Drugs sector's high set to last

THE INVESTMENT COLUMN

The pharmaceuticals sector has staged a spectacular recovery from its dismal performance in 1992 and 1993. The 33 per cent outperformance by the index against the market has been one of the best on record, although it failed to match the 55 per cent notched up in 1991, when investors fled to drugs stocks as a safe haven from impending recession.

A combination of the lifting of the threat of major US healthcare reforms by President Clinton and an outbreak of takeover fever helped lift the share prices of all the large companies last year. Most analysts are now looking forward to a continuation of the trend, albeit at a less impressive rate.

Most believe the pressure on drugs costs from governments, one of the sector's major depressants since 1991, may hit bottom this year. That should help arrest margin erosion, particularly as the cost-cutting on which recent mega-mergers have been predicted should start to bear fruit.

Perhaps even more significant, given the importance of sentiment to investment, is a possible repeat of the 1991 experience. If current forecasts prove correct and economic growth decelerates, then the sort of low double-digit earnings increases likely to be notched up by drugs companies in 1996 and 1997 will look attractive as more cyclical sectors enter a down-trend.

Finally, the optimists are pointing to further mergers and acquisitions this year, although on a smaller scale.

SmithKline Beecham could turn out to be the safest bet in 1996. The 1989 mega-merger between SmithKline Beckman of the US and the UK's Beecham which created the group is now well bedded down. It has also coped well with the ending of the patent on its best-selling Tagamet anti-ulcer drug in 1994.

A recent presentation on the group's research and development effort went down well with analysts, in contrast to similar briefings by Glaxo Wellcome and Zeneca. Products now in late-stage phase III trials and expected to come to market over the next two years could eventually represent peak sales of pounds 1bn or so.

The company should also be well placed to benefit from trends towards so-called self-medication, as people increasingly fight shy of doctors to treat themselves. The net $1.9bn (pounds 1.2m) acquisition of Sterling Winthrop in 1994 created the world's biggest non-prescription healthcare company, a strategy reinforced by last month's pounds 91m acquisition of a German maker of grocery-store medicines. More of a gamble was the $2.3bn addition of Diversified Pharmaceutical Services in the same year. DPS should allow SmithKline to cash in on the moves in the US by drugs "wholesalers" to manage the market on behalf of customers such as insurance companies.

Now the sector giant since last year's pounds 9bn takeover of Wellcome, Glaxo's attention is going to be focused in the medium term on integrating its new partner. Crucial to that will be promised cost-cuts, which brokers estimate could be a higher-than-expected pounds 800m by the end of 1998. But equally important is what it does to replace Zantac, one of the world's most successful drugs, and Zovirax, Wellcome's best-selling herpes treatment, when the patents on both run out in 1997. Zantac's profits in the following year are set to halve from just under 40 per cent of Glaxo's total now.

Imigran, a migraine remedy, could by worth over pounds 260m to the bottom line this year and the new 3TC-Retrovir anti-AIDS combination is expected to contribute a further pounds 200m or so. But, leaving aside any new blockbusters from its own R&D effort, Glaxo will increasingly have to license in new drugs from outside to fill the gaps.

If SmithKline's profits hit pounds 1.53bn in 1996, its shares down 7p at 712p, stand on a prospective multiple of over 18, reflecting the bright prospects. By contrast, the less exiting outlook for Glaxo means its shares, up 7p at 895p, are nearer a market rating of 14, assuming profits of pounds 3.2bn this year. Investors looking for a bit more excitement might turn to Medeva, whose Hepagene vaccine for hepatitis B now in phase III trials has a potentially huge market amongst the 2 billion people affected by the disease in Asia. After a strong run in 1995, the shares are still only on a multiple of 14, based on profits of pounds 95m this year.

Acquisitions

underpin Ellis

Chemicals distributor Ellis & Everard makes a lot of money out of the volatility of chemicals prices - when they go up it passes on the increase as quickly as it can and when they fall it drags its feet. The massive swings in some chemicals over the past 18 months, however, have made covering your back as a middle-man unusually difficult, so yesterday's half-year figures were especially impressive.

Pre-tax profits of pounds 13m for the six months to October were 24 per cent higher than a year ago and more than pounds 500,000 better than analysts had expected. Earnings per share, up 18 per cent to 10.4p, allowed a useful 11 per cent hike in the first-half payout from 2.7p to 3p.

Peter Wood, chief executive, reckons the price of some commodity polymer chemicals doubled and then halved again within the space of a year as Chinese demand swung unpredictably. That is good news for distributors, of course, as manufacturers and end-users become increasingly unwilling to hold substantial product stocks when there is a danger that prices could move against them.

The other good news accompanying yesterday's figures was a continuation of the string of add-on acquisitions that has characterised the profit recovery over the past three years since the last hiccup in 1992. The deals announced yesterday will add 5 per cent to sales in a full year and take Ellis into New England, where it had previously had no exposure.

Following the acquisition of Rhode Island-based George Mann, Ellis becomes the fifth-largest chemicals distributor in the US and about 60 per cent of group profits will come from America. The other, smaller purchase, of Albright & Wilson's Benelux distributor of phosphate and surfactants, strengthens its links with the recently floated manufacturer.

If the latest acquisitions do as well as the two Horneman companies bought a year ago they will be a good use of the 4.18 million shares placed yesterday to pay for the deals. Thanks to last year's buys, European sales and operating profits were up 30 per cent and 27 per cent respectively.

Ellis's shares had a storming run in 1993 but have trodden water since. On the basis of forecast profits of about pounds 25m in the year to next April, the shares, up 11p to 266p yesterday, stand on a prospective p/e ratio of 13, in line with the market. At that level, and with a 4.2 per cent yield, the shares are safely underpinned if unexciting.