by Sam Cage and Ben Hirschler

Last Updated: 2008-01-11 9:00:35 -0400 (Reuters Health)

ZURICH/LONDON (Reuters) – Drug stocks have roared ahead in a battered equity market this week but new-found investor enthusiasm for a traditionally defensive sector conceals deep-seated ills.

Switzerland’s Novartis AG is expected to highlight the problems when it kicks off the European pharmaceuticals earnings season on Jan. 17.

The industry was hit hard last year by declining sales of lucrative flagship franchises, a lack of significant new drugs and increasing generic competition.

Things will not get much better in 2008, with a possible Democrat win in the United States likely to add to pressure on prices in the world’s most lucrative market and Republican presidential hopeful John McCain also no friend of pharma.

The squeeze has prompted several drugmakers — including Novartis and the world’s two largest drugmakers, Pfizer Inc and GlaxoSmithKline Plc — to slash jobs.

Such cost-cutting will prop up sector profits in 2008, with Citigroup forecasting 10 percent growth in earnings per share this year, despite a meagre 2 percent advance in sales. That resilience augurs well for dividends.

But investors ignore sickly sector fundamentals at their peril, according to Credit Suisse.

Its analysts believe the outlook for the U.S. economy and the risk of widespread contagion — likely to prompt further defensive buying of drug stocks — will be the biggest determinant of pharma sector performance in 2008. Still, they say, the industry’s fundamentals are poor and deteriorating.

"Only if portfolio managers’ worst fears are realised does it make any sense to own such a fundamentally challenged sector," they wrote in a note this week.

Novartis — which will take a previously announced $450 million one-off charge in its fourth-quarter results for its latest restructuring — expects drugs sales growth to slow in early 2008, but a new growth wave from the middle of the year.

It is expected to post an 8 percent fall in fourth-quarter net profit to $1.48 billion due to a one-off restructuring charge and lower drugs sales, which are seen falling 1 percent to $5.97 billion, according to a Reuters poll.

"We continue to believe that the company expectations for pharmaceutical sales growth are optimistic, given the potential for increasing genericisation of certain key franchises, particularly in hypertension" where top-seller Diovan goes off patent in 2012, said Helvea analyst Andrew Fellows.


Novartis shares lost 12 percent of their value in 2007, taking major hits from delays in approval of key diabetes drug Galvus and the withdrawal of bowel drug Zelnorm from U.S. shelves.

That prompted the company to slash 2.5 percent of its workforce, aiming for annual savings of $1.6 billion in 2010, saying in December it would take a charge of $450 million in the fourth quarter for the measures.

But Novartis is not alone. Its share price decline was in line with the European pharmaceutical sector <.SXDP> in 2007 and it now trades at about 16 times forecast 2008 earnings, according to Reuters data.

That is still ahead of other European drug majors like Glaxo, Sanofi-Aventis and AstraZeneca Plc and only slightly behind Swiss rival Roche Holding AG.

"With Novartis planning to get as much bad news out of the way in this quarter as possible we see limited upside from these results," Citi analyst Amit Roy said in a note.

"Equally the market has been made aware of the negative influences, so downside surprises should also be limited," said Roy, who has a hold rating on the stock.

(Editing by Quentin Bryar)

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