Pipelines, Low Multiples to Drive BioPharma Outperformance

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

I have long found biotech and drug manufacturing to be one of the most exciting sectors. To be a winning investor, however, you need to do more than just closely follow the pipeline and trial results. You need to compare data from clinical trials against market potential. Below I review several stocks that I believe will generate strong returns over the next few months. 

Pipeline Results Driving Amgen (NASDAQ: AMGN) Bull Run

Amgen is a solid stock that has picked up more than 60% from its 52-week low and is now around its 52-week high. With a quick ratio of 3.6x, earnings growth prospects at a 10.3% rate, and just a 23.5% payout ratio, Amgen has plenty of ways to generate strong returns for shareholders. Fortunately, it has delivered impressive results recently. Just Monday, management announced that Phase 2 data from its antibody AMG 145 product yielded a 56% reduction of "bad" LDL cholesterol in patients suffering from hypercholesterolemia. And AMG 785, romosozumab, has also generated terrific results.

Revenue was 10% higher in Q3 2912, with stronger-than-expected momentum from Enbrel, XGEVA, Prolia, Sensipar, and Nplate, among others. And this was particularly impressive, since it represented a margin expansion as operating expenses only increased 7%. This expansion was driven by manufacturing restructuring and SG&A cost containment. Free cash flow also nearly doubled from one year ago to $1.6 billion. Furthermore, continued unit demand growth and stable value share in the rheumatology business indicate relatively low risk.

Going forward, there are several other reasons to be optimistic about Amgen. And even though profit share in Enbrel will decline after Nov. 2013, Amgen will still receive a 3-year royalty stream at that time. In addition, the capital structure continues to improve and allow for a recap and dividend initiation. Management has expressed that it will look to return more cash to shareholders and that this will not have an effect on how it approaches takeover activity.

Diversify With GlaxoSmithKline (NYSE: GSK) & Pfizer (NYSE: PFE)

If you are looking for larger healthcare stocks to back, I recommend considering a joint investment in GSK and Pfizer. These large drug manufacturers are cheap against historical valuation metrics. GSK is worth 9.9x forward earnings versus 10.6x for Pfizer. Yet analysts expect Pfizer to grow EPS annually by 2.4% over the next 5 years, versus 5.3% for GSK. Strangely enough, GSK is rated closer to a "sell" than a "buy," while its peer is a solid "buy" on the Street.

Assuming GSK merely meets expectations, 2016 EPS will come out to $5.15. At a multiple of 15x, this translates to a future stock value of $77.25. Discounting backwards by 8% yields a present value of $52.58. This represents more than an 18% premium to the current market assessment. If you add in a dividend yield of 5.2%, it becomes more even more evident that GSK carries favorable risk/reward.

Fortunately, on an operational level, GSK is doing greater. Gross margins and operating margins have risen to 72.2% and 27.6%, respectively, with the former inching closer to Pfizer's 81.2% level. Though a 7% miss was posted in the most recent quarter, GSK has still beaten expectations in 3 of the last 5 quarters. Yet during the last 12 months the stock has been flat, while the S&P 500 has risen 13.1%. I recommend buying on a market reversal--the multiples are relatively cheap enough to expand off of momentum.

There are several ways GSK plans on creating value. It appears to be considering downsizing European operations due to pressure on drug prices and reduced demand for vaccines. In the third quarter, sales in Europe fell 9%, so it makes sense from a risk-reward perspective to mitigate exposure. It is also aiming to conduct a Phase II study on an oral regimen that treats hepatitis C likely early next year.

Pfizer, meanwhile, has growth catalysts of its own. While profit fell to $3.2 billion as FX trends and softer-than-expected Prevnar and Lipitor revenue cut back on momentum, the company is gaining share through Lyrica, Celebrex, and Enbrel (it is actually partnering with Amgen on this). And, moreover, third quarter earnings of $0.53 also came out ahead of expectations, which represented margin expansion. In addition, the company is making investments in China to capture emerging market growth. With $24.3 billion in cash, the company has plenty of potential to pursue takeover activity of drug companies that need capital injections to take off.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of GlaxoSmithKline. Motley Fool newsletter services recommend GlaxoSmithKline. 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.

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