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Are Pharma Stocks Making You Ill?

(Guest Commentary by Rick Konrad – October 19, 2007)

Dear Subscribers and Readers,

For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary.  Rick is one of our two regular guest commentators (besides Bill Rempel) and usually writes for us every third Wednesday of the month.

In this commentary, Rick will be sharing his thoughts on the US pharmaceutical industry – and why the generics drug industry, especially for those companies that do business in Japan – may be more attractive.  Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Rick Konrad on Legg Mason and HNI Corporation” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog and should you have any questions or thoughts for Rick after reading his commentary, you can also email him at the following address.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


One of the most frustrating industries for many investors is the pharmaceutical industry. The cash flows are enormous, free cash flows are compelling, and share buybacks are very common. But the growth opportunities through the creation of a research pipeline have seemed evasive for some time.

Frequently, the drug companies come up for discussion as beneficiaries of U.S. dollar weakness. FX trends will have a positive effect on revenues and provide some tailwind for U.S. pharma companies. But it is a multi-faceted issue… The weaker dollar may increase expenses, however, as much manufacturing, and R&D as well as S,G&A is located abroad.

The European pharmaceuticals have not escaped the wrath of the R&D gods either. Astra Zeneca in particular has suffered from a lack of ability to convert its phase-3 drugs into commercial products. Not one drug that entered phase-3 made it to commercial success, zip! Here is the record since 2002:

Iressa

Lung Cancer

withdrawn

Exanta

Oral anti-coagulant

Failed phase-3

Galida

Diabetes

Failed phase-3

AZD0865

Gastro-intestinal acid related disease

Failed phase-3

Cerovive

Stroke

Failed phase-3

AGI-1067

Acute coronary syndromes

Failed phase-3

Despite the 2008 Presidential election being over a year away, healthcare has emerged as the top domestic issue for Democrats and Republicans alike. Almost all candidate proposals have been released. Next year will be filled with headlines containing additional ideas to reform the healthcare system for the nation's 47 million uninsured. The proposals of the Democratic hopefuls seem to be the most potentially dangerous to the healthcare industry. Both Sen. Clinton's and Sen. Obama's  plans would permit drug price negotiation by Medicare, as well as drug reimportation.

One bright spot in healthcare is the generic drug industry. The operating environment for generic drug manufacturers is changing rapidly as the industry matures and growth focuses on new market opportunities. Consolidation remains a key theme in the global generics industry. Within the U.S. market, generic companies have consolidated mostly to build scale. But recently the focus has shifted to finding low-cost manufacturing in Eastern Europe and elsewhere. As well, the quest for lower tax rates has influenced many of these companies.

Mature generic markets such as the U.S., U.K., and Canada are experiencing intense pricing pressure leading to interest overseas, where governments faced with rising healthcare costs are changing both patent law and healthcare reform to incentivize the manufacturers and increase generic utilization.

The U.S. remains an attractive market, with generic utilization expected to increase this year to 66%-67% and more than $37 billion worth of brand products losing patent protection over 2007-2008. The war for market share makes this a very competitive market with little room for new entrants.

Manufacturing in Central and Eastern Europe can frequently have costs that are as low as 25% of that in the States. The other rationale for manufacturing there is the highly attractive tax regimes. For example, in Czechoslovakia, there is ten years of tax relief for new companies or joint ventures; in Estonia, reinvested profits are not subject to corporate tax at all. The aging populations of Europe also provide an attractive marketing opportunity.

Certainly, the demographics of Japan are compelling. In the 2005 census, the following demographics became evident:

The overall Japanese population is shrinking after peaking in 2004;

  • Japan has the highest proportion of old people and lowest proportion of young people in the world;

  • Over 21% of Japanese were 65 years of age or older, the highest ratio in the world--this is up from 17% in the last census in 2000;

  • Less than 15% of Japanese are under 15 years of age, the lowest since census-taking began in 1920, and also the lowest in the world; and

  • The fertility rate (defined as the average number of children a woman has during her lifetime) was 1.25 in 2005, an all-time low; a rate of at least 2.1 is needed to stabilize the population.

These data confirming the rapid and accelerating aging of the Japanese population are very significant, as healthcare policies are formulated as a result of the census findings. The government in Japan faces soaring medical costs and seems to be turning to the generic industry as a solution.

The market appears to be very under-developed with generics representing only about 18% of prescription volumes (versus 67% in the U.S., 55% in the U.K., 61% in Canada) Japan is the world's second largest pharmaceutical market, trailing only the U.S. All Japanese residents are guaranteed healthcare access by one of the public health insurance programs and are permitted to receive care from any physician, hospital, or healthcare facility which results in heavy consumption of medical services and drugs…i.e. unlike in the States, where HMOs serve as effective gate-keepers.

The branded drug industry faces a Drug Price Revision to reduce the reimbursement prices from the government and enforces price cuts every other year. This has not been terribly effective in reducing health care spending. The government has proposed a goal for generics to represent 30% of volume by 2012. Another proposal introduces a cap on outpatient costs and drugs for patients 75 and over, perhaps not exactly euthanasia but certainly not a positive social trend to this aged writer!

There are three companies in Japan that seem to have the largest share of this market, Towa Pharma (4553), Sawai Pharma (4555), and Nichi-Iko Pharma (4541).

Among the American companies, only Mylan Laboratories (MYL) has access to the generic market in Japan. Mylan, following its acquisition of Merck KGaA's generics division has access to Japan through Merck Seiyaku, the fourth largest generic manufacturer in Japan, but representing merely 6% share of the Japanese generic market. Mylan's plate is quite full at the moment with a gargantuan task of integration and deleveraging ahead of it. Mylan acquired the Merck division for a total of $6.7 billion, representing a multiple of 15 times TTM EBITDA. This compares to Barr ‘s(BRL) $2.5 billion acquisition of Pliva in Eastern Europe for about 8 times EBITDA. Mylan has announced that it expects to issue $1.5-2 billion of equity and convertibles by year-end.

Merck KGaA's generics platform was in over 90 countries with key market positions in United States (#3), France (#1), Australia (#1), Japan (#4), Germany (#9), Spain (#3), and Italy (#4).

Though the transaction was strategically transformative, the integration risks remain quite high. Interestingly, MYL will now have only 46% of its sales coming from the U.S. versus a historical 80-85%. Its coverage of the Asia/Pacific region distinguishes it from most other generics given its #4 share in Japan, #1 in Australia, and #1 position in New Zealand.

Pharmaceutical stocks remain a rather forlorn place in this market and generics represent a sector that is worth monitoring for an entry. The growth opportunities are international as the world ages.

Disclaimer: I, my family, or clients have a current position in Barr (BRL) and hold no position in any of the other securities mentioned.

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