Weighing Two Drivers for Pharmaceutical Stocks

The global Pharmaceutical industry has long been plagued by fears of the “patent cliff”—the looming expiration of patents on drugs accounting for about $90 billion in annual sales between 2010 and 2015.

Once patents expire, generic pharmaceutical firms typically manufacture virtually identical drugs at steeply discounted prices, and branded-version sales can fall off the proverbial “cliff.” Anticipation of these lost revenue sources has driven Pharmaceutical stocks to historically low valuations.

Exhibit 1: “Patent Cliff”—Estimated Sales of Drugs with Expiring Patents (2010-2020)

Sources: Company Filings, IMS Health Data, Fisher Investments Research. Dollar figures of drug sales as of 2009.

Exhibit 2: MSCI World Index Pharmaceutical Industry Valuations

Sources: Thomson Reuters. MSCI World Index Pharmaceutical Industry from 7/14/2003-06/14/2011.

But the patent cliff is widely known and has already depressed valuations—meaning, looking forward, it’s likely lost much of its power to impact Pharmaceutical stocks. Additionally, the focus on the patent cliff has obscured an equally important but lesser-known positive driver: positive pipeline developments—namely, New Molecular Entity (NME) approvals. An NME is a unique drug without precedent and no derivative or version of it has been approved by the FDA. These drugs have the potential to cure or treat various diseases and disorders in a novel way. Or perhaps treat a disease for which no current treatment exists. NMEs can translate into blockbuster sales and pricing power for Pharmaceutical firms.

Perhaps it’s the lack of a catchy name or investors’ outsized focus on the negative, but most investors today are seemingly overlooking current trends in NME development. After several disappointing years of below-average development, 38 NMEs are on pace for approval this year—the highest total in years.

Exhibit 3: NME Approvals

Source: FDA, Fisher Investments Research. 2011 figure estimated.

While the patent cliff is a challenge the Pharmaceutical industry must navigate in the coming years, it’s important to place it in context with other drivers. This widely publicized concern eases in two years and, balanced against NME approvals, likely isn’t as large a negative as many presume, in our view. Weighing these two drivers in the Pharmaceutical industry seems to indicate a brighter outlook than valuations currently reflect.