By Morgan Smith
The pharmaceutical industry is like a bad episode of Desperate Housewives - long-term commitments are broken, homes are divided, new alliances are formed, and changing bedfellows is par for the course. Only, in this case, the culprit isn't the dredges of suburbia, but rather an evolution of sorts.
Pharmaceutical companies are constantly developing new drugs, finding new uses for old ones and retiring the ones that just don't work as well as they used to. Sometimes a company comes up with a new technology or finds a new drug but needs help with development and testing. Other times a company distinguishes itself so much in one technology that the other pharmaceutical companies look to it for guidance.
For instance, pharmaceutical giant Pfizer (PFE) recently teamed up with Emergent Biosolutions (EBS), the company that develops a drug that protects against biotoxic substances called BioThrax for the US military. Their focus is on SBI-087, an autoimmune drug that is being developed as an aid in rheumatoid arthritis, systemic lupus erythematosus and other autoimmune diseases. Emergent Biosolutions has the experience in autoimmune therapies while Pfizer brings to the table everything else - namely funding, development and commercialization. At the same time, Emergent Biosolutions ended a partnership with Abbott Laboratories (ABT) in late December (the agreement is in effect until March 20, 2012). The two had been developing a blood cancer drug called TRU-016 together. Emergent Biosolutions, which had actually inherited the agreement with Abbott Laboratories when it bought Trubion Pharmaceuticals in 2010, is continuing its work on the drug and recently initiated patient dosing.
With so many changes and change ups, it can be hard to know where to put your money in this industry. Personally, I think it is best to choose a company that has the size and reputation. Invariably, the big players in this game, like Pfizer, have been around long enough they know how to develop and market a drug, as well as when to cut its losses and how to develop strategic alliances, like the one with Emergent Biosolutions. When you examine these companies individually, the benefit of a strategy like this is clear.
I like Pfizer because it is an old company with an extremely strong financial position. According to Yahoo Finance, Pfizer recently traded at $21.33 a share on a mean one-year target estimate of $24.51 a share. In addition to the upside, this pharmaceutical giant pays an 88 cents dividend (4.10% yield). That means, investors buying in now would enjoy a 12-month return of roughly 19% on their investments if analysts are correct. Pfizer also enjoys a current debt to equity ratio of 0.47, putting it below the industry average and indicating that management has done a good job of overseeing the company's debt levels. In addition, the company has a quick ratio of 1.44, which shows that it is clearly able to handle any shorter term capital issues.
Recently, the company has had sub-par growth in net income - it has a high gross profit margin (almost 85%) but its net profit margin of 8.60% is trailing the industry average - but I don't think there is any cause for concern given its expanding profit margins, high return on equity and solid stock performance. Likewise, Pfizer is priced high relative to its current earnings when compared to its peers, reporting a 19.36 price to earnings ratio versus an average of 17.89 for its industry, but it is actually priced much lower when looking at its price relative to its future earnings, with a forward price to earnings ratio of 9.13 versus an average of 16.25 for its industry.
Pfizer also has a big deal upcoming. Novartis AG (NVS) recently made a bid for Pfizer's animal health business. People closer to the matter say that the division could fetch between $15 billion and $20 billion. Novartis reportedly offered $16 billion, which Pfizer rebuffed as too low. It is unclear yet whether Novartis will make a second offer, but there are rumors that German's Bayer AG is interested in the division. As good of an opportunity as selling the division could be, Pfizer is also leaning toward possibly spinning off its animal health operations. This would avoid the large tax bill and any antitrust scrutiny a sale could bring. The decision is expected to be at least a few months in the making.
Now, consider Pfizer's numbers relative to some of its larger peers, like Merck (MRK), Johnson and Johnson (JNJ) or Abbott Laboratories. Merck recently traded at $37.44 a share on a mean one-year target estimate of $41.26 a share. The company also pays a $1.68 dividend (4.40% yield), so, if analyst predications are correct, investors buying in now would realize a return of just over 14% - or several percentage points less than Pfizer. Merck is also priced higher at 9.96 times its forward earnings.
Johnson and Johnson isn't positioned much better. It recently traded for $64.27 a share on a mean one-year target estimate of $72.62 a share. In addition to its upside, the company pays a $2.28 dividend (3.50% yield), so investors buying in now could earn a 17.50% return on their investments if the analysts are right. As such, Johnson and Johnson has less predicted upside yet it is priced higher, with a forward price to earnings ratio of 11.85.
However, Johnson and Johnson has one perk - it wasn't named in the Community Catalyst lawsuits filed on March 7. The lawsuits are aimed at the coupons some big drug manufacturers like Pfizer and Merck issue to some customers to entice them to buy the name-brand product over its generic counterpart. Community Catalyst alleges that programs like this raise insurance premiums and cause consumers to reach their benefit caps more quickly.
If the suit goes through, my pick, Pfizer, could be hit but I really do not think this is the sort of suit that gets resolved quickly - whatever the verdict. In my opinion, this means that there is plenty of time to get that roughly 19% return analysts are predicting for the company over the next year. Over the longer term, the Community Catalyst lawsuit is something to be aware of. After all, the suit could easily go through and where will that leave the big pharmaceutical companies like Pfizer? Because of this, I also recommend Johnson and Johnson. The company has nearly the upside of Pfizer, but it wasn't named in the suit.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.