Investing in Drug Companies

Have you enjoyed the run up in healthcare stocks over the past few years? As a group, the healthcare sector has grown over 140 percent for an average of 28 percent per year over the last five, beating the S&P 500 broader market’s 120 percent, or 24 percent annual gain.

But recent activities in the healthcare space are tossing up a number of red flags, warning the sector’s adrenaline rush may be wearing off. Valuable patents are about to expire, and as pharma companies lose their drugs, their stocks could soon suffer withdrawals – literally.

The ticking of the patent clock is forcing the world’s largest research-based pharmaceutical company, $204 billion mega-cap Pfizer Inc (NYSE: PFE), to grow its revenues the fastest way possible – acquisition, announcing yesterday that it has raised its offer to buy U.K.-based AstraZeneca (NYSE: AZN) to $100 billion.

Both stocks rose on the news, with potential buyer PFE rising more than 4 percent while the potential buy-out AZN rose more than 12 percent, increasing its market cap to $97 billion, close to Pfizer’s offering price.

Might this be the last hurrah for those and other pharma stocks? There are other factors at play behind Pfizer’s interest in AstraZeneca, which could be signalling the healthcare sector’s financial health is not as sound as investors currently believe.

Big Pharma Revenues About to Tank

As is usual, a company in pursuit of an acquisition typically has two lists of reasons – one list it reads to the press, and the other it keeps to itself.

To the press and investors, Pfizer explained its interest in AstraZeneca is driven by its commitment to providing the best quality medications at the best possible price. Synergy between the two pharma giants would cut costs and expedite the development of new drugs to benefit more patients more quickly.

“We believe patients all over the globe would benefit from [both companies’] shared commitment to R&D, which is critical to the future success of the pharmaceutical industry, in the form of potential new therapies that help to fight some of the world’s most feared diseases, such as cancer,” Pfizer announced in its statement.

Similar cost-cutting-motivated M&A activity can be seen throughout the pharma sector in preparation for drastically lower revenues going forward as a number of patents are set to expire, allowing generic drug makers to flood the marketplace with cheaper replica medicines.

AstraZeneca, for one, will soon be losing patent protection on two of the most lucrative drugs on the market: acid-reflux treatment Nexium and cholesterol medication Crestor. In the U.S. alone, Nexium and Crestor were the second and fourth highest grossing drugs in 2013, generating a combined $11.17 billion in sales, according to data compiled by Drugs.com.

In those two drugs alone sits more than 43 percent of the company’s 2013 annual revenue of $25.74 billion. That’s a huge chunk of business about to be siphoned off by competitors soon.

You might think that in the face of upcoming patent expirations, AstraZeneca would welcome Pfizer’s $100 billion buyout offer, originally priced some 20 percent above AZN’s market cap before yesterday’s surge in its stock price.

But AstraZeneca is holding out for more. It knows what’s going on in the pharma sector – some serious repositioning.

Swiss-based $208 billion mega-cap Novartis AG (NYSE: NVS), U.K.-based $134 billion large-cap GlaxoSmithKline (NYSE: GSK), U.S.-based $63 billion large-cap Eli Lilly (NYSE: LLY) and Canada-based $44 billion large-cap Valeant Pharmaceuticals (NYSE: VRX) have either already completed major mergers and acquisitions or are actively pursuing them.

Indeed, there is more behind this flurry of M&A activity besides the publicized synergy, cost savings and product-line expansions. A good many of these are cross-border deals. There is a very good reason why overseas businesses are on American companies’ radars, reasons which are largely kept hush-hush.

The Real Reason Behind Cross-Border M&A

Analyst Jeffery Holford of Jefferies LLC estimates Pfizer has around $30 billion in profits from overseas sales still sitting outside the U.S., which it can’t do much with until the money is brought back home. The only problem is that repatriating those profits would lose as much as $9 billion in corporate income tax.

The alternative, therefore, is to put those overseas profits to work overseas. And the way to do that is to purchase overseas companies. When U.S.-based $286 billion mega-cap Johnson & Johnson (NYSE: JNJ) – the largest drug company by sales in the world – was looking for a country in which to put its foreign profits to work, it chose Ireland, which has one of the lowest corporate tax rates in Europe at 12.5 percent – less than half of America’s 30 percent rate.

Other factors behind all this M&A activity within the pharma space is the huge run-up in healthcare stocks, giving companies a lot more buying power which they are eager to make use of before it gets eroded away in a stock market correction.

Reducing Your Dose of Pharma Stock

Investors may well consider trimming some of their pharma holdings and locking-in some of their stellar gains. After five years of hyperactive growth, the pharmaceutical sector is ripe for a correction more than any other sector out there.

Patents are expiring, drastically cutting corporate revenues as generic drug makers start putting cheaper replicas on the market. The latest year-over-year revenue growth is already anaemic: GSK at 1.5 percent, AZN at 0.5 percent, NVS at 0.2 percent, PFE at -2.4 percent, and LLY at -16.4 percent. Imagine how bad the numbers will be when their most lucrative patents expire.

Yet there’s more trouble for pharma stocks on the horizon, as governments vow to keep pursing tax-dodging corporations by introducing new measures to collect tax money any way they can, and as insurance and healthcare providers keep pushing for lower prices and rebates on medicines. Add these all together and you get a sector that is under tremendous pressure to correct downward.

Yet there may still be some areas within the pharma space that could remain attractive for some time – all those underdog generic manufacturers that are rubbing their hands as they eagerly await the expiration of patents so they can move in for a piece of the action. A well-timed swap out of a large manufacturer and into a generic one might work-out in the case of a popular drug’s patent expiration.

You might even stick with what has been an analyst favorite for years… Johnson and Johnson, which stood out among its peers with one of the highest year-over-year growth rates of 3.5 percent – especially given its diversification into personal care products and other consumer staples.

As for the other large drug producers, investors might be better served slowly reducing their portfolio’s dose. The pharma-induced high may be about to lose its kick.

Joseph Cafariello