Big Pharma's Next Decade Won't Be Lost

Includes: ABT, BMY, IYH, LLY, MRK, PFE
by: Sebastien Buttet

When macroeconomists coined the words "lost decade", they referred to a prolonged slump in economic activity and poor performance of financial markets of entire countries for ten years or more. Japan had a lost decade from 1990 to 2000 after its housing bubble burst (and a second one between 2000 and 2010 when expansionary monetary and fiscal policies failed to stimulate the economy). The 1980s were a lost decade for many Latin American countries that could not afford to repay their external debt and eventually defaulted on their obligations.

Investors who bought shares of large cap pharmaceutical companies ten years ago fully understand the meaning of "lost decade". To document the lack of performance of big pharma stocks between 2001 and 2011, we ask a simple question. Suppose that you had invested a hypothetical $10,000 in Pfizer (PFE) stock ten years ago, how much would your shares be worth today, assuming that no dividends were ever reinvested?

To answer this question, we have downloaded historical stock prices from Seeking Alpha's database and compared PFEs share price at the open on January 2nd, 2001 to its price on March 1st, 2011 after the market closed. So how much would $10,000 invested in PFE stock ten years ago be worth today? The answer: A pathetic $4,347! This represents a staggering 55% loss in nominal terms. When inflation is factored in, the loss in real terms is closer to 63% assuming an average inflation rate of 2% per year.

In Table 1, we calculate today's value of $10,000 invested ten years ago in four other big pharmaceutical stocks: Bristol-Myers-Squibb (BMY), Merck (MRK), Ely Lilly (LLY), and Abbott Labs (ABT). The results are no better than Pfizer's financial performance with an average loss of 58% once inflation is taken into account. The only company with flat nominal returns is ABT.

Table 1 - Big Pharma Stocks' Performance 2001-2011


Market Price at open on 1/2/01

Market Price at close on 3/1/11

Value of $10,000 invested 10 years ago

Gain/Loss %

Gain/Loss Inflation Adjusted %































What caused the continued price decline is well known and analyzed. First, CEOs chose to deploy large amounts of capital to acquire small biotech firms with promising drugs (usually paying hefty premiums) or alternatively develop new drugs in-house. Both strategies turned out to be largely unproductive as very few drugs with multi-billion dollars sales were developed between 2001 and 2011. Second, many blockbuster drugs' patents are set to expire in the next three years causing depressed sales levels. For example, analysts estimate that Pfizer worldwide sales could fall by $10 billion next year after the patent for its cholesterol drug Lipitor expires this coming November. Finally, although the full impact of Obamacare is not fully understood yet, the balance of power is most likely tilted in Washington's favor, reducing the pricing power of big pharmaceutical companies.

Given the attractive levels at which the stocks trade with forward-looking P/E ratios at historical lows and high dividend yields (see Table 2), managers of value-oriented funds like David Einhorn's Greenlight Capital or David Tepper's Appaloosa are accumulating positions in PFE and the likes.

Big Pharma Stocks - 2011 Forward-Looking P/E and Div. Yield
Stock 2011Forward-Looking P/E Dividend Yield
BMY 12.7 4.84%
MRK 8.7 4.67%
LLY 8.1 4.59%
ABT 10.4 4.0%
PFE 8.9 3.9%

So is it too late for retail investors to put their money to work? And how aggressive should they be? Although investors should always do their homework consciously and review individual stocks' strategic opportunities and financial positions one at a time, we believe that it is not too late to start building a diversified portfolio of large cap pharma stocks. In addition, there is no need to overweight big pharma at this point since the road to recovery will be a lengthy one under most scenarios.

Five considerations motivate our favorable view of the sector:
  1. The patent expiration cliff is already priced into the stocks as reflected in the ultra-low forward-looking P/E ratio (see Table 2). This means that the downside risk is limited, which should appeal to value investors.

  2. Big pharma companies are not going out of business any time soon. Their balance sheets are very clean with large amounts of cash, high interest coverage ratio, and low long-term debt to equity ratio.

  3. Dividend yields are attractive (see Table 2) and investors are getting paid to wait. We advise investors to buy shares to collect dividends rather than to use cheaper LEAP options. Note that the strong free cash flow generation does not guarantee that dividends are 100% safe: Pfizer cut its dividend in half to acquire Wyeth in 2009.

  4. If earnings growth accelerate, multiple expansion will follow. If P/Es reach levels comparable to the overall market around 15, stock prices are poised to go up by 50% or more based on 2011 projected earnings. There is no clear evidence of new blockbuster drugs, although some companies have a strong pipeline. For example, Pfizer is currently developing potential multi-billion dollars drugs for the treatment of rheumatoid arthritis, the prevention of venous thromboembolism, and the treatment of mild to moderate Alzheimer's disease. Earnings growth in the next two years should remain low, however, reflecting depressed sales once patents expire. That is why retail investors are not late to the party and have ample time to accumulate shares.

  5. Finally, large cap pharmaceutical companies have an ace up their sleeves that could unleash value to investors very quickly: They could split themselves up and divest non-core assets. Break-ups have become popular on Wall Street as of late with ITT Industries (ITT), Marathon Oil (MRO), and Fortune Brand's (FO) as examples of recent splits. Abbott Labs has three main business divisions (prescription drugs, nutritionals, and medical device) that are largely unrelated. During Abbott's last conference call, Jami Rubin, a drug analyst at Goldman Sachs argued that Abbott's stock is currently undervalued and could surge by 30% or more should management decide in favor of a company's breakup. The break-up theme was then re-examined in an issue of Barron's, published on February 12th, 2011. Management does not seem to favor the break-up strategy at this junction. Abbott's chairman and CEO Miles D. White acknowledged that there is no current plan for a breakup; rather the company's strategy is to bring valuation at par with S&P's multiple.

Disclosure: I am long ABT, PFE, LLY, MRK.