now facing patent loss starting August 3, and Merck expects that 90% of sales will be lost within 2 months. A winner is the combination of Januvia and Janumet, both ex- Schering Plough drugs, which are used in diabetes type 2 treatment to increase the insulin made by the pancreas and decrease the sugar made by the liver. Sales of this combo are up by 30% to $1.5 billion.

Guidance is kept for an EPS of $3.75 - 3.85 despite the pressures of drugs going off patent this year.

Conclusion

Surprisingly strong numbers show that the Schering Plough acquisition is paying off on the product side. Luck was also involved here, as diabetes care is now all of the sudden the top focus of the Healthcare authorities. This makes the area very profitable for all diabetes drugs and treatment providers on a global scale. Merck is well-positioned here and can compensate for the loss of income from older drugs with new biotech drugs as well.

A good trend and at a PE of 10x 2015 consensus plus a dividend yield of 3.7% expected for 2012 the shares seem to be attractive.

Pfizer

Pfizer reported Earning Per Share some 8 cents above consensus at $0. 62. This is a jump of 25% year-over-year. Overall net income was $4.7 billion. Better than anticipated revenues of $15.06 billion were down by 6% operationally and another 3% on negative currency effects.

The operating margin was much better though at over 82% (+ 220 basis points) on ongoing efficiency measures and sales of older drugs in line with expectations, holding up quite well. Enbrel (rheuma) sales did well at $988 million (+ 8%) as did Prevnar (vaccine for pneumococcal diseases) sales at $916 mln. Lyrica, the pain treatment saw sales rise by 14% to $1.04 billion.

Guidance for 2012 is now reiterated at a revenue range of $58 to 60 billion and EPS of $2.14 - 2.24. Consensus is now at $2.21. Share buybacks of $5 billion planned for 2012 are now at $1.3 billion. Lipitor patent expiration (happened in November 2011) will continue to hit Pfizer hard in the years ahead, but this is anticipated. In Q2 Lipitor sales dropped 53% to $1.22 billion. Pfizer also announced the IPO of 20% of its Animal Health business for the first half of 2013. Existing shareholders are set to receive shares in this new company, to be called Zoetis.

Conclusion

The company had good results, with a nice beat on margins, as cost cutting is taken to the extreme by new CEO Ian Read. The driver now has to become the new drugs portfolio with many promising drugs lined up. Meanwhile, the valuation remains very modest, at 10x 2013, and the dividend remains high, at a 3.7% estimated for 2012. This is a sustainable (and rising) dividend as more shares are bought back.

Pfizer remains a good recovery story with lots of cash to do good acquisitions and sizeable share buybacks. New management is serious about rebuilding the pharma business, selling non-core assets.

Biotechnology

In the biotech field stem cell research has been evolving very well.

Stem cell transplants are used to replace bone marrow that has been destroyed by disease, chemo, or radiation. In some diseases, like leukemia, aplastic anemia, certain inherited blood diseases, and some diseases of the immune system, the stem cells in the bone marrow don't work they way they should. The stem cells can make too few blood cells, too few immune cells, or too many abnormal cells. Any of these problems can cause the body to not have enough normal red blood cells, white blood cells, or platelets.

In some cancers, such as certain leukemias, multiple myeloma, and some lymphomas, a stem cell transplant can be an important part of treatment. It works like this: high doses of chemo or radiation work better than standard doses to kill cancer cells. High doses also cause the bone marrow to completely stop making blood cells, which we need to live. This is where stem cell transplants come in. They can be used to replace the body's source of blood cells after the bone marrow and its stem cells have been destroyed by the treatment. The rescue transplant allows doctors to use much higher doses of chemo or radiation to try to kill all of the cancer cells.

The first successful bone marrow transplant was done in 1968. It was not until nearly 20 years later that stem cells taken from circulating (peripheral) blood were transplanted with success. More recently, doctors have begun using cord blood from the placenta and umbilical cords of newborn babies as another source of stem cells.

Scientists think that stem cell research is important to the future of medicine because with adequate research, stem cells have the potential to treat degenerative conditions by transplanting human stem cells into patients. Presently, many of these chronic conditions have no cure and are managed by treating the symptoms.

While the initial cost of receiving stem cell therapy may be high, it has the potential to outweigh the lifelong costs incurred through daily medications and hospitalizations. With sufficient development of stem cell medicine, chronic diseases such as diabetes, heart disease and Parkinson's disease will be effectively managed.

For example, more than ½ million Americans suffer have their first heart attack every year, resulting in injury to the heart and scarring that contributes to the gradual loss of the heart's pumping strength.Of the 1.5 million heart attacks per year in the U.S., approximately 500,000 result in fatalities. If that number doesn't open your eyes, nearly 14 million Americans have a history of heart attack or angina, and the costs related to heart attacks exceed US$60 billion per year. While stem cell research has not yet proposed an ability to reduce the occurrence of heart attacks, it is believed with refinement of current research, doctors may be able to someday reduce damage to the heart muscles if stem cells are administered after a heart attack.

A company that is on the forefront of stem cell research and stem cell drugs is Osiris Therapeutics (NASDAQ:OSIR). Another stem cell company that could become a breakthrough in the nearby future is NeoStem (NASDAQ:NBS). NeoStem's lead product candidate, AMR-001, for the prevention of major adverse cardiac events following acute myocardial infarction, has completed Phase I clinical trials demonstrating feasibility, safety and biologic activity at a threshold dose. This is the first prospective stem cell trial in myocardial infarction ever conducted that has established a statistically significant relationship between dose and effect.

So also on the stem cell front there are promising things to expect.

Generics

As a result of the high and rising costs of healthcare in all countries with more elderly and middle class patients demanding better care, the need for cheaper drugs became evident. One of the most successful companies in the generic field is Teva Pharmaceuticals (NYSE:TEVA).

Teva Pharmaceuticals

Copaxone generics threat was seen as the main reason for the ongoing negative sentiment around Teva. Now that this has been removed, the mood should turn on Teva. New management (ex BMY) is now in place to reduce the risk of the portfolio by diversifying through stakes in smaller biotech makers, and licensing income should grow as well. This takes the focus away from high levels of M&A activity that Teva has been (successfully though) involved in.

Valuation is very low now (7x 2012 EPS) and cash generation is high. If sentiment can be turned around the stock, a much higher stock price could be the in the making. Teva shares remain very attractive, despite Q2 results were below analyst's forecast.

Source: Is The Healthcare Sector In A Bright Spot?