Pharma

[Viking]

I have been spending a fair bit of time reading up on big pharma. Most of these companies trade at a PE under 10 and have healthy dividend yields. Some have little debt, some have lots. Some have solid drug pipelines, some less so. Most will see revenue hits at some point in the next few years due to patent losses. Demographic trends are very favourable. Not sure how changes in the US impacts all this. I like the idea of buying someone in Europe/UK given the dramatic fall in the Euro/GBP. 

 

Buffett owns a little Sanofi-Aventis (French) and the stock looks to be a very reasonable value.

I am less excited by JNJ; not as cheap, much larger and not likely to grow any faster.

There are a bunch of others: GlaxoSmithKline (GSK), Astra Zeneca (AZN), Novartis (NVS), Novo-Nordisk (NVD) and also in the US: Eli Lilly (LLY), Merck (MRK), Pfizer (PFE) and Forect Labs (FRX).

 

Given current valuations I like the idea of allocation 5% of portfolio to the top 2 or three players. Does anyone have an opinion of who the leaders are in this field? I am looking for suggestions on who to research further...

[Parsad]

I think the measured basket approach you are thinking of is appropriate.  Of the larger players, several have lucrative patents that are expiring and will impact their future revenues.  Alot of the future potential lies within the smaller bio-tech players, but this field is a landmine, not unlike the dot-com era.  This will definitely be the area of growth and innovation, and the cash-rich large players will be snapping them up over the next decade.

 

On another front, I would not discount the future success of JNJ.  Alot of people seem to be doing that right now.  They are the #1 or #2 player in many fields of pharmaceuticals and retail pharmaceuticals.  Powerful brands that are not that different than Coke or Wrigleys...think Band-aid, Johnson & Johnson Baby Products, Acuvue, Neutrogena, Tylenol, Splenda, Listerine and...ahem...KY Lubricants!  Cheers!   

[Viking]

Sanj, I hear you on JNJ. I do like the company; it just does not look to me to be as cheap as some of the other big pharma's (and, yes, part of the reason JNJ is trading at a higher multiple is its business is more diversified and therefore revenue losses are less of an impact due to drugs losing patent protection).

 

If JNJ was to fall closer to $55 (=4% div yield) I would likely be a buyer!

[Parsad]

Hey I agree with you...cheaper is always better!  ;D  Cheers!

[vinod1]

I have not looked into it yet, but BAX is something you might want to consider. It price got down because of a short term issue with a recent recall.

 

Vinod

[SharperDingaan]

 

Keep in mind that you're really making 3 bets here;

 

The euro players include an FX bet that the Euro will be stronger on repatriation than it is today: ie, a great return on Sanofi could turn into a loss if the Euro materially worsened. If you dont want this risk its US makers only.

 

It makes more sense to allocate > 5% to the sector, & 1 name; a long term warrant, option, convertible that limits the $ investment or reduces the risk. Your premise is that the entire sector will improve; to get a bad result, the individual maker has to perform materially below the average for the group. Somewhat unlikely.

 

5% spread over 2-3 names is minimally different to the typical index fund. To make it worthwhile you need to do materially better than the indexer to cover your additional cost; if you just do the same as the indexer that is highly unlikely.

 

SD

[biaggio]

Health care has got to be due for a rebound.

 

Has been beaten down for the last several years.

 

If we consider the demographics, it has to be one of the most important industries going forward. the problem is we all want to be healthy, but who is going to pay the price?

 

Pharma's have been some of the best businesses around in the past.

 

I have been in the HMO's thru UNH (you need to have a system with checks + balances,,,the HMO's have already built out the infrastructure + relationships...the gov't needs them.

 

I have been worried about all the blockbuster products losing their patents so I have been in Mylan labs.

 

$135 billion /year of drugs losing patent protection over the next 5 years according to IMS

 

I have also owned FRX selling at $26...they will have $3.50 in FCF the next 2 years + $13 per share in cash, buying back their shares. They are losing patents on their 2 largest products + future will depend on their pipeline which appears promising. I like the fact that they are a $8 billion company with $4 BILLION IN CASH, so they dont need multple billion dollar products to restock pipeline (as opposed to larger pharma's)

[biaggio]

I have been looking at LLY

 

almost 6% yield!

 

I think it is worth $60.

 

I just reviewed their latest 10K. I have attached my notes.

[roundball100]

Re: LLY - isn't earnings growth (or lack thereof) a concern?

[Viking]

The sense I have is pharma used to be greatly overvalued (look at a 10 year chart for pretty much any of the large players and it is UGLY); the driver was potential. Today it is clear to me that most are fairly valued and they may be quite cheap (trading near long term lows and low PE's); the driver is concern over products losing patent protection.

 

In the past, investors built castles to the sky (greed). Today they only see issues (fear). My guess is sentiment can't get much worse and we likely are near the low with valuations (for the sector).

 

Today I purchased BAX (vinod1, thanks for the tip). I am out of town for the weekend but will post my rationale next week. As I dig, I do like this sector and I will continue to dig and hopefully find a few more names... Thanks to everyone for sharing their thoughts (on both sides of the fence; please keep them coming!

[biaggio]

Re: LLY - isn't earnings growth (or lack thereof) a concern?

 

agree probably not much growth.

 

My valuation was based on 7% growth x 5 years only (est growth rate of health spending) + I feel that pharmaceuticals have been able raise their prices to keep up with inflation, so I put a terminal growth rate of 2%

 

To me appears undervalued. Get ~6% dividend while you wait.

[DCG]

I've been keeping an eye on BMY recently, as it seems cheap to me. They have some key drugs coming off pattent soon, but have some new drugs in the pipeline. I generally try to stay away from Pharma and Biotech stocks though, as they're far from being in my circle of competence.

[roundball100]

Re: LLY - isn't earnings growth (or lack thereof) a concern?

 

agree probably not much growth.

 

My valuation was based on 7% growth x 5 years only (est growth rate of health spending) + I feel that pharmaceuticals have been able raise their prices to keep up with inflation, so I put a terminal growth rate of 2%

 

To me appears undervalued. Get ~6% dividend while you wait.

 

Arguably the whole pharma space is undervalued, so the challenge is where the best relative value is within the space.  Some of what I've read suggests LLY may have decreased earnings.  6% while you wait is great if your capital is safe, but no one is offering that guarantee.  I don't have any more dry powder for pharma, but if you have an eye for decent dividend and better earnings growth prospects than LLY, you might take another look at PFE or MRK.

[biaggio]

agree there are no guarantees.

 

Have looked at MRK + PFE...LLY seems cheaper + higher yield (maybe for a good reason). They are all going to be challenged with replacing products losing patent protection. I like MRK over PFE. Have owned them all in past. Own none at the moment. But have put in low  ball bid for LLY

[roundball100]

Moving over a bit to biotech - any thoughts on GILD?  (Though you won't get your dividend.)

[rohitc99]

I analysed JNJ sometime back and wrote a small note on it. posting it below ..hope you will find it useful

 

About

Johnson and Johnson (JNJ) is a US based pharma and healthcare company. The company has three primary business segments – consumer products, pharmaceuticals and medical devices.

 

The company had a revenue of 63 billion USD in 2008. The Consumer segment includes a broad range of products used in the baby care, skin care, oral care, wound care and women’s health care fields, as well as nutritional and over-the-counter pharmaceutical products. The Pharmaceutical segment includes products in the following therapeutic areas: anti-infective, antipsychotic, cardiovascular, contraceptive, dermatology, gastrointestinal, hematology, immunology, neurology, oncology etc. The Medical Devices and Diagnostics segment includes a broad range of products such as Cordis’ circulatory disease management products; DePuy’s orthopaedic products; Ethicon’s surgical care products; Ortho-Clinical Diagnostics’ professional diagnostic products and Vistakon’s disposable contact lenses.

 

The company operates globally in a predominantly decentralized structure with over 118000 employees.

 

Financials

The consumer segment had a global sale of 16 Billion in 2008 with a 10.8% growth. The company also acquired the consumer healthcare business of Pfizer in 2007. The consumer segment had an operating profit of 16.7%, an increase of 1% over 2007.

 

The pharma segment had a sale of 24.6 billion in 2008, a decrease of around 1.2% over 2007. This business saw an increase in operating profit from 26.3% to 31% mainly due to write downs in 2007.

 

The medical devices segment had sales of 23.1 billion with an increase of 6.4% over 2007. The operating profit increased from 22.3% to 31.2% in 2008 partly due to some litigation settlements in 2008 and some restructuring charges in 2007.

 

The company has maintained a high level of R&D investment (around 10% of sales or higher) during this period. This efficiency of this investment is evident from the drug pipeline of the company which consists of around 18 drugs filed or approved and almost 25 in the stage III trails.

 

On an aggregate basis, the company has a very steady performance in the last 10 years and more. The ROE has ranged between 26-30% during this period. This improvement has been driven by an improvement in net margins from around 15% to 20%. The various asset ratios such as working capital turns have improved from low teens to around 30. The fixed asset turns has improved during this period too.

 

The company has maintained a healthy cash flow during this period and has had a dividend payout of almost 40% during this period. The balance cash has been used to pay off the small amounts of debt, invest in assets and make targeted accquisitions.The company is a zero (net basis) debt company and has a cash flow rate in excess of 10 billion per annum.

 

 

Positives

JNJ has several key positives as a business and over other pharma companies

- The company derives around 30-32% of its revenue and around 40-45% of operating profits from the pharma business segment. Although the company faces the risk of its top performing drugs going off patent, the company has a healthy pipeline to manage this risk

- The company has a medical devices division which does not face the generic or patent risk of the pharma division and is fairly profitable.

- The company has a consumer products division with strong brands and an extensive distribution network which act as a hedge to the other segments.

- The company has a deep moat in all its business segments and sustainable competitive advantage.

- The company has a decentralized operating structure with 250 operating companies across 57 countries across the globe.

- The company has strong balance sheet and consistent cash flows. The net profit and cash flow has grown at around 16% per annum for the last 10 years. In addition the company has improved its ROE and other asset rations

 

Risks

The company faces the following key risks

- Several key pharma brands (in excess of 1 bn sales) such as risperdal and Topamax have lost patent protection in the recent and will face drop in sales and profits due to generics. Success of new drugs is not a given and only a few drugs in the pipeline may replace these blockbusters. In addition, there may be short to medium term dip before the new drugs replace the loss in sales.

- The global slowdown is likely to impact the topline and bottom line growth for the next 2-3 years

- The US market accounts for almost 14 bn in sales for the pharma division and 10Bn in sales for the medical devices division. Although I have not been able to find the numbers. the profitability of these divisions in the US is fairly high. This may be at risk due to the health care reforms in the US.

- The recession in the developed markets which account for major part of the sales and profit could keep the topline and bottom line subdued for the next few years.

- The company faces litigation risks related to product marketing, pricing, product side effects and patent issues. These risks are detailed over 3 pages of the annual report and are not easily quantifiable. The company has accrued liabilities against these risk and has stated that these risks in aggregate will not have a material effect on the financials.

 

Competitive analysis

The main competitors for the company are the other big pharma companies and the generic firms such as Ranbaxy, Sun etc. We can apply Michael porter’s five factor model to evaluate the company

Barrier to entry – All the segments of the company enjoy substantial entry barriers. The pharma and medical devices have formidable barriers in the form of patents and sales and marketing network. In addition any new drug or device requires substantial R&D expenses and infrastructure. The consumer segment has barriers in the form of Brands and distribution network

Supplier power – Moderate to low in this industry. Suppliers are mainly providers of basic chemicals or contract manufacturers. The value is derived from the IPR of the drug and not from the manufacturing.

Buyer power – Low in consumer goods. However in case of Pharma and the devices segments, national programs such as Medicare have a strong leverage and with escalating cost will attempt to drive down prices.

Substitute product – none

Rivalry – There is intense rivalry in the industry from other pharma majors who are attempting to develop a similar drug and especially from the generics where the price and profits drop by as much as 90% over the course of a few years as soon as the drug comes off a patent. In addition, the generic companies are constantly trying to challenge the patents too.

 

Management quality checklist

 

- Management compensation: The company has almost 215 Million outstanding options which would result in 2% dilution. The options do not appear to be excessive.

- Capital allocation record: Fairly good. The management has maintained an ROE in excess of 25%, low debt and a dividend payout of almost 40%. In addition, the management has been engaged in acquiring other pharma companies to pull gaps in its drug pipeline and added to it too.

- Shareholder communication: The shareholder disclosure is good with clear explanation of the benefits assumptions and IP R&D (in process R&D) calculations from the acquisitions.

- Accounting practice: The overall accounting seems to be conservative. However there are some areas of concern. For example – the company has assumed long term returns on plan assets of 9%. I think that is aggressive and could result in additional charges over the years. The IP R&D (in process R&D) charges do not appear to be excessive.

 

 

Valuation

The company has approximately 12 Bn of cash flow and is selling at around 13 times earnings. The company has shown a profit growth of almost 15% per annum with high degree of consistency. At the same time the company has maintained a high level of ROE during this period too. One cannot assume such a high level of profit growth in the future as some part of this has come from the increase in net margins. However with a conservative assumption of 6-7% growth, discount rate of 8% and CAP period of 10 yrs, intrinsic value can be estimated to be between 80-85 (PE of around 20).

 

The current valuation assumes a growth of 0 or worse and gives no value to the competitive advantage of the company.  The company is currently selling at a 5 year low and appears to undervalued by comparative and absolute standards.

 

Conclusion

The company has performed well in the past in terms of fundamental performance. The sales and profits have grown at a double digit rate. In addition the company has a healthy drug pipeline at various stages of approval which could help in replacing the blockbuster drugs going off patent. The medical devices and consumer division provide stability to the earnings and help in reducing the risks of the pharma division.

The management has been a rational allocator of capital which is visible via the high dividend payout, above average ROE and sensible acquisitions. The company appears 20-30% undervalued compared to the intrinsic value which in turn can be expected to grow at 7-10% in the future.

 

[biaggio]

Moving over a bit to biotech - any thoughts on GILD?  (Though you won't get your dividend.)

 

Have not looked at it very closely, as I always thought it was priced fairly to expensive. Probably a lot more growth than LLY, MRK, PFE, etc.

 

Also I am not as familiar with its products as I am the other cos.

 

JNJ if you can get at a bargain price would be like a health ETF or mutual fund but probably better (great business. Diversified products in different areas of health care...Great write above about JNJ)

[roundball100]

Definitely  more growth with GILD (smaller company - higher risk/reward).  They also have lots of cash presently.  P/E (current and forward) lower than JNJ. 

 

I currently hold JNJ and ABT (plus small bit of PFE bought long ago ... thus way under water).  The size of JNJ and ABT limits their growth (moreso JNJ than ABT), but also should limit the downside.

 

[roundball100]

rohitc99 - thanks for the detailed write-up on JNJ.  It sounds like the future remains promising and that sooner or later, price will follow value.

[rohitc99]

roundball100

JNJ may not be a multibagger over a 5 yr time frame. however  considering the economic headwinds and opportunities outside US, it should do well. a drop in the dollar could help too

Also, if they can keep doing a few smart accqusitions once in 2-3 yrs, we may get a good upside in the long run

 

 

[biaggio]

http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2010/06/02/the-ultimate-hedge-in-economic-crisis.aspx

 

"The Ultimate Hedge in Economic Crisis"

 

interesting article from Patrick Cox (never read any of his previous stuff). Unconventional opinion. May be worth considering.

[Viking]

After reviewing the sector my top pick is Abbott Labs (ABT): well respected, good management, excellent long term track record, good capital allocators, very profitable (should earn over $4.00 in 2010 and over $4.50 in 2011), cheap (trading at a 2010 PE=11). What really separates them from the pack is their growth prospects (low double digit). Their business is also fairly diversified and they do not appear to be facing the patent cliff that others are, such as Pfizer.

 

My second pick is JNJ. I could say much of the same as ABT. The big difference is JNJ will likely grow mid to high single digits (due to its size).

 

My more speculative purchases are BAX, Pfizer and GILD. Bax has had some recent issues but I like its growth prospects looking out. Pfizer is cheap, facing a patent cliff and I am hoping it has something in its pipeline (stock price is saying no). Gilead is cheap, has no patent cliff issues and looks to be buying back lots of stock at current prices.

 

ABT, JNJ, BAX & GILD all have lots of cash and low debt.

 

Should the markets continue to sell off I will look to grow my position in ABT. 

 

[RRJ]

Sharper,

 

I did a sector play here recently -- bought 4 of the majors, a little of each, simply because (1) I'm not smart enough to figure out which of them will outperform, (2) I'm not sure anyone can predict that when you're dealing with essentially a patent portfolio (though I do like that cost and distribution advantages of the larger players), (3) but the high margins (though somewhat less going forward due to generic competition), "need to have" status of products, favorable demographics (as boomers age), and growth of the middle classes in emerging markets creating new markets, all bode well for the sector as a whole.  So I bought a small diversified (4 stocks) basket. 

 

But, I've always suspected that even this diversification is basically going to mimic a drug sector fund.  This might be okay, but I'm wondering how you might figure out your winner in this sector.  I've tried, and just can't get any special insights.  Any help is appreciated. 

 

 

 

Keep in mind that you're really making 3 bets here;

 

The euro players include an FX bet that the Euro will be stronger on repatriation than it is today: ie, a great return on Sanofi could turn into a loss if the Euro materially worsened. If you dont want this risk its US makers only.

 

It makes more sense to allocate > 5% to the sector, & 1 name; a long term warrant, option, convertible that limits the $ investment or reduces the risk. Your premise is that the entire sector will improve; to get a bad result, the individual maker has to perform materially below the average for the group. Somewhat unlikely.

 

5% spread over 2-3 names is minimally different to the typical index fund. To make it worthwhile you need to do materially better than the indexer to cover your additional cost; if you just do the same as the indexer that is highly unlikely.

 

SD

[SharperDingaan]

 

Assess if pharma is within our competency. If 'no', we'd reduce our sector risk by staying domestic.

Do we have all the major 'names'? Are there hybrid securities - convertibles, warrants, options, etc. 

What fits within our risk tolerance & time horizon, & why.

Is an alternate low fee index fund available.

 

We would benchmark against a 5% weighting to the index fund. If we invested directly via a hybrid we'd want a minimum 3-5x the index return. If we could do it via a convertible we'd use margin to neutralize our positive carry, & weight higher.

 

When it's not within your competency, the individual 'name' is pretty irrelevant.

 

SD

[biaggio]

re FRX

 

http://www.sec.gov/Archives/edgar/data/38074/000003807411000024/forest8kjune7.htm

 

"Pursuant to the ASR Contract, Forest paid $500 million to Morgan Stanley on June 3, 2011, and 9,839,752 shares were delivered to Forest on the same day"

 

It appears that FRX buying back almost 10 million shares for almost $51 per share (~ 35% premium). The shares are currently selling for $37.95.

 

Has this ever happened to anyone? i.e it appears that company is buying shares at a substantial premium.

 

I would consider selling for $50 (but I wont have a chance anytime soon)

 

Is this a way of FRX buying a large block of shares?

 

Why not just buy at the market?

 

Do folks think this is a wise capital allocation?

 

The market seems to like it, as it is hitting new highs.