Look to The Future, Buy These 2 BioPharma Stocks

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

In this environment of patent cliffs, investors are naturally on the edge about pharmaceuticals. Instead of looking to the past, however, they should look to the future. It is my belief that upcoming exclusivity losses have overshadowed strong pipeline momentum and otherwise stronger-than-expected business in core products. I encourage broadly diversifying across different risk/reward stories, with a preference towards backing the riskier stocks.

Despite Weak 3Q12, Eli Lilly (NYSE: LLY) Still A "Buy"

Over the last six months, Eli Lilly has gained 18.2% in value and still trades fairly cheap at 13.3x forward earnings. For a company that has grown EPS by nearly 10% annually over the next 5 years, I find the current market price to be overly discounting the catalysts (mentioned below). Lilly is also remarkably safe, with a beta of 0.68 and a dividend ratio of 4%, which isn't going away any time soon given a strong debt-to-equity ratio of 0.34 and a payout ratio of 55.2%. Analysts obviously take a much different attitude when they rate the stock a 2.8 out of 5, where "5" is a "sell."

But these same analysts have also been understated Lilly's performance in 3 of the last 5 quarters by an average of more than 11%. With that said, 3Q 2012 EPS of $0.79 represented a 4.8% miss against consensus.

There are still several reasons to be optimistic about Lilly. The drug producer has gained FDA approval for use of Alimta in treating nonsquamous non-small cell lung cancer and FDA approval for Tradjenta in treating type 2 diabetes in adults. In Japan, Strattera was approved for treating ADHD. And in Europe, the CHMP made 3 positive recommendations on Cialis for treating prostatic hyperplasia. Meanwhile, dulaglutide has met Phase III primary endpoints in reducing HbAlC. And current product domestic sales in Cialis, Alimta, Cymbalta, and animal health products have also delivered double-digit growth. Meanwhile, operating expenses have fallen by 3% thanks to better discipline in managing the cost structure.

I also believe the company will explore takeover activity, like other biopharmaceutical producers. Biotech M&A has risen to a 4-year high as drug manufacturers rush to find solutions to multi-billion dollar patent cliffs. AstraZeneca's decision, for example, to delay share buybacks has renewed market speculation--the company bought out Adrea at a 54% premium earlier this year. Other promising developers, like PROLOR Biotech, Dendreon, and Pharmacyclics, have been rumored to be on the takeover screens of large companies. While Dendreon is focused on cancer treatments, PROLOR is developing what is expected to be the first long-acting version of hGH. An acquisition of either firms would generate meaningful revenue synergies for an acquirer promoting to to larger patient populations.

Diverging Risk/Reward For Merck (NYSE: MRK) & Bristol Myers (NYSE: BMY)

Merck is a relatively expensive investment at 20.8x past earnings, although its historical 5-year average P/E multiple is 24.1x. While it offers a 3.7%, free cash flow generation has been relatively weak. Free cash flow of $9.7 billion in the TTM ending 1Q 2008 has gone up and down, but the average has been $6.7 billion. Ultimately, this means the company is typically generating lower than a 5% yield against its market capitalization.

Moreover, assuming the company meets annual EPS growth expectations of 4% over the next 5 years, 2016 EPS will come out to $4.19. At a multiple of 16x, this translates to a future stock value of $67.04. Discounting backwards by 6% yields a present value of $50.10, which is nominally higher than the current market cap. For higher returns, I thus recommend looking elsewhere.

Bristol could be your bridge between high returns for Lilly and high safety for Merck. It is more than 50% less volatile than the broader market, provides a 4.1% dividend yield, and has delivered tremendous earnings growth. Moreover, its free cash flow generation trends has been strong. In 4Q 2012, free cash flow generation (ttm) was $2.6 billion--in 3Q 2012, it was $7.2 billion. That's a tremendous 13.2% yield against market capitalization and something investors have yet to appreciate in light of the high 17.8x forward earnings multiple. With gross margins up to 74%, the market has overreacted to misses of 2% (2Q 2012) and 9.8% (3Q 2012) in the recent quarters. The fundamentals have otherwise been strong and is positioned to achieve record momentum through Eliquis, Orencia, and Yervoy.

All things considered, I encourage you to buy Eli Lilly for high returns and Bristol for moderate returns but greater safety. It is this kind of diversification that will make you a winner in pharmaceutical investing.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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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