The Case For (and Against) Big Pharma

Big pharma needs a miracle drug. The major drug makers are so beaten down that in some instances dividend yields, rather than the next blockbuster drug in the pipeline, are what are propping up the stocks.

Take Pfizer (symbol PFE). At its May 7 close of $19.92, the stock is off 28% since last June and is 60% below its all-time high, set in 1999. Talk about a lost decade.

The good news, such as it is, is that even as the stock stagnated, Pfizer boosted dividends year in and year out. Result: The shares now yield 6.4%. That's the kind of yield normally associated with a real estate investment trust or a master limited partnership. If not for Pfizer's juicy payout, the stock would almost certainly be lower.

What bugs Pfizer and the likes of Merck ( MRK) and Bristol-Myers Squibb ( BMY) is a set of ills for which no quick fix exists. One analyst, Credit Suisse's Catherine Arnold, says that patent expirations and a regulatory crackdown are creating a "revolutionary change" in the industry. On the other hand, with drug stocks at historic lows, dividends sweet and an aging population that needs more and better pills, it's fair to ask whether you should be buying drug stocks, despite the litany of woes.

Some experts say yes. But before we let them argue their contrarian case, let's examine the problems in more detail.

Patent cliff. While the companies can finesse some of their problems, they can do little about the biggest one. From 2010 to 2013, sales will take an unprecedented hit as patents on two dozen of the industry's most profitable drugs expire. Falling off this "patent cliff" will be drugs that now account for about 40% of Pfizer's annual sales, expected to exceed $48 billion in 2008. They include the cholesterol-lowering drug Lipitor and the erectile-dysfunction drug Viagara.

Pfizer is hardly alone in its misery. Bristol-Myers Squibb will lose protection on Plavix, a drug used to prevent heart attacks and strokes; GlaxoSmithKline ( GSK) will lose asthma treatment Advair; and Eli Lilly ( LLY) will relinquish protection on its drug to treat schizophrenia, Zyprexia.

Tough competition. Blockbluster drugs losing patents has always been bad news for drug companies, but today the situation is worse. Manufacturers of generics both here and abroad have become much more aggressive in fighting patents and getting knock-off drugs to market. One study predicts that the generics industry, which already does annual sales of $60 billion, will be able to take aim at an additional $100 billion worth of worldwide drug sales.

High development costs. So, why not just develop new drugs? Easier said than done. To start, that's costly. A widely accepted estimate is that it costs $800 million to develop a new drug, and that figure is rising rapidly. Over the past decade, only about 25 new drugs have come to market each year. However, while the number of drugs-to-market has stayed the same, research and development expenses have doubled.

Tough regulation. And as the costs rise, the Food and Drug Administration has become far more picky about what it will approve. For example, the FDA recently put a roadblock in front of Merck's proposed anti-cholesterol drug, Cordaptive. That didn't help Merck's share price, which, at $39.01, is down by more than one-third since mid January. The FDA has cracked down on all drug approvals since another Merck drug, Vioxx, was suspected of having caused heart attacks in some patients.

Politics. Finally, election-year promises from both sides threaten industry profits. Plans of both Hillary Clinton and Barak Obama include allowing Medicare to negotiate drug prices -- that effectively means regulation of drug prices. And Clinton, Obama and John McCain say they're for permitting re-importation to the U.S. of drugs that carry lower price tags in foreign countries.

All of this adds up to one bleak scenario. And yet, some smart analysts see the sector through Prozac-colored glasses.