Pharmaceuticals in 2010: JNJ, PFE, LLY

Last week I spoke of the general attractiveness of the healthcare sector, and today I want to focus particularly on pharmaceuticals. The most visible positive catalyst for the industry is that the worst-case reform scenarios – a single-payer system or a public plan with a Medicare-linked fee schedule – are no longer a threat.

Another boon to the industry could be the significant number of late stage product results are due in 2010 and 2011. In 2008 and 2009, there were very few Phase III drugs completing clinical trials that were viewed as significant improvements in the standard of care. Consequently, the news surrounding the industry had low emphasis on sources of future revenue growth and high emphasis on generic erosion. The game-changing clinical data on tap for 2010 and 2011 could help reverse investor skepticism on the industry’s pipelines – a very substantial factor in the group’s deeply discounted valuations.

Also working in favor of pharmaceuticals is that mega deals have improved the patent cliffs, and thus the industry has a better outlook to longer-term earnings than a year ago. There is also reason to believe that some additional upside could surface over the next few years for deals involving emerging markets and biologic capabilities.

As the above dynamics generate investor interest, I expect to see the valuation gap between the S&P 500 and Pharmaceuticals contract.

Here are a few of the pharmaceuticals currently on our Approved List.

Johnson & Johnson (JNJ)
It’s hard to find a higher-quality healthcare firm than JNJ. The firm’s AAA credit rating is rare among its pharmaceutical competitors. With nearly $15 billion in annual cash flow from operations, JNJ has plenty of financial flexibility to continue making strategic acquisitions, increasing their dividend, and buying back stock.

One of the more expensive healthcare companies (as measured by P/E ratio) on our Approved List, JNJ still trades at a 25% discount to the S&P 500 and about a 37% discount to its 10-year average valuation.

The firm trades at a premium to the healthcare sector because investors value its diverse revenue base (in which JNJ controls the #1 or #2 leadership spot in 70% of its products), robust drug pipeline (with 10 potential blockbusters in Phase III development), strong brand names (Tylenol, Band-Aid, Listerine, Splenda, Neutrogena, Acuvue, Audafed, Rolaids, just to name a few), and exceptional free cash flow generation. Furthermore, JNJ’s patent exposure was more prominent in the last two years than it will be in coming years.

2010 will bring clinical trial data from two of JNJ’s Phase III drugs. In the hepatitis C market, JNJ and Vertex (VRTX) are expected to report strong pivotal Phase III data on protease inhibitor telaprevir. The firm’s cardiovascular drug Xarelto is also expected to post solid data, demonstrating its ability to prevent strokes in patients with atrial fibrillation.


Pfizer (PFE)
PFE completed its acquisition of Wyeth last quarter, dramatically altering the trajectory of PFE’s patent cliff, while expanding PFE’s geographic reach (particularly in emerging markets) and other strategic (e.g. biosimilar) possibilities. Revenue will still be substantially lower in 2015 than it is in 2010, but PFE plans to use large amounts of cost-cutting to EPS basically flat across this period. If EPS is, in fact, roughly flat through 2015, then the PFE looks inexpensive compared to its peers (32% discount) and the broader market (55% discount).

PFE trades at a nearly 60% discount to its 10-year average, which is reflective of the fact that PFE is no longer the growth story it was in the past. Still, the company generates significant amounts of free cash flow and will continue to do so. PFE’s long trend of paying a growing dividend will also continue as well as their robust cash flows quickly work down debt during the next few years.

Whether or not PFE returns to their growth-glory-days will depend on their management of a massive pipeline that is heavily-weighted towards early-phase drugs. In the arthritis market, we will likely see data this year from JAK inhibitor, currently in a Phase III program – the drug has already established strong efficacy so safety will be the focus. Based on Phase II data, analysts expect the drug to make a significant dent in the rheumatoid arthritis market. Investors should also watch for data on dimebon, PFE’s Alzheimer’s treatment.

My longer-term concern with PFE is their tendency to use big acquisitions as a platform for growth. The company’s reliance on big takeovers rather than strong in-house research and smart licensing has destroyed an enormous amount of shareholder wealth.

Nevertheless, PFE is a great way to get exposure to the undervalued pharmaceutical sector and seemingly provides more sustainable dividend income than the next company of topic.


Eli Lilly (LLY)
LLY is set for decent EPS growth through 2011, but then will begin to fall sharply for what could be a multi-year period due to the loss of several major, high-margin products to generic competition. There are some regulatory and commercial concerns about several pipeline drugs in the latest stages of development, but the pipeline may still be incapable of replacing revenue from drugs losing patent protection.

While LLY looks inexpensive on a P/E basis when using 2009 or 2010 estimates, it looks expensive when evaluating the longer-term earnings trend that is substantially lower. The patent cliff loss is similar in magnitude to Pfizer’s before their Wyeth acquisition.

Thus, LLY may be forced to do a sizeable acquisition. The immediate question then becomes whether such an acquisition would lead LLY to cut the dividend, to which management persistently denies would happen. LLY management did provide a worst-case-scenario for long-term earnings in December, but the outlook remains cloudy.

So LLY is the wild card here, but contrarians may piece together an intermediate-term investment case. The company is the cheapest among its peers, sports the highest dividend yield, and has the most negative analyst sentiment, yet there is no easily identifiable sources of downside risk in the near-term.
--

Peter J. Lazaroff, Investment Analyst