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Drug companies may face challenges but they are still a good bet. Demand for pharmaceuticals remains strong, whatever the financial weather. Rachel Robson prescribes the pharma stocks to watch

Rampant economic growth and a rise in merger & acquisition activity fuelled by cheap credit meant the pharmaceutical and biotechnology sector was largely neglected during the 2003-07 bull run.

Concerns about future growth prospects, product litigation and generic rivals further dampened enthusiasm for the sector. But with credit starting to dry up and a major economic slowdown looming, this steadiest of sectors is coming back into fashion. Since 1 January this year, Pharmaceuticals & Biotechnology has been the third best-performing individual sector of the 39 tracked by Shares. This compares with a ranking of 29 three months ago and 41 when it bottomed out in March. Pharma is now one of just four sectors to have offered investors a profit this year.

Shares in AstraZeneca (AZN) plunged 21% in 2007 but have rallied by around 40% since March 2008. After a 5% stumble last year, GlaxoSmithKline (GSK) has climbed 20% since the spring. Shareholders who have invested in these stocks over recent months should be pretty satisfied with their returns. The best news is such progress is likely to continue, particularly if the UK economy hits the rocks, as history shows pharmaceutical stocks are one of the few dependable havens in a recession.

The sector boasts some pretty defensive characteristics. In the developed world especially people are living longer. According to the Office of National Statistics the proportion of the population aged 65 and over in the UK is expected to rise from 16% in 2006 to 22% by 2031, and demand for drugs will keep rising whatever else happens in the economy.

On the defensive

It would be unwise to dismiss the challenges facing the sector, even if the underperformance since 2003 and the derating suffered by the largest stocks suggests the market has largely priced in these issues.

PROBLEM 1 - SHRINKING PIPELINES

Of greatest concern to analysts and investors has been the perceived decline in research and development (R&D) pipelines. At the end of July, shares in Irish firm Elan (ELA) plummeted after an experimental Alzheimer’s drug, bapineuzumab, made by the company and New York-listed Wyeth was linked to a brain-swelling side effect in a study that showed no benefit for most patients.

Concerns have been raised over the difficulty of developing innovative new drugs, which could result in company R&D pipelines drying up. Researchers at IMS, the healthcare consultancy, say ‘the number of new chemical entities launched globally in 2007 was 27, marking a low point not seen in more than 25 years.’ The researchers point out three of these launches have the potential to become blockbusters. Two combination products launched in 2007 also have the potential to reach blockbuster size. ‘The number of new products launched is significantly lower than the average 44 per year launched during 1995-2000, and 33 per year launched during 2001-2006,’ says IMS.

The R&D pipeline shrinkage can be attributed to several factors, but most obvious is that the industry has already had great success in developing effective new drugs, so the easy wins have already been achieved.

It can be argued the R&D pipeline has not shrunk as such. In the past, pharmas developed a range of drugs with occasional blockbusters thrown in. Now the industry is more focused on blockbusters. When a drug is developed there is an expectation the product could be the next big thing. Whether this stream of blockbusters can be maintained is debatable, particularly when the time needed to get a drug through initial development, clinical trials and regulatory approval and finally into the market is so long.

PROBLEM 2 - LITIGATION

It now takes on average ten years to get through these stages: little wonder pharmas have to contend with rising costs. It currently costs around $1 billion to fund the development of a blockbuster drug through all the necessary regulatory stages.

Cost pressures are not helped by the regulators’ insistence on ever higher standards. A rising number of high-profile health scares has put yet more pressure on the big pharmas, and in some cases prompted product launch delays or recalls. Problems here have also spurred litigation claims.

America’s Merck’s had to pull its anti-inflammatory agent Vioxx off the market four years ago on the back of concerns about the number of heart attacks and strokes in patients treated with it. Merck faced a lot of litigation in the US as a result and subsequent decisions in the courts have cost the company at least $6.8 billion. Last year it recorded a pretax charge of $4.85 billion, which represents the fixed amount to be paid by Merck to settle qualifying claims.

GlaxoSmithKline’s blockbuster antidepressant Paxil/Seroxat has also faced scrutiny following concern it can cause suicidal behaviour in adolescents. The group has received many claims and lawsuits. An article published in May 2007 raised concerns the use of anti-diabetic drug Avandia could be associated with a greater risk of heart attack and cardiovascular death compared with the use of a placebo or other anti-diabetic therapies. As a result, GlaxoSmithKline has been named in product liability lawsuits on behalf of individuals and purported class action cases asserting customer fraud and/or personal injury claims on behalf of purchasers and users of Avandia. The litigation is at an early stage.

AstraZeneca has been sued in many individual personal injury actions involving its antipsychotic Seroquel, due to claims the drug can lead to diabetes and/or other related diseases. As of 16 January 2008, AstraZeneca was defending more than 8,000 served or answered lawsuits involving around 12,347 plaintiff groups.

PROBLEM 3 - GENERIC COMPETITION

On top of these challenges, big pharma groups also face patent expiries on many blockbuster drugs. This leaves them open to competition from the generics industry and potentially threatens well-established and highly lucrative earning streams – which are in turn needed to fund development work on future blockbuster products.

The generics industry was created as a way of promoting competition and reducing the price of medicines. In most cases, generic drugs are available once patent protections given to the initial developer have expired. In the past, pharma companies have coped with generic competition by developing higher priced drugs on patent that can replace those that have expired. However, with R&D pipelines declining, it is increasingly challenging for pharmaceutical companies to continue doing this, and they could see revenues weaken if they fail to replace products where patents have expired.

According to research by IMS, around $12 billion of innovative drugs will come off patent by 2008 in France, Germany and the UK alone. When AstraZeneca’s second-best-selling drug Seroquel goes off patent in 2012, 13% of group sales will be at risk. The loss of GlaxoSmithKline’s asthma drug Advair, due to go off-patent in 2010, could cost the group more than $3 billion in annual sales. ‘In the next few years the pharmaceutical industry will face immense challenges as an unprecedented number of products lose patent protection,’ commented GlaxoSmithKline’s new chief executive Andrew Witty at the company’s recent ‘strategic priorities’ meeting. ‘This will be set against a backdrop of payors searching for ever more cost-effective healthcare and escalating patient demand for new and better medicines.’

Fighting back

GlaxoSmithKline’s strategic priorities meeting highlighted pharmas are looking to tackle these issues and find new ways to generate profits. ‘We must be relentless in our efforts to improve R&D productivity and this is why we have started to implement a new vision for our R&D organisation which is science-led and focused on value creation,’ said Witty. Last year GSK spent £3.3 billion on R&D, while AstraZeneca spent $5.2 billion.

CURE 1 – ACQUISITIONS

One way to bolster a company’s R&D pipeline is through merger and acquisition (M&A) activity.

GlaxoSmithKline was formed through the merger of GlaxoWellcome and SmithKline Beecham in 2001, as both firms sought to tackle concerns about the strength of their respective product pipelines. GlaxoWellcome had itself been created by the merger of Glaxo and The Wellcome Foundation in 1995, while SmithKline Beecham resulted from the merger in 1989 of SmithKline & French/SmithKline Beckman and Beecham.

Many pharmas now look to the biotech industry to offset declining product pipelines, and it is likely M&A activity will pick up here. Traditionally biotech firms have been responsible for drug discovery, while pharmas have been responsible for drug manufacture, but over recent years this distinction has blurred. In July, Switzerland’s Roche announced it was making a $43 billion bid for the 44% of US biotech partner Genentech it does not already own. Genentech is a leading developer of cancer treatments such as Avastin, and the deal would enable Roche to expand its global presence in new anti-cancer drugs. Genentech has since rejected the bid, but has suggested it would consider a higher offer.

Recent bid approaches for biopharmaceutical firm Protherics (PTI), gene therapy group Oxford Biomedica (OXB), and vaccine developer Acambis (ACM) are likely to be the first of many set to hit the pharmaceutical and biotechnology sector over coming months. Specialist hospital medicines group IS Pharma (ISPH:AIM) and drug and alcohol testing company Concateno (COT:AIM) may be next on the target list.

Pharmas are also increasingly looking to acquire generics companies, strengthening positions in this expanding market and broadening their product range. In 2005, Novartis acquired Germany’s Hexal for $8 billion. June saw Japan’s Daiichi Sankyo acquire Indian generics firm Ranbaxy for $4.6 billion, while in July Israeli generics firm Teva said it would purchase America’s Barr for $7.5 billion.

With generic drugs so much cheaper than patented ones, teaming up with generics firms also allows big pharma groups to expand into emerging markets more easily. An example of this is GlaxoSmithKline’s recent joint venture with South African generic drug firm Aspen. The deal will provide GlaxoSmithKline with priority access to a portfolio of 1,200 potential new products, specific to emerging market needs.

CURE 2 – PATENT EXTENSIONS

In their attempts to fight generic competition, some firms also continue to look for ways to extend existing patents by finding new uses or changing the formulae. In April, AstraZeneca reached a settlement with Ranbaxy Laboratories over the patent for its top-selling drug Nexium. The deal meant sales of the product are protected until 2014 and AstraZeneca’s shares jumped 7% on the day of the announcement (15 April).

AstraZeneca was not so lucky in May after it had its European patent for the use of Symbicort in the treatment of chronic obstructive pulmonary disease (COPD) revoked, following an appeal from generic manufacturers Norton Healthcare and Generics UK. The patent is one of two covering the Symbicort combination used to treat COPD throughout Europe. The original expiration for this patent was 2018.

New York-based Pfizer recently entered an agreement with Ranbaxy Laboratories to settle all its patent litigation worldwide involving blockbuster cholesterol drug Lipitor. The deal will delay the release of generic versions in the US until 30 November, 2011. Lipitor’s patent was previously due to expire in 2010 and with the drug having generated revenues of £12.7 billion in 2007, the additional year will be a huge bonus to Pfizer.

CURE 3 – MAKING IT PERSONAL

Pharma firms are attempting to tackle stricter regulations and health concerns through personalised medicine. Using knowledge of a person’s genetic make-up, companies can pre-determine which drugs will be most effective for that person.

Curidium Medica (CUR:AIM), a developer of personalised medicines for central nervous system disorders, is one example of this. The company’s proprietary technology platform, Homomatrix, identifies patient subgroups. It uses a collection of pattern recognition tools, specific sequences of mathematical algorithms and customised statistical methods which analyses human biological datasets. The group’s blood diagnostic test, PsychINDx, classifies patients with schizophrenia/bipolar disorder into four subgroups, each associated with distinct underlying disease mechanisms and specific drug targets.

By using technologies such as these, response rates to drugs become much higher. ‘Not every patient is the same when it comes to showing a response to a drug,’ explains chief scientific officer Dr Anne Bruinvels. For example, a statin drug used to lower cholesterol levels could only work for 30% to 70% of users, but by using a personalised medicine, the right drug can be selected for the right patient, boosting patient compliance.

Also, in the long run, drug development costs could fall because patients chosen for clinical trials would be those most likely to respond based on their biological data. Bruinvels says costs might go up initially because tests will need to be done to select the suitable patients, but ultimately selecting patients most likely to respond to the drug will reduce the failure rate of trials, improve safety levels, and therefore lower development spend.

There are already a handful of personalised medicines on the market. Herceptin, for example, helps treat breast cancer. According to figures from The Case for Personalised Medicine, a report by the Personalised Medicine Coalition, around 30% of breast cancers are characterised by over-expression of a cell surface protein called human epidermal growth factor receptor 2 (HER2). Women with this type of breast cancer do not respond well to standard therapies, but the development of an antibody drug Herceptin specifically inhibits the HER2 receptor and has greatly improved the survival rate of women with this type of cancer. Molecular diagnostic tests have been developed to measure either HER2 protein levels or gene copy numbers to identify those patients likely to benefit from Herceptin treatment.

Another example is Gleevec, which treats chronic myelogenous leukaemia and malignant gastrointestinal stromal tumours. Figures from The Case for Personalised Medicine report say over 90% of patients receiving Gleevec respond positively to initial treatment, and many experience complete remission.

The prospects for personalised medicine are exciting and it offers a lot of answers to the challenges facing the pharma industry. Yet there are still hurdles to be overcome. ‘Currently, the evidence establishing a clear-cut case for personalised medicine remains largely anecdotal rather than statistical, but that is to be expected for such a nascent field,’ say experts at the Personalised Medicine Coalition. They add there is little hard evidence ‘on the impact of a personalised medicine approach on pharmaceutical industry productivity or healthcare economics.’ However, in some cases this approach has led to ‘cost savings in the administration of healthcare, demonstrated itself to be a viable business strategy for product development, and most importantly, proved its benefit to patients.’

Soothing earnings profile

Pharmaceuticals is still a highly profitable business. GlaxoSmithKline’s second-quarter results saw the group post a pre-tax profit of £1.8 billion, in excess of analyst expectations. AstraZeneca’s interim figures also surpassed market forecasts and resulted in the group increasing its full-year earnings guidance. Core pre-tax profits for the first six months were up 8% on a reported basis (or down 2% at constant exchange rates) at $5.1 billion. Sales increased by 10% on a reported basis (or 3% at constant exchange rates), to $15.6 billion.

Such solid earnings growth will be just what investors will seek if UK economic growth lives down to Mervyn King’s forecast of a possible recession. Data from the equity strategy think-tank Mirabaud Securities shows how the pharmaceutical sector has outperformed in each of the past four UK downturns – 1973-75, 1980-82, 1990-92 and 2001-02

With these attractions in mind, Shares has therefore picked out three stocks which currently look to offer best tonic to investor’s portfolios.

GlaxoSmithKline (GSK) £12.77 BUY

Market cap £66.9 billion

2009 PE 12.2

2009 EPS Growth 3.9%

2009 yield 4.6%

1m relative strength 3.3%

12m relative strength 14.7%

Positive second-quarter results, a new chief executive and an acquisition set to open up opportunities in the generics market all make GlaxoSmithKline an attractive investment opportunity. New chief executive Andrew Witty clearly has strong ideas about how he wants the company to move forward and is particularly keen to expand into emerging markets. The company has already made its first step here through its recent acquisition of South Africa’s Aspen and further acquisitions are likely. GlaxoSmithKline’s experimental treatment for leukaemia, being developed with Danish firm Genmab, recently proved effective in a pivotal phase III trial. The treatment could reach the market by mid-2009 and could become a multi-billion dollar seller. GlaxSmithKline also has a strong launch pipeline in Japan, with more than 25 product opportunities either registered or to be filed with regulators over the next two years.

AstraZeneca (AZN) £26.26 BUY

Market cap £38.2 billion

2009 PE 10.2

2009 EPS Growth 6.8%

2009 yield 4.3%

1m relative strength 10.9%

12m relative strength 26.1%

A pipeline of 143 projects, including 100 projects in the clinical phase of development, and a $2 billion restructuring and synergies programme mean AstraZeneca’s share price should continue prosper. The company focuses on six key areas: cancer, cardiovascular, gastrointestinal, infection, neuroscience and respiratory & inflammation. Like GlaxoSmithKline, the firm has been looking for ways to bolster its R&D pipeline, and in 2006 it acquired Cambridge Antibody Technology, then MedImmune in 2007. Over the past six months, 20 projects have progressed to their next phase (including seven molecules entering first human testing), 15 compounds have been added from Discovery Research, and three compounds have been withdrawn. Even after the recent strong outperformance, a 2009 PE of 10.2 and yield of 4.3% mean the shares are good value.

Shire (SHP) 964p BUY

Market cap £5.4 billion

2009 PE 17.7

2009 EPS Growth -3.4%

2009 yield 0.6%

1m relative strength 16%

12m relative strength -13.4%

A stronger pipeline and an upgrade for its full-year guidance for revenue growth mean Shire is becoming an increasingly attractive investment. The company has acquired eight new products since the start of 2007 and is increasing its R&D spend to around $500 million. The group recently upgraded full-year sales growth guidance from the mid-to-high teens to progress of at least 20%. Shire is another company to have seen recent board changes, with its former chief financial officer, Angus Russell, becoming chief executive in June, and its former chief executive, Matthew Emmens, becoming chairman at the same time. Graham Hetherington was appointed chief financial officer in July. Shire is also in the process of acquiring Jerini in Germany, with the deal expected to complete in the third quarter of this year, and Shire should benefit from its near-term revenues and long-term growth prospects.