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Summary

  • JAZZ has been carried lower recently due to an industry-wide sell-off.
  • JAZZ is a highly efficient and profitable company with high levels of solvency and a low risk profile.
  • JAZZ is undervalued relative its peers and the S&P 500.
  • Proposed trade offers risk of 7% downside for 34% upside growth.

Last year was a year in which the Biotech industry could do no wrong in the eyes of the retail and institutional investor communities. In fact, over the twelve-month period, the iShares Nasdaq Biotech ETF (NASDAQ:IBB) more than doubled in value. In a seemingly stagnant environment in which real revenue growth is scarce, the Biotech industry provided an opportunity for investors to seek high returns. Companies of the likes of Biogen and Celgene stole the spotlight, and had investment pundits worldwide hitting the buy button. The following chart tracks the performance of the iShares Biotech ETF relative to the S&P 500 (NYSEARCA:SPY).

(click to enlarge)Jazz vs SP500

It is evident that the Biotechs were the institutional darlings of the past year. Hedge funds and other smart money poured into these firms at a record pace in an attempt to grab a slice of the 2013 gains. But then, at the beginning of March 2014, the entire dynamic of the stock market changed. The previously high-flying momentum stocks, such as Tesla Motors, Netflix, and Biogen quickly fell out of favor as investors turned to dividend-paying value names and slower-moving Utilities. Retail investors who held the IBB over the past month have experienced a tumultuous dive into bear territory, and have likely lost a good chunk of their gains. Investment bigwigs have been squawking non-stop regarding where there may still be value in the sector, to no avail. However, this week, one of my all-time favorite companies appeared in my deep-discount screener- Jazz Pharmaceuticals (NASDAQ:JAZZ). I feel that there is significant upside potential here, and that, at present levels, we may be seeing an inflection point. Jazz has pulled back for the simple reason that there is a risk-off mentality sweeping the industry broadly, and Jazz has come down too far, as it does not embody the overvaluation that led to the sell-off.

Firm Overview:

Jazz Pharmaceuticals, which is headquartered in Dublin, Ireland, is a global biotechnology firm that identifies, develops, and commercializes several medications for a wide range of medical applications. The company's core products are Xyrem (cataplexy), Erwinaze (lymphoblastic Leukemia), Prialt (chronic pain), among others. The firm also offers various products for use in oncology and hematology applications, and has more than five drugs in clinical testing stages.

Fundamentals:

The screener that I use is set to identify equities that are fundamentally undervalued with respect to the S&P 500. It seeks to identify financially strong companies that are drastically undervalued in terms of price-to-earnings, price-to-book, and price-to-free cash flow. For a company to appear in the screener, it must meet stringent solvency, growth, and efficiency parameters. For example, no company with a current ratio less than 1.5, or earnings growth under 10% will qualify. Jazz actually topped the list as my highest conviction trade last week, however, there were some worrisome technical conditions that lead me to wait for better price action before recommending the stock to my Seeking Alpha followers. However, I feel that, at current levels, Jazz provides a lucrative entry point. The following chart displays Jazz's fundamental ratios and provides some insight into the firm's position relative to its competitors.

(click to enlarge)Ratios

As can be seen above, Jazz is significantly more profitable than its closest competitors, even though the closest competitor listed has a market cap almost six times larger than Jazz. The company has clearly achieved the benefits of economy of scale, yet has not grown to nearly the size of its competition. The company also makes more rewarding investments, as can be seen by the higher returns on assets and equity. However, the most attractive of the figures listed above are the amount of cash per share and the current ratio. The combination of the aforementioned metrics signals that Jazz's management is keen in accepting only profitable investments, and has a particular focus on solvency. In an industry that is deemed "high-risk, high-reward", Jazz seems to have contained its risk, while still managing to outperform its peers in terms of profitability. Jazz also has been stockpiling cash in an effort to prepare for future outlays- a strong signal for investors.

Relative Valuation/Multiple Analysis:

Surely, the most compelling aspect of this investment proposition is Jazz's valuation relative to the market and its competition. The following chart demonstrates that Jazz is drastically undervalued on a relative basis:

Valuation Measures

Jazz

Teva

Abbott

Celgene

BIIB

Market Cap (intraday)5:

7.55B

43.16B

58.05B

56.12B

67.59B

Enterprise Value (Apr 8, 2014)3:

7.28B

54.83B

58.07B

54.85B

67.52B

Trailing P/E (ttm, intraday):

37.06

34.16

23.18

41.01

36.61

Forward P/E (fye Dec 31, 2015)1:

12.8

10.97

15.23

14.43

20.38

Forward PEG Ratio:

0.61

4.18

1.48

0.77

1.43

Price/Book (mrq):

5.57

1.94

2.35

10.2

8.07

Enterprise Value/Revenue (ttm)3:

8.34

2.7

2.66

8.45

9.74

Enterprise Value/EBITDA 6:

16.2

9.77

13.08

23.3

22.39

While the S&P 500 is currently trading at 18x earnings, Jazz Pharmaceuticals has a forward P/E of only 12.8. This metric alone suggests that Jazz has potential upside of 40% before arriving at the market's current value level. This suggests that Jazz should be trading at levels as high as $182.78. I believe that the recent biotech sell-off was triggered by the industry's high valuation relative to the S&P 500. However, Jazz actually is undervalued with respect to the market, while most of its larger counterparts trade at P/Es around 20. Another metric that I consider is the forward price-to-earnings-growth ratio, or PEG ratio. The PEG ratio measures a company's P/E ratio divided by its earnings growth rate. Generally speaking, a PEG ratio of <1 signals that an equity is undervalued. Based on the forward PEG ratio for Jazz, shares should be trading at $179.90, which also suggests significant upside of 38%.

Technical Analysis:

As I mentioned before, there were some technical indicators that held me back from presenting this stock last week. In the interest of brevity, I will simply point out the bearish trends that can be found in the following chart.

(click to enlarge)Head and Shoulders Jazz

The first price pattern that can be seen in the chart is the ever-morbid head and shoulders pattern. You will notice that the price initially peaked at $160, before falling back to roughly $145. Then, it drove upward before peaking at $175, and fell back to develop a second shoulder in the $140-$150 range. Then, the stock continued lower, breaking the neckline at $145. This pattern is seen by chartists as a strong bearish indicator-- and notice that the price continued its free-fall to current levels around $130. There is also a "triangle of death" built into this head and shoulders pattern, which is another bearish indicator. However, the stock has bumped up against a key support level at $121.54, and held that level, which I see as a suggested pivot point. If we see a bit of consolidation here, the shares might develop a stronger level of support here, capping the downside for your investment. Now check out the next chart, which includes some overlays and lower indicators:

(click to enlarge)Jazz Techs

When we narrow our horizon a bit and add some overlays, the chart begins to paint a very bullish picture. In my opinion, the most telling technical indicator is the slow stochastic. Here, we see that the stochastic has moved deep into oversold territory, and we are even seeing the %k cross the %d from below, which is a strong trigger point for a reversal in price action. For instruction on how to read the stochastic oscillator (which can be extremely useful), check out my recent InstaBlog article on Apple. Further, the Relative Strength Index reads a level of 30, which is seen by chartists as oversold territory as well. Finally, the Moving Average Convergence/Divergence Oscillator also shows a highly oversold condition, as the oscillator sits below zero. Notice in the previous chart that the last time the stock traded in overbought territory, it was sitting around the $175 level- almost exactly the level suggested by the valuation metrics outlined in the valuation section above. Based on this chart, I feel strongly that $130 is an attractive entry point.

Risks:

There has been speculation recently that Jazz Pharma will purchase Ariad Pharmaceuticals for a premium of up to $20 per share. While I believe that this is an unlikely acquisition, it is important to identify this transaction as a risk factor for the trade I propose in this article. While a purchase of Ariad could add pipeline and long-term value for Jazz, in the near term, it poses a risk for our "swing trade." I do not feel that this acquisition will close, as it will not add profitability for Jazz. The only reason I feel this purchase could potentially be lucrative for Jazz is that it could bring Jazz into a lower tax bracket, thus saving the company tax dollars in the long term. Also, it is important to note that there is a relatively strong point of resistance at $140.70. If shares of Jazz fail to break this resistance level, we could see a loss of momentum, at which point I would change my stop-loss to a trailing stop at roughly 2.5%.

Conclusion

Jazz Pharmaceuticals has presented investors with a unique opportunity to capture strong capital gains in an industry that has recently been rocked by institutional selling pressure. Based on my calculations and an entry point near $130, Jazz has potential upside of roughly 34%. Given the chart above, along with current industry and market conditions, I would give this trade about one month to pan out. To protect the downside on this trade, my recommendation is a stop-loss at a price either $122 or $117, as both are strong resistance levels in the chart. With an entry point of $130, a target of $175.00, and a stop at $121.54, the risk/reward relationship is favorable. In fact, we are shooting for a gain of 34%, while limiting our downside to 7%, net fees.

Feel free to contact me for a copy of my stock screener parameters.

Source: Jazz Pharma: Risk 7% Downside, 34% Upside To Fair Value