Morningstar Advisor - August/September 2010 - 29

Reform’s Impact on Pharma’s Earnings
2011 2012 2013 2014 2015 2016 2017 2018 2019

Abbott Laboratories ABT AstraZeneca AZN Bristol–Myers BMY Eli Lilly LLY GlaxoSmithKline GSK Johnson & Johnson JNJ Merck/Schering MRK Novartis NVS Pfizer/Wyeth PFE Sanofi SNY

–3% –3% –6% –5% –2% –2% –4% –2% –3% –2%

–3% –2% –5% –6% –2% –2% –4% –2% –3% –3%

–3% –2% –6% –5% –2% –1% –4% –2% –3% –3%

–1% –1% –2% –2% –1% 0% –1% –1% –1% –1%

0% 0% –1% –1% 0% 0% 0% 0% 0% 0%

0% 0% 0% 0% 0% 0% 0% 0% 0% 0%

0% 0% 0% 0% 0% 0% 0% 0% 0% 0%

0% 0% 1% 1% 0% 0% 1% 0% 1% 0%

1% 1% 2% 2% 1% 0% 1% 0% 1% 1%

The FDA now demands more safety data on these drugs, and the agency has delayed several of the industry’s major pipeline products, including Eli Lilly’s cardiovascular drug Effient, Merck’s cardiovascular drug Tredaptive, Novartis’ NVS diabetes drug Galvus (which might not enter the U.S. market), and Schering-Plough’s anesthesia drug Bridion. In each of these cases, approved treatment options already exist, which allowed the FDA to delay new treatments without a major backlash from doctors and patients. In response, big pharma firms are moving away from primary-care treatments to diseases with unmet medical needs in therapeutic areas such as oncology, neurology, and immunology. Treatments focus on small patient populations, but the lack of options for these patients increases the odds of FDA approval. According to GlaxoSmithKline, orphan drugs take 20% less time in clinical trials and face regulatory approval times that are 50% faster than those of traditional drugs. Further, the probability of approval for an orphan drug is double that of a traditional drug. Quicker development times result in lower drug-development costs, which play well into pharma’s efforts to cut costs without hurting productivity. The FDA also is aggressively helping firms develop new drugs to treat diseases that lack therapies. For the first time, the FDA ran two programs (at the Keck Graduate Institute in February and the University of Minnesota in August 2009) to educate industry insiders on the benefits of developing new orphan drugs. We think this outreach reflects a sincere willingness of the agency to support new orphan-drug applications. In addition to a more-receptive regulatory environment, drug developers like orphan drugs for another reason: profits. Treating rare diseases can lead to big money. One reason is that in the orphan-drug market drug companies hold all the pricing power. During the past decade, managed-care organizations have consolidated, enabling them to demand

Data as of June 30, 2010. Figures are estimates and measure the reform bill’s yearly effect on each stock’s earnings per share.

Investors, however, should think long term and consider the industry’s fundamentals and opportunities. By 2014, we estimate that the volume created by the increased number of insured patients will mitigate the cost pressures of reform. By 2019, we estimate that reform’s measures will add 1% to the industry’s EPS. Because of their sharper focus on drugs, Bristol-Myers Squibb BMY and Eli Lilly face the biggest swings in earnings. In 2011, both companies will see their EPS decline 5% to 6%. But as the reform benefit becomes a net positive for the industry, the two firms will earn the most from reform, with just more than 2% growth to EPS in the latter part of the next decade. Another aspect that investors are ignoring is that the industry has been aggressively cutting costs out of the system, a fact largely obscured by the reform-related earnings hit. Restructuring programs that were put in place the past couple of years are already pumping up the group’s margins and should position it on a solid earnings growth trajectory. If cost cutting and the minor outcome of reform are not enough to perk investors’ interest, two larger developments that are transforming the industry should. Pharma companies are redeploying research and development

resources that at one time focused on primary-care markets in maturing economies to fast-growing, underserved emerging markets and to making revolutionary “orphan drugs” that treat rare diseases. These changes should yield stronger pricing power than the industry has today, longer shelf lives for drugs, and a lower cost basis.
A Push for Orphan Drugs

In some ways, the move to develop niche drugs, or “orphan drugs,” was set in motion by industry failures. Since the heyday of primarycare blockbuster drugs in the late-1990s, there have been several controversies in which the safety of popular drugs were questioned. In 2004, for example, Merck MRK recalled its arthritis drug Vioxx after it showed dangerous cardiovascular side effects. Makers of Redux and Fen-Phen withdrew the diet drugs back in 1997 because of serious heart and pulmonary side effects, and the litigation costs mounted the following decade. More recently, GlaxoSmithKline GSK has faced calls to withdraw its diabetes drug Avandia, which studies have linked to a heightened risk of heart attacks. These setbacks and others have created a risk-averse Food and Drug Administration, especially for drugs that target diseases for which treatment options already exist.

MorningstarAdvisor.com 29


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Morningstar Advisor - August/September 2010

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2010

Morningstar Advisor - August/September 2010
Contents
New on MorningstarAdvisor.com
Contributors
Letter From the Editor
What Aspects of Health-Care Reform Will Most Affect Your Clients?
Bonds, Chicago Style
Investment Briefs
Which Risk Are You Managing?
Eye on the Prize
Advisors Can’t Rely on Fidelity Alone
Health Care Gets Back to Business
An Opportune Time to Bet the Pharm
Reform’s Impact on Other Health-Care Industries
Top Takeover Targets in Biotech
After Reform, Narrow-Moat Firms Have Strong Prospects in Diagnostics
Health-Care Investing Alive and Well
Quest for Knowledge
Four Picks for the Present
How to Make Your Bond Portfolio Inflation-Resistant
Weeding Through the Energy Patch
Uncertainty and Value in Basic Materials
Stock Market Doom-Busters
Hunting Down European Debt-Dodgers
Mutual Fund Analyst Picks
50 Most Popular Equity ETFs
Undervalued Stocks With Wide Moats
VA Sales Slip a Bit in First Quarter
New at Morningstar
Star Wars, the Sequel
Morningstar Advisor - August/September 2010 - Morningstar Advisor - August/September 2010
Morningstar Advisor - August/September 2010 - Cover2
Morningstar Advisor - August/September 2010 - 1
Morningstar Advisor - August/September 2010 - 2
Morningstar Advisor - August/September 2010 - Contents
Morningstar Advisor - August/September 2010 - 4
Morningstar Advisor - August/September 2010 - 5
Morningstar Advisor - August/September 2010 - New on MorningstarAdvisor.com
Morningstar Advisor - August/September 2010 - 7
Morningstar Advisor - August/September 2010 - Contributors
Morningstar Advisor - August/September 2010 - Letter From the Editor
Morningstar Advisor - August/September 2010 - What Aspects of Health-Care Reform Will Most Affect Your Clients?
Morningstar Advisor - August/September 2010 - 11
Morningstar Advisor - August/September 2010 - Bonds, Chicago Style
Morningstar Advisor - August/September 2010 - 13
Morningstar Advisor - August/September 2010 - Investment Briefs
Morningstar Advisor - August/September 2010 - 15
Morningstar Advisor - August/September 2010 - Which Risk Are You Managing?
Morningstar Advisor - August/September 2010 - 17
Morningstar Advisor - August/September 2010 - 18
Morningstar Advisor - August/September 2010 - Eye on the Prize
Morningstar Advisor - August/September 2010 - 20
Morningstar Advisor - August/September 2010 - 21
Morningstar Advisor - August/September 2010 - Advisors Can’t Rely on Fidelity Alone
Morningstar Advisor - August/September 2010 - 23
Morningstar Advisor - August/September 2010 - 24
Morningstar Advisor - August/September 2010 - 25
Morningstar Advisor - August/September 2010 - 26
Morningstar Advisor - August/September 2010 - Health Care Gets Back to Business
Morningstar Advisor - August/September 2010 - An Opportune Time to Bet the Pharm
Morningstar Advisor - August/September 2010 - 29
Morningstar Advisor - August/September 2010 - Reform’s Impact on Other Health-Care Industries
Morningstar Advisor - August/September 2010 - 31
Morningstar Advisor - August/September 2010 - 32
Morningstar Advisor - August/September 2010 - Top Takeover Targets in Biotech
Morningstar Advisor - August/September 2010 - 34
Morningstar Advisor - August/September 2010 - 35
Morningstar Advisor - August/September 2010 - After Reform, Narrow-Moat Firms Have Strong Prospects in Diagnostics
Morningstar Advisor - August/September 2010 - 37
Morningstar Advisor - August/September 2010 - 38
Morningstar Advisor - August/September 2010 - 39
Morningstar Advisor - August/September 2010 - 40
Morningstar Advisor - August/September 2010 - Health-Care Investing Alive and Well
Morningstar Advisor - August/September 2010 - 42
Morningstar Advisor - August/September 2010 - 43
Morningstar Advisor - August/September 2010 - 44
Morningstar Advisor - August/September 2010 - 45
Morningstar Advisor - August/September 2010 - 46
Morningstar Advisor - August/September 2010 - 47
Morningstar Advisor - August/September 2010 - 48
Morningstar Advisor - August/September 2010 - Quest for Knowledge
Morningstar Advisor - August/September 2010 - 50
Morningstar Advisor - August/September 2010 - 51
Morningstar Advisor - August/September 2010 - Four Picks for the Present
Morningstar Advisor - August/September 2010 - 53
Morningstar Advisor - August/September 2010 - How to Make Your Bond Portfolio Inflation-Resistant
Morningstar Advisor - August/September 2010 - 55
Morningstar Advisor - August/September 2010 - 56
Morningstar Advisor - August/September 2010 - 57
Morningstar Advisor - August/September 2010 - Weeding Through the Energy Patch
Morningstar Advisor - August/September 2010 - 59
Morningstar Advisor - August/September 2010 - 60
Morningstar Advisor - August/September 2010 - Uncertainty and Value in Basic Materials
Morningstar Advisor - August/September 2010 - 62
Morningstar Advisor - August/September 2010 - 63
Morningstar Advisor - August/September 2010 - Stock Market Doom-Busters
Morningstar Advisor - August/September 2010 - 65
Morningstar Advisor - August/September 2010 - Hunting Down European Debt-Dodgers
Morningstar Advisor - August/September 2010 - 67
Morningstar Advisor - August/September 2010 - Mutual Fund Analyst Picks
Morningstar Advisor - August/September 2010 - 69
Morningstar Advisor - August/September 2010 - 70
Morningstar Advisor - August/September 2010 - 71
Morningstar Advisor - August/September 2010 - 50 Most Popular Equity ETFs
Morningstar Advisor - August/September 2010 - 73
Morningstar Advisor - August/September 2010 - Undervalued Stocks With Wide Moats
Morningstar Advisor - August/September 2010 - 75
Morningstar Advisor - August/September 2010 - VA Sales Slip a Bit in First Quarter
Morningstar Advisor - August/September 2010 - 77
Morningstar Advisor - August/September 2010 - 78
Morningstar Advisor - August/September 2010 - New at Morningstar
Morningstar Advisor - August/September 2010 - Star Wars, the Sequel
Morningstar Advisor - August/September 2010 - Cover3
Morningstar Advisor - August/September 2010 - Cover4
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