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Back to Part XXIII - Oilfield Equipment And Services Demand Rising

By Mark Bern, CPA CFA

If you are joining the series for the first time, you may find it informative to refer to the first article in the series, "The Dividend Investors' Guide to Successful Investing," where I provide more details about my process for selecting companies for my master list and details about why I use the metrics that I do.

Today's focus is one of the most difficult industries to completely understand. There is much information investors need to consider in their assessment of companies in the pharmaceuticals (drug) industry. There are also many large, dividend-paying companies to choose from and I want to provide my views on as many as possible. It is for this reason that I have decided to break this industry coverage into two separate articles. There are many variables that can make a huge difference in the prospects of any one company in the industry; much having to do with pipeline success, failure and depth. But there are other externalities that affect the participants in the drug industry. Politics can be a big factor on the future profits of drug companies. I recall that back during the Clinton Administration, drug companies' stocks got hammered just because of the potential threat of a bill to change in healthcare policy that eventually did not become law. When the threat seemed imminent drug companies' stocks were cheap. Investors who were willing to take a chance made a small fortune. Investing in drug companies has generally been a no-brainer for most portfolios over many decades. But, over the last decade, it has become much more difficult and investors have had to become far more selective or, alternatively, they have had to develop a much higher tolerance for pain.

While the dividends have been very good, revenues and earnings have not been growing as consistently and reliably as in the past because of several factors. Among these factors, competition from generics and having blockbuster drugs coming off patents combined with less effective drug development pipelines have caused drug companies the greatest heartburn. Add to this the competing regulatory environments in Mexico, Canada, Europe and elsewhere relative to the U.S. along with both legal and illegal online competition and the future becomes more complex. Then there is lax and inconsistent regulatory enforcement by U.S. officials in the Customs and Border Patrols and geographic price discrimination, which also add another layer. Of course, there is also the potential for political interference, which could bring back the nightmare of the 1990s. I intend to provide a glimpse into some of these issues here in my first article on the drug industry so that readers can better understand my perspective. I will also highlight at least two of the companies that have made my list here and will complete discussions on individual companies in the next installment.

Pipeline issues, generic competition and drugs coming off patent will be discussed briefly in regard to each of the companies listed in the assessments later. This is a widespread issue but the effects differ greatly from one company to another. So, I would like to start off by providing a bit of background on why prescription drugs tend to cost more in the U.S. than in other countries. Obviously, country-specific regulations vary greatly so I want to try to use one example of discrepancy that most people are aware of: Canada. Why do drugs cost less in Canada than the U.S.? There really are several reasons but the greatest one is price controls.

"Canadian law authorizes a review board to order a price reduction whenever the price of a drug exceeds the median of the prices in six European countries plus the United States. Since all the European countries intervene in various ways to hold down drug costs, Canada in effect piggy-backs on other countries' price controls."

The article is short but worth reading.

Another article I found provided a broader description of what causes the differences, "Why Are Medications Cheaper in Canada?" In addition to the price caps imposed by Canada's federal government the Canadian provinces are also involved in another way.

"Each of the Canadian provinces, like Quebec and Ontario, has a drug formulary that puts restrictions on the use of new and expensive medications. Since the provinces provide the bulk of drugs to higher users of medication, (seniors), they have the power to negotiate directly with pharmaceutical companies to lower prices for a medication to get on the formulary. In Ontario, for example, the formulary includes less than 35 percent of new medications."

Additionally, "Canadian pharmaceutical companies have lower liability costs than U.S. drug companies. Canadians are not only less likely than Americans to sue healthcare providers or drug companies but when they do sue, awards and damages are a lot lower than in the U.S. In the U.S., some economists consider the cost of liability insurance for a drug company to be similar to a "tax" on medications."

Both articles describe price discrimination as another factor. Here is a way to think about geographic price discrimination within the U.S. If I buy a Big Mac meal at the airport in New York City or Washington, D.C., it will cost me about 50 percent more than if I buy the exact same meal at the McDonald's located two miles off the Interstate 66 in Waynesboro, Virginia. The second article goes on to say:

"The most important factor, however, may be the difference in the standard of living between the two countries. The average Canadian's standard of living is 20 percent to 30 percent lower than the average American's standard of living. This difference affects the price that a drug company sets for a brand name drug."

The relevant point is that if drug companies were forced to charge less in the U.S., then drug companies would have less incentive to spend the huge amounts of money required to develop new drugs because the companies would have less ability to recoup those investments. This is just one more way that U.S. citizens have contributed to the world economy without knowing about it. If the U.S. does not continue to shoulder the load to keep innovation flowing to create new and novel drugs, will there be any in the future? These are difficult questions to answer. One thing we can expect is that the risks born by the drug industry would increase and the investors would need to adjust to the new reality.

The Affordable Healthcare For America Act does not directly address prescription drug affordability except for filling in the gap in coverage for seniors on Medicare. Currently, about 82 percent of people who do not fill prescriptions due to cost considerations (48 million Americans in 2010) have health insurance according to this article.

I do not believe for one minute that this issue will not come under scrutiny again in Congress at some future point, especially with all the baby boomers about to enter the senior vote category. The point I want readers to understand is that, in my opinion, we can no longer buy a drug company stock and forget about it. This is an industry that is going through transition in many forms. Each company faces competition for market share from more sources than ever before. Each company deals with major drugs coming off patent differently. Most major drug companies have ample cash flows to enable acquisitions or strategic alliances to help bolster pipelines. These companies have developed broad-reaching marketing and distribution networks that can be leveraged. Those assets, along with capital investments to support expensive research and trial efforts, entice smaller companies in the industry into alliances to share revenue with large, drug companies with deeper pockets. Thus, it seems to me that those large drug companies that are most successful in capital deployment for the best returns are the ones we need to try to identify.

I realize, of course, that there will be a lot of disagreement with some of my picks as we will all have varying opinions on how well each company will perform in the future. None of us is perfect, including yours truly. But the companies and my opinions contained in these articles are my own and based upon my assessments. Each investor should do his or her own due diligence on each company they consider for investment. Having said that, I want to encourage readers to share information, within the comments section, about any company in the industry whether it supports or disagrees with my views. The more informed we are, the more likely we are to make better investing decisions.

My first candidate for the list is Teva Pharmaceuticals (NYSE:TEVA). Many of my followers know that I have written several articles on TEVA and believe that this company has excellent potential for the future as it derives revenue from both branded and generic drugs and is also expanding into biologics (creating products using biological processes instead of chemicals). It is the largest generic drug manufacturer in the world. It is often first in line to release generic versions of blockbuster drugs coming off patent. The company is best of breed, in my opinion, on the generic side of the business. It is also expanding both in generic and branded drugs through acquisition. The debt level is somewhat high by industry standards but manageable and the company has a history of using debt to make strategic acquisitions and then paying that debt down over time. I expect that ratio to drop significantly over the next five years.

In the first half of 2012, the company launched 12 new generic products that represent $17 billion in branded sales. It also expects to launch 20 more generic products representing $13 billion in branded sales over the remainder of 2012. Obviously, TEVA will only command a portion of the market share in each new generic drug it manufactures and the prices will be only a fraction of the branded value. But no other generic drug company has TEVA's reach or reputation with its global distribution network. Let's see how TEVA stacks up by the metrics.

Metric

TEVA

Industry Average

Grade

Dividend Yield

2.1%

3.5%

Fail

Debt-to-Capital Ratio

39.0%

18.0%

Fail

Payout Ratio

18.0%

40.0%

Pass

5-Yr Average Annual Dividend Increase

23.5%

N/A

Pass

Free Cash Flow

$1.21

N/A

Pass

Net Profit Margin

24.2%

19.0%

Pass

5-Yr Average Annual Growth in EPS

16.7%

2.0%

Pass

Return on Total Capital

14.0%

12.5%

Pass

5-Yr Average Annual Growth in Revenue

13.3%

1.3%

Pass

S&P Credit Rating

A-

N/A

Pass

Two fails and eight passes is a pretty decent score. The debt is high due to the recent acquisitions of Barr Pharmaceuticals (2008) for $7.5 billion, a German generic Ratiopharm (2010) for $5 billion, a Japanese generic Taiyo Pharmaceutical (2011) for $934 million, and Cephalon for $6.8 billion. Total acquisitions since 2008 exceed $19 billion, yet debt approximates $14 billion. The company has reduced debt approximately $500 million in the first half of 2012. Regarding the dividend; it may be lower than the industry average but I like the record of increases and the prospects for that trend to continue as I expect the payout ratio to continue to gradually rise to accommodate dividend increases. The payout ratio is currently well below the industry average so there is ample room for continued growth somewhat above the EPS growth trend for several more years. My five-year target price for TEVA is $61 which would result in an average annual total return of about 12 percent.

My next candidate comes from the other end of the dividend spectrum. AstraZeneca (NYSE:AZN) has increased its dividend in each of the last nine years. Yahoo! Finance shows the dividend as $1.80 and a yield of 3.8 percent. Do not believe it! AZN paid a dividend of $1.95 in the first quarter of 2012 and has already announced a dividend payment of $0.90 with the ex-dividend date of August 7, 2012. That totals $2.85 for a yield of 6.1 percent. The first half of 2012 has been a tough period for AZN, but I think that most of the bad news is behind the company.

Management is not standing still; it has cash and it knows how to use it. Acquisitions and distribution deals recently made will help shore up the pipeline and keep dividends well covered. The debt level is slightly above the industry average but remains very manageable and the company generates ample free cash flow to fund additional acquisitions in the future. The company's EPS may not grow as much as we would like, but the company should be able to manage additional dividend increases at a rate similar to the past five years without increasing the payout ratio above the industry average. This is a stock that is likely to remain stable within a relatively small range due to its predictable revenue and earnings streams. I believe that the worst will be over by late 2012 or early 2013. Management has effectively placed adequate pressure to the wounds being suffered through patent expirations and I expect EPS to begin to rise slowing at some point beginning in 2013 due to cost control activities and the benefits of recent acquisitions and distribution agreements. Even then I only expect EPS to increase at a snail's pace. It is the dividend and prospect for the rising income that makes AZN a finalist. I also expect that the P/E will eventually grow to around 10 time EPS. So, this is an income and value play. Let's look at the metrics.

Metric

AZN

Industry Average

Grade

Dividend Yield

6.1%

3.5%

Pass

Debt-to-Capital Ratio

24.3%

18.0%

Neutral

Payout Ratio

35.0%

40.0%

Pass

5-Yr Average Annual Dividend Increase

13.9%

N/A

Pass

Free Cash Flow

$5.23

N/A

Pass

Net Profit Margin

29.7%

19.0%

Pass

5-Yr Average Annual Growth in EPS

13.2%

2.0%

Pass

Return on Total Capital

33.5%

12.5%

Pass

5-Yr Average Annual Growth in Revenue

8.5%

1.3%

Pass

S&P Credit Rating

AA-

N/A

Pass

One neutral and nine passes is an excellent report card. It is unfortunate that the future will not be as good as the past. However, management has proven its mettle and is taking steps to ensure that the company will remain intact, competitive and able to continue increasing that exceptional dividend. Add in a little margin expansion as the stock recovers in coming years from the current maladies, and we get some potential appreciation to go with the yield. My five-year price target for AZN is $56 which would result in an average annual total return of about 10 percent, most of which will come in the form of dividends.

That concludes this installment of my assessment of the pharmaceutical industry. I will try my best to finish the next piece on Thursday. I hope you are finding this series interesting and informative. If you would like to read my assessments on other industries, a complete list of all articles in this series is available with the articles listed both chronologically by date of publication and by industry in my blog titled, "The Dividend Investors' Guide to Successful Investing Index Concentrator." As always I welcome comments and will attempt to answer any questions. The exchange of information is always welcome and it is how we all become better informed investors.

Source: The Dividend Investors' Guide: Part XXIV - America's Addiction To Drug Companies