Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Long Term Headwinds for Pharma

|Includes: ABT, CRL, CVD, JNJ, Pfizer Inc. (PFE), PRGO, TEVA

There are long-term structural challenges facing pharmaceutical companies today that are only now beginning to be priced into the stock market.  Of the many challenges already inherent in a business that is primarily priced by the market on the expectations of its pipeline of future products, I would like to focus on long term margin contraction.  Although there is much to celebrate in the future of medical treatment from a patients perspective, the profitability of those advancements is coming under threat of two key factors.  Efforts by cash-strapped European and American governments to control health-care spending will result in the following...

1) higher costs associated with proving the safety of new treatments will result in additional costs for patents pending, as the gov't moves to reduce its reliability for malpractice.

2) the length of time in which new drugs are protected under patent will be put under constant pressure by gov't subsidized health care programs needing to reduce costs in order to stay solvent.

To reiterate: 

it will continue to cost companies more money to develop and seek approval for new treatments. (Costs go up)
those new treatments will face a shortened market cycle in which to recuperate cost. (Sales go down)

margins in the pharma sector will contract over time (P/E multiples contract)

It is in the governments best interest to increase the regulatory standards of approving new treatments to reduce liabilities assumed under gov't provided care and to bring generic drugs to market more quickly to bring down the cost of providing said treatment.

We are already beginning to see this take effect.  Begin by reading the 4Q conference calls of Pfizer (NYSE:PFE) and Johnson and Johnson (NYSE:JNJ).  Pfizer CEO Ian Read is slashing the massive research budget at the world's largest drugmaker to deliver on a 2012 profit forecast and is laying off more than 2,000 researchers and said further steps are likely to shrink Pfizer's operations as it plans for the loss of billions in revenue from drugs whose patents are expiring.  This sentiment was reiterated by Abbott Labs (NYSE:ABT) by its recent announcement to lay off 1,900 employees.  Johnson CEO William C. Weldon said in his conference call that the company has come under heightened regulatory scrutiny due to a series of recalls of its products and also mentioned efforts by governments to control health care spending as contributing factors in the companies recent underperformance.

The net result of this as investor is that large cap pharma companies will most likely see slower growth and reduced margins for their products over time.  We may also project that this trend will substantially benefit contract research organizations (CRO's) such as Covance (NYSE:CVD) and Charles River Labs (NYSE:CRL), as big pharma is forced to outsource its R&D work to specialty shops in order to reduce costs.  Secondly, we must also assume that competition from generics such as Teva (NYSE:TEVA) and Perrigo (NASDAQ:PRGO) will not only continue unabated but will increase over time.  Finally, we may also infer that acquisitions will continue to play the dominant role in large cap pharma's ability to expand its product offerings and drive future growth.  I'm not saying that the drug companies won't have future growth or continue to grow dividends at a healthy rate, what I am saying is that the multiple the market is willing to pay for that growth will continue to contract due to the factors outlined above.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.