Avoid Big Pharma Value Traps

By Bill Edson - August 9, 2012 | Tickers: HPQ, JNJ, MRK, NVS, PFE | 0 Comments

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Value investors can apply methods suggested by legendary short-seller Jim Chanos to screen out value traps in declining and challenging industries. I will apply his concerns about the cost of acquisitions to big pharmaceutical companies, many of which are losing patent protection for their prescription drug products. Despite enticing dividends, investors should look elsewhere.

Acquisitions as Shadow R&D Costs

Legendary short-seller Jim Chanos recently made news when he identified Hewlett-Packard (NYSE: HPQ) as a short candidate. He cites a secular change, courtesy of Apple (AAPL), which led movement from personal computers to mobile devices and away from old-school personal computer companies like Hewlett-Packard. Mr. Chanos is concerned that Hewlett-Packard’s management will refuse to age gracefully and instead will acquire other companies in desperate attempts to acquire lost market share.

This prognosis is eerily similar to concerns expressed by Evaluatepharma.com in its World Preview 2018:

“The patent cliff in its own right may not be the problem: more the reactions of management to it. For a company facing a patent cliff, a declining share price could even be seen as a sign of a successfully run company – if excess cash is being returned to shareholders via dividends. If a drug company were simply to collect the cash flows and put the money in the bank the share price would remain stable, a model adopted by PDL Biopharma…But because most managers do not follow this business model, they start spending the surplus cash, thereby creating a riskier company, with the assumption that revenues and earnings can be smoothed.”

Drug Development is Getting Tougher

The pharmaceutical game is getting harder. The FDA requires that new drugs beat old ones in terms of efficacy, and decades of testing have increased savvy in exposing costly side effects. To be approved, a new drug has to set a new record. Consider Bapineuzumab, a drug candidate co-developed by Pfizer (NYSE: PFE) and Johnson & Johnson (NYSE: JNJ) as an Alzheimer’s treatment. It failed to affect patients’ conditions in the first large trial period.  Bapineuzumab was designed to counteract beta-amyloid, a noxious protein that many believe is a cause of the disease. Many predicted that this trial would fail as the drug had not caused significant improvement in the phase 2 trial, however, so neither company saw substantial losses because of this outcome. The drug is still being tested, and it is hoped that this drug might show some results with Alzheimer’s patients who do not have the ApoE4 gene that puts individuals more at risk and causes worse cases of the disease.  It is also speculated that that Bapineuzumab would be more effective in a group of Alzheimer’s patients in which the disease was not so far advanced.  Although there are a lot of unknowns in trying to find a treatment for Alzheimer’s, a drug that would improve either the cognition or functionality of people with Alzheimer’s would be worth billions.

Worse yet, there is heightened competition between research teams who compete over market share in ever-smaller untreated or undertreated illnesses. Consider how Johnson & Johnson’s prostate cancer treatment drug Zytiga may soon have some competition. Medivation’s (MDVN) cancer drug enzalutamide is up for evaluation by the Food and Drug Administration this year, and could even be approved by September. Enzalutamide, unlike Zytiga, is effective by itself and does not have to be used in conjunction with the steroid prednisone. Enzalutamide’s trial period was very successful, having few serious side effects and lengthening participant’s lives by at least 4.8 months, even the men whose cancer had metastasized and had undergone chemotherapy.

Though this is nothing new, treatments run the risk of creating detrimental side effects. Remember Audrey Singleton? She sued Wyeth in 2010 over the company’s lack of communication about the cancer risk associated with the menopause drug Prempro, and now Pfizer is paying for it. Pfizer, who acquired Wyeth after the first wave of litigations swept over the drug company, is now having to shell out some major cash in order to settle cases related to this drug.  In Singleton’s case alone, Pfizer is being forced to pay $10.4 million.  Over 6 million women were on Prempro until a study in 2002 showed that taking this medication increased the risk of getting cancer.  Pfizer has already paid $869 million in settlements for 60% of litigations filed over this drug, and has earmarked another $330 million to deal with other outstanding claims related to this drug.

Checking Valuations

First, investors should check to make sure that these firms are cheap. After all, the common factor of bargains and “cheap for a reason” value traps is that they trade at low valuations. If they are pricey, it’s clear that investors should stay away. Consider the following four largest pharmaceutical companies by market capitalization:

None of these firms are cheap on the basis of price-to-earnings valuations. Only Novartis (NYSE: NVS) is reasonably valued.

Screening for Cash Inflows

Mr. Chanos warned how acquisitions are the back-door way to double-up on research & development spending. R&D spending is immediately expensed according to US GAAP (Generally Accepted Accounting Principles), but is largely capitalized in an acquisition. This distinction allows firms which engage in acquisitions to keep earnings free from R&D expense. Their peers that internally develop their brands and technology would be at a disadvantage vis-à-vis accounting rules, since their earnings would be lower after expensing research and development costs.

This means that investors should pay careful attention to acquisition expenditures and free cash flow adjusted for acquisition payments. Net acquisition cash flows were subtracted from free cash flow below:

These numbers for adjusted free cash flow after acquisitions highlight how Johnson & Johnson is the only consistent cash generating juggernaut. Of the remaining firms, Merck (NYSE: MRK) has the best track record of cash outflows while the others are more sporadic.

Conclusion

Of these firms, Johnson & Johnson is the only one which consistently generated operating cash outflows each year for the past five years. Though it is a cash generating machine it is not cheap based on its price-to-earnings ratio. Income investors should shy away from all of these firms, but should consider buying Johnson & Johnson if its valuation multiples become more attractive.

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