Investing in Big Pharma

Many of its monster patents have expired, but Big Pharma is undervalued, trim and feeling fine.

Gel capsules pass through a sorting machine on the production line at a Sanofi-Aventis SA factory in Compiegne, France, on Friday, Oct. 8, 2010 (Photo: Antoine Antoniol/Bloomberg/Getty)

Many investors breathed a sigh of relief last November when the patent for Lipitor, the bestselling drug in history, expired. The buildup to this more than US$100-billion drug’s off-patent date was tremendous. For months, if not years, people wondered how Pfizer, the company that sold the drug, would survive after its cash cow of a pill stopped providing the milk. The company’s stock did take a hit last summer, partly due to those fears, but for the most part, investors were happy to put the speculation behind them.

A number of other popular drugs went off patent during the past few years, including the multi-billion-dollar blood thinner Plavix, and Valtrex, a blockbuster herpes and cold-sore drug. Concerns over these patent expiries, coupled with the recession, caused many investors to flee Big Pharma stocks altogether. But drugmakers have been prudently preparing for these off-patent dates, and the pharma industry is historically a highly regulated, defensive sector; people will continue buying medication even when money is tight. Add decent dividends to the mix and this is a business you should want to hold in volatile markets.

A lot of people still think of the pharmaceutical industry as a free-spending behemoth that counted on a handful of brand-name drugs such as Lipitor, Viagra and Prozac to make up for all the misses. But, says Cameron Scrivens, the co-manager of RBC’s Global Health Sciences fund, the threat of losing market share to makers of generic equivalents dramatically changed the way these companies operate. Most have cut their sales forces and excess layers of management. They have improved their balance sheets, filled product holes through mergers and acquisitions and are now spending less on research and development. Scrivens points out that in 2011 R&D as a percentage of sales was 16.4%. That’s down a full percentage point from the average R&D spend in the previous four years.

Companies have also given up betting on the big one. Now, there are more niche drugs in the development pipeline. It’s likely that no one product will explode, says Linda Bannister, a senior health-care research analyst with Edward Jones, but a few could do well enough to keep revenues robust. “You don’t need home runs anymore,” she says. “You just need to hit singles and doubles.” That said, there are some medicines being tested that could significantly boost profits. Some say certain Alzheimer’s and obesity drugs currently in trials could be as big as Lipitor.

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Pfizer (NYSE: PFE)
P/E: 10.2 | Yield: 3.5%
1-yr. total return (C$): 32.1%

This New York–based pharmaceutical giant is an “ongoing turnaround story,” says S&P Capital IQ analyst Herman Saftlas. It’s been buying stock and cutting costs, and its acquisition of rival Wyeth in 2009 helped diversify its offerings.

Merck & Co. (NYSE: MRK)
P/E: 11.4 | Yield: 3.7%
1-yr. total return (C$): 33.8%

New Jersey–based Merck is also one of Saftlas’s favourites. Not only has it improved its pipeline over the years, but he thinks its new CEO, Ken Fraizer, is “brilliant.”

Novartis AG (NYSE: NVS)
P/E: 16.2 | Yield: 4.1%
1-yr. total return (C$): 2.1%

This Swiss giant may be based in Europe, but that shouldn’t stop investors from considering its stock. Linda Bannister, an Edward Jones analyst, says Novartis is one of the more diversified companies on the market. It sells everything from brand name and generic drugs to diagnostic tools and surgical products.

Johnson & Johnson (NYSE: JNJ)
P/E: 13.7 | Yield: 3.4%
1-yr. total return (C$): 13.8%

Both Bannister and Saftlas like Johnson & Johnson, based in New Brunswick, N.J. The company is better known as the maker of Tylenol and Band-Aid, but it has a large and profitable pharmaceutical division too. In Q2, overall sales were down due to the underperforming consumer products market, but its drug division was up.

Even if these companies continue on a slow and steady trajectory, increasing demand from aging populations and a growing middle class in emerging markets will keep sales climbing. Herman Saftlas, an analyst with S&P Capital IQ, says that the elderly use twice as many medications as young people do. So naturally, as baby boomers age, they will spend more on drugs. He also says U.S. health-care reform could be a boon to the industry. Assuming the law doesn’t get repealed under a Republican administration, 30 million more Americans will get access to medication.

Emerging markets also offer upside. As with electronics, cars and other goods, the demand for drugs will increase as developing-nation populations make more money and acquire a western standard of living. According to New Jersey–based IMS Health, emerging markets will nearly double their spending on medicines from US$194 billion to about US$375 billion by 2016. China, specifically, is promising for Big Pharma because people there trust brand names. The question is how much these new consumers will be willing to pay. Currently, they pay less than developed countries for drugs, so companies don’t make as much money there. But, says Saftlas, as incomes grow, so too will the cost of drugs.

All of this adds up to some solid growth potential. David Sykes, vice-president and director of TD Asset Management, expects earnings to grow between 3% and 5% per year in the coming years. Making the sector even more attractive is the 3.5% to 5% dividends many of these companies pay. And because of all the off-patent concerns, the sector is undervalued compared to the broader market and its own historical valuations. Right now, it’s trading at about 10 times earnings, compared to the S&P 500’s 13.5 times.

There are still some risks. A lot of the new medicines with the greatest potential are in the final stages of testing. This stage—Phase 3—is the hardest to pass. It’s highly possible that some of the drugs the industry is most excited about may come to market later than expected, or not at all. As well, if the U.S. government takes on the responsibility for buying drugs, it may force better pricing terms on producers, which could hurt revenues. However, volume should make up for any price pressure, says Saftlas.

It’s important to look beyond the balance sheet to the types of drugs being tested. Overall, the number of medicines in development is going up. IMS Health reports that between 32 and 37 new patents will be launched every year until 2016, up from 25 to 30 between 2005 and 2010. Many companies will have a lot on the go, but look closely at what they’re working on. “It’s about quality and quantity,” says Saftlas. He tries to determine just how big the drugs will be, what type of competition each may have and whether they serve an under-represented marketplace.

Both the new drug pipeline and the firm’s current offerings have to be diverse. If one drug makes up 80% of revenue, then be careful. Sykes says it’s much better if a company has 20 drugs, each accounting for 5% of revenues. Also check to see when drugs are going off patent. While patents last about 20 years, there may be only eight or nine years left by the time a drug gets approved for sale. If a company has a blockbuster that’s set to expire in 18 months, think twice about buying in. A business that has numerous drugs with varying patent expiration dates is less risky.

Scrivens advises that investors stick to brand-name companies. Generic pharmaceutical companies operate in a more competitive market with enormous price pressures. Plus, generic manufacturers are more expensive, trading at about 15 times earnings.

When it comes to valuations, price-to-earnings is the best place to start. Sykes says anything in the nine or 10 times range is attractive, especially for a company growing by 4% to 6% each year. Also look at the free cash-flow yield, says Scrivens. He likes to see it at around 10%.

For Canadians, owning some of these stocks will not only provide income but also diversification, as there are few domestic pharmaceutical stocks to choose from. “Canadians should be excited about this because they don’t have the opportunity to invest in health care here,” says Scrivens. “These are some of the largest companies in the world, and they’re cheap. It’s a great opportunity.”