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Drug stocks have performed healthily


NEW YORK -- A year ago, the prescription on drug stocks was clear: Avoid them. That was splendid advice -- for investors who did just the opposite.

An investment of $1,000 in Pfizer Inc., which will split its shares in June, a year ago is worth $1,680 today. That's a 68 percent return in 12 months, not counting dividends.

Eli Lilly & Co. shares have climbed 64 percent in the same period. Marion Merrell Dow Inc. shares are up 62 percent, while those of Merck & Co. have risen 57 percent. The overall Standard & Poor's Corp. drug index is up 55 percent from a low last April.

Once widely diagnosed as unwise investments, drug companies have been among the stock market's healthiest performers in the last year. And they continue to find favor on Wall Street.

"Just a year ago, some people were saying industry growth would be down this year," said Larry Smith, a pharmaceutical analyst at Hambrecht & Quist. "Since then, these stocks have had an enormous bull-market run and they still have a ways to go."

In a typical doom-and-gloom outlook, one analyst in March 1993 warned the industry was encountering fundamental problems, most notably an imminent collapse in prices.

There was good reason for the pessimism. Bill Clinton, who had made health care reform a centerpiece of his campaign, had just taken office. By last April, the S&P; drug index had tumbled about 40 percent from the election. With reform still a hot issue, a cloud remained over the industry as investors nervously awaited the outcome.

The reforms, which among other things called for a 17.5 percent reduction in prices of brand-name drugs bought by the government's Medicare and Medicaid programs, threatened to curtail industry profits. Medicare is the federal health insurance program for citizens 65 or older. Medicaid provides assistance to the poor.

Hoping to head off government intervention, drugmakers pledged to keep price increases near the rate of inflation -- then about 3 percent a year -- compared with 8 percent to 10 percent a year for the previous five years.

That alone represented a major concession by the drug companies, which had grown largely through price increases. Between 1985 and 1991, drug prices had jumped 66 percent, for example, three times faster than overall consumer prices, according to Families USA, a Washington-based consumer group.

The industry already was coping with demands from cost-conscious operators of managed care companies.

Their presence could hardly be ignored by drug companies: by late 1993, HMOs made about 50 percent of all U.S. prescription-drug purchases, compared with 22 percent just two years earlier. The self-imposed price caps further reduced the prospects of what had been a high-growth business.

But as the cloud of health-care reform lifted, drug prices began to climb out of the basement. The shares' recovery was given further impetus as drug companies took aggressive steps to become more competitive.

To protect margins from the smaller price increases, they cut costs, slashing about 25,000 jobs from their payrolls in 1993. Pfizer eliminated 3,000 jobs, or 7.4 percent of its workforce. American Cyanamid Co. cut 2,500 jobs, about 9 percent of its total, and Upjohn Co. cut 1,500 jobs, or 8 percent.

Still, many analysts felt the job cuts weren't enough. Early last year, Paul Brooke, a senior health-care analyst at Morgan Stanley, said that unless drugmakers took further dramatic steps, including acquisitions, earnings growth could slide to well below 10 percent for the next few years.

Merck already had startled the industry when in 1993 it bought the nation's largest mail-order drug retailer, Medco, in an effort to ensure a market for Merck products. Medco doesn't sell Merck )) products exclusively, but the proportion of Merck drugs it sells has increased since the acquisition.

Other drugmakers, including SmithKline Beecham PLC and Eli Lilly Co., also have bought distribution companies.

Yet it wasn't until drugmakers began to merge with rivals that many investors took notice. Consolidation, analysts argue, is taking excess capacity out of an otherwise fragmented industry. That's expected to give drug companies a better negotiating position with managed-care companies.

Jack Lamberton, a pharmaceutical analyst at NatWest Securities New York, was negative on the industry in April last year. Yet after American Home Products Corp. surprised the market in August by making a hostile takeover offer for American Cyanamid, he changed his outlook.

"Once you introduce hostile takeovers, the excess capacity can begin to be removed," Mr. Lamberton said.

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