It's Pipeline That Matters Most

 | May 01, 2013 | 12:49 PM EDT
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No matter how many times I say it, people don't seem to get it.

The pharmaceutical business is not about near-term earnings estimates or earnings just reported, it's all about pipeline, what's in the works, what could be blockbuster.

We are seeing all of that play out in today's trading. First, Merck (MRK) reports a quarter that is widely panned and people decide that Merck's "had it." But Merck has 35 drugs in the pipe and many of these could add very much in the out years. That's why Merck's committed to buying $15 billion of its stock now, because management knows that it has some huge drugs that will be terrific in the future. So why not try buying back $15 billion dollars in stock, or 10% of the company in the interim? Why not give people a 3.75% yield to wait for the Phase II and Phase III drugs that will be powering the numbers when 10% of the company was bought in cheap.

But then there's Allergan (AGN) today. I had high hopes for its macular degeneration drug because Allergan has such a fabulous ophthalmological pipeline. But the drug's being delayed because right now the drug's results aren't up to snuff. So, the stock falls about 10%t. Meanwhile, this great news for Regeneron, which has the best current drug out there for macular degeneration and the competitive woes from a much more establishes company just vanished. That gives Regeneron more money to develop its pipeline, assuring you more growth in the future. It doesn't hurt, by the way, that Regeneron's stock was heavily shorted because it went into the S&P 500 last night, causing a spike that wiseguys thought would be given up today. Whoops, the pipeline of Allergan wrecked that trade.

We've had some tremendous earnings disappointments from high-profile drug companies that simply ended up meaning nothing. Consider Lilly (LLY). It didn't hit the number, but it sure held out hope for a valid drug to treat Alzheimer's. We didn't hear anything blowout about the pipelines of Pfizer (PFE) and Bristol-Myers (BMY), so those legitimately sold off. But Pfizer is committed to bringing out value in other ways, including splitting the company up, so the pipeline isn't as important as others. But Bristol seems to have a gap, so that stock's not bouncing.

Johnson & Johnson (JNJ), on the other hand, has a terrific pipeline and a chance to split up so it is still worth betting on. The best of all might be Smith Klein, which has a robust pipeline AND a good yield, very similar to Merck, which, again, obviated the worries about the near term. That's why it didn't get hit when it missed sales estimates.

How am I so sure that pipeline matters the most? Because in the 1980s Merck seemed to be out of gas. Its big heart drug franchise was losing steam. Other drugs weren't moving the needle. But it was working on a promising anticholesterol drug, one that lowered cholesterol rather quickly. The science of the importance of lowering cholesterol was unproven, but Merck thought it could show, over time, the value of that anticholesterol agent. The Street figured one day it could be worth $200 million to Merck. Turns out it was one of the largest contributors ever to Merck's earnings, but the big move occurred as we followed the stock through the pipe, not after it was approved, as I watched Merck double and then double again as the trial results came through. The amazing thing about the anticholesterol franchise? Pfizer, sensing how big it could be, bought Warner-Lambert, an also-ran company that had another cholesterol lowering agent in its pipe. Turned out to be the smarted acquisition of all time in the drug world, as Lipitor, Warner-Lambert's drug, did $13 billion in sales in its last year before going off patent. By the way, if you had focused on Pfizer's near-term earnings during the period it bought Warner-Lambert , you would have been shorting the heck out of the stock.

And because pipeline is what matters, you would have been dead wrong.

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