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Executive Summary

[NYSE & AMEX LISTED ISSUES] Merck (up 43 points to 137) and Johnson & Johnson (up 16-1/2 to 52-5/8) each gained over 45% in market price during 1985, but the two blue chips had relatively mediocre performances on Wall Street compared with the across-the-board gains of the drug and drug diversified NYSE and AMEX stocks. More than one quarter of the 38 stocks tracked by the "F-D-C" weekly drug and diversified indices in 1985 gained over 50% during 1985. Marion (up 24-1/8 to 45-3/4) more than doubled; Syntex (up 22-1/2 to 46-3/4) and Upjohn (up 63-3/8 to 133-1/2) were not far behind with gains of over 90%. The broad drug and drug diversified stock surge carried both the "F-D-C" Composite index and the Poharmaceutical Component index to their largest single-year gains in the twenty-four years since "The Pink Sheet" began tracking weekly performances. The 39.4% increase in the "F-D-C" Composite index compares favorably with the overall bull market -- outgaining both the Dow Industrials (up 27.7%) and the Standard & Poor's 400 (up 25.9%). The Dow closed the year at 1546.67 -- just short of its pre-Christmas high of 1553.10. The boom in drug issues was reflected in P/E inflation. By year end, only three of the 16 issues in the "F-D-C" Pharmaceutical Component were carrying P/E ratios under 15 -- and one of those companies, Robins, was in Chapter 11. By contrast, at the end of 1984, only four of 17 stocks in the Pharmaceutical Component had P/Es over 15. Merck's 45.7% Market Value Increase Is Issue's Best Single-Year Performance Since 1958 SmithKline Beckman ended the year with U.S. drug sales of over $1 bil. but still no rejuvenation in the market's eyes. It carried a P/E ratio of 12 into 1986. Erbamont finished with a P/E of 14. Lilly and Schering, with P/E ratios of 15 and 16 respectively (up substantially in each case from the year before), also have relatively low P/Es in the drug group despite big market years. The extent of the pharmaceutical stampede in 1985 is indicated by the Merck and J&J performances. In normal years, either company had a runup of historic proportions; in 1985, they were in the middle of the pack. Merck's 45.7% run-up in 1985 is the stock's best single-year since 1958, when, spurred by the launch of Diuril (hydrocholorothiazide), Merck sales first topped $200 mil. In recent years, Merck's price growth has been retarded by the disappointing performance of its class of 1981 drug products (including Blocadren and, to a lesser extent, Dolobid); the withdrawal of potentially important products from the pipeline (Indosmos and Zelmid, omeprazole); and the vulnerability of mature products to generic competition (Aldomet and Indocin). In the four years before 1985, Merck gained only 9-3/4 net points for a compound annual growth rate of 2.5%. The turnabout in Merck's performance was aided by the market's late acknowledgment of a series of on-schedule new drug introductions by the firm in the U.S. For several years, Merck has been describing a large group of products targeted for introduction in 1985-1986: three of the products reached the market in late 1984 and 1985 (Tonocard, Primaxin, and Vasotec). Among Merck's potential products for the late 1980's which are drawing continued attention are a recombinant hepatitis B vaccine, the H[-antagonist Pepcid (famotidine) and the quinoline anti-infective Noroxin (norfloxacin). Those products could reach the market by 1988. Further out are the cholesterol lowering agent mevinolin and biosynthetic atrial natriuretic factor. Almost half of Merck's 1985 gains came in the final two months of the year. As in 1958, a major new cardiovascular product helped fuel the market. Since Nov. 1, when FDA notified Merck that the angiotensin converting enzyme (ACE) inhibitor Vasotec was "approvable," Merck stock has advanced nearly 20 points. The stock peaked at 137-3/4 before closing the year at 137. Vasotec is being introduced by Merck in the middle of January. Merck's product will be the second entry into the ACE inhibitor class. The category was developed by Squibb with Capoten. The imminent competition with Merck didn't cool Squibb's market year: the stock gained 26-1/8 points (48.5%). The apparent balance in Merck's pipeline in 1985 -- between emerging products to replace maturing lines and major potential for future -- looks like a model for adapting to the post-ANDA period. The investment community also began to read positive signs that J&J is adapting to both the changed drug business and the cost conscions hospital products business. After weak market years in 1983 and 1984, when the stock suffered from the scare of DRG effects on its hospital products business and the withdrawal of Zomax, J&J had its best performance in 14 years in 1985. Among the positive factors noticed by analysts was the continued rebound of Tylenol. The ibuprofen OTC introductions actually aided the rebuilding of Tylenol by providing a higher price umbrella under which Tylenol prices could also increase. With a last-out/first-back approach, FDA gave J&J the first new NSAID approval late in 1985 for Suprol, a little more than two years after negotiating the Zomax withdrawal by the firm. With a general analgesic indication, Suprol (to be marketed by McNeil and Ortho) may be a natural replacement for Zomax. During 1985, J&J filed NDAs for three new Janssen compounds -- the analgesic/anesthetic Alfenta (alfentanil), the nonsedating antihistamine Hismanal (astemizole), and the gastric motility agent Motilium (domperidone). Ortho has an NDA pending for a monoclonal antibody for use as an immunosuppressant in renal transplants, and McNeil has NDAs pending for the long-acting anti-psychotic Haldol and for the calcium channel blocker Vascor (bepridil), which is sublicensed from Carter-Wallace. In addition to its drugs in the pipeline, J&J's investments in biotechnology became more visible, with two agreements announced during the second half of the year. An August agreement with Amgen will give J&J marketing rights to three rDNA compounds -- interleukin-2, erythropoietin, and a hepatitis B vaccine. All three products are now entering clinicals. The Amgen agreement literally brought J&J's erythropoietin development project back to earth. The company had previously been pursuing the project in conjunction with Mc-Donnell-Douglas on space shuttle flights. The J&J/Cytogen agreement is a technology marriage of equipment and biotechnology -- with joint research planned for monoclonal antibodies for use as imaging agents with Technicare's magnetic resonance imaging system. Both J&J and Carter-Wallace lost ground in August on reports of adverse reactions to bepridil in Europe. Carter-Wallace subsequently announced that it had cancelled all clinicals. J&J said it would continue clinical studies for angina. Both companies are still looking to market the drug for angina. Carter-Wallace, which could have had a tough time with the bepridil news on the "Street" in a bad market, rode the uptrend to a 20-1/2 point gain to close at 48-1/8. Carter-Wallace's staying power in 1985 points out one of the subplots of the market year: the revived interest in the consumer product segments of drug based companies. C-W got a positive response from the market with its purchase of Youngs Drug Products. In mid-summer, with the stock trading in the $39-$40 range, E.F. Hutton analyst Lynne Pauls called the stock "one of the most attractive drugs stocks in our universe on the basis of new product flow and momentum in existing businesses." The analyst called the acquisition of the contraception products "excellent," comparing C-W and Youngs as two "aggressive consumer product marketers" with "complementary distribution systems." The market interest in consumer products was buoyed by three of the big mergers of the year: the Monsanto purchase of Searle and the auctions for control of Revlon and Rich-Vick's. In the bidding for the three companies, four well-heeled suitors made serious and generous takeover bids. Procter & Gamble took two of the auctions, buying Rich-Vicks out of the grasp of Unilever in early October and Searle's consumer products business from Monsanto one month later. Rorer Begins Year By Fending Off Cooper, But Business Mix Remains Attractive To Suitors The Revlon breakup flushed out the interest of American Home Products and Beecham for Norcliff Thayer. American Home was the first winner with an aggressive bid for Norcliff (and Reheis Chemical) in the $350 mil. range only to be topped by Beecham with a $360 mil. bid to Revlon's new owner, Pantry Pride. The high prices -- P&G paid 17 times earnings for Rich-Vicks -- set immediate bench-marks for the market to use on other consumer product units in the drug area. It also left at least two unsatisfied suitors (American Home and Unilever) and several others (including Pfizer) who were widely perceived as having an interest. The strain of merger mania pervading drug and health care businesses infacted Rorer from start to finish in 1985. The Rorer experience highlights one of the ironies of the 1985 run-up -- while making management's fiduciary responsibility to improve shareholder's value easy, the volcanic market activity probably made managing a lot less fun in 1985. Rorer began the year by repulsing overtures by Cooper Labs and ended the year a target of arbitrage speculation and a large upstream buyer in the drug business. Rorer was perfectly positioned at the center of merger speculation, with an existing Rx drug business, an established consumer products business and a potentially marketable medical device business (for a breakup in the style of Pantry Prides' disposal of Revlon). During the autumn merger activity, the stock was bid up as high as 47. Rorer cooled the speculation with its own large purchase, buying Revlon's ethical drug business for $690 mil. in an agreement set in late November. The purchase with borrowings will significantly increase both Rorer's debt and its potential marketing clout. It cooled the arbitragers' ardor (in conjunction with a denial by Sandoz of interest in Rorer) but may in the long-run raise the total value of Rorer substantially. Rorer closed the year as an independent with a net gain of 41.6% in stock price (up 10-1/2 to 33-3/4). Two other firms with consumer businesses, Sterling and Schering, were bid up by takeover speculation. Schering jumped 61.5% on a 22-1/8 point gain to 58-1/8. Sterling was up 30.3% to an 8-3/4 gain to 37-5/8. One of the vital signs pointing to the speculation about Schering-Plough was a shift towards increased institutional holdings in the company. According to recent Standard & Poor's figures, institutions have increased their holdings in Schering-Plough by 12.5% during 1985. On December 3, 1984, 335 institutions held 30.4 mil. shares of Schering (59.9% of the outstanding shares) with an average holding of 90,746. On Dec. 2, 1985, 359 institutions controlled 34.2 mil. shares of Schering (66.6% of the outstanding) with an average holding of 95,265 shares. Schering's management was one of the first to try to carve a major stake in the rDNA industry in the late 1970's and it seems unlikely that the company would be a willing merger partner in 1986 -- the year when the first U.S. approvals for interferon products are possible. Schering broadcast its attitude toward merger inquiries with a suit against Hutton in mid-December, alleging improper use of confidential information to aid a takeover attempt. Syntex Vaults Nearly 50% In Second Half On Gardrin, Cardene NDA Filings Schering has trimmed back its corporate profile in recent years and could be positioned to make a similar move in 1986 -- especially if needed to ward off an unwanted suitor. The Plough business, which is now a pure consumer products business without the radio stations, scould be an attractive divestiture. Pfizer, which was believed to be searching actively for consumer health businesses in 1985, was up 20% in trading for the year on a 8-3/8 point advance to 50-5/8. The gain would have been more substantial except for a tailing off in mid-December, when the stock lost more than five points between Dec. 13 and the year end. The market ostensibly reacted to a potential Feldene scare from U.K.; Pfizer faces two more tangible problems from new competition: the effect of Merck's Primaxin on the cephalosporin antibiotic market (Pfizer's Cefobid); and the entry of another branded nifedipine in the U.S. in late January (a challenge to Procardia). Miles, the U.S. subsidiary of Bayer (which developed nifedipine), plans to start marketing the product as Adalat this month. Syntex (up 92.8% on a 22-1/2 point gain to 46-3/4) continues to ride naproxen's continued clean performance, its Rx status and impressive growth. In FY 1985 ended July 31, Naprosyn (naproxen) and Anaprox (naproxen sodium) had worldwide combined sales of $420 mil., up 14.5%. The Syntex stock accelerated during the second half of the year coinciding with announcement of two NDA filings for major new products. During the fall, Syntex completed the NDA filing for its prostaglandin anti-ulcer compound Gardrin (enprostil) whose b.i.d. dosing analysts expect may give the product an edge over the other compounds of its class approaching the U.S. market, Searle's Cytotec (misoprostol) and Upjohn's Arbacet (arbaprostil). In addition, Syntex also began filing its NDA for the calcium channel blocker Cardene (nicardipine) in angina. With its stock selling around 30 in late August-early September, Syntex was the subject of several analysts' buy recommendations in early fall including a Goldman Sachs report in early September highlighting the enprostil launch in Mexico and recommending "aggressive purchase of the stock." Goldman Sachs predicted that "launches of enprostil and nicardipine will commence abroad ]in fiscal 1986 ended Sept. 30[, and newly developed medical evidence may well elevate the investment community's opinion of the former." Syntex' sale of its lagging opthalmic business in November to Pilkington Bros. PLC for $60 mil. was also seen as a plus by the "Street". In addition, analysts are predicting the divestiture of the firm's dental products business some time in the future. Taking into account a two-for-one split in mid-December, Syntex increased over 45% during the last six months of the year and closed Dec. 31 at an all-time high. Two companies in the Diverisifed Component, Warner-Lambert and Pennwalt, used the good market climate to do some pruning and take some bad news. The market reacted to the castor oil treatments with the attitude that, although the news was tough to swallow, it must be good for the companies. Warner-Lambert began December with the announcement that it would charge $550 mil. to fourth quarter earnings, to cover the writedown and sale of its three hospital supply/medical device businesses -- IMED, Deseret and Reichert -- as well as the consolidation of certain foreign plants, the discontinuation of some product lines and the establishment of an early retirement program. Though substantial, the $7.10 a share writedown was perceived by the financial community as a positive move by Warner-Lambert. Barron's ended the year with a congratulatory column, headlined "Just What the Doctor Ordered." The stock climbed in December despite the big charge to earnings. The issue reached a high of 49 before backing off slightly to close at 47-1/2, a 36.7% increase for the year. While extracting W-L from the lower margin device side of the health business and allowing the company to focus more carefully on drugs and consumer health products, the divestitures raise the stakes for the company in its bet on the pipeline. With Maxicam still stalled at FDA and facing additional trouble from safety questions in France and the support from the Helsinki study on Lopid still pending, the company is putting more pressure on its pipeline products in the distant future. To the 1985 bull market, the strategy loocked good. In a similar pruning move, Pennwalt announced a major restructuring program involving a $62 mil. pretax third quarter writeoff. The charge reflected the shutdown of two chemical plants and the divestiture of two other businesses. Again, the market liked the strong medicine. The stock, which was trading in the $37 range at the time the announcement was made in September, finished the year strongly, advancing over five points to close at 42-3/4, aa nearly 10% increase for the year. Like merck, Lilly's run-up in 1985 (up 45-1/2 to 111-1/2) reflected the "Street's" enthusiasm for a good balance between short and long term R&D. In the immediate future, Lilly will benefit from the recent launch of its ceftazadime product, Tazidime, and its anti-emetic Cesamet. In the short term, analyst interest has been picqued by the serotonin uptake inhibitor fluoxetine, which was recommended for approval by FDA's Psychopharmacologic Drugs Advisory Cmte. as an antidepressant in October. Fluoxetine's long-term potential is expected in novel indications such as obesity, alcoholism, and smoking cessation. Lilly prepared for the long term with an acquisition agreement with Hybritech. The first acquisition of an emerging biotech company, Lilly's purchase of Hybritech for nearly $375 mil. established a benchmark for biotech consolidation. Long-term bets on the drug pipeline stacked up on Upjohn in 1985, as it climbed from 70-1/8 at the beginning of the year to close at 133-1/2. Almost $2 bil. in 1985 dollars were bet on a minoxidil NDA for baldness (Regaine) which wasn't even filed with FDA until December, 1985. With FDA facing the hairy issue of evaluating a risk/benefit ratio for a drug with a cosmetic benefit, the early betting on Regaine is very heavy. For upjohn, which isn't generally managed for the convenience of analyst predictions, the 1985 run-up is an unusual period of bald, undisguised market affection. Despite the big 1985 gains, Upjohn carried a favorable ValueLine rating as a timely investment into 1986. Also high on the ValueLine investment survey among the drug stocks are Lilly, Marion and Syntex -- with the highest timeliness ratings. Second tier ValueLine ratings went to Abbott, Bergen Brunswig, Bristol-Myers, Merck, Pfizer, Schering-Plough, SmithKline Beckman, and Squibb. Marion has been a prime example of sustained market preference and performance throughout the decade. As a pure drug play with a strong flagship product, Cardizem, Marion has the easily calculable earnings growth that attracts the financial markets. Since the close of 1980, the stock's per share value has increased by a multiple of 10, representing an annual compound growth rate of over 57% during that period. Marion's strategic challenge as Cardizem matures is to avoid the one-product reliance that it experienced in the early 1970's with Pavabid. Abbott's appearance on the timely rating list is a compliment to the company's diversification from hospital supplies into diagnostics and drugs. The issue moved up 64% (41-3/4 points) in a year in which its two major competitors in the hospital parenteral business (Baxter and American Hospital Supply) merged. Despite the adverse impact of earnings from a reorganization of its Clairol appliance div., dilution associated with the acquisition of Genetic Systems, and continued aggressive promotional spending on Nuprin, Bristol-Myers (up 26.5% on a 13-7/8 gain to 66-1/4) held its own on the "Street" in 1985 with its fourth straight annual gain in the 25% range. Bergen Brunswig (up 9-1/2 to 32) and McKesson (up 14-1/8 to 52-3/8) shared in the market's excitement about the drug business. The strong wholesaler gains came despite the costs of continued consolidation. McKesson, for example, completed its coast-to-coast coverage with the $161 mil. purchase of Spectro in April. That deal was followed quickly with a $100 mil. acquisition of Mass Merchandiser and then the NYC wholesaler, S-P Drug for $80 mil. The expenditures didn't scare the market: for the first time in two years, McKesson was a net gainer. Bergen made four wholesaler acquisitions -- Allen, Davis, Synergex and Berry -- and a followup purchase (Cibcoa) to its Commtron consumer electronics business. The growth and Bergen's predictions of 10% growth through acquisition in fiscal 1986 sat well with the market. According to the performances of Bergen and McKesson, the cloud of the diversion charges and the investigation of the gray market did not affect the investment community's view of wholesaling in 1985. Charts omitted.

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