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Batten the hatches

1 December 2011 By Robert Cyran

Shares of pharmaceutical companies traditionally weather economic storms with aplomb. In 2008, for example, drug stocks sustained less damage than the S&P 500. Yet the sector today looks astonishingly cheap relative to the rest of the stock market. Austerity measures from strapped governments everywhere explain this conundrum.

Investors haven’t lost their desire for safe havens. Consumer staples stocks, like Procter & Gamble and Colgate, trade at premiums to their 2012 estimated earnings of some 20 percent on average to the S&P 500. By contrast, big U.S. drugs firms, from Pfizer to Lilly, trade at discounts of about 20 percent on average using the same measure. That’s nearly the lowest they’ve traded in the past 30 years, according to Deutsche Bank.

Big Pharma’s problem is simple. Developed countries account for most of their sales, and governments foot the bill. Sums vary from country to country. While government pays for slightly less than half of all health care in the United States, the figure is about three-quarters in most European nations.

But lawmakers everywhere are looking for cost cuts, and have the clout to demand them. For example, last year’s U.S. healthcare reform bill pledges to save $500 billion over 10 years, including drug discounts and $2.5 billion of annual fees on government-reimbursed sales by pharma companies. In Europe, most governments have cut prices and moved to increase the use of cheap generics.

Such measures should intensify. Healthcare spending, which accounts for about 18 percent of U.S. GDP, is rising steadily in developed nations as populations age. It is therefore becoming a greater chunk of government spending, too. While such outlays tend to be popular, they’ll need to be reduced in the absence of higher taxes to close deficits.

Estimating the size of the cuts is difficult because of political uncertainties. In Europe, drug prices fell about 3 percent in 2010, and this year should be worse. Washington’s budget “super committee” studied various cuts before declaring failure. But as an illustration, Sanford Bernstein estimates that simply making some Medicare patients pay Medicaid prices would cut about 5 percent of earnings at the average drug firm.

Given intractable deficits in many developed nations, and increasing worries about their ability to raise money at reasonable rates from bond investors, further slashing on healthcare seems inevitable. Pharma’s discount is deserved, because these stocks are no safe haven in an austerity storm.


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