In the midst of exclusivity losses and rising competition from generics, biopharmaceutical companies are substantially discounted against intrinsic value. I continue to be bullish on the industry's secular trends and find that the next wave of growth for large players, like Eli Lilly (NYSE:LLY) and Pfizer (NYSE:PFE), will come from acquiring developmental drugs and biosimilars. Two smaller, less-known firms that I am also optimistic about AstraZeneca (NYSE:AZN) and Watson Pharmaceuticals (WPI). While these two producers are near their 52-week highs, multiples still remain low on a forward earnings basis. Below, I review the fundamentals of each company.
Not nearly as well as known as Lilly or Pfizer, AstraZeneca is an unsuspecting value play. It trades at a respective 7x and 7.6x past and forward earnings with an impressive dividend yield of 6.2%. The bad news? Analysts think the drug manufacturer is a downside story. They currently rate the stock closer to a "sell" than a "buy" and expect EPS to decline 2.7% annually over the next 5 years.
One prime area of concern is the supply chain issues stemming from the new Enterprise Resource Planning system. In the first quarter, management had expressed how supply could be under pressure from the new system and, accordingly, lowered guidance. Experts believe the issue has to do with logistics and warehousing. For example, Hershey once implemented ERP and missed the Halloween and holiday seasons because of related issues. But this issue, as a whole, needs to be considered in the context of an innovative firm. AstraZeneca is known for innovation.
AstraZeneca has grown earnings 13.7% annually over the preceding five years and ROA, ROE, and ROI are all still high in the double-digits. Moreover, fostamatinib is a potential game changer in 3Q12 when backed along major licensing deals. The emergence of a new CEO should also inject new blood into the company. I believe he will steer the company away from disruptive large-scale takeover activity and focus more on protecting Toprol and Seroquel from generic competition. The launch of Brilinta will further help boost the investment case in the absence of managerial missteps.
Watson is another smaller name firm that offers attractive upside. While it lacks a dividend yield, it is still cheap at 9.7x forward earnings. The company is also limited from downside with 63% lower volatility than the broader market. Analysts currently rate the stock a "buy" with a $87.11 price target according to FINVIZ.com.
More fundamentally, Watson has several areas where it can drive appreciation. The company became the third biggest drug manufacturer with the acquisition of Actavis and now has a large global population to upsell products. The deal helps to increase margins through spreading out fixed costs in economies of scale. It also eliminates much of the exposure to domestic patent cliffs and refocuses business more on emerging markets. It also comes at a time of impressive organic growth in generics, such as Concerta and Lovenox. By succeeding in hard-to-manufacture drugs, Watson has been able to generate abnormally high ROIC.
In regard to the Supreme Court's decision to uphold PPACA, some have argued that it will benefit the managed care sector. This side claims that demand will increase for drugs as a result of the mandate, but I don't believe this will offset fees and rebates. Margin pressure in Europe and weak vertical integration will, moreover, be offset by a greater international footprint. Emerging markets offer attractive margin opportunities due to the fragmented distribution of pharmacies. Up until the Actavis takeover, Watson was overly dependent on oral contraceptives and US generics and struggled under limited vertical integration. Now, the firm can internally source more raw materials to reduce operating costs. Accordingly, I recommend buying shares.
Eli Lilly trades at just a respective 11.4x and 11.9x past and forward earnings with a generous 4.5% dividend yield and 33% less volatility than the broader market. But, according to FINVIZ.com the company is currently rated a 3 out of 5 with "5" being a "sell" among analysts.
Pomaglumetad methionil (mGlu2/3) failed to meet a primary endpoint in regard to reduction in PANSS in both the predefined and overall genetic populations. With that said, the Phase 3 study HBBN in acute schizophrenia and Phase II HBCO are currently underway and will increase speculation as data disclosure dates near. An additional registrational study will likely be necessary for HBBN if it meets is successful in the first study. Since pomaglumetad methionil did not indicate a positive difference from the placebo in the Phase II study, I don't think it likely to succeed in later ones. This is worsened by the candidates's seizure risk. Even still, the worst is priced into the stock.
Analysts anticipate EPS falling 8.1% annually over the next 5 years, which contrasts with 9.8% growth over the preceding 5. ROA, ROE, and ROI are all in the solid double-digits, so I recommend buying from better-than-expected results. The company beat expectations by 18% in 1Q12 and by 7.4% in the preceding quarter. While decadal growth has been disappointing at less than a 5% CAGR for EPS, management is focused on the long-term. I believe once investors begin to realize the benefits of a Lilly investment - its generous dividend yield, proven management, low multiples, and low volatility - shareholder value will recover. I expect declining interest in technology investments to shift interest over to biopharmaceuticals.
Pfizer is one of my favorite stocks on the Street. In the healthcare sector, Johnson & Johnson (NYSE:JNJ) just edges out Pfizer as the most valuable company. But J&J trades at 12.3x forward earnings versus 10x for Pfizer, so the latter has more earnings power. Suffice to say, emerging generic competition for Lipitor has put a bit of a "wet blanket" on value creation. Shares have become substantially undervalued as a result.
Most upsetting, the company's long-awaited phase III data for Alzheimer's treatment bapineuzumab was disappointing. The candidate, which has been co-developed with J&J, showed no cognitive or functional benefit for patients. The theory behind bapineuzumab is that it would act as a monoclonal antibody binding to a protein, beta-amyloid, shown to be toxic to the nervous system. Bapineuzumab had four studies with more than 4K patients, but now the door has opened yet again for competition. Lilly is currently developing solanezumab, and there has been a paucity of available data. The announcement wasn't unexpected, and Pfizer and J&J are continuing with the other three trials to explore options. With 36M worldwide suffering from dementia, this is a multi-billion dollar race several times over - any positive effect on patients could be lucrative.
Analysts currently rate the stock a "buy" according to FINVIZ.com. While the company is currently a great hedge against uncertainty (thanks to the 3.8% dividend yield and 0.7 beta), it wouldn't take much for the firm to offer considerable upside. If, for example, the company grows EPS by just 2.3% over the next 5 years, it would be worth $35 at a 14x multiple. Discounting backwards by 8% yields a present value of $23.82 - in-line with the market's assessment. But this growth forecast is extremely bearish. A more reasonable discount rate of 6% would put the firm at an intrinsic value of $28. Coupled with the lucrative dividend yield, Pfizer has compelling risk/reward.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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