Biotechnology offers some of the most attractive risk/reward opportunities given the inelasticity of underlying demand and the opportunity for revenue acceleration from blockbuster drugs. Eli Lilly (LLY) and Pfizer (PFE) face significant headwinds with patent expirations, but both have significant catalysts in store. Based on my multiples analysis, review of the fundamentals, and DCF model, I find tremendous upside for Pfizer.
From a multiples perspective, both companies are reasonably priced. Lilly trades at a respective 10x and 10.6x past and forward earnings while Pfizer trades at a respective 19.5x and 9.1x past and forward earnings. Both also offer high dividend yields - 4.1% for Pfizer and 5.1% for Lilly - while being 30% less volatile than the broader market.
At the fourth quarter earnings call, Lilly's management nevertheless noted challenges to operations:
"[R]evenue declined by 2% in Q4 to just over $6 billion. You'll also see that gross margin as a percentage of revenue decreased 2 percentage points from 80.1% to 78.1%. The decreases in both revenue and gross margin percent was due to lower sales of Zyprexa and, to a lesser extent, Gemzar following their patent expiration.
This quarter's total operating expense defined as a sum of R&D and SG&A grew 2%. Within operating expenses, marketing, selling and administrative expenses grew 7%, while R&D expenses declined 6%. The growth in marketing, selling and administrative expenses was driven primarily by our diabetes collaboration with Boehringer Ingelheim and, to a lesser extent, by the mandatory pharmaceutical manufacturer fee associated with U.S. healthcare reform. The reduction in R&D expense was due to charges in the base period Q4 2010".
With the firm rated closer to a "sell" than most other companies on the Street, the potential for high risk-adjusted returns is very real. The company is exposed to one of the greatest patent expiration dilemmas in its market. With 90%+ margin products Zyprexa and Cymbalta facing greater competition, management has emphasized cutting costs. But as much as the market has highlighted the downside to the patent expirations, not enough attention has been placed on the firms' catalysts. I am particularly attracted to the companies' focus on cancer treatments which have the greatest potential to drive sustainable free cash flow. At the same time, the partnership with Boehringer Ingelheim helps reduce pipeline uncertainty in advancing DPP-V inhibitor Tradjenta. Solanezumab has the potential to be a game-changer in the Alzheimer's market.
Consensus estimates for Lilly's EPS forecast that it will decline by 27.7% to $3.19 in 2012, grow by 14.1% in 2013, and then decline by 27.2% in 2014. Assuming a multiple of 13x and a conservative 2013 EPS of $3.59, the rough intrinsic value of the stock is $46.67, implying 20.1% upside.
Pfizer similarly fads patent expiration issues. But this is more than offset by penetration into emerging markets and cost reductions. The firm is ranked #1 in emerging markets, which are expected to undergo accelerating growth in demand. And in terms of cost, the firm is well positioned to unlock synergies from the Wyeth takeover. Fourth quarter results were roughly inline with expectations as sales fell 5% due to patent expirations (the most notable of which was for Lipitor. The company may be known for having a poor pipeline, but beneath this reputation can be found three significant catalysts: Eliquis (atrial fibrillation), tofacitinib (rheumatoid arthritis), Xalkori (cancer). Eliquis has been so promising that it gained a priority review by the FDA and may have peak sales of $3B.
Consensus estimates for Pfizer's EPS forecast that it will decline by 1.7% to $2.27 in 2012 and then grow by 3.1% and 3.8% in the following tow years. Modeling a CAGR of 1.7% for EPS over the next three years and then discounting backwards by a WACC of 9% yields a fair value figure of $31.43, implying a stunning amount of upside.