The global pharmaceutical companies’ long-term prospects are excellent, given the aging population in the industrialized world and rising incomes in developing countries. But pharmas do face short-term challenges.

Chief among the concerns of many companies is the fact that they have few new products in the pipeline to bring to market in the next few years.
In the same time frame, other products will come off patent, which means lower-priced generic versions will enter the marketplace, forcing prices lower. New price levels will be 25% or even 20% of previous levels, says Charles Burbeck, head of global equities at HSBC Halbis Partners in London.

Generic companies are also increasingly challenging patents so they can start producing their own versions sooner. A number of firms face “quite significant challenges” to their patents, says Burbeck.

For example, New York-based Pfizer Inc. , which holds the patent on popular cholesterol-lowering Lipitor, has had its patent challenged in both British and U.S. courts. Lipitor accounts for more than US$10 billion — or 20% — of Pfizer sales, and 75% of those sales are in the U.S. While the patent challenge in Britain came down in Pfizer’s favour, the more important U.S. challenge will be decided in the next few months. But Heather Pierce, a portfolio manager at AIM Funds Management Inc. in Toronto, is optimistic; the British decision, she says, “sends a message to the industry that ‘We will protect intellectual property rights’.”

But that applies only to the industrialized world. Pharmaceutical companies also need to be concerned about generic products in newly industrialized countries, such as India and China, where intellectual property rights are not as well defined. Long term, Pierce is optimistic about drug sales in those regions but considers encroachment of intellectual property one of the risks of doing business there.

Another challenge for pharma companies is the U.S. Food and Drug Administration. As a result of some high-profile cases — in which companies had to withdraw drugs because of alleged side effects — the FDA is getting tougher, requiring more detail and longer testing before approving new drugs. New Jersey-based Merck & Co. , for example, withdrew pain reliever Vioxx a year ago; Wyeth of Madison, N.J., withdrew two diet drugs in 1997.

There is also a lot of downward pressure on drug prices, particularly in the U.S., which has both the highest prices and the highest drug use per capita, says Burbeck. Soaring health-care costs mean large purchasers, such as health insurers and companies with their own health plans, are looking for ways to control, if not lower costs. One option is to mandate use of generic drugs wherever possible; another is to negotiate large discounts with pharmaceutical firms.

The new Medicare Modernization Act, which comes into effect Jan. 1, 2006, poses little short-term threat. Although, under the act, the government will pay for drugs for retirees over the age of 65, the legislation specifically forbids the government from negotiating with drug companies. Indeed, the act could result in increased sales, to people who previously couldn’t afford the medication. However, analysts expect that continued increases in health costs will, in time, lead to an amendment to the legislation to allow for negotiation with drug companies.

Further ahead, however, prospects are rosy for pharmaceutical companies. Aging populations in the industrialized world will translate into increased sales per capita. The average annual number of prescriptions for those aged 65 to 74 is 9.4, and 11.5 for those 75 and older, says Richard Wong, a portfolio manager at Winnipeg-based Investors Group Inc. , vs 2.3 for those aged 25 to 34.

Economic growth in the developing world means higher incomes and the ability to pay for drugs. With huge populations in China and India, even a small increase in percentage terms in the “middle class” translates into huge potential sales. China currently spends about 1% of its gross domestic product on health care, compared with 16% of GDP in the U.S., says Pierce.

Then there is the supply side, and a long list of unmatched medical needs, says Burbeck. There are products that are not fully effective or that have side effects, so there is plenty of opportunity to develop new drugs that are more effective and/or have fewer side effects. There is also enormous potential for drugs that improve therapies and prevent disease.

@page_break@In 2003, scientists completed the mapping of the human genome — all 25,000 genes in the chromosomes of every cell. One result: about 4,000 targets for drugs have been identified, compared with the 500 currently targeted. This could mean the development of medication directed at specific areas of pain. Another application is personalized medicine. This
strategy is based on the building of DNA databases from which it is possible to identify the medications that will or will not work on a particular person, and the genetic characteristics that make certain people vulnerable to particular diseases.

Much of this work will take time. In the meantime, quite a few pharmaceutical stocks are trading at discounts. So, should, investors buy now? The answer, in most cases, appears to be “Not yet.” The next wave of new drugs is probably still several years away.

However, there are some firms that global investment managers interviewed by Investment Executive say are worth buying now:
Switzerland-based Roche Holdings AG, Sanofi-Aventis SA of France and Wyeth.

> Roche holdings. Pierce likes Roche because of “solid management, a very
strong growth profile, excellent cash flow, a very strong pipeline of new products, identifiable barriers to entry for competitors and no patent issues.” She also likes the fact that the company focuses on a few areas, including immune diseases and oncology, rather than trying to cover all bases.

Burbeck also likes Roche’s mix of business and successful investments. In 1990, Roche acquired a majority stake (56.1% as of Dec. 31, 2004) in Genentech Inc., a large U.S. biotech firm that has had a number of successful cancer products. One is Avastin, which is effective on different types of cancers. Pierce notes that Roche has the rights to sell Genentech products outside the U.S., and they accounted for 21% of Roche’s prescription drug sales in 2004. By comparison, Roche products accounted for 64% of sales; 15% came from Japan’s Chugia, in which Roche has a 50.6% majority interest. Roche acquired its stake in 2002 and merged Chugia with Roche Japan.

Roche is the world leader in diagnostics — sophisticated blood testing for diseases using chemicals, some of which are patented. Accounting for about a quarter of Roche’s US$13.8 billion in sales in the six months ended June 30, 2005, diagnostics is a big growth market because people are now being tested regularly and for an increasing number of diseases. Roche is also at the forefront of personalized medicine, Pierce adds. In January it received FDA approval to launch AmpliChip, a device to identify reactions to various medications.

Vaccines is Roche’s third main business. One of its products, Tamiflu, is being stockpiled by governments around the world because it is considered the best protection against avian flu. Vaccines is another growth area because globalization means viruses travel around the world quickly. And viruses mutate, so changes to the vaccines will constantly be required.

Burbeck says Roche is one of the more expensive pharma stocks, trading at around 24 times forward earnings, but he thinks it is worth buying. It has risen strongly in the past five years, in stark contrast to the industry average, which has remained relatively unchanged.

Roche’s net income was 3.2 billion Swiss francs (US$2.7 billion) in the first six months of this year, vs SF3.1 billion for the same period a year earlier.
Sales were SF16.6 billion (US$13.8 billion), vs SF14.5 billion a year ago. In 2000-04, sales gained 9% in SF terms but 48% in U.S.-dollar terms, reflecting the SF’s appreciation in value against the US$ in the past few years. The company spends 15%-16% of its sales on R&D. Long-term debt was SF7.4 billion (US$5.7 billion) as of June 30.

Roche’s 160 million voting shares are traded on the Swiss Stock Exchange, and its 702.6 million non-voting shares are traded on the Swiss, London and other European stock exchanges, and on the New York Stock Exchange as an ADR, with two ADRs equalling one non-voting share. The ADRs closed at US$72.35 on Oct. 14.

> Sanofi-aventis. When Sanofi-Synthelabo purchased Aventis in late 2004, the result was Sanofi-Aventis. Sanofi-Synthelabo’s focus was cardiology and it developed Plavix and Avapro, which are both still under patent.
Aventis brings a variety of other drugs, such as Allegra, an antihistamine for allergies, and Lovenox, a blood thinner. The combined company also has a vaccine business, which is working on protection against the avian flu.

The merger provides the opportunity to rationalize and produce efficiencies, says Andrew Waight, portfolio manager at Altrinsic Global Advisors LLC in Toronto and manager of CI Global Health Sciences Fund.
He adds that patents on most of the firm’s current drugs won’t expire for a few years.

There is also an exciting possibility in the pipeline. Called Acomplia, this “miracle drug” is said to reduce weight, lower cholesterol and control diabetes. It is expected to get final FDA approval by yearend and be on the market in early 2006. Standard & Poor’s Corp. says sales of Acomplia could hit US$2 billion-US$5 billion at their peak.

In May, Moody’s Investors Service Inc. upgraded the company to A2 from A1, saying it is rapidly generating synergies from the merger and will probably reach the targeted 1.6 million euros (about US$1.3 billion) in savings while maintaining strong sales. Cash flow is being used to reduce debt, and management is committed to repaying the acquisition debt within five years. Refinancings have also improved liquidity.

Strong drug portfolio

Moody’s says the firm is well diversified, has a strong drug portfolio and is highly profitability. S&P calls it one of the fastest-growing pharmaceutical firms and is impressed by its R&D spending of US$4.9 billion a year, the third-highest of any company.

Sanofi-Aventis had sales of 13.1 billion French francs (US$16.8 billion) in the first half of this year, vs a pro forma (including both previous companies) F12.2 billion in the same period a year earlier. Net income was F3 billion (US$3.8 billion), vs F2.3 billion a year ago. the firm spends about 14%-15% of its sales on R&D. Long-term debt was F7.1 billion (US$8.6 billion) as of June 30.

Sanofi has 1.4 billion shares trading on Euronext Paris and as ADRs on the NYSE (with two ADRs equal to a common share). The ADRs closed at US$41.66 Oct. 14, vs about US$30 in 2002, trading at 13.8 times forward earnings.

> Wyeth. Wyeth is Waight’s other pick. It was badly hurt by the withdrawal of its diet drugs in 1997, which not only harmed its reputation but has also cost it US$21 billion to settle lawsuits.

But, Waight says, the firm has almost seen the end of both the stigma and the litigation, and now is the time to buy. The stock is trading at a discount at 14.5 times forward earnings. Wyeth has an opportunity to control some of its operating expenses and further leverage its earnings, he says.

S&P and Moody’s both like the company’s scale, market position, diverse drug portfolio and limited exposure to drug patent expirations over the next several years. But both ratings agencies are concerned about the potential for further litigation in the diet lawsuits.

Moody’s also notes there are risks of increased competition in core product categories, as well competition from generics when antidepressant Effexor XR’s patent expires in 2008.

Wyeth’s big sellers are Effexor, with US$3.3 billion in sales in 2004;
Enbrel, for treating rheumatoid arthritis at US$2.5 billion; Protonix, a proton pump inhibitor, at US$1.6 billion; and Prevnar, a vaccine for invasive pneumococcal disease in children, with sales of US$1.1 billion.

Net revenue in the first six months of this year was US$9.3 billion, vs US$8.2 billion a year earlier; revenue has increased 33% in the past four fiscal years. Net income was US$2.1 billion in the six months, vs US$1.6 billion a year earlier. Wyeth spends about 13% of sales on R&D. Long-term debt was US$7.9 billion as of June 30.

Wyeth’s 1.3 billion shares trade on the NYSE and recently traded around US$45 a share, for a market cap of US$60.4 billion. In 1999, before the full impact of the diet-pill problems was felt, its share price was US$68. IE