Give Bristol-Myers the Benefit Over Merck

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The pharmaceuticals industry has been in a state of turmoil for decades. But some companies are handling it better than others. For example, Bristol-Myers Squibb (NYSE:BMY) stock is up 15% so far this year while Merck (NYSE:MRK) has lost 10% of its value. Why the difference? And should you invest in either of these Big Pharma companies?

Prior to the 1980s, the drug industry was one of the most profitable in the world — a typical pharmaceutical company could earn a five-year average return on equity of nearly 40%. The reasons for that high profitability were powerful:

  • Patented drugs. High R&D spending regularly yielded new drugs that a company would patent — then the company would enjoy almost 20 years of unchallenged high profits with regular price increases.
  • Marketing to doctors. Doctors prescribed drugs with a strong push from drug company sales and marketers who gave the doctors free samples and took their families on vacations that included some “medical education.”
  • Limited competition. Pharmaceutical companies were unchallenged by significant competition, hence they were able to operate in a way that maximized their shareholder returns without concern for price cutting.

But starting in the 1980s, all those profit-enhancing industry forces collapsed, sending the industry into a long period of greater turmoil with which it still is trying to cope. These changes have lowered the industry ROE to 22.2% — below the S&P 500 average of 24.6%.

Among the biggest profit-reducing changes:

  • Rise of Pharmacy Benefit Managers (PBMs). Companies offering health care-created PBMs use their negotiating leverage to take away some of doctors’ drug prescribing power. Now, if a patient who gets corporate health coverage has a medical problem, the PBM usually will only pay for the lowest-priced drug that solves the problem.
  • Emergence of new competitors. Generic drug companies manufacture off-patent drugs at much lower costs than do the fully integrated pharmaceuticals companies. Those generic manufacturers get the revenues when those PBMs require the prescription of a low-priced drug. Moreover, biotechnology companies have come up with new approaches to drug development, and their focus often gives them higher-patented drug development success.
  • Rising cost of developing new patented drugs. In the 1980s, it used to cost $400 million to develop a new drug — now it costs an average of $1.3 billion (although some believe that figure is massively inflated). At the same time, big pharmaceutical companies are increasingly finding that they are unable to discover blockbuster drugs to replace the ones that come off patent. As a result, they often try to make up for it by acquiring a biotechnology company that is further along in the development process.

Merck formerly was considered the gold standard of the industry — it attracted the top people and made the most money. But that began to fall apart in the 1980s thanks to the rise of Medco Health Solutions (NYSE:MHS) — a mail-order drug company and PBM that Merck acquired in 1993 as I wrote in my book, The Technology Leaders, to try to get back control of the prescribing process. That did not work, and Merck spun off Medco in 2003.

Now Merck faces the prospect of being one of the companies that will suffer a total projected $135 billion in lower revenues if President Barack Obama’s deficit reduction plan goes into effect. That’s because the plan would require these makers of brand-name drugs to give a 23% rebate to the U.S. government for low-income Medicare beneficiaries who get a subsidy to pay for coverage, according to Bloomberg.

Meanwhile, Bristol-Myers has been working on new drug development and has achieved some success. On Monday, Jeffries published a report saying that Bristol-Myers could be an acquisition target on the strength of two of its drugs — a skin cancer treatment and a heart drug awaiting U.S. approval. Jeffries also raised its price target from $27 to $35. Its skin cancer treatment Yervoy generated $95 million in second-quarter sales — beating sales expectations. And Jeffries raised expectations for its blood thinner Eliquis.

What does all this mean for investors? Let’s compare them based on valuation and recent earnings performance:

Given the headwinds facing the industry — reflected in weak 2012 earnings expectations — neither of the two companies looks like a bargain. But if forced to choose, I would pick Bristol-Myers because of its lower P/E and the possibility of a takeover.

Peter Cohan has no financial interest in the securities mentioned.


Article printed from InvestorPlace Media, https://investorplace.com/2011/09/bristol-myers-merck-bmy-mrk-pharma/.

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