BIG PHARMA STOCKS: GOOD FOR YOUR GRANDPA, GOOD FOR YOU

In this world of constant change, one thing seems eternal: Big Pharma just keeps minting money.  Many of the biggest names in American Pharmaceuticals have endured for decades. Is there a reason for this longevity?

I’ll admit it; I’m getting to the age where weird things are starting to happen to my body. Hair is disappearing from where it should be, and appearing where it should not be. Things are starting to ache for no apparent reason. Just looking at a cookie translates to extra pounds. I am also getting to the age where a bit of nostalgia can be warranted. Do you know what a great weekend was when I was a kid?  Perhaps we would go to the mall to check out what was on sale at Sears; maybe we would cruise by Payless Shoes to see if anything fit; and of course we would capture every fun moment on Kodak film. Telling us that all three of these corporate giants would be bankrupt by 2019 would have been as credible as telling us that the Moon was made of cheese.

It’s surprising how quickly big corporations can roll over and die. Sometimes they just miss an obvious technological fork in the road (wanna rent a video from Blockbuster?). Other times they explode like Mount Vesuvius (Lehman Brothers). Most often, however, they just slowly rot away (have you suffered through a visit to Sears lately?)   

Against this backdrop, we can contrast the seemingly evergreen status of America’s Pharmaceutical Giants. Johnson&Johnson was founded by….you guessed it, the Johnson brothers, all the way back in 1885. In Indiana, they grow both corn and pharmaceuticals; Eli Lilly was founded all the way back in 1876. But all of these youngsters pail in comparison to the granddaddy of them all…..Pfizer.  If you can believe it, Pfizer was founded in by two German Immigrants in 1849. 1849! When Pfizer was founded, owning slaves was legal, there was no such thing as a camera, and electricity hadn’t been discovered.

Needless to say, investors in $PFE, $LLY, and $JNJ have enjoyed generations of prosperity while poor Sears shareholders have been passing through the nine levels of hell.  In fact, had you invested $1,000 in Johnson and Johnson in 1977, the year of my birth, today you would have a mind boggling $85,999. The company went public in 1944, and, somewhere out there, there are families that have been reaping outsized benefits for more than 70 years…..

Running Scared

So America’s pharmaceutical titans have somehow stayed forever young while corporate behemoths in other sectors have not stood the test of time. What is the magic trick?

I believe that the trick to achieving solid longevity in the business world is to feel your own mortality every day. Big Pharma draws strength from it’s smash hits; world beaters such as Prozac, Lipitor, and Viagra come to mind. But each billion dollar baby is born to die; due to our very well established legal system related to patents, every high ranking Pharma Exec understands explicitly that no one pill or potion will last forever.  Big Pharma is notorious for employing every legal and semi-legal method for extending medical patents, and wringing every last penny from blockbuster drugs. However, behind closed doors, executive teams know, down to the month, exactly when their Golden Goose will stop laying eggs.

So you could call this “Innovate or Die.”   This is the genius of our American Creative Machine. As much as the scoundrels running Big Pharma would love to  ride one or two big products forever, they just can’t. Due to the laws of our land, Big Pharma has a unquenchable thirst for new products and new technologies.

Let’s contrast Big Pharma’s situation with the more typical scenario in other sectors of the economy.  There are too many sad stories to count. The pattern is typically that a fortune 500 company has a huge hit product on its hands, that reliably prints cash year after year, and perhaps even decade after decade. On some level, they know that the party can’t last forever, but they don’t KNOW it in their bones. Who wants to be the vice president who greenlights big corporate spending on R&D when that very same R&D threatens to replace the company’s existing cash cow?  For example, did you know that Kodak engineers actually INVENTED the digital camera?

“It’s no exaggeration to say Kodak invented digital photography. In 1975 Kodak engineer Steve Sasson created the first digital camera, which took photos with 10,000 pixels, or 0.01 megapixels — about a hundredth of the resolution that low-end camera phones have today. Kodak didn’t stop there; it worked extensively on digital, patenting numerous technologies, many of which are built into the digital cameras of today……”If you want to point back to the most pivotal moment that caused this,” says Hayzlett, “it was back in 1975 when they discovered the digital camera and put it back into a closet……In 1995 the company brought its first digital camera to market, the DC40. This was years before many others would get into the digital game, but Kodak never took advantage of its early start. Philosophically, the company was steeped in the film business, and to embrace digital meant cannibalizing its own business. “It’s a classic business strategy problem,” says Miriam Leuchter, editor of Popular Photography. “Their whole business was tied up in film and in printing. So while they’re developing this business technology, there’s not a big incentive to push it very far.”

(Mashable.com, Pete Pachael, 1/20/12)

This same sad story has been repeated hundreds of times across the Fortune 500. On the most basic level, major corporations are filled with people who don’t fully control their own businesses, and who aren’t big risk takers anyhow. That’s why they work for a Fortune 500 company.  Big Pharma certainly doesn’t like risk. But they have no choice. Even in the glory days of Viagra, when Pfizer was swimming in cash, they knew that Viagra would one day go generic. They could predict Viagra’s death down to the month. If anyone was about to bumble into any good new innovations in the lab, shoving that nascent innovation into a closet would be the last thing Pfizer would want…

Never Say Die

Of course, things still go wrong in the pharma industry. Even executive teams with the intent to innovate sometimes bet on the wrong race horse, or get devastated in a product safety scandal, or get mired in board room infighting. But very, very few major pharma concerns have gone the way of Kodak or Montgomery Ward. Rather than go bankrupt, Big Pharma laggards tend to get acquired.

This is because even floundering pharma labs tend to retain assets that have value to someone. For example, even branded meds who are past their prime and now dwell in the “generic” bargain bin still generate substantial revenue every year. Additionally, every major pharma balance sheet has a line item for “In progress Research & Development.”  Just because a certain executive team has not been able to realize full value from a pipeline doesn’t mean that the research wouldn’t have value for someone.

Lastly, certain assets might not be quite good enough to shine on their own, but make a lot more sense in a combined portfolio. For example, let’s say your sub-optimal pharma concern has a diabetes medicine that occupies the number three market share for a certain niche. While that medicine might be viewed as an “also ran” in your board room, it suddenly would become a lot more valuable to someone else who is looking to plug a hole in an already strong diabetes franchise. And so the game is played.

For example, in just the decade between 2000 and 2010, Pfizer swallowed up no less than three multi-billion dollar Big Pharma Rivals; Warner-Lambert, Pharmacia, and Wyeth.  This is not even counting the dozens of smaller companies that Pfizer consumed.

How do these acquisitions work out for shareholders?  I’ll give you one hint; much better than things have worked out for shareholders of Sears.   One example is Schering-Plough, a faded pharmaceutical Titan that fell into Merck’s arms during the chaos of the 2009 Financial Crisis. Let’s say that you owned 1,000 shares in Schering-Plough in 2008, just prior to the announcement of the transaction. That would have given your stake a value of $28,000. As per the terms of the merger, you would have received $10.50 in cash for each share you owned, plus roughly .6 shares in the newly augmented Merck.

So, at time of closing you would have walked away with $10,500 in cash, plus 600 shares trading at roughly $30 each, for a market value of $18,000.  Today, those $MRK shares trade at $81. If you have reinvested your dividend over the last ten years of your ownership in the combined entity, those original shares that your received in payment would be worth $41,464. Failure never looked so great!! Compare those results to the hideous fate suffered by Sears investors…

Even marginal pharma giants wind up producing bonanzas for the patient investor. What’s not to love?

Innovation can be hard. Innovation can be scary. Innovation can be risky. But a nation born of revolution has spawned laws and norms that force even the most spineless pharma execs to confront their fears. The results are great advances for patients, and great profits for investors. Just what the doctor ordered!

DISCLOSURE: The Sick Economist owns shares in $MRK and $LLY.