Bristol Myers May Cure Your Portfolio Better Than Merck

The pharmaceuticals industry has been in a state of turmoil for decades. But some companies are handling it better than others. For example, Bristol Myers Squibb (NYSE: BMY) stock is up 15% so far this year and Merck (MRK) has lost 10% of its value. Why the difference? Should you invest in either of these companies?

Prior to the 1980s, the drug industry was one of the most profitable in the world -- a typical pharmaceutical company could earn a five-year average return on equity of nearly 40%. The reasons for that high profitability were powerful:

• Patented drugs. High R&D spending regularly yielded new drugs that a company would patent and then enjoy almost 20 years of unchallenged high profits with regular price increases
• Marketing to doctors. Doctors prescribed drugs with a strong push from drug company sales and marketing people who gave the doctors free samples and took their families on vacations that included some "medical education."
• Limited competition. Pharmaceutical companies were unchallenged by significant competition and hence they were able to operate in a way that maximized their shareholder returns without concern for price cutting.

But starting in the 1980s, all those profit enhancing industry forces collapsed -- sending the industry into a long period of greater turmoil with which it is still trying to cope. These changes have lowered the industry ROE to 22.2% -- below the S&P 500 average of 24.6%.

Here are the biggest profit reducing changes:

• Rise of Pharmacy Benefit Managers (PBMs). Companies offering health care created PBMs to use their negotiating leverage to take away some of doctors' drug prescribing power. Now, if a patient who gets corporate health coverage has a medical problem, the PBM will usually only pay for the lowest priced drug that solves the problem.
• Emergence of new competitors. Generic drug companies manufacture off-patent drugs at much lower costs than do the fully-integrated pharmaceuticals companies. Those generic manufacturers get the revenues when those PBMs require the prescription of a low priced drug. Moreover, biotechnology companies have come up with new approach es to drug development and their focus often gives them higher patented drug development success.
• Rising cost of developing new patented drugs. In the 1980s, it used to cost $400 million to develop a new drug -- now it costs an average of $1.3 billion (although some believe that figure is massively inflated). Big pharmaceuticals companies are increasingly finding that they are unable to discover blockbuster new patented drugs to replace the ones that come off patent. As a result, they are spending more money than ever to try, but they frequently fail and end up trying to make up for it by acquiring a biotechnology company that is further along in the development process.

Merck was formerly considered the gold standard of the industry -- it attracted the top people and made the most money. But that began to fall apart in the 1980s thanks to the rise of Medco Health Solutions (MHS) -- a mail-order drug company and PBM that Merck acquired in 1993 as I wrote in my book, The Technology Leaders, to try to get back control of the prescribing process. That did not work and Merck spun off Medco in 2003.

Now Merck faces the prospect of being one of the companies that will suffer $135 billion lower revenues if President Obama's deficit reductino plan goes into effect. That's because the plan would require makers of brand name drugs to give a 23% rebate to the U.S. government for low-income Medicare beneficiaries who get a subsidy to pay for coverage, according to Bloomberg.

Meanwhile Bristol Myers has been working on new drug development and has achieved some success. Monday Jeffries published a report that Bristol Myers could be an acquisition target on the strength of two of its drugs -- a skin cancer treatment and a heart drug awaiting U.S. approval. Jeffries also raised its price targe from $27 to $35.  Its skin cancer treatment Yervoy generated $95 million in second quarter sales -- beating sales expectations. And Jeffries raised expectations for its blood thinner Eliquis.

What does all this mean for investors? Should you buy or avoid Merck and Bristol Myers? Let's compare them based on valuation and recent earnings performance:

• Valuation -- Bristol Myers. Bristol Myers (1.69) has a lower Price-Earnings-to-Growth (PEG) ratio -- 1.0 is considered fair value -- than Merck (3.86) -- calculated based on 2011 earnings growth. Specifically, Bristol Myers has a P/E of 15.9 on earnings forecast to fall 9.8% to $2.05 in 2012 but will enjoy a 9.4% earnings boost in 2011. Merck has a P/E of 34.7 on earnings forecast to grow 2.9% to $3.84 in fiscal 2012 with 9% growth in 2011.
• Earnings reports -- Merck. Merck has met or exceeded expectations in all of the last five earnings reports while Bristol Myers has beaten expectations in only four of the last five earnings reports.

Given the headwinds facing the industry -- reflected in weak 2012 earnings expectations, neither of the two companies looks like a bargain. But if forced to choose, I would pick Bristol Myers because of its lower P/E and the possibility of a takeover.