Searching for Values in the Drug Stock Universe

In yesterday’s Pfizer piece I mentioned I had planned a broader look at the drug stocks, but focused only on the story du jour. Here are some thoughts on the sector that I wrote before the Pfizer news:

Not too long ago I wrote about pharmaceutical giant Pfizer (PFE) and how it trades at a seemingly steep discount to its peer group, and boasts a 3.9% dividend yield to boot. With the broad equity market having rallied sharply since August, investors looking to get a little more defensive can often find solid bets in the healthcare space. I decided to look at 12 of the larger drug companies to see if any other values are out there other than Pfizer. It appears there are.

I have actually been underweight healthcare stocks for some time. This had little to do with a lack of confidence in the macroeconomic outlook for the sector, and everything to do with the fact that I just couldn’t really find too many bargains. While many of the drug stocks still appear to be fully valued, sideways trading in several stocks in biotechnology has resulted in extreme price-earnings multiple compression.

Followers of the sector know very well that biotech stocks have traditionally traded at premiums to their big pharma counterparts, mainly due to the fact that they tend to be smaller, and therefore one big product breakthrough can have a dramatic effect on the company, and fuel substantially higher earnings growth. It appears in today’s market, however, that the two subsets of healthcare have converged as far as valuations go. As a result, I think there are opportunities for investors to capitalize.

Below you will see summaries of a dozen drug companies, sorted in ascending order of forward P/E ratio. Also included are current dividend yields and projected growth rates in 2007 for both sales and earnings. Grouping the names in this manner makes it a lot easier to spot the relative values.

In group “A” you will find the aforementioned Pfizer, which trades at a discount to its peers. Sanofi (SNY) is close, but yields about 50% less. Glaxo (GSK) rounds out the trio of below-market multiple stocks, but Pfizer still looks the best to me based on valuation and their dividend. Also, you may have read that the new CEO there recently decided to cut 20% of their salesforce. Further cost cutting is likely, and expect dividend increases to be consistent over time.

The second group of stocks (“B”) are those that trade around a market multiple. In this group, I highly favor Amgen (AMGN). I know they lack the 3-plus percent dividend of Eli Lilly (LLY) and Merck (MRK) but the double digit growth rates are very impressive, and AMGN has rarely traded at a sub-16 P/E.

Groups “C” and “D” are mostly biotechnology companies, but somehow both Bristol Myers (BMY) and Schering Plough (SGP) are trading at a premium to Genzyme (GENZ) and Biogen (BIIB) despite far less growth potential. Again, the fat dividend yields are a factor here, but I still believe there should be a valuation gap between biotechs growing at double digit rates and big pharma muddling around in the single digits.

Full Disclosure: Peridot owns shares of Pfizer and Amgen

Pfizer Setback Disappointing, Not Catastrophic

I was actually planning a broader pharmaceutical post today, but in light of the Pfizer (PFE) news over the weekend, I just wanted to talk about them a bit first. Peridot has a small holding in PFE, and will not be selling into today’s weakness. My bias would be to buy more, not sell. The news that the company is abandoning its lead cholesterol-fighting compound is obviously hardly a positive development. However, despite losing a key drug in its pipeline, the reasons I like Pfizer have not changed dramatically with this news.

Pfizer still trades at the lowest multiple in the big pharma group. Investors can certainly argue that such a price is warranted given the issues with their development pipeline, coupled with the fact that they are projecting flat revenues for 2007 and 2008. That said, once growth resumes in 2009 and beyond there will be outsized upside potential with such a depressed stock price. The bar will be set quite low when business begins to turn.

The stock is down more than 10 percent today to $24 per share. The current $0.96 annual dividend puts the stock’s yield at around 4 percent. I would expect a dividend increase to be forthcoming. A boost of 15% or more (to at least $1.10 per share) equates to a 4.6% yield, which is more than that of a 30-year U.S. treasury bond.

A floor on the stock due to the large dividend is not the only reason the shares are attractive at $24 each. Investors should expect accelerated cost cutting measures by management, increased share buybacks to appease upset investors, as well as an increased focus on M&A to boost their product pipeline. These moves will be largely received well on Wall Street, as they will allow the company’s earnings per share to hold up well (and even grow) for the next couple of years until new products can fuel larger growth in the drug business.

With the stock yielding 4 percent and trading at 12 times earnings, the downside for PFE is limited. Don’t get me wrong, this is a longer term play. The stock is not going to $30 overnight. However, the stock will pay you like a long-term bond while you wait for the picture to improve, and if some new blockbuster drugs do come to market over the next several years, there is no reason to think the stock could not reach the 40’s again. Add in the dividend payments and this defensive healthcare play could meaningfully boost portfolio returns over that time.

Full Disclosure: Long shares of PFE at time of writing

As Predicted, More Biotech Buyouts

When I wrote about the Merck (MRK) deal to acquire Sirna Therapeutics (RNAI) on 10/31 and predicted more biotech deals were coming, I didn’t realize it would only take a week and a half. Last night, Genentech (DNA) announced plans to acquire Tanox (TNOX) for $20 per share in a deal worth more than $900 million. The all-cash tranasaction is expected to close by the end of the first quarter.

Tanox is not a company that has gotten much attention on Wall Street, in terms of product potential or as a possible buyout candidate. Like I said in my last piece, it is very tough to know which of these small and mid cap biotechs will get bids. It appears there are some royalty synergies with this deal, which explains in part why DNA targeted them.

On another note, shares of Genentech have been flatlined for a while now (see the chart below) and are beginning to not look as overvalued as they have in the past. While a 30 forward P/E would rarely be considered extremely cheap, further weakness in DNA shares might allow for an attractive entry point for a firm that can grow earnings north of 20 percent per year.

CVS/Caremark Deal Creates Pharmacy Powerhouse

Many investors are scratching their heads after the announcement of a blockbuster deal that would, if approved, combine CVS (CVS) and Caremark Rx (CMX) into a pharmacy goliath with a $40 billion market value and $90 billion in sales. Caremark has been very active in the M&A game in the past but this deal in particular surprised a lot of people. There are obvious synergies between a PBM and an actual pharmacy and it will be interesting to see exactly how the deal turns out, both for customers and for shareholders.

What exactly was the motivation for such a deal? Several ideas come to mind. First, Wal-Mart’s recent decision to price a 30-day supply of generic drugs for as little as $4 is a real threat to the likes of CVS, Walgreen’s (WAG), and Rite Aid (RAD). By merging with Caremark, CVS opens up new, stronger avenues to compete with Wal-Mart (WMT). For one, they can enhance their mail order prescription business (mail order script fills have stronger margins than retail fills). Second, now when Caremark works with corporations and customers on benefit program management, they can steer clients toward CVS retail stores or one of their own mail order pharmacies.

Cost synergies seem inevitable with this deal as well. Computer systems can be made far more efficient with the company adjudicating the claims and the pharmacy filling the scripts on the same team. Cash collections will also likely be improved since the pharmacies and the PBM will not be trying to squeeze each other for their own cash flow gains.

All in all, the combination of bricks and mortar pharmacy, mail order pharmacy, and pharmacy benefits manager makes logical sense. The size and scope of the deal, along with its associated integration, might have made some leery in the past to make it happen. However, Caremark has shown a willingness to make game-changing deals (they acquired AdvancePCS, a large competing PBM several years ago and it proved a very successful transaction).

It will be interesting to see what, if any, response Express Scripts (ESRX) and Medco Health (MHS) decide on. I could also imagine that many Caremark shareholders will be upset with this deal and might even vote against it. Will they be able to halt the deal entirely? Perhaps, but it’s too early to tell. Caremark and CVS will definitely have to sell the deal to naysayers though, and do so convincingly.

Merck Paying $1B for Sirna, More Deals Likely

Pharmaceutical giant Merck (MRK) is clearly looking for ways to boost growth. It’s no secret that big pharma companies face increasing competition from generic drugs and pressure to keep rising healthcare costs in check. Small to mid size acquisitions of biotechnology companies are a solid way for companies like Merck, Pfizer (PFE), and Glaxo SmithKline (GSK) to strengthen their product pipelines.

On Monday we learned that Merck is paying more than $1 billion for Sirna Therapeutics (RNAI). It’s is quite possible that they overpaid. After all, MRK is paying $13 per share in cash, a premium of more than 100 percent over Monday’s closing price. However, overpaying by a couple hundred million dollars isn’t a big deal for a company the size of Merck if several of Sirna’s products eventually reach the market.

There is no doubt that deals like this one will continue. I am generally leery of trying to predict which firms will get taken out next. So, I would suggest that biotech investors pick stocks that have solid fundamentals, not just those that some speculate could get a bid from big pharma.

As for the pharma companies themselves, I like Pfizer at current levels ($27 per share). It trades at a discount to most of the other pharmaceutical companies and yields well over 3 percent. Pfizer has done mid size deals before and likely will do so in the future. In fact, I made a ton on a company called Esperion Therapeutics when it was bought out by Pfizer for $1.3 billion.

With a hefty yield and a below-market multiple, conservative, defensive, income-oriented investors should take a look at PFE. A recent analyst downgrade has knocked the stock down a buck.

Full Disclosure: I own shares of Pfizer personally, as do some of my clients.

 

Time to Cover Express Scripts Short

Two months back I wrote that shares of Express Scripts (ESRX), a leading pharmacy benefits manager, were bloated at $93 each. A P/E of 30 for the company was simply unsustainable. Today ESRX is down nearly $10 to $74 per share after issuing an in-line earnings report. Although I would not do a complete 180 and go long quite yet, I do think it is time for ESRX shorts to be covered for a 20% gain. Where should the money go? I’m interested in taking a look at Aetna (AET), which is down more than 20% today to $36 per share.

A Healthcare Opportunity For Investors?

If you look at the fundamental outlook for the healthcare industry over the next couple of decades you can’t help but be impressed. After all, the demographic shifts our country is going to see as the baby boomers retire is quite compelling. From an investment perspective, leading companies serving our aging population stand to profit tremendously.

However, the current market climate for such stocks is quite interesting; healthcare stocks are getting hammered with investor interest lackluster at best. We know big pharma is facing severe headwinds. But insurance firms are down, as are medical device companies, not to mention the brutal sell-off in biotechnology in recent weeks.

It’s true that any government-led reform to the healthcare sector could be negative for these companies to a certain degree. Right now, cost containment within Medicare and Medicaid is pretty much non-existent. If policy makers took firm action to bring costs down, pricing pressures would compress profit margins for essentially all healthcare firms.

However, how likely is such broad reform? And even if it does occur, will it completely cancel out all the incremental business gained from the aging boomer generation? I think these are important questions to ask when analyzing the sector and I suspect there are some excellent values beginning to surface, and prices could certainly continue falling in the short-term as governmental involvement is always more of a concern during election years.

Loyalties Aside, ESRX is Bloated

Shares of my former employer, Express Scripts (ESRX), a leading pharmacy benefits manager in the U.S., are going to fall a few points this morning. Earnings reported last night were 2 cents above expectations but the momentum traders wanted more.

Express Scripts had beaten estimates by a fairly wide margin in recent periods, and bulls were undoubtedly hoping for another “beat and raise” quarter. They got the “beat”, but not the “raise”.

Full year guidance remained at $3.10 to $3.22 per share in earnings. ESRX rarely misses guidance, so they will be fairly conservative. They don’t raise guidance often, and when they do, it’s usually only once per year.

At $93 per share, the stock was trading at 30 times 2006 earnings coming into the latest report, historically an astronomical multiple for a PBM company. It’s true that accretive acquisitions are boosting growth rates above competitors like Medco (MHS) and Caremark (CMX), but 30 times earnings for ESRX is too rich, in my view.

As a result, profit taking is in order, and investors have already begun that process this morning.

Cramer Pump Sends NMTI Up 34% After Hours

Nothing really surprises me anymore, but today’s action in NMT Medical (NMTI) is absolutely ludicrous. NMTI is a micro cap medical device company that closed today’s regular session at $17 per share.

Tonight on CNBC’s Mad Money show, Jim Cramer led off the hour-long episode by recommending NMTI, saying it could go to $100 if their new migrane product is approved. If the trials fail, his downside projection was $10 a share. Given the risk/reward he sees, Cramer pumps the stock for several minutes and the stock quickly jumps over 33%, or $6 per share, to $23 and change.

The reason I bring this up is because NMT Medical is one of 10 stocks featured on Peridot Capital’s 2006 Select List, published earlier this month. Thanks to many individual investors who were silly enough to put in a market order to buy, simply based on Cramer’s recommendation, I was able to sell a decent chunk of stock at between $23.09 and $23.75.

First of all, if you purchased our 2006 Select List and are lucky enough to be holding shares of NMTI right now, I strongly suggest taking some profits tonight in after-hours trading, or on Monday if the mark-up holds early next week. There is no fundamental reason for the stock to be up at all, let alone more than 30 percent.

It is true that the company’s devices could be a huge hit if they prove effective, but human trials have not been completed. This stock is very speculative, as was noted in our report, and is not for every investor. In fact, we tabbed it the lone “speculative pick” in the group of 10 companies we profiled in the report. Please trade with caution, especially if you are a fan of Cramer’s show. These are very dangerous waters for retail investors.

Another interesting twist is that NMT, not NMTI, spiked $5 during Cramer’s show, as investors bought the wrong stock with a similar ticker symbol. NMT is a municipal bond fund that closed at $15, but some people paid $20+ for it in after-hours trading. Another example that if you’re not careful, you can lose 25% of your money on a trade within minutes.

Genentech’s Q3 Highlights Healthcare Cost Issues

There is little arguing that the rising cost of healthcare is one of the biggest issues hampering the U.S. economy. Next year, average health insurance premiums are expected to surpass $14,000 per family. That will represent one-third of the average household income in this country. The main reason for such staggering costs are prices for prescription drugs. Drug expenditures, which were $12 billion in 1980, hit $179 billion in 2003. That’s an average increase of 12.5% per year, more than 4 times the historical rate of inflation.

Investors need look no further than the Genentech (DNA) Q3 earnings report to see exactly how crazy drug prices have gotten. Genentech’s newest and second-best selling drug, Avastin, costs a whopping $140 for a day’s supply. That equates to $4,400 per month and $53,000 per year. Should a drug for colon cancer really cost 20% more per year than the average household income in the United States? I bet very few could argue it should.

The argument for limiting the costs of prescription drugs centers around the idea that limited profit potential will result in less research and development, and therefore fewer novel therapies for the world’s most lethal diseases. Without the ability to make a significant profit, proponents of a healthcare free market say, drug makers will lose the incentive to discover new drugs for cancer, heart desease, etc.

However, a simple analysis of Genentech’s third quarter income statement shows that this theory, while it makes sense in economic terms, simply isn’t true when you actually look at the numbers. Here are some key facts from DNA’s latest earnings release:

* Genentech’s drug mark-up (retail price versus manufacturing cost) is 662%

* Only 38% of the drug company’s profit is reinvested into research and development, and net profit after tax actually surpasses total R&D expenditures

* Drug company net profit margins are nearly 20%, higher than any other major industry

And the one that is important to understand when hearing the debate on spiraling costs for prescription drugs:

* If retail prices for Genentech’s drugs were reduced by 50% effective immediately, the company would still be able to spend the same amount it does today on R&D and would have more than $400 million left over in excess profit every year