5 Strong Pharmaceuticals To Buy Now For Gains In 2013

Includes: AZN, GSK, MRK, NVS, PFE
by: Dividend Kings

There are few things quite so profitable as a government sanctioned monopoly. And when that monopoly is granted in a market with growing demand (the result of irresistible demographic forces), the stage is set for considerable value creation.

Yes, the pharmaceutical industry is a profitable one. But that river of profits comes with a dark side. Regardless of the size of these companies, they and their shareholders have learned, to the dismay of both groups, that research and development efforts do not necessarily scale. That is, it is difficult to forecast the payoff of an incremental $1 billion spent in R&D. With a need to constantly replenish their roster of patent-protected drugs, many pharmaceutical companies have aggressively used their financial heft to buy the innovation that they are increasingly hard-pressed to deliver internally. Great deal for biotechnology companies, questionable deal for pharma shareholders.

Here I will analyze five of the giants, and see how they stack up. In this analysis, I will focus on measures suggestive of management's ability to operate with financial discipline, rather than digging into the pipeline of drugs in development for each of these behemoths.

Pfizer (NYSE:PFE)

SG&A: Over the past three years, SG&A as a % of sales has jumped to 32.5% from 30.5%.

Research & Development: While this expense increased 16.5% between FY09 and FY11, when viewed as a % of sales, it appears that management has managed to wring some efficiencies out of their massive R&D program. The amount has dropped more than two percentage points, to 13.5% from 15.9%.

Cash and Short-Term Investments: $3.5 billion in cash and $23.3 billion in short-term investments sat on the balance sheet as of FY11.

Debt: Net Debt is $42.3 billion, down considerably from $55.7 billion in FY09. Leverage has dropped to 1.4x, from 2.2x.

Goodwill: At $45 billion, goodwill is a worryingly high 54.8% of shareholders' equity ($82.2 billion), up nearly 8 percentage points since FY09.

Merck (NYSE:MRK)

SG&A: Over the past three years, SG&A as a % of sales has dropped to 28.6% from 31.1%.

Research & Development: Another case of a nominal increase paired with a decline as a % of sales. At nearly $8.5 billion, the 17.6% of sales that Merck spent in FY11 shows considerable improvement over the 24.2% level of FY10.

Cash and Short-Term Investments: $13.5 billion in cash and $1.4 billion in short-term investments sat on the balance sheet as of FY11, representing increases of 45% and over 390%, respectively, as compared to FY09 levels.

Debt: Management has been conservative with leverage. Net Debt is $4 billion, down considerably from $8.2 billion in FY09. Leverage has dropped to 0.2x, from 0.8x.

Goodwill: Goodwill tells the story of a management team that has been (at least relatively speaking) conservative in terms of doing its R&D in the markets rather than in the lab. At $12.1 billion, goodwill is only 22.3% of shareholders' equity ($54.5 billion), and the nominal value has fluctuated by less than $250 million since FY09.

AstraZeneca (NYSE:AZN)

SG&A: Somebody is showing restraint. With sales up only 2.4% over the period (to $33.6 billion in FY11), SG&A was reduced from $11.1 billion and 33.8% of sales in FY09 to $9.2 billion and 27.5% of sales in FY11.

Research & Development: Nearly flat sales seem to have spooked management into pumping an additional $1 billion into R&D, which rose to $5.5 billion and 16.4% of sales, from $4.4 billion and 13.4% of sales in FY09.

Cash and Short-Term Investments: Cumulatively, these two are virtually unchanged between FY09 and FY11, was $11.5 billion, now $11.9 billion.

Debt: Another conservative management team. Net debt is a miniscule $2.1 billion, for leverage of only 0.1x.

Goodwill: Management may be spending on R&D, but they are doing their research the old-fashioned way (i.e. in the lab). Goodwill is virtually unchanged at $9.9 billion, 42.4% of shareholders' equity in FY11.

GlaxoSmithKline (NYSE:GSK)

SG&A: Managing costs is tough. When sales are growing, it is easy to lose discipline, and when sales are declining, it is incredibly difficult to rationalize costs quickly and steeply enough to keep pace with the decline. The team at GlaxoSmithKline has nearly managed it, though. With sales down 7.1% since FY09, SG&A has been reduced by $850 million, ticking up less than half a percentage point from 29.8% to 30.1%.

Research & Development: Falling sales and reduced spending (down $400 million since FY09) in a major pharmaceutical company! This is a management team to watch.

Cash and Short-Term Investments: Cumulatively, these two are down approximately $2 billion since FY09, to $9.4 billion.

Debt: $14.3 billion in net debt sounds like a lot, but it is hard to get worried about leverage of only 0.8x (the same level as FY09).

Goodwill: Up only $400 million (to $5.8 billion) since FY09, as a % of shareholders' equity it has exploded to 46.7%, from 33.6% in FY09. Declining shareholder's equity (down $3.7 billion) will do that.

Novartis (NYSE:NVS)

SG&A: Sales up 21%, SG&A up $1.5 billion in nominal terms and down three percentage points (to 32.0%, from 35.1%) between FY09 and FY11? Call that a win.

Research & Development: I worry when I see companies with strong sales growth jacking up their R&D spend in this industry, it smacks of a lack of discipline. The increase was nearly $1.9 billion between FY09 and FY11, though as a % of sales it looks somewhat between, rising less than one percentage point (to 17.6%, from 16.9%).

Cash and Short-Term Investments: Cumulative increase of $2 billion (now $8.1 billion).

Debt: Looking at leverage, it seems that not much has happened here, with the value coming in at 0.9x, up from 0.3x in FY09. But that masks the explosion in the nominal value (up $12.3 billion) to $17.7 billion.

Goodwill: Whenever you see a big jump in goodwill (in this case, $18.4 billion), you cross your fingers that whatever "transformative acquisition" lives up to its promise. Goodwill is now 47.0% of shareholders' equity.

Place Your Bets

There are no weaklings in this bunch. Each company is financially strong and has a broad base. They can ramp up investment or go out and buy something if their pipeline starts to look worrisome, and their sheer size promises cost cutting opportunities if and when necessary.

With that said, AstraZeneca looks like the best pick of this group. On a relative valuation basis, it looks cheap at 5.4x EBITDA (TTM), and as a bonus, investors can look to the 27.1% return on equity management has delivered (actually second best in this group to GlaxoSmithKline's eye-popping 63.1%, but the market seems to have bid that company up far enough). With sales basically flat over the past three years, this looks like a company that is just a little too boring to get the attention it deserves. I urge investors to consider buying these five stocks now, and let their disciplined management teams get to work for you.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.