03/09/2007
Pharmaceutical sector is now facing significant headwinds
Lance Phillips is head of overseas investment at Standard Life Investments
We have been concerned about trends in the pharmaceutical industry for some time. Having been through a purple patch of discovering blockbuster drugs in new therapeutic areas, followed by industry consolidation and cost cutting, many of the big-cap pharmaceutical companies appear to be facing headwinds.
Although the sector has underperformed in the last year, we are unconvinced the market has fully priced in the issues facing many companies.
The first major challenge has been R&D productivity – scale beyond a certain point does not necessarily bring greater efficiency.
It is also unlikely there are easy finds left in small molecule chemistry for the major disease groups. The result for the big-cap pharmaceutical companies has been weak pipelines and a new focus on buying or licensing in promising drug ideas from smaller technology firms.
Astrazeneca has identified a need to buy new drugs to fill its pipeline. The downside is that these deals are increasingly expensive.
It has also become more difficult to get approval for new drugs. After the withdrawal of Merck's Vioxx drug, on the back of worries about increased incidence of heart failure, the US Federal Drugs Administration (FDA) has become more concerned with drug side-effects and safety.
For the FDA, approving non-novel drugs with (by definition) untested side-effect profiles will be low priority.
There is also the issue of controlling healthcare costs. Governments, healthcare services and insurers are keen to limit the growth of spending on pharmaceuticals. This is impacting the prices achieved for non-novel drugs and willingness to reimburse non-essential drugs.
A recent high-profile case involved Sanofi's weight-loss drug, which Germany designated a lifestyle drug and refused to reimburse. The US has focused on the overuse of some drugs – particularly Amgen's Epogen, used to combat severe anaemia in cancer and renal failure patients.
In portfolio terms we have been light most of the big-cap pharmaceutical companies. Exceptions have occurred where we think the market has fully discounted future prospects.
Within healthcare we have focused on stocks where we have a material, non-consensus view of the future of the company. Two good examples are a Spanish stock, Grifols, and the US company Baxter. Both are involved in making pharmaceutical products from blood plasma.
The general backdrop to the industry has been improving. After years of oversupply, we have seen supply-demand return towards balance. Demand for some products is growing rapidly as new indications are found and more people in developing countries are able to access treatment for diseases.
Generally, it is difficult to bring new supply to market. It takes up to five years to build a new plant, validate equipment, produce a trial product run and prove product stability.
There are also rules against importation of plasma-derived products from non-EU and non-US countries.
Grifols is in the enviable position of having most of the industry's spare capacity. It should therefore benefit from higher prices for its products and higher volumes. We do not think this has been fully priced in by the market. Baxter has been through painful restructuring and is reaching the point where the strength of its plasma business will start to shine.
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
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