Healthcare Stocks to Consider Buying

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

Note: This article has been amended to remove TRADJENTA as Eli Lilly's leading products--it is developed and commercialized through an alliance between Eli Lilly and Boehringer Ingelheim International GmbH & Co

To address the patent cliff, several large pharmaceutical companies have been actively reinventing their businesses in terms of pipeline updates and strategic changes. Below, I present my take on two leading producers with a focus on the headwinds and opportunities.

Unlocking value

Last year, Abbott Labs (NYSE: ABT) made the bold decision to split into two distinct trading companies. Investors and analysts have been keen to see what has come of the spinoff. AbbVie (NYSE: ABBV), which split from Abbott, has been paying attractive dividends with a yield of 3.7% and a projected EPS growth rate of 11% in the next five years. A rising concern about the company is the ticking clock for its drug Humira.

The drug has generated enormous amounts of revenue for the company in the past years with 2012 alone registering sales worth $9.3 billion. The problem is that patent rights to the drug will expire in 2016. After 2016, generic forms of the drug will be available. This means that sales will drop greatly as other companies attempt to get a share of the cake.

Abbott has fared well after the split--beginning with a bang: the diagnostic segment grew 15.8% compared to the same period a year earlier. Ultimately, I see this segment representing the company's future. Toward that end, the company should consider takeover activity.

St. Jude Medical (NYSE: STJ)for example, is an attractive potential target. At 12x forward earnings, it is cheap compared to peers. At the same time, it would mitigate downside by offering a more predictable stream of free cash flow.  St. Jude has grown by a rate of nearly 10% over the past five years and is expected to do so over the next five years. While this transaction is very unlikely, I believe a similar buyout will be made by Abbott to increase stability.

Facing headwinds for Lilly

Eli Lilly (NYSE: LLY) is a diversified pharmaceutical company that has a presence in around 130 countries. The company reported that it had made several breakthroughs in the introduction of new drugs. In Europe, the Cialis drug was approved by the European commission for treatment of BPH symptoms. Amyvid was also approved for the treatment of cognitive impairment in adults with Alzheimer’s disease and other diseases known to cause cognitive impairment.

Erbitux received approval in Japan for treatment of neck cancer. The same drug, taken together with certain chemotherapy regiments, was also approved in Canada as the first treatment for colorectal cancer.

Going forward, the company expects 2013 revenue to amount to $23 billion. Gross-margin guidance was also pegged at 78%. I believe that much of the growth in coming years will come come from reinvestments from sales in the animal health division, as well as business from the Japanese market and emerging economies. Lilly is also positioned to accelerate growth in its leading products, such as Alimta, and Humulin, among others.

And it will certainly need all of the acceleration it can get. Patent rights for the Zyprexa drug have been lost and generics are already posing competition that have crushed sales. The company will also lose patent rights in the United States for the drug Cymbalta at the close of the year. But Lilly’s balance sheet is quite strong, so investors should be confident that the company will be able to fund its 2013 capital expenditure, which amounts to $900 million and active R&D expenditures.

Conclusion

Abbott and Lilly offer very different risks and potential rewards. The former trades at 15.8x forward earnings versus 18.8x for the latter. However, Abbott is less of a pharmaceutical producer now and is need of some added stability post-split. Return on invested capital is still strong at 14.8%, so the company has room to create value by increasing exposure to new sectors. Lilly already has growth catalysts in place, so it is less likely to experience positive or negative surprises in the near-term.

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David Gould has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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