What to Watch for at These 3 Drug Firms

Phillip is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In light of three indicators that point to increased sales at drug companies -- an economic recovery, an aging baby boomer population, and Obamacare -- medication firms are gearing up for major profits. If they aren't already making changes, they likely will in the next couple years, as the unemployment rate improves to 7.4% from over 10%, as baby boomers develop medication dependency, and as Obamacare embeds itself next year. These three companies either have made improvements (or could make improvements) to their competitive positions.

Bayer could benefit from selling MaterialScience

Bayer AG (NASDAQOTH: BAYRY.PK) is holding onto its MaterialScience business, despite the transparent plastics that it manufactures not being as in demand due to a falling DVD market. The pharmaceuticals portion of operations is growing to the point where it will be much larger than the plastics unit, and this could result in the company ridding itself of MaterialScience so that it can concentrate on the booming drug sector. Once that happens, I anticipate the company will realize a higher profit margin.

The aging baby boomers, who continually increases the demand for drugs, has already prompted Pfizer to sell its animal health operation, Zoetis, earlier this year. After the consolidation, Pfizer experienced higher growth expectations from analysts, which shot the share price up. The same could happen with Bayer if it decides to focus more on drugs.

If the company does split off its MaterialScience unit, I'd buy shares of the stock. However, even with the segment still in the firm, the company has a profit margin of about 10%. Furthermore, revenue has increased by an average of 8.5% in each of the last three years, which is impressive for a company that is generating about $40 billion of revenue annually.

Analysts are wrong about Novartis

Novartis AG (NYSE: NVS) looks set to improve profits. The company is consolidating its expenses to the point where it will eat up less revenue. Decreasing expenses often means increasing profits with which the company can pay off debt, and that means lower annual debt repayments and further decreasing operating expenses. This is just what has happened in the last two years despite falling revenue. This is a sign of improving long-term financial health.

<img alt="" src="http://media.ycharts.com/charts/98c48b6a161e3f4f592f65cb047d7dd3.png" />

NVS Debt to Equity Ratio data by YCharts

Decreasing debt means that even if revenue is dropping, the company can still earn more than it did when revenue was higher. For example, from 2011 to 2012, the company recorded $1.8 billion less in revenue, but $470 million more in profits. If the firm can continue to consolidate expenses, it will provide more value for shareholders.

I believe analysts have missed this in their estimates. They say EPS will drop by 3% this year and only gain 4.5% next year. In reality, however, an improving profit margin will net a higher EPS return even if revenue falls slightly.

Mallinckrodt can focus on R&D

Mallinckrodt PLC (NYSE: MNK) could face challenges by continuing to focus on generic drug manufacturing. I anticipate less revenue than would be realized from manufacturing a drug from a name-brand. This is because there is much more pressure on the company to offer the drug at a reduced price even though the medication is essentially the same and often has identical production costs. 

However, the company has recently become an independent firm, which will allow it to have more say about what it does with its money. That could prompt additional investment into research and development. New products would support growth and equip this firm with what it needs to compete with the big players.

Analysts anticipate the June IPO was set too high, as the first year's EPS is pegged at $2.90, but will drop to $2.53 in the next year. However, keep an eye on the company's research and development budget, and if that increases, expect increased revenue at least two years down the road.

Signs to look for

While I don't think any of these companies are a buy right now, be ready to make a purchase given any one of three situations: Bayer sells MaterialScience, Novartis continues to lower its debt, or if Mallinckrodt increases its R&D budget by more than 10%. The next several months are sure to provide investors with a sign of things to come for many years ahead.

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