3 Potential Longs From Hedge Funds' Top Healthcare Stocks

By Ashish Sharma - June 26, 2012 | Tickers: ESRX, JNJ, MRK | 0 Comments

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Every quarter, Bank of America analyst Mary Ann Bartels comes up with an analysis of 13F filings by the major hedge funds. Her report consists of the major buys and sells by the big funds and lists their top holdings in each sector. Here’s a list of the top ten healthcare stocks that major hedge funds were holding at the end of last quarter according to her report.

I scanned the above list for good long candidates, and Express Scripts (NASDAQ: ESRX), Johnson & Johnson (NYSE: JNJ), and Merck (NYSE: MRK) appear to be the most compelling.

Express Scripts is likely to benefit from the positive outlook for the PBM industry, based on an aging population that uses more prescription drugs. A number of branded patent expiries over the next 12 months should also help its margins. In addition, its Medco acquisition makes it a clear market share leader based on prescription volume and would bring ~$1 billion in cost savings. Geographic expansion (Europe) and new services (such as personalized medicine) are other key drivers to watch going forward.

ESRX shares are trading trade at just 11.88x forward earnings despite a 23% expected EPS growth rate from the current year to the next; this is a significant discount from the company’s historical forward multiple of ~19x. I believe some of the discount is warranted given the company’s levered balance sheet after the Medco acquisition. However, its multiple is likely to improve in the future as it is using its cash to repay its debt and strengthen the balance sheet.

Johnson and Johnson has underperformed the broader markets and its pharmaceutical peers in the last year. There were several factors responsible for this: its subsidiary, McNeil, being hit with a Consent Decree in March on three manufacturing facilities following a number of highly publicized OTC recalls; increased generic competition for Concerta, Levaquin and Razadyne; and macro pressures which caused procedural volume to dip below historical trends.

I believe most of these headwinds are now behind the company. Johnson and Johnson is likely to see organic growth re-accelerate in 2012, driven by a robust pipeline of drugs like Incivo, Zytiga, Edurant and Xarelto. These launches are expected to push solid growth and improve margins through 2012. McNeil's situation will also gradually improve as J&J works through its Consent Decree with the FDA.

Further, procedural volume trends are increasing as physician office visits stabilize. JNJ is currently trading at 11.97x 2013 consensus EPS estimate. I believe it is a good buy at the current price and its organic growth could likely act as a catalyst for the stock. The potential share repurchase following the closure of the Synthes Inc. acquisition could also provide a boost.

Merck is trading at a forward PE of 10.81x and has a dividend yield of 4.20%. In addition to this low valuation and a good track record of returning cash to shareholders, Merck’s pipeline opportunity is also compelling. Odanacatib (osteoporosis) is the main product to watch out for. Other important drugs in the pipeline include its sleep drug Suvorexant, Anacetrapib (a CETP inhibitor which lowers bad cholesterol and raises good cholesterol) and Tredaptive. Merck is well positioned for a rise from the current depressed levels with several  phase III data releases approaching over the next 12-18 months. I find the risk-reward profile of the stock compelling.

To sum up, a healthy outlook for PBM markets and company-specific catalysts like merger synergies make Express Scripts a good buy; organic growth re-acceleration and a robust drug pipeline make Johnson and Johnson attractive; and Merck is a good buy given its low valuation and several imminent data releases.

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