Pharma Wary of Healthcare Reform

Highlights include Schering-Plough Corp. (SGP), Bristol Myers Squibb Co. (BMY - Analyst Report), Johnson & Johnson (JNJ - Analyst Report), Abbott Laboratories (ABT - Analyst Report) and AstraZeneca plc (AZN - Analyst Report).

Healthcare Reform a Major Wildcard for an Already-Hurting Pharma Industry

Big Pharma is faced with ever-increasing challenges. Patent expirations of major drugs over the next few years will significantly constrain revenue, margin and earnings growth. A more stringent and understaffed FDA means longer approval times, a more costly application process and fewer drug approvals.

The next threat to the pharmaceutical industry may come from provisions in President Obama's proposed budget.

The President has made no secret of his plans to overhaul the U.S. healthcare system, including proposals to reduce government spending on prescription drugs. His proposed budget, which was released last week, includes language surrounding the re-importation of drugs from other countries in an effort to lower drug costs. President Obama also strongly supports establishing FDA guidelines to approve biologic generics. The FDA currently does not have a means to approve generic biologics, given the complexity involved in copying and manufacturing biologics.

The result of all the issues facing Big Pharma will result in slowing revenue growth. Excluding the potential impact from President Obama's budget proposals, we model the average revenue of the largest 20 pharmaceutical and biotech companies to grow at a CAGR [compound annual growth rate] of only 2.4% from 2008 through 2013, and we expect zero revenue growth in the period 2011-2013. This compares to annual revenue growth of 7.5% from 2005-2008.

In response to slowing revenue, these companies have been furiously trimming headcount and reducing manufacturing costs in order to try and preserve margins. Gross margins of the top 20 pharma and biotech companies averaged 77.8% in 2008, down just 60 basis points from 2005. Operating margins over the same period increased 300 basis points to 32.5%.

Our models, which do not currently include an impact from Obama's proposals on healthcare reform, forecast gross margins to fall 110 basis points from 2008 through 2013 due to pricing pressure from generic alternatives and mild drug-reimportation. Margin contraction will clearly be significant greater if the government starts mandating prices and re-importing greater numbers of drugs from overseas. However, despite the gross margin pressure, our models show at 70 basis point improvement in operating margin for the 20 largest companies from 2008 through 2013 as a result of increased cost-cutting, mainly to overhead and lower-level R&D.

However, we expect revenues and margins to both suffer if President Obama's budget proposals on drug re-importation and generic biologics get through Congress. Importing drugs from other countries would essentially put a cap on drug prices and immediately force down revenues and margins for drug companies. Generic biologics would have a similar effect in the biotech industry.

Companies which rely on significant partnering and licensing arrangements, such as Schering-Plough (SGP) typically run tighter margins and have some of the lowest tolerance to falling drug prices. Bristol-Myers (BMY - Analyst Report) also relies heavily on licensing, but has one of the most aggressive cost-cutting programs in place in order to contend with increasing competition.

Expect companies with more diversified revenue streams such as Johnson & Johnson (JNJ - Analyst Report) and Abbott Labs (ABT - Analyst Report) to fare relatively well if the President's vision for healthcare reform comes to fruition. AstraZeneca (AZN - Analyst Report), which has a number of key drugs coming off-patent within the next few years, will see revenues and margins significantly contract through at least 2013. Expect this to be compounded if cheaper branded drugs are re-imported from foreign countries.

Read the full analyst report on SGP

Read the full analyst report on AZ

Read the full analyst report on JNJ

Read the full analyst report on BMY

Read the full analyst report on ABT