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Big pharma's poison pill

Defensive pharmaceutical shares should be outperforming a volatile market. But many are not - and some think the sector is becoming a value trap
June 14, 2012

When it comes to seeking safety in defensive sectors, the stock market seems to be doing its best to prove Shakespeare's dictum that "when sorrows come, they come not single spies but in battalions". As well as the troubles facing tobacco shares, which we examined in last week's sector focus, pharmaceutical companies are particularly in the grip of the bears. Since the start of the year they have experienced an average fall in share price of 11 per cent. That's terrible for companies that should have benefited from turbulence in other parts of the market. For FTSE 100 constituents, that sort of drop is enough for investors to reach for the pills. But, unfortunately, the underperformance of defensive shares in weak markets is becoming an increasingly common theme.

The share price charts for the pharma majors really aren't pretty. And, in the broader sector, which includes medical device manufacturers and other specialists, has seen the world turned upside down with the best-performing companies not really traditional drugs companies at all, but a mixed bag of semen merchants (Genus), snake-bite treatment salesmen (BTG) and obscure biotech firms (Proximagen) that do not really share any particular operating characteristics. Rather, in each case, the market has latched on to a positive characteristic - such as exposure to developing markets - and bid up the shares accordingly. That has left pure pharmaceutical shares looking unusually exposed as they grapple with a complex set of regulatory and operating problems.

The price of everything

Two years of austerity measures have started to put pressure on medicines prices on both sides of the Atlantic. The problems in the eurozone are never far from the headlines and this has undeniably affected the outlook for companies with a big presence in major medical markets. For example, Germany has introduced some of the biggest cuts to the prices that insurers will reimburse for medicines in years, with a knock-on effect as other countries take this as a reference point. Shore Capital estimates that prices for pharmaceuticals will decline by an average of 4 per cent. That is mirrored by the strength of generic competition in the US as blockbuster medicines go off-patent, along with the impact of recent health reforms, which are estimated to have knocked about 1 per cent from US pharmaceutical sales.

There have also been surprises in developing markets where, after several years of double-digit gains, sales growth at some companies is now coming in much lower than expected. There is not really any agreement as to why this has happened. It could be down to fragile sentiment - there is evidence that even in fast-growing economies consumers are feeling the squeeze from rising prices - or, more simply, every patient that can afford expensive western-style treatments is already receiving it.

Austerity for pharmaceutical & healthcare companies in 2011*
COMPANIES IMPACTShare price YTD %
AbbottHealthcare cuts in Europe affect 2011 results marginally +9%
AstraZenecaGeneric loss: $3bn; US sales -2.3%; Europe sales -11%-12%
Bayer (Pharma)Sales rise below market average+14%
GSKFlat US sales, European sales -5%-2.8%
Novartis1% fall in global sales-8%
Roche1% sales fall caused by European and Japanese price cuts-5.5%
PfizerLoss of Lipitor patents-0.4%
SanofiGeneric competition causes 4% fall in European sales-6.5%
ShirePrice reductions seen for specialist medicines, though not traumatic-18.5%
Smith & NephewPrice pressure for orthopaedic products of at least -3%-3.1%

*Shore Capital research

 

Picking a winner

As the table above demonstrates, there is a value in differentiating between different types of pharmaceutical company. The likes of Abbott Laboratories and Bayer, whose share prices have both performed well, have pharmaceutical arms that form part of a diversified conglomerate that embraces medical technology, in Abbott's case, and complicated crop science and chemicals products at Bayer. This has helped offset underperformance at the pharma division. In the long term, the industry may simply have to accept the lower margins that come with conglomerate status if the future is to be secured. Companies such as GSK and Novartis are well along that road; GSK's takeover battle for Human Genome Sciences is, in fact, part of its strategy of marrying products produced outside of its R&D structure to its well-developed marketing machine.

The contrast with AstraZeneca could not be greater as the company under the stewardship of former chief executive David Brennan - himself a replacement for the decent, if subsequently hapless, Sir Tom McKillop - made a determined effort to stay a pure research company. That could now change when new management takes over as the company has to decide whether to follow GSK's lead and go for predictable, if boring, sales, or find another way to make its existing model work.

 

IC VIEW

The phrase "value trap" is increasingly used when talking about pharmaceutical shares. Nevertheless, the income on offer from the likes of AstraZeneca and GSK - yields are now over 5 per cent - is hard to beat. Indeed, if nothing in the economy is growing and investors are content to chase negative yields on gilts, there are definitely worse places to park your cash, as the depositors in Bankia will testify. However, with the outlook for the industry less than certain, it will pay to be picky.

FAVOURITES
Under the circumstances, keeping US sales flat was a good result for GSK after running the gauntlet of regulatory action over some of its marketing tactics, along with the lingering fallout from the withdrawal of controversial diabetes treatment Avandia. In addition, the ongoing takeover saga with Human Genome Sciences is keeping potential buyers sitting on the fence while the outcome is determined. That said, GSK's diversification strategy gives it the classic profile of a defensive share - predicable sales and a good dividend yield - and, despite the market turmoil, the share price really isn't off that much.

OUTSIDERS
Shire is not an obvious candidate for outsider status, but its share price fall has also been noted. Investors Chronicle's Trader, Dominic Picarda, writes: "Shire's share price has been in a fairly determined downtrend since peaking in February at an all-time high of £23.13. And there are few clues that it is not about to find its feet quite yet. Significant lows in Shire tend to form after the price has become oversold on its weekly relative strength index, a measure of momentum. However, it has not so far registered an oversold reading on this indicator. One objective for this move lies at 17.60 and really robust support doesn't kick in until 15.30. Only a sustained move back above its 55-day exponential moving average (20.03) will signal a resumption of its long-term gains." In addition, fundamental investors will point to lower profits growth this year, as well as the slightly puzzling takeover of Dermagraft (Advanced Bio-healing), which some investors will remember as a venture unsuccessful enough that even Smith & Nephew decided to get rid of it.