Reap profits from the war on cancer

By Jim Jubak

Do you own the right drug stocks or the wrong ones? Is your portfolio ready for all the changes sweeping the drug sector?

I'm not talking about the momentary fears of what will happen to drug-company profits when a Congress with a Democratic majority is seated in January.

Sure, drug stocks have taken their lumps since the Democrats swept the board in the Nov. 7 elections. Shares of Merck (MRK, news, msgs) fell 7% in the two days after the election. Pfizer (PFE, news, msgs) dipped by 5% from Nov. 7 through Nov. 10. Novartis (NVS, news, msgs) dropped 6% from the election through Nov. 14.

Investors fear that Democrats are serious about their pledge to repeal the current ban that prevents the federal government from negotiating lower drug prices for seniors subsidized through Medicare's drug benefit. And that the new Democratic majority in the House and Senate will revive legislation to allow the import of cheaper drugs from other countries and launch investigations into charges of lax safety standards at the Food and Drug Administration.

No wonder drug stocks have stumbled.

A sea change in the sector

But investors should look past the effects of the November election on drug stocks to the longer-term trends in the sector.

While everybody on Wall Street is worried about how Congress might crimp drug company profits, the leadership in the drug sector is undergoing a sea change. For the first time ever, sales of oncology (cancer) drugs in 2006 will outstrip sales of the anti-cholesterol drugs that have been the industry's best sellers, according to market researcher IMS Health. In 2007, sales of cancer drugs will grow nearly three times as fast as drug sales overall, while sales of anti-cholesterol drugs will creep ahead by just 1% to 2% in 2007. That's a drop from projected growth rates of 6% to 7% for anti-cholesterol drugs in 2006.

That's good news for companies (and stocks) such as Genentech (DNA, news, msgs) and Novartis and bad news for companies such as Pfizer and Merck.

This isn't the only shift ahead for the drug sector in 2007. For example, the world's emerging-market countries -- those with a per-capita gross national income of less than $20,000, according to IMS Health's way of counting -- will contribute 30% of growth in drug sales next year. That's almost equal to the 36% of growth contributed by the U.S. market, even though emerging-market countries now make up just 17% of global drug sales. Drug sales in emerging market countries India, China, Brazil and Turkey grew by 10% in 2006 and, IMS projects, will grow by 10% in 2007. Growth in the U.S., on the other hand, will slow to 4% to 5% (from 6% to 7% in 2006) and will slow in Europe to 3% to 4% (from 4% to 5%).

Generics will continue to take market share and patented drugs will continue to lose share. The generic market will grow by 13% to 14% in 2007. Patented drugs with a sales value of $16 billion will lose patent protection in 2007, on top of the loss of patent protection on $23 billion in drugs in 2006. And, IMS Health concludes, sales of new patented drugs won't be enough to offset these losses.

It won't be a bad year for drug companies and their stocks. The global market will grow by 5% to 6% in 2007, making the sector a good shelter from potential storms in 2007.

But it will be a different year. Are you ready?

A static year for anti-cholesterol drugs

The shift in market leadership from anti-cholesterol heart drugs to anti-cancer treatments is the big story in my opinion. The anti-cholesterol market is likely to stay roughly static next year with sales growth of 1% to 2%. That's not the kind of growth drug stock investors are used to or willing to pay up for. No wonder shares of Pfizer, whose anti-cholesterol drug Lipitor is the world's best seller in this category, are trading at just 16 times trailing 12-month earnings and 13 times projected earnings. That's way below the 22 or 23 price-to-earnings ratio that the stock commanded in 2004 and 2005.

Why the slowdown in the anti-cholesterol market? Massive penetration in the developed markets that adopted these drugs first hasn't reduced the number of new patients for the drugs. (The need for anti-cholesterol drugs goes up as your income goes up, and you adopt more and more elements of a U.S.-style diet.) And patients and doctors in emerging markets are opting for cheaper generic versions. Increasingly, that's true in the developed world, too. (No wonder, since generics can cost 30% to 80% less than brand-name versions. Brand-name anti-depressant Prozac goes for about $6 a pill while the generic version, fluoxetine, sells for about 20 cents.) And patients don't actually have to buy the generic version for the maker of the patented drug to feel the pressure. Pfizer's Lipitor, protected by patent until 2011, is facing stiff competition in 2007 from the generic version of Merck's Zocor.

Cancer drugs speed ahead

And why the acceleration in the oncology market? Chalk part of it up to demographics: As the world ages, more and more people are surviving the diseases that once killed them before they had a chance to develop cancer. So as the world ages, cancer is a bigger problem for more and more of the world's population.

But this market wouldn't be growing so fast if it weren't for another huge change: More and more anti-cancer treatments work. Survival rates have improved so much that some cancers can be considered treatable chronic diseases, and others are on track for treatment as preventable conditions. All this will lead to 20% growth in the oncology drug market in 2007. Remember that the drug market as a whole is projected by IMS Health to grow by just 5% to 6% in 2007 and the anti-cholesterol market by 1% to 2%.

It's hard to quickly redirect the energies of a big drug company even when the market's shift is so pronounced. Anti-cancer drugs accounted for just $2 billion of Pfizer's $51 billion in sales, or about 4%, in 2005. And the next big drug due to come down the pipeline at Pfizer, Torcetrapib, is an anti-cholesterol drug. That drug was the star of Pfizer's recent analyst day -- and with potential annual sales of up to $10 billion, the excitement is understandable. But while Torcetrapib re-enforces Pfizer's hold on the anti-cholesterol market -- especially in light of the 2011 patent expiration for Lipitor -- it doesn't give Pfizer a franchise cancer drug.

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