* All data are as of the close of Thursday, November 6, 2014.
* Emphasis is on company fundamentals and financial data rather than commentary.
The Generic Drugs industry is one of opportunism, lying in wait like a tiger in the tall grass, waiting for the opportunity to pounce on its next prey.
What are its prey? Blockbuster drugs whose patent protections are about to expire.
"Immediately after the patent for Cymbalta (duloxetine) expired in mid-December 2013, six companies introduced generics to the top-selling antidepressant," Lab Express Scripts informs.
Such stalking and preying by generic drug manufacturers who quickly replicate brand name drugs once their patents expire is not only permitted by regulators but very much encouraged, as it brings the costs of expensive drugs down substantially - benefiting not only patients but also health plans and ultimately the government healthcare system itself.
In fact, generic drug companies are currently in the middle of a sweet spot four years long from 2012 to 2016 referred to as the "patent cliff", when dozens of extremely profitable brand name drugs lose their patent protection. Not only are generic drug manufacturers salivating over the potential spoils, but healthcare plans and governments are too.
"Patent expirations for over 36 major brands [from 2012 to 2016], and efforts from health plans and regulators to curtail drug spending [will] shrink brand dollars in the U.S. market through 2016," Drugs.com predicts.
By how much will brand name drug costs shrink? "Patent expirations up to 2016 will reduce brand spending in worldwide developed markets by $127 billion, but will be counterbalanced by generic spending, resulting in a five-year global savings of close to $106 billion," Drugs.com informs.
Did you note the savings? Generic drugs can reduce $127 billion worth of brand name drug expenses to just $21 billion, saving $106 billion. That's a reduction in drug costs by over 83%.
Not only does this mean big savings for health plans and patients alike, but it also means big profits for the generic drug manufacturers and their investors. Over the past 12 months, the three largest U.S. companies in the space - Actavis Plc (NYSE: ACT), Mylan Inc (NASDAQ: MYL), and Zoetis Inc (NYSE: ZTS) brought in some $22.28 billion in revenues representing 21% of their combined market caps of $106.08 billion.
And the companies' stock appreciation has been relentless because of it, as noted in the graph below. Since the economic recovery began in March of 2009, where the S&P index has gained 200% and the SPDR Healthcare Sector ETF (NYSE: XLV) has gained 205%, Mylan has risen 350% while Actavis has risen 850%. Third largest Zoetis has been trading publicly only since February of 2013, yet it too has climbed impressively with gains of 30%.
On an annualized basis, where the S&P index has averaged 35.29% and the healthcare fund XLV has averaged 36.18%, Zoetis has averaged 17.14%, Mylan has averaged 61.76%, while Actavis has averaged 150% per year!
The Generic Drugs industry is expected to run through a rough patch over the immediate term, with earnings shrinkage foreseen for the current quarter, as tabled below where green indicates outperformance while yellow denotes underperformance.
Yet the coast looks clear beyond, with earnings growth expected to quintuple that of the industry in 2015, before settling down to a modest beat over the next five years.
Zooming-in a little closer, the three largest U.S. companies in the industry are seen putting in a split performance in the current and next quarters, with Actavis and Zoetis under-growing while Mylan outgrows the broader market.
But come 2015 and beyond, all three are seen outgrowing their earnings by up to as much as double the S&P's average earnings growth rate.
Yet there is more than earnings growth to consider when sizing up a company as a potential investment. How do the three compare against one another in other metrics, and which makes the best investment?
Let's answer that by comparing their company fundamentals using the following format: a) financial comparisons, b) estimates and analyst recommendations, and c) rankings with accompanying data table. As we compare each metric, the best performing company will be shaded green while the worst performing will be shaded yellow, which will later be tallied for the final ranking.
A) Financial Comparisons
• Market Capitalization: While company size does not necessarily imply an advantage and is thus not ranked, it is important as a denominator against which other financial data will be compared for ranking.
• Growth: Since revenues and expenses can vary greatly from one season to another, growth is measured on a year-over-year quarterly basis, where Q1 of this year is compared to Q1 of the previous year, for example.
In the most recently reported quarter, Actavis posted the greatest revenue growth year-over-year by a substantial degree, while Zoetis delivered the least.
Since Actavis' earnings growth is not available, the metric will not factor into the comparison. Yet it is worthy to note that Mylan's earnings growth outpaced Zoetis' by 8 times.
• Profitability: A company's margins are important in determining how much profit the company generates from its sales. Operating margin indicates the percentage earned after operating costs, such as labor, materials, and overhead. Profit margin indicates the profit left over after operating costs plus all other costs, including debt, interest, taxes and depreciation.
Of our three contestants, Mylan operated with the widest profit margins while Zoetis had the widest operating margins. Meanwhile, Actavis contended with the narrowest margins in both.
• Management Effectiveness: Shareholders are keenly interested in management's ability to do more with what has been given to it. Management's effectiveness is measured by the returns generated from the assets under its control, and from the equity invested into the company by shareholders.
In returns on assets and equity, Actavis' management team outperformed Mylan's team on assets, while Mylan's team beat Actavis' team on equity. But since Zoetis' returns are not available, neither metric will factor into the comparison.
• Earnings Per Share: Of all the metrics measuring a company's income, earnings per share is probably the most meaningful to shareholders, as this represents the value that the company is adding to each share outstanding. Since the number of shares outstanding varies from company to company, I prefer to convert EPS into a percentage of the current stock price to better determine where an investment could gain the most value.
Of the three companies here compared, Mylan provides common stock holders with the greatest diluted earnings per share gain as a percentage of its current share price, while Actavis' DEPS over stock price is the lowest.
• Share Price Value: Even if a company outperforms its peers on all the above metrics, however, investors may still shy away from its stock if its price is already trading too high. This is where the stock price relative to forward earnings and company book value come under scrutiny, as well as the stock price relative to earnings relative to earnings growth, known as the PEG ratio. Lower ratios indicate the stock price is currently trading at a cheaper price than its peers, and might thus be a bargain.
Among our three combatants, Mylan has the cheapest stock relative to forward earnings, while Actavis' stock is cheapest relative to company book value and 5-year PEG. At the overpriced end of the scale, Zoetis' stock is the most overvalued in each.
B) Estimates and Analyst Recommendations
Of course, no matter how skilled we perceive ourselves to be at gauging a stock's prospects as an investment, we'd be wise to at least consider what professional analysts and the companies themselves are projecting - including estimated future earnings per share and the growth rate of those earnings, stock price targets, and buy/sell recommendations.
• Earnings Estimates: To properly compare estimated future earnings per share across multiple companies, we would need to convert them into a percentage of their stocks' current prices.
Of our three specimens, Mylan offer the highest earnings percentages over its current stock price in all time periods, while Zoetis offers the lowest percentage for all periods.
• Earnings Growth: For long-term investors this metric is one of the most important to consider, as it denotes the percentage by which earnings are expected to grow or shrink as compared to earnings from corresponding periods a year prior.
For earnings growth, Mylan is projected to deliver the greatest growth in the near quarters, while Actavis is seen delivering it in 2015 and beyond. At the low growth end of the spectrum, Zoetis is expected to deliver the slowest growth rate for the most part.
• Price Targets: Like earnings estimates above, a company's stock price targets must also be converted into a percentage of its current price to properly compare multiple companies.
For their high, mean and low price targets over the coming 12 months, analysts believe Mylan's stock has the greatest upside potential and greatest downside risk, while Zoetis' stock is believed to have least upside potential and Actavis' is seen having the least downside risk.
• Buy/Sell Recommendations: After all is said and done, perhaps the one gauge that sums it all up is analyst recommendations. These have been converted into the percentage of analysts recommending each level. However, I factor only the strong buy and buy recommendations into the ranking. Hold, underperform and sell recommendations are not ranked since they are determined after determining the winners of the strong buy and buy categories, and would only be negating those winners of their duly earned titles.
Of our three contenders, Actavis is best recommended with 11 strong buys and 12 buys representing a combined 92% of its 25 analysts, followed by Zoetis with 6 strong buy and 6 buy recommendations representing 80% of its 15 analysts, and lastly by Mylan with 7 strong buy and 7 buy ratings representing 70% of its 20 analysts.
Having crunched all the numbers and compared all the projections, the time has come to tally up the wins and losses and rank our three competitors against one another.
In the table below you will find all of the data considered above plus a few others not reviewed. Here is where using a company's market cap as a denominator comes into play, as much of the data in the table has been converted into a percentage of market cap for a fair comparison.
The first and last placed companies are shaded. We then add together each company's finishes to determine its overall ranking, with first place finishes counting as merits while last place finishes count as demerits.
And the winner is… Mylan by a needle, outperforming in 13 metrics and underperforming in 8 for a net score of +5, followed very closely behind by Actavis, outperforming in 10 metrics and underperforming in 6 for a net score of +4, and finally by Zoetis at the end of the alphabet, outperforming in 4 metrics and underperforming in 14 for a net score of -10.
Where the Generic Drugs industry is expected to underperform the S&P broader market substantially this quarter, outperform substantially in 2015, and outperform modestly beyond, the three largest U.S. companies in the space are expected to split perform over the near term, while all three are seen outgrowing the broader market in 2015 and beyond.
Yet after taking all company fundamentals into account, Mylan stands first among its peers given its lowest stock price to forward earnings, highest revenue over market cap, highest profit margin, highest EBITDA over market cap, highest earnings over current stock price in all time periods, highest earnings growth in the current and next quarters, and best high and mean price targets - handily winning the Generic Drugs industry competition.