Investing

Don’t push Big Pharma off a cliff just yet

It has been described as both a cliff and a wave, but whatever you call the fact that…

It has been described as both a cliff and a wave, but whatever you call the fact that an unprecedented number of pharmaceutical drugs will lose their patent protection in the next few years, the transition sets the stage for a host of investment opportunities — and potential pitfalls.

Between 2011 and 2013, drugs that account for more than $90 billion in annual pharmaceutical sales will lose their patent protection. Eli Lilly & Co. (LLY), for example, will lose Zyprexa next year. In 2012, Bristol-Myers Squibb Co. (BMY) will lose Plavix, Pfizer Inc. (PFE) will lose Lipitor, and Merck & Co. Inc. (MRK) will lose Singulair.

To be sure, drug patents expire all the time. But when large blocks of popular brand-name drugs move toward expiration all at once, it opens the doors for generic- drug makers and causes investors to re- adjust their thinking about the whole pharmaceutical sector.

At this point, the key is not to follow the herd by avoiding Big Pharma and loading up on generic-drug makers. Indeed, as the market braces for the wave of patent expirations, some of the best moves may be against the grain.

For example, a case can be made that the market has overreacted to the patent cliff and that the health care sector is undervalued.

“Right now, on a relative-valuation basis, the health care sector is cheaper than it's been in 15 years, and dividend yields for the sector are at 15-year highs,” said Andy Acker, who manages the $634 million Janus Global Life Sciences Fund (JFNIX) for Janus Funds.

“We've been underweight large-cap pharma for most of the past 10 years,” he added. “But the valuations in the health care sector are so attractive right now.”

OTHER ISSUES AT PLAY

At first blush, it might seem like the wave of patent expirations could be enough to cut the entire health care sector off at the knees. But while the looming wave of expirations will affect the entire pharmaceutical chain — from drug makers to distributors to wholesalers and even some retail drug stores — the sector as a whole is actually being pulled down by a combination of issues including health care reform in the U.S. and pricing pressures in Europe. As those issues are resolved, the outlook for the sector could improve.

Meanwhile, as big pharmaceutical companies lose their patent protections, many are starting to adjust through consolidation and diversification.

Last year Pfizer paid $68 billion for rival Wyeth Inc., which led to big cost savings in the form of job cuts, but also trimmed the combined research-and-development budget to about $9 billion, from about $12 billion, according to original R&D estimates for the combined company.

The $41 billion acquisition of Schering-Plough Corp. by Merck last year is another example of how the industry is simultaneously building scale and cutting costs.

Another way that the drug makers are adapting is by expanding into other areas of health care. This was seen in December when French drug maker Sanofi-Aventis (SNY) moved into the U.S. consumer health care market with its $1.9 billion acquisition of Chattem Inc.

Also, as companies look to replace the revenue from expired patents, smaller biotechnology firms with drugs in the development pipeline, such as Gilead Sciences Inc. (GILD) and Genzyme Corp (GENZ), become attractive acquisition targets and a good play for investors.

“There are some midtier biotech firms with terrific pipelines,” said Steven Roge, a portfolio manager with R.W. Roge & Co. Inc., which has $200 million under management.

For example, he estimates Genzyme's fair-value price to be about $55, or about $5 above its current share price.

“A larger company might pay $70 or $80 [a share] to acquire Genzyme,” Mr. Roge said.

“Most of the pharmaceutical companies aren't that sophisticated when it comes to acquisitions,” he said. “They're looking at the pipeline potential, and they'll throw the valuations to the side.”

Questions, observations, stocks tips? E-mail Jeff Benjamin at [email protected].