Investors, mindful of the fact that people don't stop getting sick when times are tough, have traditionally viewed pharmaceuticals stocks as a good bet in a weak economy. But these days analysts and shareholders worry that the drug business isn't its vibrant old self anymore. Recently, amid economic uncertainty, drug shares swooned because of investor concerns that the era of double-digit revenue growth and robust profit margins is over.
Among the industry's problems are soaring development costs and fewer blockbuster drugs to drive long-term sales growth. Competition from ge-neric manufacturers and demands for deep discounts from large buyers, like state governments, are driving down prices, compressing margins and raising the specter of more industry consolidation.
One potential acquisition candidate is Wyeth, formerly the Wyeth-Ayerst Laboratories division of American Home Products Corp. The drugmaker ranks 11th in the industry in terms of global sales. When Robert Essner joined Wyeth in 1989, it was part of a conglomerate that had stakes in food manufacturing, agrochemicals, medical devices and household products. Since becoming CEO in 2001, Essner has shifted Wyeth's focus. Today the company derives 80 percent of its annual revenues from selling prescription drugs such as Effexor (an antidepressant), Enbrel (for rheumatoid arthritis), Prevnar (a pneumococcal vaccine) and Protonix (for acid reflux). Another 15 percent of sales comes from over-the-counter remedies like Advil and Robitussin, with the remainder coming from animal health care products.
But during that transformation Wyeth has operated under a cloud of litigation. Its diet drugs Redux and Pondimin, when taken in combination with phentermine, may have caused heart disease and other serious conditions in some 5.8 million people. Wyeth settled a class-action suit over the so-called fen-phen drugs for $16.6 billion in 2002. But claims outside that settlement persist. Late last month a Texas jury awarded $1 billion to the family of a woman who claimed to have contracted a pulmonary ailment from the medication. Wyeth expects the award to be slashed upon appeal and doesn't foresee increasing the remaining $3.5 billion it has reserved against fen-phen claims.
The legal woes have obscured Wyeth's strong performance. Sales grew by nearly 9 percent last year, to $15.9 billion, and operating earnings were up 10 percent. Wall Street expects 12 percent profit growth in 2004. With no major patents expiring until 2008 and a pipeline of promising new drugs, the company is well positioned for the future. But its shares, at about $40 each, are flat with year-ago levels after nearing $50 last summer. Essner recently discussed his company's prospects with Institutional Investor Contributor Andrew Osterland at the company's Madison, New Jersey, headquarters.
Institutional Investor: How has Wyeth changed since you joined it?
Essner: A lot of people's image of this company is based on American Home Products. The company and our business model are very different now, and sometimes we have to jar people out of their expectations. We've divested nonpharmaceutical businesses and strengthened operations through acquisitions and licensing agreements. Most importantly, we strengthened research and development. We didn't have much of a drug discovery culture, but now we think we're competitive with anyone.
What characterizes productive R&D?
We've focused our scientists on making drugs useful to patients and doctors. Some companies are nervous about being overt in this expectation. We aren't. You can do great science, get hundreds of patents and yet not produce drugs that make a difference. Our role is to make drugs that change people's lives.
Is the industry in a new era of fewer blockbuster drugs coming to market?
Developing blockbuster drugs used to mean targeting a big disease like hypertension, developing a drug and selling millions of units at moderate prices. A lot of companies still define that as their goal. The problem is, those areas of research have been deeply mined over time. So we look at markets that don't exist or maybe exist in a primitive form. A case in point is rheumatoid arthritis, which used to be treated with chemotherapy agents. The side effects were maybe as bad as the disease. Now we have Enbrel, and we think that market is as big as hypertension. We're building enough capacity to sell about $6 billion annually.
How vulnerable is Wyeth to competition from generic manufacturers?
We're insulated for several years from generic competition. Our first major drug to come off patent is Effexor in 2008, and our three other top drugs have patent protection out past 2008.
Wyeth is considered attractive to acquirers. Is bigger better in the industry?
Scale per se is not an advantage. Once a company can invest more than $1 billion in R&D, scale isn't as much of a factor. In fact, statistics suggest that mega R&D networks are not as productive as small outfits. Scale is more of a challenge than an asset. We are desirable not because of our scale but because we have an attractive portfolio and a good R&D pipeline.
What is your strategy regarding alliances and licensing partnerships?
I think there are a lot of deals that aren't economical. We've tended to move our partnerships into earlier stages of drug development. If you're willing to go in earlier, there's more risk, but there are also better terms.
You recently outsourced clinical data management to Accenture. Why?
There is an enormous amount of data produced from Phase III studies [late-stage clinical trials with humans], and the infrastructure needed to handle it is huge. We found we could speed up the process by outsourcing. Drug development is a race against the patent clock. If you eliminate one month of development, the economic benefit is enormous.
Wyeth has had problems producing enough drugs, in the case of the Prevnar vaccine, and generally in complying with Food and Drug Administration standards. Have you fixed these?
The problem with Prevnar has less to do with capacity than with the nature of making biological drugs. It's as much an art form as a science, and much more difficult than making small molecular drugs. Like live organisms, they mutate and evolve in ways that are not always predictable. We've added some redundancy to our capacity that we wouldn't have built if everything was working right. FDA standards have changed dramatically in the past five years, and several years ago we probably didn't keep as on top of it as we should have. But since then we've done a lot to bring ourselves up to the highest standards.
When will the legal issues surrounding fen-phen be resolved?
Most of it is behind us, although there are still issues we have to confront. The settlement we created with the plaintiffs' bar has unfortunately been abused, and we've been flooded with invalid and inappropriate claims. We're still defending ourselves in court. The U.S. system for resolving these kinds of disputes desperately needs reform. It's been a painful chapter in our history. I think we've been successful in not letting it affect our operations. Since the diet drugs came off the market, our sales, profits and investments have all grown dramatically.
How will the new Medicare drug benefit plan affect Wyeth?
I don't think it's a big positive. Because of the effect on pricing and margins due to more consolidated buyers, the impact on our sales and profits will probably be slightly negative to neutral.
The importation of cheaper branded drugs from Canada is now a hot political issue. How do you deal with that?
Most companies, including Wyeth, have policies to discourage illegal shipments of drugs back into the country. In most countries generic drugs are actually more expensive than in the U.S. That's because governments tend to reward imitation more than innovation. The U.S. government needs to see these price controls as discrimination against U.S.-developed drugs. Other countries need to open up their trade policies and bear their fair share of the cost of drug development.
Wyeth, along with its peers, has underperformed the market dramatically over the past 18 months. What will get your stock price rising?
I think the litigation has cast a bit of a shadow over us. Investors shouldn't look at the pharmaceuticals market as a whole but rather at individual companies. We're not all riding the same wave as much as we used to. Some companies have great potential, and others will struggle. We have three major things going for us: a great product line today, one of the strongest pipelines in the industry -- with more than a dozen drugs in Phase III trials -- and no generic competition in the immediate future.