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By Ed Channing | Published Aug 06, 2012

Pharmaceutical companies are worth revisiting

With the continued economic uncertainty, the compression of yields on UK government bonds and the expectation that returns on cash could stay low, investors are wondering whether pharmaceutical firms deserve a fresh look. Members of the sector not only pay high levels of income as dividends, but are also actively buying back their own shares. Does the potential for gain in the sector justify its risks?

The pharmaceutical sector has had a turbulent few years in the run-up to the well publicised ‘patent cliffs’ affecting a number of the mega-cap pharmaceutical companies during 2012-13.

A number of these companies’ key drugs were coming off patent, raising fears that they would be copied by manufacturers of generic copies. The fear of cheap generic drugs destroying profit margins outweighed the fact that shares in the sector looked good value. Some commentators labelled certain big pharma companies as ‘value traps’.

Approaching patent cliffs

Investors are correctly focusing on the current patent cliffs within the sector. However, with uncertainty comes change, and the sector has started to reinvent itself by cutting its costs, selling off non-essential businesses and focusing on acquisitions to replenish its drug pipeline. This has been highlighted recently with the high profile sale of SMA by Pfizer to Nestlé and the purchase of Ardea Biosciences by AstraZeneca for $1.3bn (£815m). Pfizer is undertaking a root and branch reconstruction of its operations following the loss of its US patent on Lipitor last November. Lipitor was not only described as the most successful drug in the pharmaceutical industry’s history, but also contributed between $12bn-13bn in global sales for the company, $6bn of which were in the US.

The rush for growth at the beginning of 2012 meant that the pharmaceutical sector has underperformed relative to the rest of the market. Its returns are seen as being driven by a rerating of companies’ valuations, rather than an expansion of their activities. This, however, hasn’t always been the case. Pharmaceutical firms once formed the backbone of growth-orientated portfolios. The sector reinvented itself by expanding its non-core businesses in the 1970s, undergoing an explosion of research and development in the 1990s and consolidating in the 2000s. As it moves through 2012 into 2013, the pharmaceutical industry could become a more streamlined, profitable and growth-orientated sector over the coming decade.

Dependent on the US market

One criticism of the pharmaceutical sector is that it is overly dependent on the US market. Although it would be wrong to underplay the importance of the US market, the rise in disposable income in the advanced developing markets has increased in importance. This is a situation that is expected to continue and therefore reduce over-reliance on the US. The change in appetite in the developing markets towards western consumer brands within the growing middle class in China, for instance, has been an unexpected driver. As disposable incomes have risen, consumers have been willing to purchase more expensive western brands rather than cheaper generic alternatives.

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