Teva 50% Undervalued, Arena And Vivus More Speculative Value Stocks
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
While the economy is uncertain, some sectors are not really influenced one way or another - as strange as that sounds. Biotech, for example, will either deliver effective catalysts or go nowhere - either way; it will be targeting almost perfectly inelastic demand. Cures for debilitating conditions will be demanded by sufferers at, theoretically, an infinite price. Even treatments for unmet needs are not very dependent on the economic climate. Those who currently are obese will pay the same price now that they would for a weight loss treatment if the economy were strong.
I encourage investors to broadly diversify across the healthcare sector. I believe the market is currently cheap due to aggressive assumptions of risk. Yes, product recalls and poor clinical trials are something to be feared; but I find that some biotech giants are being discounted at rates higher than 15%. That is only reasonable for more speculative and emerging producers.
Arena Pharmaceuticals (NASDAQ: ARNA) and VIVUS (NASDAQ: VVUS) are two biotech companies that have generated substantial returns as speculative plays. Over the prior twelve months, Arena’s value increased by 643.8% while Vivus gained 238.5%. The former's lead product, lorcaserin ("Belviq"), was recently approved by the FDA - the first weight-loss drug to receive such an honor in over a decade. Vivus has a weight-loss candidate that is expected to be approved by the FDA shortly.
Of course, Arena and Vivus lack an impressive history; but that doesn't matter because companies - especially biotech - are valued based on the future. Over the past 5 years, Arena's losses have dipped from $238M to $109M. With Belviq ready for the market, the company's positive free cash flow days are right around the corner. The company will receive approximately 40% of sales profits, and it is unclear how much demand Belviq can create. What is clear, however, is that demand will be high domestically with 35.7% of US adults classified as obese and no state meeting the nation's Health People 2010 guideline of sub-15% obesity rates. Medical costs related to obesity were approximately $147B in 2008. Moreover, weight loss needs have grown, since obesity has seen a dramatic increase over the last two decades. 42% of adults are expected to be classified as "obese" by 2030.
It is unclear how much revenue Arena and Vivus will get from the approximately $60B obesity market, but I believe the cash flow generation will be enough to finance successful future R&D efforts. A $2B valuation for Arena and a $2.7B valuation for Vivus that is dependent on the success of an anti-obesity drug are, however, speculative. The FDA may end up approving both, but weight loss drugs have had a notorious past and competition will remain intense. I encourage only a small speculative holding.
By contrast, the larger - perhaps, one can say, "more boring" - BioPharma producers appear significantly undervalued. One company in particular that I am optimistic about is Teva Pharmaceutical (NYSE: TEVA). The $34.8B Israeli firm generated north of $3B in free cash flow last year, which is roughly $500M more than in 2008.
Teva currently trades at 12.3x past earnings and only 6.8x forward earnings. Analysts currently rate the stock a "buy" with a $51.82 price target. Over the past 5 years, the company has grown EPS 36.8% annually; but, it is only expected to grow 7.7% over the next 5. In my view, this sets the bar low for greater-than-expected performance. Nevertheless, assuming the company merely meets consensus, 2016 EPS will be around $7.29. At a 13x multiple, the future stock value of the company is $94.77. A 10% discount rate would yield a price target of $58.84 for nearly a 50% margin of safety on top of a 2.5% dividend yield and a beta of 0.35. It would take around an absurd 20% discount rate for Teva to be fairly valued.
While Teva is both a value and safe play, Vivus and Arena remain speculative. I recommend broad diversification across biotech but a particularly large holding in Teva. Uncertainty in the broader economy will not likely have an impact on the sector's performance.
TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Teva Pharmaceutical Industries. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.