From patent cliffs to Obamacare implementation, the conventional wisdom is that BioPharma is in a world of pain. As I have noted previously, drug manufacturers will face a non tax-deductible fee based on market share that ranges from $2.5B to $4.1B based on market share due to Obamacare. A separate 2.3% constitutional tax will be placed on medical devices starting next year, which really puts a damper on Abbott Labs (ABT) split. Next year, a 3.8% surtax on investment income and an additional 0.9% Medicare tax will be imposed on individuals making more than $200K per year. Qualified dividends and capital gains taxes will also more than double from 15% to nearly 40%.
The dividend taxes will drag down shareholder value in high income-yielding healthcare companies, since equities are priced based on a given after-tax dividend yield and if the after-tax distribution falls, it follows that shareholder value must also decline. BioPharma has a low beta, so there is also not much room for speculation.
Despite the above headwinds, I am still attracted to the sector. Eli Lilly (LLY) trades at just a respective 11x and 11.5x past and forward earnings versus corresponding figures of 18.6x and 12.3x for Johnson & Johnson (JNJ) and 20x and 12.1x for Abbott. The respective dividend yields are 4.6%, 3.6%, and 3.2%. Investors should be mindful, however, that companies that typically offer high dividend yields do so sometimes - and by no means always - because there are limited growth opportunities. Ditto for companies with low multiples. Given that Lilly has the lowest multiples and the highest dividend yield while Abbott has just the opposite, it will be illuminating to look at growth expectations.
Over the last 5 years, Lilly yielded 9.8% annual EPS growth versus a 1.4% decline for J&J and a staggering 22% growth for Abbott. One important thing to note is that valuing BioPharma is not about the past and all about the future. Producers have different phases of growth that come and go, and while we can get a general sense of the future based on patent cliffs and FDA decisions, it is hard to extrapolate over a decade long period.
With that said, analysts forecast EPS declining 8.1% annually for Lilly over the next 5 years versus 6.6% growth for J&J and 8.5% for growth for Abbot. In this case, dividend yields and multiples appear to be a good indication of expected growth prospects.
If EPS realizes 2013 EPS of $3.70, it will realize 2016 EPS of around $2.87 based on current expectations. By that time, however, growth prospects will be much better for the firm and a multiple of 15x is reasonable. That would put the future value of the stock in-line with where it currently stands. The dividend yield will also be reduced to an after-tax yield of 2.8% if the dividend tax hikes materialize (although I do not anticipate this). I thus encourage investors to stay on the sidelines unless rumors of productive R&D or buyouts materialize.
J&J will have 2016 EPS of around $6.69 if it meets consensus expectations and no more. At a 15x multiple, this would translate to a future stock value north of $100. Discounting backwards by 8% yields a price target of $68.30. Thus, while J&J may appreciate by an average of 10% over the next 5 years on top of a 3.6% dividend yield, there is not a substantial margin of safety. The beta on the firm is 0.6 so there is also not much room for high risk-adjusted returns. Again, I recommend investors stay on the sidelines until catalysts arise and there is room for more speculation. J&J is a great company, but there are more undervalued picks right now.
Abbott, in my view, is one such company with a reasonable discount to intrinsic value. If it achieves 2013 EPS of $5.36 and grows 8.5% annually thereafter, it will realize 2016 EPS of $6.85. A 15x multiple would place the future stock value at $102.75. Discounting backwards by 7% yields a price target of $73.25. The reason why I give Abbott a lower discount rate than its peers is because (1) the firm has grown 22% annually over the last 5 years so 8.5% annual growth forecasts seem too bearish, and (2) the stock has the lowest beta of 0.3.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.