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Executive Summary

Forest Labs' 20%-plus earnings growth from niche markets is making it one of the select few pharmaceutical companies still in favor on Wall Street in the continuing market trough. Forest's 3-1/8 point gain for September helped the company to close up 7.5% in the third quarter to 37-1/2. Forest is being helped by a perception that it is insulated from the market pressures facing most drug companies. The company is flying high with nine analysts rating it "buy" or "strong buy" and three "neutral" at the end of September. In July, Forest reported earnings growth of 25.6% in its fiscal first quarter after posting 29.7% earnings growth for its fiscal year ended March 31. Shearson analyst Richard Silver noted in a July 8 report that "Forest remains one of the few 20%-plus earnings growers in the drug industry, continuing to buck the negative trend experienced by many of the large-cap companies." Forest's September run-up, however, was based on an old- fashioned market mover: a new product approval story. Forest's anti-influenza drug Flumadine was approved by FDA Sept. 17 with labeling suggesting a side-effect advantage over the only marketed influenza drug, DuPont Merck's Symmetrel. The company should also benefit from the increased lay media and health care professionals' attention to influenza being generated by reports of a virulent strain hitting the U.S. this fall and winter. Although the Flumadine application took seven years to clear FDA, Forest managed to obtain approval within 14 months of licensing the drug from DuPont Merck and just three months after filing a supplement covering a new raw material supplier in mid- June. Other new product opportunities, including the antibiotic Monuril, the lung surfactant Infasurf and the Alzheimer's drug Synapton, continue to draw investors to Forest. During the quarter, the company also licensed a second investigational Alzheimer's treatment, AF102B, from Japan's Snow Brand Milk Products Ltd. While Forest traded up based on traditional Wall Street measures of drug company success, the overall pharmaceutical index shifted into neutral as the gearing up of the Clinton health care reform plan and the proposed Merck/Medco merger drove investors to contemplate now ways to value the industry. The pharmaceutical component of the "F-D-C" index of NYSE and AMEX traded stocks closed the quarter down 3.7%. The composite index of drug, diversified, chain and wholesaler stocks was down 2.5%. As drug stocks moved well into their second year in the glare of changing views on America's health care system, many investors appear to be waiting for an epiphany that will permit them to see the future for pharmaceuticals. An Aug. 18 statement by New Jersey Gov. Florio (D) that the Clinton plan would not include price controls was seized on as an early talisman and sent the drug stocks climbing. The pharmaceutical component of the "F-D-C" index closed up more than 10% for the week. However, despite another uptick when President Clinton publicly reiterated the no price controls prediction, no long-term recovery materialized, in part because the details of the Clinton health plan described several price review mechanisms that looked to many like controls. The pharmaceutical component of the index finished the quarter virtually unchanged (down .5%) from its Aug. 20 close. By the end of the quarter, more and more investors appeared to be adopting the view that the current slump in drug stocks may be just the beginning of a longer trough as the pharmaceutical market place transforms itself -- with or without health care reform. One long-time industry watcher, Kenneth Abramowitz of Bernstein Research, told an IMS America/Princeton Entrepreneurial Resources seminar in Trenton, N.J. Oct. 6 that he believes health care stocks in general will be out of favor for as long as five to 10 years as the market transforms. That prediction matches another key market indicator -- the amount of venture capital going into start-up firms. According to a recent analysis of the biotech business by Ernst & Young, 48 seed investments and investments in first-stage firms occurred in the year ended June 30, and 109 companies received money from venture capitalists. That level of start-up activity is similar to the hot period of company formation investment in 1988 ("The Pink Sheet," Sept. 20, p. 12). Ernst & Young execs estimate that some of that activity represents betting by investors that the pharmaceutical and biotech sectors will recover as favored segments by the public markets in about four years -- when those start-ups would be ready for a first round of public money. Abramowitz argues that the slow period for the drug companies on Wall Street provides an opportunity for long-term investment by drug execs. The analyst suggests that while the industry should be diligent in cutting costs wherever possible, it should simultaneously "raise R&D spending 10%-15% or more forever, purposely faster than sales growth." Since the industry will be out of favor on Wall Street for the foreseeable future, he suggested, companies should take advantage of the reduced pressure on short-term performance in exchange for a stronger product position when the sector recovers down the road. The proposed acquisition of Medco by Merck, a self-proclaimed paradigm shift on the part of Merck, signaled the new world order for pharmaceutical stocks. Where once drug companies promoted themselves to analysts based on the premium-priced "blockbusters" in their product pipelines or on the market, companies are now stressing the breadth of product lines, pipeline depth and cost effectiveness. Where sales force size was once the measure of a company's marketing might, "capitation," "shared risk" and "clinical outcomes" have become the watchwords in deals with pharmacy benefit managers. As the market place shifts, companies have become more willing to discuss publicly their discount/bundling strategies. In a July appearance before the New York Society of Security Analysts, Lilly suggested that it was making deals to provide all antibiotics for certain buyers in exchange for a per capita fee. In the wake of the Merck/Medco announcement, other companies have been discussing similar arrangements. Ortho Biotech President Dennis Longstreet told the IMS/P.E.R. seminar that his company has "guaranteed efficacy" programs in place for Procrit. Under the deals, Ortho agrees to replenish free of charge any supplies of Procrit erythropoietin used in anemia patients who subsequently require transfusions, Longstreet said. Once again, the biggest winners on the pharmaceutical component of the index were generic firms: Barr (up 37.5% to 24- 3/4), Biocraft (up 10.6% to 28-3/4), Circa (up 32.7% to 8-5/8), Halsey (up 38.5% to 6-3/4), K-V (up 21.3% to 20-5/8), Mylan (up 7.8% to 29-3/8) and Pharmaceutical Resources, Inc. (up 24.7% to 12-5/8). Generic drug firms continue to be perceived as likely winners under market reform. The value of generics, however, has not been lost on brand name manufacturers. During the quarter, Lilly became the latest company to disclose plans for an in-house generic division. Other companies, such as Lederle and Abbott, began to highlight their existing generic businesses more prominently in public. Investors, however, apparently do not perceive the incursions of brand name firms into the generic market as a threat to the generic industry. Many continue to expect brandname companies to opt for takeovers of the independent generic firms on the model of Marion Merrell Dow's acquisition of Rugby. The generic industry, however, lost one round of the battle to market the largest selling pharmaceutical (ranitidine, Glaxo's Zantac) before the end of the decade. A ruling in the patent case brought by Glaxo against Novopharm upheld the validity of Glaxo's second Zantac patent. If the ruling stands on appeal and Glaxo successfully defends the patent in a second case against Genpharm, the company will end up with more than 17 years of market exclusivity for Zantac, with generic competition forestalled until 2002. Glaxo closed the quarter up 2-1/8 (12.6%). The company also likely benefited from the negative FDA advisory committee meeting on SmithKline Beecham's application to switch Rx Tagamet to over- the-counter status. The patent victory leaves Glaxo in the somewhat awkward position of wanting to spread the good news of extended market exclusivity to the financial community without crowing too loudly and drawing political attention. The company excluded the press from an appearance at a Bear, Steams investment seminar soon after the court decision. By the end of the quarter, financial analysts were beginning to accept the proposition that now standards of valuation for brand name drug stocks would be necessary. Alex. Brown's Barbara Ryan, for instance, accepted much of Merck's "new paradigm" rhetoric in a Sept. 2 report. "The pharmaceutical industry of the future will be an oligopolistic structure with few sellers meeting purchasers' demand through lower unit costs and outcomes data," she predicted. "The successful pharmaceutical companies of the future will be large and vertically integrated with high market share and lower per- unit prices made possible by greater efficiencies and economies of scale," Ryan concluded. A counter-trend to the vertical integration by pharmaceutical manufacturers and marketers may be represented by the recent acquisition of a small mail-order firm, Tel-Drug, by Cigna. The implied strategy in the Cigna move is for the payer to integrate backward to be the supplier of pharmaceuticals instead of contracting with an independent mail-order or pharmacy benefit firm to provide the service. Merck itself did not benefit from its role as the bellwether for the new market, dropping 4-3/4 points (13.4%) to close the quarter at 30-3/4. Merck shares dropped sharply immediately following the merger announcement, as the agreement will result in dilution for Merck shareholders. Many analysts who favored the merger also suggested buying Medco stock as a cheaper way to buy into Merck. While Merck shares continued to languish during September, there were signs that it is winning over analysts to its new paradigm. According to Zacks Investment Research, 12 of 41 analysts following the company rated it a "strong buy" with six more rating it a "buy." Only two analysts recommended selling the stock. Twenty-one of the 41 analysts following Merck were neutral on the stock, according to Zacks, and that neutral posture seemed to capture the market's sentiments toward drug stocks in the quarter. Analysts are overwhelmingly neutral toward large-cap pharmaceutical stocks, with a majority recommending no action on Glaxo (14 out of 23), Bristol-Myers Squibb (19 of 35), Warner- Lambert (19 of 34) and Lilly (22 of 32), according to Zacks. With the broad pharmaceutical market in flux, analysts have been looking for niches or safe harbors within the industry. Like Forest, Schering-Plough has been drawing attention as that type of investment. In September, against the ebb tide of the Clinton health plan kick-off, Schering-Plough jumped 4-3/4 points to close at 65-7/8. After a stand-out performance in the first six months of the year, Schering-Plough lost ground in July and August following disappointing quarterly results. The September rebound helped the company recover to close the quarter off only 3-7/8 (5.6%). The stock was helped in September by a meeting of FDA's Generic Drugs Advisory Committee to discuss albuterol metered-dose inhalers. Many analysts interpreted the meeting to mean that Schering's Proventil MDI would be free of generic competition through 1994. On Sept. 15, S. G. Warburg cited the meeting in upgrading the stock to a "buy." A Barron's encomium to the stock in the Oct. 4 issue of the financial weekly reflects Schering's current favor and explains the reasoning behind a current belief that Schering may dodge some of the potential problems facing other major drug companies from the Clinton plan. Because many of Schering's products are used by patients under the age of 65, some analysts are projecting that the company will not be affected by Medicare pricing restraints on the drug business. The impact of the approval of Flumadine on the market value for Forest contrasts with the market reaction to approval of Warner-Lambert's Cognex. The addition of a niche market drug to a smaller company like Forest was welcomed as likely to contribute directly to bottom- line growth. The long-delayed approval of Cognex, once hailed as a blockbuster, was greeted ambivalently and is being viewed as a test of the ability of a larger company to successfully promote a product with a modest labeling description of efficacy to an untapped market. News of the approval had no impact on Warner-Lambert's stock price apart from a one-day, two-point upward blip. In the context of concerns about HMO coverage of the drug and a patent suit brought by Hoechst, the Cognex approval did nothing to offset the difficulties posed by an August consent decree with FDA resulting in the shut down of much of Warner-Lambert's manufacturing. Warner-Lambert finished the quarter down 4-3/4 (6.7%) to 66-1/8. By the end of the quarter at least one analyst, Lehman Brothers' Jerome Brimeyer, felt that Warner-Lambert's slump presented a buying opportunity. In a Sept. 30 report, he argued that the decision by two HMOs not to cover the drug would have little impact given the relatively limited penetration of the Medicare market by HMOs. Brimeyer noted that the company has said that "almost all state Medicaid programs are likely to cover the drug." Since "many Alzheimer's victims eventually become eligible for Medicaid," he argued, this augers well for the drug's success. He forecasts peak sales of Cognex of $300 mil. and a near term target stock price for Warner-Lambert in the mid-70's.

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