The 9 Levels Of Healthcare / Biotechnology And Who Should Invest - Part 1

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Includes: BMRN, BMY, JNJ, NVS, PCYC, REGN
by: Brian Nichols

It can be very confusing to navigate the healthcare sector, more specifically those companies in drug development. More than likely, you are not a physician or a scientist, so it can be very difficult to understand clinical trials, patents, data and market opportunity in the space. With that being said, I am breaking down the space, into nine segments, so that you can decide which stocks might be best for you.

Mega Pharma

By now you have most likely heard of the patent cliff in the healthcare industry. This is the process in which many big name drugs have come off patent and are available for generic manufacturing. For many of the largest companies in the space, this transition has been quite difficult. However, in this largest of segments, these companies are minimally affected, due to being so large and so well protected.

The size of this particular space is quite formidable in terms of market presence, but very small in actual total number of companies. These are the ultimate secular investments, those that will perform regardless of market conditions. Johnson & Johnson (NYSE:JNJ) is the best example, a business that operates in a large array of segments. The company has its Worldwide Pharmaceutical business, which produced sales of $25.4 billion last year. Then, it has Worldwide Medical Devices adding $27.4 billion and a Consumer segment attributing $14.4 billion, reflected in the end-of-year report.

Each of Johnson & Johnson's segments is secular, therefore making an investment in JNJ the cornerstone of a safe portfolio. The company pays out a 3% yield, having increased its yield 33% over the last five years, and has seen steady gains with the overall market. An investor may want to explore JNJ if they seek safety first and returns second, because the stock has a yield that is better than most fixed income investments, and will allow you to invest in a company that should last through the ages.

Big Pharma

The Big Pharma segment of healthcare is widely considered to be one of the safest places to invest money in the market. These are companies that range significantly in size, but almost all return great yields to shareholders. There are companies such as Bristol-Myers (NYSE:BMY) with revenue of $17.62 billion - then there are companies such as Novartis (NYSE:NVS) with sales of almost $60 billion. Both companies pay good yields and are considered by most to be "Big Pharma." The question of investment then becomes, "Which one do you believe is valued the best, is the safest, and has the best pipeline?"

In my opinion, Novartis is the best in the Big Pharma category, being almost the same size as JNJ, but not quite as diversified. This is a company with an incredible pharmaceutical presence, and is an industry best in research. Just last year the company had 12 major approvals with recently launched products contributing $16.3 billion to its full-year. The company also has a mindboggling 138 products in its pharmaceutical pipeline, and over 200 projects total in clinical development.

By having such a strong presence in newly approved products combined with an industry best pipeline, Novartis makes a great investment for those seeking safety in Big Pharma. A person would invest in such a company for the same reasons that they would invest in the Mega Pharma segment: safety and consistency. However, in many ways I believe Novartis is the better investment compared to JNJ. Because although JNJ is more diverse, Novartis is cheaper with a trailing P/E ratio of 18.31 and a forward annual dividend of 3.60%, a 46% increase over the last five years. Not to mention, with such a large pipeline, it is very likely to see the company grow significantly over a course of many years.

Wannabe Big Pharmas

While we have the massive presence of companies such as JNJ, Novartis and Pfizer, there is also a new up-and-coming segment of companies with "almost" Big Pharma valuations that are creating buzz in the industry. These are fast-growing companies that the market has rewarded with high valuations, and these are also companies with limited products that have either Orphan statuses and/or blockbuster potential. In recent years, as growth slowed in Big Pharma and the largest patents were lost, this new class of stocks arose, and continues to rise higher every year.

There are many examples of companies in this category, but my favorite is Regeneron Pharmaceuticals (NASDAQ:REGN). Regeneron is a company valued at $17 billion with sales of just $1.38 billion. Therefore, its price/sales ratio of 12 is three-four times greater than that of Big Pharma. Its large premium to sales and its forward P/E ratio of 30.00 is due to its potential and its growth. You see, Big Pharma stays consistent with very little top-line growth while companies, such as Regeneron, are just tapping into their potential. Accordingly, many believe companies such as Regeneron could become the next Novartis, Pfizer or Bristol-Myers.

Another staggering difference between Big Pharma and the "Wannabe" Big Pharmas is products. Currently, Regeneron has just three products on the market, with its biggest being an eye drug, EYLEA, which returned sales of $838 million last year and has peak sales of $4 billion. The company has another product for colorectal cancer, ZALTRAP, which returned sales of $31 million in just four months of launch last year, and a smaller product with very little peak sales potential. However, its very large pipeline and its development partnership with Sanofi are encouraging for both future sales and in keeping current costs lowered.

Based on my description, Regeneron sounds like a slam-dunk, although as an investor you do have to consider if such a stock is right for you. This is not a cheap stock, it is valued for perfection, and those who invest in such a company accept such risk. These are companies that are typically too expensive to be acquired, meaning you need operational perfection in order for the investment to return consistent gains. Thus, when assessing stocks in this category you must ask yourself if these Wannabe Big Pharma will actually continue to grow and reach Big Pharma status.

Mid-Cap Speculative/Growth

In this next category we are looking at companies that are on pace to become Wannabe Big Pharmas. These companies always have approved products and decent revenue, but also have a drug in late-stage development or in early launch that has blockbuster potential. As a result, these companies often trade with valuations relative to fundamentals that are consistent with Wannabe Big Pharmas, but have market caps that are less. In a sense, it is a way for the investor to buy stocks, such as Regeneron, at a cheaper and earlier state in development - that is assuming it becomes a Wannabe Big Pharma and doesn't disappoint.

A good example in this category is BioMarin Pharmaceuticals (NASDAQ:BMRN), a company that is valued at $7.85 billion and has revenue of just $500 million. As you can see it is roughly half the size of Regeneron, but is actually more expensive with a price/sales ratio of 15.20. Last quarter the company saw sales growth of 22.30%, but its upside is not tied to its current product line, but rather its pipeline and its late-stage product, GALNS. Back in November the stock rallied 30% after very encouraging Phase 3 data regarding GALNS, which treats a rare genetic disorder called Morquio A Syndrome. The product is expected to be a potential blockbuster, expected to double the company's total sales. Much like Regeneron, this one product is driving the company's valuation, but it is also a very innovating pipeline that is creating such a buzz.

In regards to companies such as BioMarin or Pharmacyclics (NASDAQ:PCYC), you are investing on upcoming success. Typically, these companies have the same catalysts or upside as the larger companies such as Regeneron. However these are not as developed. With the larger companies, like Regeneron, you already know that the catalyst for gains is present. But with companies in this category, you are mostly assuming that the catalyst will present itself. Like I said, these stocks also have great upside, and are great investments for those who find Regeneron attractive. The main thing to consider is that these too are expensive - and because of the expense, you don't want too many being held in your portfolio, in the event that high expectations are not met.

Conclusion

As you can tell, this is a rather lengthy discussion. As a result, I will continue with the bottom five segments early next week. This will move us from the more stable investments into a speculative area with more risk and significantly more upside. As we proceed, you should realize even more so that one investment in the space may not be enough to be fully diversified in the industry. Stay tuned.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BMRN, REGN over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.