Morningstar Advisor - August/September 2010 - 43

Acker: I would say it’s two things. One is the

fact that I mentioned: We’re getting the pressures from the taxes and fees now. For example, the bill was passed in late March. 16000 Pharma companies had already given their guidance for 2010 earnings, and then 13000 some aspects of the bill were made retroactive. So, we had earnings revisions as these taxes 10000 came into effect. Everyone saw earnings going down. Then on top of that, you’ve had 7000 the cuts in Europe. Pricing pressure is usually higher in Europe than in the United States. Companies see, on average, 2% to 3% price cuts per year in Europe; in the United States, we generally see price increases in the low-to-mid-single digits. This year, however, with the austerity measures and the budget deficits in Europe, we’re seeing price cuts in places like Greece, Spain, and Germany that are higher than we’ve ever seen before. I think there’s a worry that this is going to become the norm. We’ve got 10% budget deficits. Are we going to see 5% price cuts every year? Longer term, people realize that the health-care costs in the United States are going to be much higher than expected, and that will be an issue.
Jenner: Yes, I agree. It’s much easier to

more difficult to get new drugs approved; and the generic patent wave—which some people call the patent cliff, which peaks in 2012 when a lot of old drugs lose their patents. All of these factors are making pharma companies figure out how they can grow. One way is to look for sustainable franchises. Pharma companies want to get off of this treadmill of having a drug on the market for 10 years, getting a lot of sales, but then seeing it go generic. There’s new focus on things like vaccines, which generally persist even after patents expire; consumer products, which tend to have higher multiples because you establish a brand; and emerging markets. So, when Pfizer buys Wyeth and Merck buys Schering-Plough, they’re getting access to products that have longer lifecycles, but they’re also taking out significant cost, above what we’ve ever seen before in the pharma industry. Pfizer and Wyeth combined had an $11 billion to $12 billion R&D budget. We expect that to come down to about $8 billion for the combined entity. Everyone’s cutting back. They’re not developing me-too drugs anymore. They’re really pushing for more innovative therapies. We always focus on innovative companies, companies that are addressing unmet medical needs. If you have a company that has a new therapy for cancer, a new therapy for diabetes, a new therapy for Alzheimer’s— these are unmet medical needs. Even in a tougher reimbursement environment, people are going to pay for these drugs. So, they are attractive assets, and they tend to get taken out from time to time.
Jenner: That’s right. Damien, you asked, how

T. Rowe Price Health Sciences PRHSX
$16K

13 S&P 500 TR 10

Category Health Morningstar Rating

Expense Ratio (%) 0.87 5-Yr Anl Total Rtn (%) 6.41 5-Yr Anl TR % Rank Cat 4

QQQQ
Minimum Investment $2,500 Data as of June 30, 2010

see a stunning example of value destruction. That is not to say that one of these can’t work. I’m just saying caveat emptor, because statistically these have not been opportunities for investors.
Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Feb-05Aug-05Feb-06Aug-06Feb-07Aug-07Feb-08Aug-08Feb-09Aug-09Feb-10 Mar-05Sep-05Mar-06Sep-06Mar-07Sep-07Mar-08Sep-08Mar-09Sep-09Mar-10 Apr-05Oct-05Apr-06Oct-06Apr-07Oct-07Apr-08Oct-08Apr-09Oct-09Apr-10 May-05Nov-05May-06Nov-06May-07Nov-07May-08Nov-08May-09Nov-09May-10 Jun-05Dec-05Jun-06Dec-06Jun-07Dec-07Jun-08Dec-08Jun-09Dec-09Jun-10

Conover: That’s a great point. I think the most

dangerous words in the investing community are, “This time it’s different.” But is this time different? The purchase prices on some of those acquisitions were lower and the cost synergies appear to be higher. Jenner: I’m hopeful that it can be different, but

whack an industry and say you’re going to get 10% less today than you did yesterday than see pensioners riot in the streets and have it on CNN.

M&A: A Path to Growth
Conover: Let’s talk about mergers and acquisitions. In 2009, we saw some massive acquisitions. Pfizer PFE took over Wyeth. Merck MRK took over Schering-Plough. Why did these mergers happen? How can investors benefit from them? Acker: A lot of the mergers were a response to

pressures in the pharmaceutical industry. We’ve seen global pricing pressure; R&D productivity that has been declining for years; very high regulatory barriers, where it’s

can investors benefit? Statistically, large mergers have not created value. Pfizer, for example, bought Warner-Lambert in 2000 and then bought Pharmacia in 2004, and now they have bought Wyeth. If you go back and march through time and ask what was Pfizer’s market cap, what did they pay for these companies, and what is it now, you will

I’m skeptical. I’m hopeful that Merck and Schering-Plough will be more valuable than they were individually. But I’m not making a large bet that it will be different. What generally happens with these mergers is that both companies have substantial cost infrastructures that get reduced because they eliminate duplicative efforts, and there is some value in that, but it’s a one-time thing. Then, on the back end, what happens is that you have dysfunction in the pipeline, and the core essence of these companies is to bring important new medicines to the market. Dysfunction in the pipeline, in my opinion, is why these mergers haven’t added value.

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