Pharma? Think small
While big drugmakers stumble, their nimbler rivals are delivering products -- and profits.
(FORTUNE Magazine) - If you're looking for a growth play in the drug business, small is better.
Small Pharma, known to Wall Streeters as the specialty pharmaceuticals sector, is brimming with innovative little companies that are often overlooked by investors. On the whole, Big Pharma stocks have been poor performers over the past half-decade. Though many of the industry giants still represent solid long-term investments, they can hardly be considered the growth drivers they once were.
As product pipelines dried up and companies faced pricing pressure from generic makers--and Congress--Big Pharma shares began a long, slow descent. Since Jan. 1, 2001, in fact, the Amex pharmaceutical index has dropped 19%. Over the same period, the Russell midcap health index, which comprises a host of smaller specialty-drug companies, has risen a stunning 69%.
The march of medical innovation hasn't slowed; it has merely shifted to the small and mid-sized drug companies and biotechs. Many are nimble niche players. They home in on a particular area of research, like cancer, central nervous system disorders, or heart disease. Still others focus on underserved markets like dermatology, deemed too tiny in potential sales for Big Pharma.
But when Small Pharma does discover a potential mega-seller, companies like Bristol-Myers Squibb (Research), Eli Lilly, Merck, and Pfizer have been increasingly writing big checks, either to acquire their wares or to strike licensing deals. As a result, nearly 40% of the new medicines unveiled by Big Pharma in the past five years originated in small and midsized company labs.
Some of the drug sector's most exciting new medicines--and indeed, whole new product categories--are coming from Small Pharma.
Cephalon (Research), with a market cap of $4.8 billion, has forged a path in central-nervous-system research. The company's bestselling drug, Provigil, a remedy for narcolepsy, is also heavily prescribed for late-night shift workers, truckers, and airline pilots who need to stay alert and focused.
Cephalon, based in West Chester, Pa., has also built a robust pipeline of promising compounds: Vivitrol, a forthcoming injectable medicine to treat alcoholism; a cancer-pain reliever dubbed "OVF;" and Nuvigil, a follow-on version of Provigil.
In addition, Cephalon's experimental attention-deficit treatment has sparked some recent interest on Wall Street. The drug, called Sparlon, could benefit from an FDA panel's recent recommendation that ADHD drugs carry a warning about cardiovascular risks. Cephalon claims clinical tests show that its ADHD medicine, a nonstimulant, is safe.
Morgan Stanley analyst Marc Goodman believes Cephalon's pipeline--especially its emerging cancer franchise--is "underappreciated" by investors. Cephalon has promised an ambitious schedule of product launches in the next 15 months and hopes to double revenues, to $2 billion, by 2008.
In addition, Cephalon emulates its Big Pharma brethren, often using targeted acquisitions to scoop up noteworthy compounds; it has bought five firms in the past five years. The company also won big on the legal front recently, successfully fending off four manufacturers poised to sell generic Provigil. The stock traded recently at a price/earnings ratio of 24. After attending Cephalon's recent R&D symposium, Goodman raised his year-end price target for Cephalon to $83.
Kos Pharmaceuticals (Research) competes head-to-head with Big Pharma in one of the industry's toughest markets: cholesterol-lowering. The company's Niaspan, a $432-million-a-year drug, not only lowers cholesterol but also raises so-called good cholesterol (or HDL) more than other remedies currently on the market.
Later this year, Kos is expected to release a combination of Niaspan and generic Zocor. Although both Pfizer (Research) and Merck (Research) have similar combination drugs in the works, Kos is likely to reach the market a full year ahead of its larger rivals--sometime in 2007 or 2008. As a result, analysts believe, Kos could gain a significant share of the emerging HDL market by 2009.
With a P/E of roughly 15, the $745-million-a-year company is trading at a 28% discount to the average stock in the specialty pharma group. And with a market cap of $2 billion, "Kos is clearly a takeover candidate," says Amy Stevens, specialty pharmaceuticals analyst with Susquehanna Financial Group.
"Buying a company like Kos could protect Merck's or Pfizer's cholesterol franchise. It's definitely something you can envision happening in the next year."
Founded in 1992, Collagenex has sales of $26 million and a market cap of $227 million, making it the smallest and potentially riskiest company of the three. It originally marketed and developed low-margin dental remedies. But in 2002 a study found that its drug for severe gum disease, Periostat, could also clear up acne.
The Collagenex executive team seized the opportunity to transition the company into higher-margin dermatology sales and research. Meanwhile, Periostat lost patent protection, causing a drop in sales that put Collagenex in the red in 2004.
Now the company markets a handful of proprietary skin treatments. Aiding a projected return to profitability by 2008 is an experimental rosacea remedy called Oracea. The drug is awaiting FDA approval, which is expected this summer.
Oracea would be a first-in-class oral product for rosacea and could garner peak sales of about $125 million by 2010. Collagenex also possesses an acne pill known as Incyclinide, in Phase II testing. Adam Greene, a specialty-pharma analyst with First Albany Capita, has a strong buy rating on Collagenex and has set a year-end share-price target of $19. In this case, thinking small could pay off big.