Pharma earnings and the implicit deal

One might think that in both pharma and the equity markets, reality usually prevails over hyperbole and wishful thinking. In pharma, outcomes data constitute the prime mover. Likewise on Wall Street, the business is premised on the notion that accepted measures of margins, growth and profitability will eventually determine the course of events. Perhaps the key concept here concerns the ambiguity of "eventually,” because until that occurs, vast fortunes can rise and fall from hyperbole. 

Some of pharma's recent earnings reports provide a ready example. On Tuesday the blogosphere crowed about Pfizer's quarterly profit rising 25 percent even as the company's top-selling brand, Lipitor, lost patent protection. Pfizer's stock rose more than 2 percent on the news. Yet if one looks just slightly beyond the headline, the news is far from sanguine.

Much of Pfizer's gain came from cost cutting and divesting assets. Overhead costs fell 17 percent in the quarter, while research and development expenses declined by 24 percent. Pfizer is preparing to sell its nutrition unit to Nestle for $11.85 billion and divest its animal-health business through an IPO. At the same time, second-quarter revenue fell 15 percent below the comparable period last year, while new brands failed to make up the shortfall.

So why the rousing headlines from what is actually an uninspiring earnings report? Skeptics argue that Wall Street and certain sectors co-operate on a mutually profitable, implicit deal. Wall Street's sell side needs to tout various sectors to investors for the underwriters to earn their fees and the brokers their commissions.

Company officers in those sectors then make their operations management conform to the storyline created by the sell siders. Since the compensation of most senior executives is heavily weighted toward "shareholder value," i.e., the direction of share price, the hype serves their interests very nicely.

Buy side fund managers, for their part, know the game but they go for it anyway. The fund managers know hype is a self-fulfilling prophecy that can stimulate demand for a stock. If they're into the game early, they can profit from the appreciation as later investors bid up the price.

So an honest, perceptive analyst who looks at companies and derides the emperor's lack of clothes will antagonize sell siders, buy siders and the sector's managements. Pity the poor, honest analyst.

For pharma the reality remains fairly straightforward. The fundamentals appear dour as long as the pharmaceutical sciences produce new drugs that are only marginally better than cheaper generics, while third-party payers (public and private) grow more unwilling to pay the premium prices of such brands

Despite that, pharmas will maintain acceptable stock prices as a defensive play as long as drug companies continue to pay a 4 to 5 percent dividend in a low interest environment. But when (rather than if) interest rates begin to rise, pharma will find it challenging to attract capital.

So one can choose an honest assessment of reality or the financial markets. Have at it.


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