From generic competition and patent cliffs to regulatory hurdles and product recalls, the market has bemoaned biotech and pharmaceutical risks. They may have to add another factor in the "risk column": Obamacare, formally known as the "Patient Protection and Affordable Care Act." While mandate costs have gotten all of the attention of late, the Affordable Care Act is a constitutional tax in more ways than one.
By imposing a 3.8% surtax on investment income on top of an additional 0.9% Medicare tax for those making over $200K, Obamacare takes away one of the major benefits in biotech investments, namely the dividend distributions. Markets theoretically price equities at a certain after-tax dividend yield, and the only way for the market to return to the equilibrium yield if after-tax dividend distributions fall is to reduce shareholder value. The drop in stock price will also be even more considerable if the Obama administration is successful in raising dividend taxes on job creators outside of the Affordable Care Act.
The Affordable Care Act also directly taxes the healthcare sector. Drug manufacturers will face an annual non tax-deductible fee ranging from $2.5B to $4.1B based on market share. There will further be a 2.3% excise tax on medical devices sold in 2013 and thereafter.
With that said, the market has already factored in much of this "taxing" environment. Furthermore, several large producers in the field are significantly safer than what the market appreciates. Pfizer (PFE) and Merck & Co. (MRK) rank amongst my top picks while I am more on the sidelines with Bristol Myers (BMY). Pfizer and Merck trade at a respective 9.6x and 11.3x forward earnings versus 18.2x for Bristol Myers. Pfizer and Merck also have more liquidity on a quick ratio basis.
As the second largest firm within the healthcare sector, Pfizer is a free cash flow machine. It generated $18.6B worth of free cash flow last year, which represents more than 10% of market cap. By contrast, Bristol's 2011 free cash flow was only 7.7% of market cap. Patent cliffs are troubling for any biopharmaceutical company, but the sector is all about acquiring catalysts that can refuel catalysts.
Indeed, one of the common problems in valuing biotech through a discounted cash flow analysis is to assume a fixed growth into perpetuity. In reality, biotech goes through different phases of growth and past successes could generate a treasure trove of cash to yield future ones. Pfizer, for example, has $24B in cash and generated $18.4B in operating cash flow over the trailing twelve months. It probably will use much of this cash to buy out emerging candidates that can excite back investors.
At the end of the day, however, growth is uncertain. The best way to then see how much of a "bang" you are getting for your buck is to see what is the margin of safety against consensus expectations. Pfizer is expected to realize $2.35 in 2013 EPS and then grow just 2.3% annually over the near-term. This means 2016 EPS of around $2.52, which, at a 15x multiple, translates to a future stock value of $37.80. Pfizer is incredibly safe with a dividend yield of 3.9% and a beta of 0.7, so a discount rate of 8% is reasonable. This implies a price target of $25.73 and, while not great, was based on bearish growth assumptions. Over the past 5 years, Pfizer has grown annually by 6.9%. Analysts thus rate the stock a "buy" according to FINVIZ.com.
Merck appears to have similarly strong risk/reward. 2013 EPS is expected to be around $3.68 and grow roughly 4.7% annually in the near-term. If 2016 EPS hits $4.42, the future stock value will be $66.30 on a 15x multiple. An 8% discount rate yields a $45.12. Again, this is not incredible upside but it is also low due to bearish expectations. Analysts lean on the optimistic side of the stock according to FINVIZ.com and the dividend is compelling at 4.1%. Safety is generally better than what the market appreciates, since a margin of safety can already be found on bearish assumptions.
In my view, Bristol is a riskier investment than both Merck and Pfizer. It trades relatively highly at a respective 15.5x and 18.2x past and forward earnings. Growth prospects are limited and are forecasted to grow by 1.5% annually over the next 5 years. That means approximately 2016 EPS of $2.19, which translates to a $32.85 future stock value. An 8% discount rate justifies a stock decline of ~35%. Consensus currently rates the stock near a "hold" but this is complicated by what will likely be negative growth over fiscal years 2012 and 2013. I anticipate a full recovery near 2013, which will serve as an inflection point for accelerating stock gains across the broader market. If Bristol is still experiencing a decline, it will be hard to excite investors from momentum elsewhere. Accordingly, I recommend holding out and backing Pfizer and Merck for favorable risk/reward.
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.