2 BioPhama Stocks To 'Buy', 1 To 'Hold'

By David Gould - August 20, 2012 | Tickers: JNJ, MRK, TEVA | 0 Comments

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As several large pharmaceutical companies are hit by multiples waves of patent cliffs, healthcare investors must be able to discern the difference between low multiples of undervalued firms and low multiples of futureless shells. Under such an environment, manufacturers of generic drugs, like Teva Pharmaceutical (NYSE: TEVA), have an overly discounted growth story going for them. Others, like Merck (NYSE: MRK), have room for multiples expansion as investors flock to safer stocks. And still others, like Johnson & Johnson (NYSE: JNJ), will lose their appeal as investors seek stronger peer returns. Below, I review the fundamentals of each company.

Teva Pharmaceutical

Teva is one of the cheapest stocks on the Street with a forward PE multiple of 6.7x and relatively high growth forecasts. During the second quarter, earnings were virtually in-line with expectations at $1.28 per share. Revenues grew 19% over the same quarter last year, and guidance was reaffirmed. Sovereign debt crises abroad also didn't deter international strength with European sales growing 12% off of 2Q11. This was largely due to the take-back of Copaxoone rights and inclusion of products acquired from Cephalon. Overall, the financial results provided room for optimism.

Strong top line data from the GALA Phase III clinical trial are a catalyst for future value creation. 40 mg/1 ml of glatiramer acetate injection has demonstrated that the product significantly reduces disease activity with favorable tolerability and safety. Successful launches of generics of Apothecon and Lipitor also provide a means for investors to gauge how well Teva does under a climate of pharmaceutical exclusivity losses. Fortunately, the company is already off to a solid footing. In the very first day, Teva outperformed competitors and grew in smaller markets ranging from Swedan and Finland to Romania, Australia, and Bulgaria. Japan is also a major catalyst with Daiichi Sankyo being well positioned to exploit the positive secular trends for generics.

It is also a strong plus that the US District Court for the Southern District of New York has found that Novartis, Mylan, and Momenta infringed upon Teva's patent claims. There will likely be an appeal from the defendants; but, it appeals that Copaxone is still well protected. With much of the headwind gone, investors can begin to focus on the long-term fundamentals.

Merck

Merck is one of the safer drug manufacturers out there with a 3.8% dividend yield and 36% less volatility than the broader market. On the other hand, it trades at 19.5x past earnings, and 4.6% annual EPS growth does not merit calling the firm a "value play." Mid-single-digit ROA and ROI, coupled with shaky free cash flow generation, further weaken the bull case for buying.

If Merck is able to grow EPS by 4.6% annually, it will realize 2016 EPS of around $4.28. At a 17x multiple, the future value of the stock should be $68. This means Merck offers a very strong 10%+ return with the dividend yield. The problem is that the company is not that undervalued. If you discount my future stock projection back by an 8% rate, the present value is roughly in-line with the current market assessment.

During the second quarter, revenue rose 5% sequentially - beating analyst expectations. 11% growth domestically was driven by strong returns from Januvia and late-cycle drugs Zetia and Singulair. Perhaps most importantly, the company has showcased the soundness of its Schering Plough acquisition. Increased margins demonstrate meaningful cost synergies in an uncertain climate. I am also optimistic about the firm's new bone drug, odanacatib. The company's last bone drug, Fosamax, produced $3 billion annually before its patent expiry in 2008. Efficacy for odana is believed to be so strong that the clinical trial was stopped early. To capitalize off of this momentum, investors are encouraged to buy shares now.

Johnson & Johnson

As the largest healthcare company in the world, J&J commands a large economic moat. It still trades, however, overly high at respective PE and forward PE multiples of 22x and 12.7x. 7.7% annual EPS growth is forecasted over the next 5 years, but I do not find that the company has that many value drivers to justify more than a "hold" recommendation.

During the second quarter, earnings were slightly better than expected at $1.30 per share. But US sales still fell 1.2% from LEVAQUIN and CONCERTA generic competition. Disease sales, excluding LEVAQUIN's generic headwinds, grew 20% off of a successful INCIVO launch and market penetration for PREZISTA and INTELENCE. Supply problems for DOXIL/CAELYX are also disconcerting. Even though the FDA recently gave a priority review designation for XARELTO, I have still largely been disappointed with the candidate's prospects going forward.

As it stands, J&J would be worth $102.30 by 2016 under growth assumptions and a 15x multiple. Discounting backwards by 8% yields a present value in-line with the current market assessment. High diversification and a low beta may make J&J a safe stock, but it also results in relatively limited upside as current investors have largely taken advantage of the strong fundamentals.

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