Is the Pharma Industry Facing Pharmageddon?

The pharmaceuticals industry has always been one of the riskiest in the market. Companies operating in the pharma industry are required to invest heavily in research and development on drugs whose outcome is highly unpredictable. Companies like Pfizer (NYSE: PFE), Merck(NYSE: MRK), and Johnson & Johnson (NYSE: JNJ) among others, have toiled this red flagged industry for years. Note that, despite the risks associated with investing in the industry, the potential upside is always enormous. No wonder, they say, “the higher the risk, the higher, the return.” But this is not always the case.

What’s in this industry anyway?

The Pharma industry holds one of the biggest potential upsides across all sectors. Perhaps only Technology and Energy can compete on equal footing. Nonetheless, the attractiveness of this industry is yet the biggest peril for investors. Sounds like a paradox? Well, here is the deal. Some investors view the industry as next to gambling. Indeed, if a company, say Johnson & Johnson, manages to get things right and gets approval from Food and Drug Administration (FDA) to proceed with the licensing and the manufacture of a certain drug, then the returns are usually skewed to the right. The opposite is usually true.

A good example is the anticipated launch of three drugs by Pfizer, which have fuelled the demand for its stock, pushing it to a new five and a half-year high of $27.65, on February 1. The company received approval from FDA for its Rheumatoid Arthritis treatment available in pill form in November 2012, although it is yet to receive the marketing materials approval. It also received two more approvals in January.

Elsewhere, Johnson & Johnson is expected to improve significantly during the current campaign following the approval by FDA for a drug that is expected to treat a form of resistant tuberculosis that is uncommon in the U.S., but growing globally. On the other hand, Mylan is said to have received final approval from FDA for its Abbreviated New Drug Applications (ANDA) for Rizatriptan Benzoate Orally Disintegrating Tablets. The drug is a generic type of Merck’s Maxalt MLT and Maxalt tablets.

The Pharmageddon?

According to a report published by PriceWaterhouseCoopers (PWC) in November 2012, the pharma industry is expected to more than double its current value to the tune of $1.3 trillion by the year 2020. However, for large pharmas to romp in tandem with the industry, they are expected to change their game by diversifying their services and products, as the quandary of costs balloons to levels that could threaten disintegration. Indeed, this is already very evident with the rate of spin-offs already witnessed in the industry.

Additionally, pharma companies are looking to buy small drug makers. Pfizer has already expressed interest in acquiring Israel-based Protalix BioTherapeutics, in a deal valued around $1 billion. One major advantage of making such acquisitions is that it widens customer access without having to develop structures and market niche. This reduces R&D costs, something PWC pointed to be essential, if the big pharma companies are to realize the 2020 dream.

Another major problem facing the Pharma industry is the luck of talent. The pharma industry has shed 150,000 employees within a space of six years, but is now claiming to be running short of the right people to run their businesses.

Furthermore, rising costs in R&D are cannibalizing on margins. If this continues, the companies might begin posting distressed balance sheets, as cash reserves diminish. This explains one of the reasons behind the spin-offs, which analysts view as an attempt to “let go” of the unyielding units.

The companies have also been forced to stash cash in tax friendly countries in a bid to fund the heavy investment in R&D as well as possible acquisitions. For Instance, Merck, which is also the third-largest drug-maker in the U.S., in 2009 brought more than $9 billion from abroad without paying any U.S. tax to help finance its acquisition of Schering-Plough.

Bottom Line

The report by PWC suggests that pharma companies should focus on managing R&D costs and adverse outcomes associated with drug production rather than selling drugs. The companies look too far ahead before strategizing on how they could minimize the impact of the two quandaries. As evidently revealed, a good outcome will always pay dividends, and handsomely. But once again it’s never guaranteed.

This year, Pfizer would be an awesome buy following the three approvals from FDA, Johnson & Johnson has nothing to lose as it looks to launch more drugs during 2013, and therefore short term could be a wise investment. Merck, on the other hand, will have to overcome its most recent setback (in ongoing litigation over its osteoporosis drug Fosamax). The company has already received several downgrades from analysts following the news. Stay on the fence with Merck.