Genentech’s Q3 Highlights Healthcare Cost Issues

There is little arguing that the rising cost of healthcare is one of the biggest issues hampering the U.S. economy. Next year, average health insurance premiums are expected to surpass $14,000 per family. That will represent one-third of the average household income in this country. The main reason for such staggering costs are prices for prescription drugs. Drug expenditures, which were $12 billion in 1980, hit $179 billion in 2003. That’s an average increase of 12.5% per year, more than 4 times the historical rate of inflation.

Investors need look no further than the Genentech (DNA) Q3 earnings report to see exactly how crazy drug prices have gotten. Genentech’s newest and second-best selling drug, Avastin, costs a whopping $140 for a day’s supply. That equates to $4,400 per month and $53,000 per year. Should a drug for colon cancer really cost 20% more per year than the average household income in the United States? I bet very few could argue it should.

The argument for limiting the costs of prescription drugs centers around the idea that limited profit potential will result in less research and development, and therefore fewer novel therapies for the world’s most lethal diseases. Without the ability to make a significant profit, proponents of a healthcare free market say, drug makers will lose the incentive to discover new drugs for cancer, heart desease, etc.

However, a simple analysis of Genentech’s third quarter income statement shows that this theory, while it makes sense in economic terms, simply isn’t true when you actually look at the numbers. Here are some key facts from DNA’s latest earnings release:

* Genentech’s drug mark-up (retail price versus manufacturing cost) is 662%

* Only 38% of the drug company’s profit is reinvested into research and development, and net profit after tax actually surpasses total R&D expenditures

* Drug company net profit margins are nearly 20%, higher than any other major industry

And the one that is important to understand when hearing the debate on spiraling costs for prescription drugs:

* If retail prices for Genentech’s drugs were reduced by 50% effective immediately, the company would still be able to spend the same amount it does today on R&D and would have more than $400 million left over in excess profit every year

BioCryst Rally Warrants Trepidation

Shares of biotech firm BioCryst Pharmaceuticals (BCRX) have caught fire lately after worries over a potential Avian Flu pandemic have flooded media outlets. The stock is up 80 percent to $17.65 already this month and has tripled in the last three months, giving the company a market cap of nearly half a billion dollars.

To say this violent move to the upside is based on speculation would be a dramatic understatement. The excitement over BCRX comes from a flu vaccine that the company actually scrapped in 2002 after it failed late stage clinical trials. However, with Avian Flu worries running rampant, the company has decided to bring back the drug and test it on bird flu. Early indications show it might have some kind of positive effect, but it’s way too early to conclude the drug, Peramavir, would be successful in preventing the spread of Avian Flu.

Investors, though, haven’t really focused on the downside (an ineffective drug brought back into testing only to get shelved again), but rather only on what it could do, become heavily useable in case a pandemic of Avian Bird Flu does sweep the globe. What happens if Avian Bird Flu goes the way of SARS, and in several months we never hear of it again? Or what happens if BioCryst’s drug shows to not work, or not work any better than drugs that have already been approved by the FDA for the flu (TamiFlu from Gilead, for instance)?

There is no doubt that BCRX shares have momentum right now as individual retail investors gobble up shares while the media hypes the potential death toll from an Avian Flu pandemic. Such momentum could drive the stock higher in the short term, with $20 or $25 very feasible. However, for BCRX to maintain its current share price for the longer term, after the hype dies down, a lot of things need to go perfectly, most of which the company and investors can’t control. If that doesn’t happen, remember that BCRX was a $3 stock in April of this year.

Spiraling Healthcare Costs

I just got a notice in the mail from United Healthcare. My premium will be going up by 21 percent on November 1st. That’s right… 21 percent in a single year. Although politicians campaigned on the issue, and Bush and Kerry continually pointed to the rising costs of healthcare as a grave concern during the 2004 presidential debates, nothing has been done about it. This is despite the fact that annual premium increases of 15 to 25 percent have been commonplace recently, with overall inflation only running 2-3 percent per year, and wages that have been flat for four years running.

All we can do really, aside from shopping around for better rates (which I’m doing), is try and make some of this money back via the healthcare portion of our investment portfolios. United Healthcare (UNH) will continue to grow earnings at double digit rates as long as Washington doesn’t help us citizens out with healthcare reform. And that industry growth will persist regardless of whether gasoline is $1, $2, or $3 a gallon, or if Fed Funds are priced at 3%, 4%, or 5%.

Arbitrage Monday

For those of you out there who like to play the merger arbitrage game, take a look at today’s merger announcement between OSI (OSIP) and EyeTech (EYET). OSI is paying $15 cash and 0.12275 shares for each EYET share in a deal expected to close by year-end. The current 5.6% discount on the deal represents a nearly 17% annualized return for arbitrageurs.

Big Pharma Has Tough Road Ahead

Texas Jury Finds Merck Liable in Death of Man Who Took Painkiller Vioxx, Awards Widow $253.4M

Big pharmaceutical companies like Merck (MRK) and Pfizer (PFE) are a lot riskier to own than many believe. Sure they have nice dividends and low P/E’s, but a lack of new drugs to make up for patent expirations, and extreme legal uncertainties will make it tough for these companies to grow.

Before today’s award, Merck was hoping its total Vioxx liability from the thousands of open cases would be no more than $10 billion. Well, the very first judgment against them today should raise some eyebrows.

Many people are recommending the big drug stocks for their fat yields and historically low multiples, but I have been taking the other side of the coin, and will continue to avoid these names.

Amgen Report Could Prompt Closing of Genentech Gap

The 2nd quarter earnings report from biotech giant Amgen (AMGN) issued Tuesday night was a blowout, no question about it. With much of the biotech acclaim going to Genentech (DNA) in recent years, AMGN has flown under the radar and now investors are clammering to catch up. In fact, the stock is up $10 today to $80 per share. However, even with today’s run-up does Amgen still represent relative value in the biotechnology sector?

I would have to answer “yes” to that question, even though I would wait for a dip before buying any shares. Genentech trades at 52 times 2006 earnings against just 22 times for Amgen. Not to say that these multiples should be identical, but such a discepency most likely reflects an overly optimistic view on DNA and fairly lackluster sentiment surrounding Amgen. I see no reason why Amgen should garner less than 25 times earnings given its strong drug pipeline and 15% growth rate.

BSX Hits New Low

Shares of medical device maker Boston Scientific (BSX) are hitting new lows today at $29 per share. The stock now trades at less than 14 times this year’s expected earnings, despite being the leading maker of a new class of heart devices known as drug-eluting stents. These new stents are coated with drugs that help patients heal from cardiovascular surgery and are widely becoming the de-facto standard within the industry.

As has always been the case with medical devices makers such as BSX, Guidant (GDT), St. Jude Medical (STJ), and Medtronic (MDT), competitive concerns continually drive share price fluctuations. While Boston Scientific is in the lead today, Johnson & Johnson (JNJ) has solidified the number two position and will surely be helped by its pending acquisition of Guidant. Both Medtronic and Guidant have yet to begin selling their drug-eluting stents, but they are in testing. Within a year or two, most players will have competing products on the market, cutting into Boston’s lead. Hence, BSX shares are making multi-year lows today.

The good news though, is that the number of competitors is decreasing due to consolidation in the industry. The medical device market is still growing at a double digit clip annually. Although BSX’s stent market share will likely decline in coming years, the company will remain a strong competitor and currently trades at a steep discount to the other companies in the industry. The stock’s near-term momentum is definitely down, but investors should keep a close eye on Boston Scientific, as an opportune time to buy the beaten-down shares will most likely present itself at some point in the future.

When Do You Buy Pfizer?

A one-year chart of Pfizer (PFE) looks more like a black diamond slope in Vail than a stock price graph. The stock has fallen almost 40 percent over the last 12 months. Now, at$24 per share, you hear a lot of recommendations to buy PFE. The 3.1 percent dividend yield is very attractive, combined with a 2005 p/e ratio of less than 12.

After holding off in the low 30’s and high 20’s, Pfizer shares at today’s prices don’t have too much downside if you want to try and catch a falling knife. A Celebrex withdrawal would prompt significant selling, but aside from that, most of the bad news has been priced in.

The issue really is growth. Money managers on CNBC will exclaim that Pfizer hasn’t traded at 11 or 12 times earnings in years, with historical p/e ratios ranging from 17 to 30 times over the last decade. The problem is, Pfizer was growing nicely back then, at a 15 percent annual rate. Those days appear to be over as mergers have created a company with more than $52 billion in sales. At this point, a new blockbuster drug (defined as $1 billion in annual sales) contributes less than 2 percent to Pfizer’s total sales.

As a result, sales are expected to be essentially flat. The current 2006 revenue estimate for Pfizer is less than 2 percent higher than the company’s actual 2004 sales. While 11 or 12 times eanrings may be too modest a valuation, the days of 17-30 multiples on the major drug companies are over in my opinion.

Merck Cuts 2005 Guidance (We warned you!)

Just to follow-up the piece I put out here about a month ago on embattled pharmaceutical giant Merck (MRK), here’s an update on what the company said this morning. Merck cut its 2005 earnings guidance to $2.47 per share (their range is $2.42-$2.52), citing the withdrawal of Vioxx. Consensus estimates had been for a profit of $2.57 for next year.

Last month, I suggested that 2005 estimates might prove tough to hit (analysts estimated $2.60 per share at that point). During today’s conference call, the Company failed to mention anything about setting aside reserves for Vioxx-related litigation. Merck will have to address this at some point in the new year and many believe they will have to allocate $10-$20 billion to settle claims.

The company remains adamant that it will not cut the dividend, which stands at $1.52 per share. This still seems unrealistic given the need for Merck to set aside reserves and also continue its R&D in order to replace, not only Vioxx revenue, but also Zocor when its goes off patent in 2006. Maintaining a payout ratio of 62% ($1.52/$2.47) seems like a poor use of cash flow. Once management realizes this, the dividend will be the first thing they cut.