Tuesday, October 30, 2012

Big Pharma, Big Yield: 4 Stock Picks

If you have been an investor in big pharmaceutical companies over the last several years, you're probably wondering when you will get a return on your investment. The Pharmaceutical Holdrs Trust (PPH) is down approximately 10% over the last five years. Though they are giant cash generators, shares of pharmaceutical companies have remained depressed due to pending patent expirations, anemic pipelines, and a very cautious FDA. It is hard to imagine that all of these worries are not priced into the shares now. If investors begin rotating into defensive sectors, the big pharmaceutical companies may once again have their day in the sun. Did I mention that you'll get paid handsomely to wait?

I picked four pharmaceutical companies whose shares could benefit when investors warm up to the sector again. To begin my search, I looked for stocks that yield greater than 3%. That search came back with eleven large cap names. I narrowed the search by eliminating companies that have not grown earnings over the last five years. The stock with the largest dividend yield, AstraZeneca (AZN), yields 7.7%. I eliminated it from the list because its payout ratio is over 100%. Coming up with eight names, I picked the stocks with the best combination of price/earnings, price/owner earnings, and growth prospects. Here are my four picks.

Lilly (LLY)

Lilly is re-establishing itself as a diabetes company. The company has several promising compounds in the pipeline for treatment of the worldwide epidemic. Lilly has suffered from pipeline setbacks and regulatory violations. However, the company has refocused and has a promising future. Lilly could potentially be acquired or make acquisitions itself.

The company has a market cap of $39.5 billion. Shares trade at a forward P/E of 8 and yield 5.75%. Lilly has grown revenue at an annualized rate of nearly 10% over the last five years. They have grown earnings at an annual rate of 20% over the same period of time. With shares trading at a price/owner earnings ratio of 8.25, shares look very attractive.

Bristol-Myers Squibb (BMY)

Bristol-Myers Squibb is focusing its research efforts on difficult to treat diseases such as cancer and diabetes. The pipeline looks promising with drugs for deep vein thrombosis, cancer, kidney transplant rejection, and diabetes. Shares are up only 4% in the last twelve months, as investors continue to worry about big patent expirations.

Shares of Bristol-Myers yield just over 5%. With a market cap of $43 billion, BMY could become a take-over target once new compounds are approved. Bristol-Myers trades at a forward P/E ratio of 11.7. The company has grown earnings at a 4% annualized rate over the past five years. Shares look like a value with a price/owner earnings ratio of 10.4.

Abbott Laboratories (ABT)

Abbott Laboratories is a leading healthcare company with four main product segments; pharmaceuticals, medical devices, diagnostics, and nutritional products. The company recently won an appeal overturning a $1.67 billion patent-infringement judgment against it. The suit was brought by Johnson & Johnson (JNJ) over Abbott's arthritis drug, Humira. Humira generated $5.5 billion in sales in 2009. Abbott doesn't have the patent expiration cliff that other large pharmaceutical companies have. Yet, the share price has stayed depressed along with the sector. Over the last twelve months, shares are down 12%.

Abbott has a market cap of $73.7 billion. Shares trade at a forward P/E of 10.3 and yield 4%. Abbott has raised its dividend for 37 consecutive years. The company has grown revenue at an annualized rate of 9.5% and earnings at an annualized 6.6% over the last five years. Abbott's price/owner earnings ratio is a reasonable 14.35. As one of the best run pharmaceutical companies, Abbott's shares are undervalued.

Johnson & Johnson (JNJ)

Johnson & Johnson has spent a lot of time in the news recently, and not for positive developments. The company has had a string of recalls affecting a whole line-up of products, including children's. While no person has actually been harmed by the manufacturing flaws, the company's reputation has. Consumers and investors alike have been displeased with the handling of the recalls. Despite being plagued with the problems, the company has continued to produce strong earnings. However, sales were down 5.1% in Q4 2010, due in part to the recalls. Sales should improve now that the company seems to have put the worst of the problems behind it and manufacturing has been shifted to unaffected facilities.

Now may be the time to pick up shares of the company at a nice discount. Johnson & Johnson's shares trade at a forward P/E ratio of 12.3 and have not participated in this year's stock market rally. Year to date, JNJ is down almost 5%. The stock yields 3.62%. Johnson & Johnson has increased its dividend for 48 consecutive years. The company has grown revenue at an annualized rate of 4% over the last five years. It has grown earnings at an annualized rate of more than 7% over the same period of time. JNJ trades at a price/owner earnings ratio of 11.72. Johnson & Johnson is still a premier company. It will once again find its way, even if that eventually requires a management change. Until then, you can pick up shares at a depressed level and let the dividend pay you.

Below is a side by side comparison of the valuation metrics for the four companies.

Market Cap $39.5 B $43.6 B $73.7 B $163.8 B
Recent Price $34.09 $25.49 $47.64 $59.64
Forward PE 8.01 11.72 10.36 12.28
Dividend Yield 5.75% 5.18% 4.03% 3.62%
5 Year Div. Growth Rate 4.90% 2.90% 9.90% 10.60%
Payout Ratio 43.00% 54.00% 58.00% 44.00%
Price/Book 5.13 4.81 3.26 8.47
Price/Cash Flow 5.89 8.5 10.22 10
Price/Earnings Growth N/A 31.64 1.73 2.23
Price/Owner Earnings 8.25 10.4 14.35 11.72
Return on Equity 68.98% 33.77% N/A 67.90%
Debt/Equity 0.88 0.59 N/A 0.48
Revenue TTM $23.10 $19.5 B $35.2 B $61.5 B
Operating Cash Flow FYE $6.86 B $4.49 B $8.74 B $16.39 B
Capex FYE $694 M $424 M $1.02 B $2.38 B
Capex/Cash Flow FYE 0.1 0.09 0.12 0.15
5 Year Rev. Growth Rate 9.50% 0.90% 9.50% 4.00%
5 Year Cash Flow Growth Rate 19.10% 3.80% 8.90% 6.20%
5 Year Earnings Growth Rate 20.10% 4.40% 6.60% 7.30%
Net Profit Margin 21.97% 15.92% 13.15% 21.65%
Current Assets $14.84 B $13.27 B $22.32 B $42.72
Return on Assets 16.35% 9.98% 7.78% 34.65%
Long-term Debt $6.77 B $5.33 B $12.56 B $9.18 B

Pfizer (PFE) is one additional stock I like in the sector. It did not make this list because it has failed to grow earnings over the last five years. In fact, they are flat. Pfizer trades at a forward P/E ratio of 8.4 and yields 4.24%. Pfizer has a price/owner earnings ratio of 9.82.

The fact is that few sectors are as cheap as pharmaceuticals. The problem is they have been cheap for a long time. Investors have left the industry for dead. I argue that it will come back. This is really about as undervalued as these companies have ever been. Despite the patent expiration troubles, I expect there is very little downside risk left in these stocks. I do not know how long these stocks will remain depressed. However, one day investors will come back to this sector. In the meantime, these four solid companies pay big dividends.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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