Ratings agencies received a lot of criticism for their handling of debt ratings during the waning days of the housing bubble and the resulting crash-crunch. If Moody's (MCO) recent upgrade of the pharmaceutical sector is any indication, it looks like they may not have improved their timeliness all that much. In fact, investors approaching the Big Pharma sector today aren't likely to find many bargains and may in fact be buying into a somewhat overheated market.
They Were Right Once
It was about one week ago that Moody's came out with its upgrade, moving the sector to "stable" from "negative" after having downgraded the sector in 2007.
To be fair, that original downgrade was a good one - the sector basically peaked in mid-to-late 2006 and saw almost three years of lousy performance before cratering in early 2009. In fact, several Big Pharma stocks (including Sanofi (SNY), Glaxo (GSK), and Lilly (LLY)) are still below those 2006 peaks. Moreover, Moody's had the reason(s) right too - severe pressure to sales from patent expirations on major drugs, insufficient clinical progress to replace those sales internally/organically, and macroeconomic risk.
Sound Reasons For The Upgrade … A While Ago
And now Moody's is basically sounding the "all clear" - saying that the sector is basically through the worst of those patent cliffs. Likewise, the ratings agency has pointed to ongoing threats represented by efforts to limit healthcare spending and the ongoing economic malaise in the U.S. and Europe.
My principal objection has to do with the timing of this upgrade. None of the patent expirations were surprises; investors had known for quite some time that the patents would be expiring and that generic entrants would be sapping the revenue of major drugmakers like Pfizer (PFE), Merck (MRK), and Bristol-Myers (BMY).
What's more, the drug companies were already well along the path of taking reactive measures - shedding large numbers of marketing and R&D professionals, engaging in M&A to better leverage existing infrastructure, and selectively in-licensing or acquiring promising drugs to recharge the pipeline. At the same time, the industry has been pretty successful at lobbying efforts aimed at keeping a relatively protected status for branded prescription drugs.
Said differently, why didn't this upgrade come in 2010 or 2011 when all of these factors were basically known to the equity markets?
Debt And Equity Are Different Games
I do think it is quite relevant to observe that Moody's ratings are aimed at the credit (debt) markets, not the equity market. While equity investors often have to be willing to invest ahead of an actual turn in reported performance, debt investing is a different game altogether; one that doesn't necessarily reward the same sort of risk-seeking behavior.
That said, more than a few stock market sites and analysts have picked up on this upgrade as a referendum on the Big Pharma sector. I think that could be a mistake, at least insofar as many stocks have already enjoyed a rebound and there still meaningful risks to the sector.
For starters, while it is true that the worst of the patent hits are over (though Lilly and AstraZeneca (AZN) still have some fairly sizable risks there), the industry is not exactly brimming with near-term growth prospects. Whether due to conservatism (in the case of Pfizer and Merck) or portfolio mismanagement (Lilly and AstraZeneca), it's not as though sector-wide revenue looks about to go on a tear. Moreover, I believe most of these companies have cut all of the fat they had (and some muscle as well) and may struggle to reproduce past levels of margin leverage without more growth.
And there are ample risks that go just beyond basic business. As FiercePharma recently observed, many Big Pharma companies are seeing unpaid invoices accumulate in their European operations as many countries struggle with their fiscal budgets. That represents a real risk to working capital management, to say nothing of the difficult optics of "greedy drug companies" denying drugs to countries that can't pay. At the same time, there's increasing pushback on pricing in the U.S. and the launch of biosimilars threaten to sap lucrative profit streams from biological drugs.
The Bottom Line
Operationally, I think Pfizer, Merck, Sanofi, and Roche (OTCQX:RHHBY) are arguably in the best shape, with Johnson & Johnson's (JNJ) drug operations also looking much stronger, and a post-split AbbVie (the pharmaceutical side of Abbott Labs (ABT)) more interesting than commonly thought. Likewise, I do think Glaxo's pipeline may well be undervalued today. In fact, my list of "dislikes" is pretty limited - largely just poorly-run Lilly, AstraZeneca (in the beginning of a turnaround), and the always-expensive Novo Nordisk (NVO).
The problem for me is valuation; a lot of these stocks have done quite well this year and there aren't many clear bargains left in the sector. While Pfizer, Roche, Sanofi, and Glaxo still offer reasonable potential for new investors, there just aren't many bargains left. Consequently, Moody's may well be right that the pharma sector is in meaningful better shape now, but enterprising early investors have already picked the low-hanging fruits.