Big Pharma Has Lost Its Way

 | May 03, 2013 | 7:23 AM EDT  | Comments
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Stock quotes in this article:

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gild

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celg

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biib

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regn

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If you want to do basic research to develop all new molecules to conquer diseases that can't easily be conquered, chances are you'll have to hire Charles River Labs (CRL) to do the testing. This company can do it faster and more cheaply than anyone else can. It is the acknowledged leader, and no one can dispute that.

But you also can't dispute that Charles River had a weak quarter -- and that a lot of that weakness stemmed from big pharmaceutical companies' unwillingness to spend to develop new molecules that may or may not succeed in conquering a hard-to-beat disease.

On Thursday, when I interviewed Jim Foster, the CEO of Charles River, I realized that I was talking to the flip side of the multi-billion-dollar buybacks and dividend boosts at big pharma. This money they are spending on Wall Street, I believe, would be best spent at Charles River. In this case, they'd be getting the "go -- no go" of new prospects, an incredibly expensive process. This is something that Allergan (AGN) confirmed when it acknowledged how expensive it is to test new drugs on a miss that it had for a new macular degeneration drug.

Instead, what many of these big pharmaceuticals are doing is strictly harvesting what is there, what is known, what is in Phase 3. They're not doing the basic stuff that could or could not product drugs in 2018.

Contrast that with the other cohort that chooses Charles River -- the biotech companies. While their spending is sometimes inconsistent, it's nothing they would ever scrimp and save on. These companies are risk-takers that are always rolling the dice on something new. They aren't trying to husband resources, fire people, close down facilities or do anything else necessary to make Wall Street's numbers. 

Is it any wonder, really, what Wall Street wants? Eli Lilly (LLY), Bristol-Myers (BMY), Pfizer (PFE) and Merck (MRK) are doing well because they are the equivalent of bonds with higher coupons. In addition to those names, the big winners are Gilead (GILD), Celgene (CELG), Biogen (BIIB) and Regeneron (REGN) -- all huge risk-takers with healthy pipelines.

Take Merck, a stock that I like very much for my Action Alerts Plus charitable trust. At the moment, it is probably the most adventurous and bold of the major pharmas. It has 35 compounds in the mix that are hoping for approval someday, with a crackerjack research team put together by Ken Frazier, who is committed to restoring Merck to its old glory.

Yet, at the same time, Frazier is committed to spending $15 billion buying back stock. Shouldn't some, if not a large part, of that money go into research that could be hit or miss?

But that's not how it works. That money goes to buying back stock so as to shrink the shares-outstanding float. In this way, the existing earnings, plus the new approvals, combine to give the company a decent earnings-per-share growth path. That, plus the dividend -- which gives you a hefty and safe 3.7% yield – satisfies everything you need from a capital-preservation standpoint.

But surely if the Federal Reserve starts tightening and rates go up to compete with Merck, this one would be headed down, no matter how much stock is bought back.

Celgene, Regeneron, Biogen and Biogen Idec, on the other hand, have drugs that could be huge in the outyears. We are paying up for them now in order to get in ahead of the big run in earnings. These names are your capital-appreciation chits.

Sure, it takes all kinds to make a diversified portfolio. But the simple truth, from the No. 1 drug-testing firm in the U.S., is that the majors aren't spending on what they should be spending on -- the long-term pipeline. While they can harvest all the short-term research they want, it is the long-term prospects that ultimately determine the direction of a drug stock. We own these stocks for the elixir of long-term growth, not the bounty of short-term payback.

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