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ALZA IS DECEMBER DARLING IN BULLISH 1990 MARKET FOR PHARMACEUTICAL STOCKS: SEARCH FOR SECURITY IN UNSTABLE ECONOMY LEADS TO DRUGS, HIDES BLEMISHES

Executive Summary

Alza was the hottest of the hot pharmaceutical group as 1990 came to a close and the market turned to drugs as an antidote to recession, high oil prices and war fears. Adding over 16% to its value in the last month of the year, Alza finished 1990 at 50-7/8. All of the issue's seven-point net gain for 1990, in fact, came in the final month, and the stock closed the year at the top of its trading range. As it roared along in December, Alza raised $ 167 mil. from $ 750 mil. of LYONS (liquid yield option notes) due in 30 years. The darling status is not new for Alza. It has been an active speculative play several times during its 22-year history. What may be different this time is the tangible existence of a significant product (Pfizer's Procardia XL) and the prospect of about a half-dozen legitimate commercial prospects on the horizon, including the Procter & Gamble coventure for a periodontal antibiotic. Alza was hoping for at least one new product to clear FDA by year end, but none were included in the year-end wave of approvals. Alza retreated three points in the first three days of 1991 trading. The December surge in Alza and the interest in delivery system specialty firms was also apparent in a big year for Elan Pharmaceutical, up 52.8% in price for the year to close at 20-5/8. Elan, which got a boost late in the summer with the multiple launches of Verelan, was surpassed in market performance by only two other issues among the 49 drug and drug-related NYSE and AMEX issues in the "F-D-C" Index. With Lederle and Wyeth-Ayerst combining to launch Verelan (sustained release Verapamil) for Elan, the drug delivery firm was able to get 1,500 detail people behind the initial promotion push. The top two Index performers for 1990 were Barr Labs rebounding 82.1% (to 8-1/4) and U.S. Bioscience jumping 57.6% (to 19-1/2) on the approach of its first product. The top performer in the previous year, Mylan, suffered a 15% retreat after its meteoric jump of over 170% in 1989. U.S. Bioscience advanced almost 10% in the month of December alone when Hexalen received final FDA clearance at the end of the month (see related story p. 12). For a recent start-up, U.S. Bioscience is on a fast-track. It ended 1990 with a market valuation of over $ 323 mil. Continuing up for the sixth consecutive year, the F-D-C pharmaceutical index average gained 20.8% during the twelve months. More than half of the 27 issues in the pharmaceutical component had double-digit percentage gains for the year as the drug companies stood out from the general gloom as a safe harbor from the dim downward trend. The F-D-C pharmaceutical component advance compared to the 4.34% decline in the Dow 30 Industrials average for the year and a 6.56% drop in the S&P 500 average. The drug component's 20.8% gain was just short of half of its 45% bound in 1989, but it was perhaps more impressive than the previous year in comparison to the rest of the market performance. Sixteen of the 28 issues that comprised the F-D-C pharmaceutical component in 1990 were net gainers for the year (see box page 21 for the top gainers during the year; a tabulation of the performance of the 49 index issues appears on pages 24-25). (NEW LINE) (NEW LINE)1990 PERFORMANCE OF THE 49 PHARMACEUTICAL/DIVERSIFIED DRUG/CHAIN & WHOLESALER LISTED STOCKS USED IN THE WEEKLY "F-D-C" INDEX: HIGH, LOW AND CLOSE FOR THE YEAR The "F-D-C" Composite Index and its four components are based on 28 Pharmaceutical stocks, 10 Diversified Drug stocks, 7 Chain Drug stocks and 4 Medical Supply Wholesalers. The Pharmaceutical components lists two types of common shares of SmithKline-Beecham, SBE and SBH, both of which are traded in the U.S. SBE is the more actively traded. (FOOTNOTE) n1 2-for-1 split. * Traded on American Exchange.(END FOOT) The drug industry's perceived strength versus the rest of the market was widely ballyhooed by the pharmaceutical specialists in the investment community and the broader market watchers. The drug analysts formed a uniform chorus in their assessments of the generally positive prospects for the industry. Their views were reflected in year-end reports with headlines such as "An Investment Prescription For A Slow Economy: A Dosage of Drug Stocks" (Mabon Nugent, October 8) and advice such as recommendations for "strong overweighting of drug stocks" (Goldman Sachs, November 28). In one December report on 13 drug firms, there was virtually no sign of a general recession. The lowest earnings per share growth estimate for a company in 1991 was a prediction of a 13% advance for American Home Products. The top EPS growth in the group was projected at 38% for Rhone-Poulenc Rorer -- a daunting challenge in even the best of times. The bullishness on pharmaceuticals is not limited to the cognoscenti. More general investment services such as ValueLine tout the drug industry across-the-board as a good bet going into 1991. At the end of the year, the drug industry ranked second among all industry segments in ValueLine's assessment behind only the foreign telecommunication industry. Ten drug stocks carried that investment service's top rankings for safety and growth at the end of the year: Abbott, Bristol-Myers Squibb, Glaxo, Johnson & Johnson, Lilly, Merck, Pfizer, Schering-Plough, Syntex and Warner-Lambert. The Commerce Department also looks to the drug industry for a good year in 1991. Its annual U.S. Industrial Outlook for 1991 predicts a 4.1% real growth rate for the drug industry as a whole. Pharmaceutical preparations are projected by Commerce to grow at 3.5% and maintain their ranking as 30th among the 184 SIC industry codes. Biological products rank higher on the commerce chart at eighth, with a 6.2% growth forecast in the year just getting underway. In the rush to cloak the drug industry with the anti-recession mantle, the financial community passed over a wide array of disconcerting events. In many ways, the investment perspective of the industry was aided by the bad news of the larger, big-picture stories of the year. Events that might have elicited handwringing and pessimism in normal years caused only slight side glances in 1990. The market looked past a number of potential political pitfalls: the real challenge to the drug industry's pricing prerogatives and marketing practices from the Medicaid rebate program; the converging threats to the important Puerto Rican tax breaks; and an apparent softening of the industry's political effectiveness in Washington. Stock performance also looked past the gloomier sides of individual company stories to the brighter long-term picture. The SmithKline Beecham experience in 1990 illustrates that optimism. In a normal year, how would the market react to a company that voluntarily gave up exclusivity and high margins on one of its long-term profit engines (Dyazide), faced narrowing indications for one of its most visible new product candidates (granisetron), struggled with the costs and personalities of a new merger organization (an $ 870 mil. writeoff for consolidation and a large influx of new faces from the outside in top management), and wrestled with the impact of a severe government-imposed discount formula on its leading product, Tagamet? In 1990, the answer was easy. The market declared SmithKline Beecham global, undervalued and experiencing the healthy pains of a second corporate adolescence. SBE equity units (the more actively traded of SmithKline's two U.S. stock issues) jumped 22.9% for the year to close at the top of its trading range at 53- 1/4. When SmithKline gave up market exclusivity on Dyazide by licensing it to Rugby for generic distribution, the market responded favorably viewing the move as a clever way of evergreening profits from an aged product. The financial community's reaction has not gone unnoticed by other companies, and several firms with products nearing patent expiration are reportedly being more receptive to inquiries from generic marketers for licenses on major mature products. Syntex, which faces the December 21, 1993, expiration of its naproxen patent, is very open about its desire to be the leading supplier for multisource manufacturers. The company has begun running carrot-and-stick advertisements in trade publications declaring its intent to be a top quality supplier of the active ingredient following patent expiration and to enforce appropriate process patents. Because of the Rugby deal, several analysts are projecting a slower downslope for Dyazide sales as the product becomes multisource for the second time in its strange up-down-up-down sales pattern. SmithKline is apparently on track to meet analyst projections of sales in the range of $ 240 mil. in 1990 despite the Rugby alliance. If the firm can prevail in court against the generic companies that used fraudulent ANDA filings to move into the Dyazide business in 1988, then it may generate further income from Dyazide ("The Pink Sheet" June 18, T&G-8). With Tagamet, SmithKline faces two big challenges: increased competition in the ulcer class (where it appears to be losing share to Prilosec as well as Zantac) and the marketing/pricing disruptions of the new Medicaid rebate law. The challenges may be particularly difficult in Tagamet's case but similar situations are being faced by almost every U.S. drug company. Reputedly an aggressive marketer with managed care organizations, SmithKline may have some sizable existing discounts. The company will have to decide whether to try to change those discounts or risk having to match them to the Medicaid business. To keep the Medicaid discounts manageable, the firm quickly signed at least one agreement (with Florida) at the time of enactment of the Medicaid rebate plan in early November. That agreement was at the 12.5% discount rate. One of the markers to watch as an indicator of the general effect of the Medicaid rebate program is whether the price of Tagamet is forced down further to state programs based on pursuit of the "best price" concept. Overall for the industry, the Medicaid rebate program will dominate many pricing questions in the upcoming year. Its rather quiet acceptance by Wall Street was another clear example of the market's ability to look past potentially tough news in 1990. In almost any other year, a federally-mandated rebate in the U.S. could have started a panic as the dreaded first step toward price restraints in the last unfettered major pharmaceutical market. The program is estimated to save the government (and, by inverse, to cost the industry) approximately $ 3.5 bil. over five years. One example of the Street's unperturbed attitude to the Medicaid program is a short assessment by Goldman Sachs analyst Prem Lachman, MD. Acknowledging that the industry's "pricing flexibility" in the future will be changed by the rebate program, Lachman then estimates that the overall effect on earnings will be relatively minor. In the short-term, Lachman contends, "Medicaid discounts should have a limited effect to drug industry earnings and profits ... (on the order of 5" to 10" for large companies like Merck and Bristol-Myers Squibb, and 10" or more for smaller companies)." In the longer perspective, Lachman accepts the industry view that the access to the market for new products and pricing flexibility for those products essentially will be preserved or enhanced. The very nature of the political process that made the Medicaid rebate so difficult for the drug companies to stop in Washington may have ameliorated the impact of the program on the financial markets. Buried as part of the overall budget debate, Sen. Pryor's (D- Ark.) drug price cuts were virtually unassailable. Once adopted in principle by the Office of Management & Budget as a budget-cutting device, the Pryor rebates could not be effectively attacked by industry. But they were also hard for the financial sector to comprehend because of the noise of the larger budget battles. Whatever the effect of the rebate plan on sales, the program's "best price" language (requiring firms to meet the best existing market prices in deals with Medicaid) is having an impact in marketing and pricing. U.S. pharmaceutical divisions are being obligated to review and rethink the discounting and product bundling approaches of dealing with managed care. Some companies reportedly are finding it difficult themselves to determine their existing best prices on individual items because of the intricate bundling agreements that exist across groups of products. That problem may actually protect some products by making it difficult for state governments to determine the best prices in the private markets. A noteworthy aspect of the Medicaid rebates to watch in 1991 will be the reaction of the major managed care buyers to price chages. If drug companies act to narrow their price ranges by getting rid of some discounts to the private sector, those managed care buyers may complain loudly. The extent to which their complaints are heard and acknowledged by the media or politicians may have a large effect on the severity of the next round of pricing challenges to the industry. Some managed care buyers are already complaining. One prominent West Coast managed care operation already maintains that some of its low price contracts are being cancelled, ahead of renewal dates. Drug companies are apparently approaching the changes cautiously and trying to perform a balancing act: raising prices on products that would be available to Medicaid and lowering prices that are more specifically aimed at hospital and institutional buyers (such as unit dose items). The Medicaid wars also uncovered a darker side of intra- industry relations that may have an impact on the future investment attractiveness of the drug industry. In their natural efforts to seek the best programs for their individual product lines, several firms appeared to let revenge against competitors take an undue prominence. Firms with tight price policies, for example, took delight in the problems a best price policy created for discounting firms. Similarly, SmithKline and Glaxo have recently crossed swords vengefully on Capitol Hill over tax breaks, with little real competitive advantage at stake. SmithKline started the fight with complaints about duty reductions for ranitidine and Glaxo responded with questions about SmithKline's use of Sec. 936 tax credits. Changes to either policy could hurt a number of firms in the industry. That type of competition in the political sphere can be dangerous. It can create a split-house image that encourages attacks on programs such as Sec. 936 or R&D tax credits, both of which were singled out for late-year criticism by one of the industry's most vociferous critics, Rep. Stark (D-Calif.). Using a Congressional Research Service review of the 936 tax breaks, Stark estimated that the drug industry saved as much as $ 1.4 bil. in taxes by manufacturing in Puerto Rico in 1987 ("The Pink Sheet" Dec. 17, p. 14). The Sec. 936 tax break is always vulnerable in a period of budget shortfalls. It is getting attention from an unemployment angle as well. Rep. Hiler (R-Ind.) weighed in against the credits during 1990 in response to the closing of an OTC drug plant in Elkhart by American Home Products. The plant was shut as part of AHP's review of capacity in the post-Robins merger period. Hiler took up the cause against 936 on the grounds that the drug industry is exporting jobs to Puerto Rico ("The Pink Sheet" Oct. 8, T&G-12). The various threats to the industry's use of the tax savings program combine with the continuing debate over statehood, independence and commonwealth status for the island to make the future for Sec. 936 look less predictable. Again, however, the financial markets were not too concerned in 1990. Mabon Nugent's James Kenney observed on October 8 that "the industry is already casting about for other tax shelter possibilities, i.e., expansion of facilities in Ireland, or startup production in Singapore." As an example of other options available, at the end of the year, Schering-Plough noted that it was expanding its Brinny, Ireland facility to handle all of the lyophilizing and packaging for Intron for the world market, and GM-CSF, a biological collaboration between Schering-Plough, Genetics Institute and Sandoz. Intron, which has now reached over $ 150 mil. in annual worldwide sales, is a key product for Schering, one that the company has taken to calling it "a new drug for the next 10 years" because of its expanding indications. The most alluring new marketing stories in 1990 appeared to belong to Pfizer. In addition to the successful transfer of the standard release nifedipine market to Procardia XL, Pfizer built a new market in antifungals. Its Diflucan doubled the overall market for that class of drugs to $ 200 mil. during the product's first year of sales. Pfizer is starting 1991 with another new product, Cardura (doxazosin) a cardioselective alpha blocker to be sold by the recently enlarged Roerig sales force. Based on the favorable November 19 advisory committee review of sertraline, Pfizer looks poised to be the first to compete with Lilly in the U.S. in the lucrative serotonin reuptake inhibitor antidepression class. The firm also has potential near-term new products in Minipres-XL, Reactine (cetirizine, an anti-histamine), and Xoma's (Xomen-E5 anti-septicemia product). The Xoma product (and its competitor from Centocor, Centoxin) may actually be aided by the potential hostilities with Iraq. The anti-endotoxins may be pushed to wider acceptance by their use in treatment of combat victims. Centocor has said that its product has already been cleared for use by the military in Operation Desert Shield. On the Street, Pfizer has been getting some further notice in recent weeks for its claims for its next generation calcium channel blocker, amoldipine (Norvasc). The company has been saying that the new generation product could surpass the $ 700 mil. annual sales of the Procardia family by the mid-1990's. Pfizer is also warming hearts with a new personality. The recently-introduced products have helped to re-establish a research image for the firm and the shifts in top management are putting new faces in contact with the public for the company. Two other firms got surprisingly good greetings from the Street for new faces: Abbott and American Home Products. At Abbott, the company thrived despite an uncomfortable year of corporate soap opera as ex-Chairman Robert Schoellhorn left amidst a suit-countersuit. For the year, the firm showed an 11-point gain for a 32.4% advance, on top of a 41.7% advance the year before. While pharmaceuticals remain a relative sidelight at Abbott, the firm has received attention for the potential use of Hytrin in benign hypertrophy. Some of that attention was unwanted from FDA for promotion of an unapproved use, but the financial community is sensitive to the problem being treated because of Merck's closely- watched Proscar development project. Abbott's drug research is showing the ability to keep in the running with the top firms on some projects. For example, Abbott's work on new approaches to asthma treatment was paired with Merck's first publication of clinicals with its leukotriene project in The New England Journal of Medicine at the end of the year. The firm has a new product to market for 1991 as well. Its long-pending benzodiazepine hypnotic ProSom was approved by FDA at the end of 1990. The praise for the changes at American Home Products come, characteristically, despite the company's stolid and standoffish public demeanor. In a mid-October report for Shearson Lehman, analyst Mary Ellen McCarthy said she was surprised and impressed by an encounter with representatives of Wyeth-Ayerst's new R&D group. "We recently had a rare opportunity," McCarthy wrote, "to meet with American Home Product's senior R&D management at the National Eye Institute/Juvenile Diabetes Foundation meeting and were struck with the positive changes that have taken place -- unnoticed by Wall Street -- at this sleepy division." McCarthy focused on the R&D rejuvenation and revived prospects for Alredase (tolrestat) and other pipeline projects. But Wyeth- Ayerst is also having apparent success putting together the five businesses that had to be merged in recent years: Robins, Elkins- Sinn, Wyeth, Ayerst and Ives. Recently, for example, the firm merged the injectable businesses into a combined Institutional Products Division. Wyeth-Ayerst also earned some good wide publicity for its adoption and successful shepherding through FDA of the Population Council's Norplant FDA registration. Sales of the five-year contraceptive will begin in February. The firm continues to have the steady Premarin conjugated estrogens product. The product is unchallenged in the marketplace again by generics, but that may not last long. FDA considers the creation of guidelines for generic competitors to Premarin as the "first and foremost" guideline priority under the new director of the generic drugs division, Roger Williams ("The Pink Sheet" Dec. 17, T&G-4). FDA's decision to look at the generic approval criteria for conjugated estrogens may help Barr Labs, which has been carrying on a long, and unusually public, struggle with FDA to get a generic version of the product approved. Rep. Dingell remains on the side of a generic approval for Premarin ("The Pink Sheet" Dec. 24, T&G-10). FDA's revamped generic drugs division is also setting the development of generic guidances on cefaclor (Lilly's Ceclor) prior to that product's patent expiration two years hence as a test of its ability to anticipate pressures for generics due to changes in patent status on major products. The chances of future generic competition for Ceclor and a perceived slowdown in the growth of Prozac took some of the shine off of Lilly's stock market performance. The stock advanced 7% for 1990 after a 60% jump the year before. Late in the year, Lilly President Gene Step reminded analysts that some of the company's antibiotics are tough to copy as generics. Specifically, he said that "some competitors may be in for a big surprise" because of the complexity of cefaclor production processes. The toughest patent protection project of the 1990s probably goes to Glaxo which has set for itself the task of keeping Zantac an exclusive product through the year 2002. One patent on the product expires in 1995, but Glaxo is now maintaining that that patent is for an unmarketed version of the product. If Glaxo can take Zantac to 2002, it will realize the full 17-year patent life for the product and set a new model for other firms to try to match. Glaxo's challenge in the next two years will be to see if it can get the world pharmaceutical markets to accept the substantially higher prices for its replacement products in the asthma market. The firm brought on salmeterol (Serevent) in the U.K. at 10 times the price of albuterol. The premium will be less (about double) in the U.S. but still will be sizable. Glaxo may also face difficulty if the asthma market trends away from inhaled beta-agonists. A December 8 article in Lancet suggests a potential relationship of inhaled beta-agonists with asthma morbidity in New Zealand. The drug studied in the Lancet report was fenoterol. Exhibiting one of the most attractive qualities to the market, Glaxo is showing predictability in its development projects. The firm made a tight deadline for the development and NDA approval for Zofran (ondansetron) in the U.S., where it got approval just after the New Year (see related story, p. 3). Its salmeterol filing appears to be ahead of schedule based on FDA's acceptance of foreign data. On the other side of the NDA development equation, however, Glaxo's efforts to register the Alza albuterol system Volmax have been stalled for more than a year. Charts omitted.
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