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With the health care reform legislation expected to provide coverage for approximately 32 million previously Americans starting in 2014, the pharmaceutical industry should derive benefit from the new law taking effect - even accounting for the rising costs these companies might face because of this legislation. In this article, I will analyze 4 pharmaceutical majors by performing a fundamentally based valuation analysis. The companies selected for analysis are Pfizer (PFE), Merck (MRK), Bristol Myers Squibb (BMY) and Novartis (NVS). The table that follows presents basic information about the subject companies.

Company Basics

PFE

MRK

BMY

NVS

Market Cap (Billion)

201

142.6

76.5

178.4

Debt to Equity Ratio

38%

30%

48%

17%

Stock Performance 5 Yr

58%

26%

123%

38%

Stock Performance 1 Yr

28%

23%

36%

38%

Dividend Yield

3.4%

3.6%

3.0%

3.3%

PFE is by far the largest company in the group with a market capitalization of over $200 billion while BMY is relatively the smallest company on the list with a market capitalization of $76.5 billion. The four companies have a very similar, but respectable dividend yield ranging from 3% to 3.6%. NVS has a noticeably lower debt to equity ratio of 17%. Comparing the stock performance, BMY is the runaway winner having increased in price by 123% over the past 5 years. MRK is a laggard by this metric having appreciated in value by 26% during this time period.

Growth Rates:

Next, I evaluated the historical growth rates of revenue, income, EPS, book value and the projected growth rates. These are summarized in the table shown below:

Growth Rates

PFE

MRK

BMY

NVS

Revenue

10 Year

3%

8%

-2%

9%

5 Year

4%

14%

-2%

9%

1 Year

-13%

-2%

-17%

-3%

Income

10 Year

14%

-1%

-4%

7%

5 Year

12%

13%

-2%

-4%

1 Year

46%

-2%

-47%

4%

EPS

10 Year

14%

-4%

-3%

7%

5 Year

11%

6%

1%

-5%

1 Year

53%

-1%

-46%

3%

Book Value

10 Year

0%

3%

-1%

0%

5 Year

2%

7%

-3%

1%

1 Year

-5%

-1%

-1%

1%

Growth Projections

Next Year

6%

7%

17%

6%

Next 5 Year

3%

3%

8%

5%

All the companies selected for analysis experienced a decline in revenues during the last financial year with BMY leading the way with a decline of 17%. However, PFE increased its earnings by 46% and had a 10 year annualized growth rate of 14%. NVS also reported positive 10 year and 1 year growth rates in net income and EPS. Additionally, NVS was the only company on the list to increase its book value last year. Going forward, BMY is projected to grow at an annualized rate of 8% while MRK and PFY are expected to increase their earnings at an annual rate of 3%.

Margins

After analyzing the growth rates, the next step was the evaluation of gross and operating margins of the 4 firms. The results are presented in the table below. PFE and NVS have done a nice job of maintaining their operating margins. The two companies posted similar operating margins in the 20% range. BMY's gross margins expanded to 73% compared to the 10-year average of 70%, however, the operating margins fell from 22% to trailing twelve margins of 7%.

Margins

Averages

PFE

MRK

BMY

NVS

Gross Margins

10 Year

81%

72%

70%

73%

5 Year

80%

67%

72%

71%

Last Year

81%

65%

74%

67%

TTM

81%

65%

73%

67%

Operating Margins

10 Year

21%

20%

22%

21%

5 Year

21%

14%

24%

21%

Last Year

21%

20%

13%

20%

TTM

21%

18%

7%

20%

Profitability:

Operations

Averages

PFE

MRK

BMY

NVS

ROIC

10 Year

10%

17%

18%

14%

5 Year

8%

14%

24%

12%

Last Year

11%

8%

8%

10%

TTM

12%

8%

6%

10%

ROA

10 Year

7%

10%

13%

11%

5 Year

6%

9%

16%

9%

Last Year

8%

6%

6%

8%

TTM

8%

6%

4%

8%

PFE reported the strongest ROIC ratios last year and it is the only company on the list which has increased its returns. MRK and BMY have experienced a sharp decline over the past 10 years. Coming to ROA, PFE and NVS have generated a respectable ROA of 8% compared to 6% for MRK and 4% for BMY during the past 1 year.

Valuation:

Having developed a good idea about the fundamentals of the 4 companies, the next step was to perform relative valuation. The multiples used in the analysis were based on historical analysis of individual companies and industry multiples. The table below presents the valuation analysis results.

Valuation

PFE

MRK

BMY

NVS

Next Yr Est

$2.34

$3.74

$2.12

$5.41

EPS Growth Rate

3%

3%

8%

5%

Future EPS (5 Yr)

$2.57

$4.15

$2.72

$6.69

Expected P/E

18.7

16

18

18.7

Price 5 Yrs Out

$48.08

$66.45

$49.00

$125.19

Unlevered Beta

1.14

1.14

1.14

1.14

D/E Ratio

20%

15%

10%

12%

Current Tax Rate

35%

35%

35%

35%

Levered Beta

1.29

1.25

1.22

1.23

Risk Free Rate

2%

2%

2%

2%

Risk Premium

6.00%

6.00%

6.00%

6.00%

Size Premium

-0.36%

-0.36%

-0.36%

-0.36%

Cost of Equity

9.4%

9.1%

8.9%

9.0%

Fair Value

$30.72

$42.93

$31.94

$81.36

Current Price

$28.43

$47.25

$46.57

$72.59

% Overvalued

-8%

9%

31%

-12%

As shown in the table above, PFE and NVS trade at a modest discount to their fair values and appear attractive at current levels considering their yields. BMY is significantly overvalued and is a short candidate in my opinion. MRK is modestly overvalued and should be avoided at current levels.

(Kindly use this article for information purposes only. Please consult your investment advisor before making any investment decision.)

Source: Pharma Majors: 2 To Buy, 1 To Avoid And 1 To Sell