From high dividend yields to low betas, healthcare stocks are exceptionally safe. While the patent cliffs at Pfizer (PFE) have significantly limited growth expectations, product flops at Johnson & Johnson (JNJ) have put investors back on the sidelines. In my view, however, the sector is by and large undervalued. In this article, I will run you through my DCF model on Watson Pharmaceuticals (WPI) and then triangulate the result with a review of the fundamentals against Pfizer and Novartis (NVS). I find Pfizer and Novartis to be more undervalued than Watson right now.
First, let's begin with an assumption about the top-line. Watson finished FY2011 with $4.6B in revenue, which represented a 28.5% gain off of the preceding year: acceleration. I model 12.5% per annum growth over the next half decade or so.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 56% of revenue versus 18.5% for SG&A, 5% for R&D, and 2.6% for capex. Taxes are estimated at 35% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10% yields a fair value figure of $85.51, implying 17.3% upside. While this margin of safety is sizable, it does not meet the 25% threshold that I consider merits calling it a value play.
All of this falls within the context of strong momentum:
"Watson is off to a great start in the first quarter of 2012. Net revenues increased 74% to $1.5 billion. Non-GAAP earnings per diluted share were up 84% to $1.64 per share. Adjusted EBITDA increased 70% to $367 million in the quarter. If you exclude the $0.52 contribution from the sales of generic LIPITOR this quarter, non-GAAP earnings per share were up 26% from last year. We also had a very busy quarter in terms of strategic global expansion of our company. We are aggressively integrating the Ascent business acquired in late January, which made us the fifth largest generic company in Australia and the leader in Southeast Asia. The integration is progressing very well and many financial and IT-related items have already been completed".
From a multiples perspective, however, it quickly becomes apparent that there are cheaper options. Watson trades at a respective 34.2x and 11.8x past and forward earnings versus 14.9x and 9.6x for Novartis and 21.5x and 9.8x for Pfizer.
Consensus estimates for Pfizer's EPS forecast that it will decline by 2.2% to $2.25 in 2012 and then grow by 4% and 3.8% in the following two years. Assuming a multiple of 13x and a conservative 2013 EPS of $2.32, the stock would hit $30.16. Exclusivity losses to Lipitor and other blockbuster drugs has put the company into selling mode. In the process, Pfizer has been able to raise a meaningful amount of cash to fund R&D and accretive takeover activity.
Consensus estimates for Novartis' EPS forecast that it will fall by 3.4% to $5.38 in 2012 and then grow by 2.6% and 13.9% in the following two years. Assuming a multiple of 13x and a conservative 2013 EPS of $5.49, the stock would hit $71.37 for 34.6% upside. Novartis offers a very high dividend yield of 4.6% coupled with limited volatility, as evidenced by its beta of 0.58. Accordingly, risk/reward is very favorable at Novartis.
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