By the Numbers: A Look at Major Drug Manufacturers

by: Charlie Anderson

Here, here, here, here, and here, not to mention countless other places. These are the people who want you to sink your money into the drug manufacturing business. They say that these businesses have high yields, which they do. The average for the 15 biggest and brightest is 3.2%, 50% above the S&P 500 (NYSEARCA:SPY) average. They say that these companies have wide economic moats, competitive advantages. This is true, Morningstar gives more "wide economic moat" ratings to the major drug manufacturers than to any other industry. Not only this, but the 15 biggest have an average market cap of $90 billion, so they must be safe, right? Wrong. Below are the numbers: the cold, hard facts on the 15 biggest and most-followed major drug manufacturers available to American investors.

First, a look at the biggest of the 15. Size can create economics of scale and yield a much larger R&D budget. The top three by market capitalization are Johnson & Johnson (NYSE:JNJ) at $166 billion, Pfizer (NYSE:PFE) at $164 billion, and Novartis (NYSE:NVS) at $154 billion. While these companies are in the lead, both Pfizer and Johnson & Johnson are losing ground. The returns on invested capital at these two firms have declined over the past few years by 26% and 9%, respectively. These two industry leaders are reverting to the mean. Now on to the second selling point for the industry: yield.

The average yield for the 15 companies in the sample group was 3.2%. Within this, there are some stars. GlaxoSmithKline (NYSE:GSK) pays 5.0%, AstraZeneca (NYSE:AZN) yields 8.0%, and Eli Lilly & Co (NYSE:LLY) yields 5.7%. GlaxoSmithKline, unlike the other two, is not increasing its yield. Astrazeneca and Eli Lilly have increased their yields over the last four years by 19% and 16.2% p.a., respectively. These above-average yields would suggest that the stocks are cheap, and so here's a look at the cheapest of the group.

Merck (NYSE:MRK), AstraZeneca, and Eli Lilly & Co top the list of the cheapest. Eli Lilly clocks in at 7.9, with Merck at 8.7 and AstraZeneca at 9.0. Now, you ask, are these low valuations justified? In the case of Merck, yes. Merck's earnings per share were down a jaw-dropping 95% YOY in 2010. Now a look at the fastest growing shares on the list, to see if any of these cheap companies are deals.

The average 3-year EPS growth for this list was 0.8%, so any growth represents an above-average performance. Two of the smaller players crush the average: Novo Nordisk (NYSE:NVO) and Bristol-Myers Squibb (NYSE:BMY). Bristol-Myers Squibb has problems of its own that will be discussed later, and Novo Nordisk is growing at 23% p.a., but with a P/E of 26.7, the growth is priced in. That is twice the sample's average price-to-earnings ratio. The final winner came as a bit of a surprise: Eli Lilly. Now a cohesive look at value and price.

The average PEG ratio for the sample was 1.54, and that didn't include the 6 companies with declining earnings. There were only four companies of the 15 that had a PEG ratio below one, representing earnings growth higher than the P/E ratio: Eli Lilly (0.41), Bristol-Myers Squibb (0.72), AstraZeneca (0.86), and Novartis (0.87). The only way for this growth to create value for the shareholder is to earn above-average returns on the capital that is reinvested in the business.

The average return on invested capital was 16.6% with little variation. The only way for the manufacturers to consistently earn high returns on invested capital is to spend heavily on research and development, and even then it is not assured. Novo Nordisk, AstraZeneca, and GlaxoSmithKline topped the list, but Eli Lilly, Bristol-Myers Squibb, Merck, and Johnson & Johnson also beat the average. Despite the logical connection between returns and R&D spending, there was no statistical link. Nonetheless, take a look at R&D spending as a percentage of sales.

Although there was no statistical evidence that R&D spending was tied to growth or ROIC, it is still a good figure to predict future success or failure in developing profitable goods. The average was 15.8%, and there was a clear relation between below-average R&D spending and mentions on the above lists. Stocks with below-average R&D spending were mentioned an average 1.3 times, and those above-average were mentioned 2.6 times. The number of times each of these companies topped the sample group is a good proxy for whether it is a value trap or a great investment.

Most of the companies on this list were hardly mentioned. Abbott Labs (NYSE:ABT), Allergan (NYSE:AGN), Bayer (OTCPK:BAYRY), Roche (OTCQX:RHHBY), Shire, and Sanofi-Aventis (NYSE:SNY) didn't top the lists once. Johnson & Johnson, Merck, Novartis, and Pfizer only made it once. Pfizer, Novartis, and Johnson & Johnson only were listed because of thier size. Almost all of these companies have economic moats, these three aren't special. They aren't outstanding in growth, value, yield, or efficiency. There seems to be no reason for their critical acclaim. AstraZeneca and Eli Lilly, on the other hand, were each mentioned four times. This makes them the fastest-growing, cheapest, highest-yielding, and most efficient major drug manufacturers that you've never been advised to buy.

Disclosure: I am long AZN. I also plan to enter long LLY.