Warning: Rebound may be over for Big Pharma

This sector has been back in vogue, but investors could miss out on further upside without careful stock selection.

By StreetAuthority Jun 11, 2013 9:32AM
Prescription medicine expenses © Don Farrall, Photodisc, Getty ImagesBy David Sterman

As investors were picking up the pieces after the dot-com implosion, they came across another troubled sector.

A series of looming patent expirations on key drugs meant that major pharmaceutical companies were on the cusp of a decade-long sales drought. Investors responded by dumping shares, as the AMEX Pharmaceutical Index ($DRG) plunged from 400 in late 2001 to just 250 a year later.

A decade later, Big Pharma's "patent cliff" was still a key concern, and this index remained far from its previous highs. Yet in recent quarters, Big Pharma has come back with a vengeance, as shares have moved back to the levels seen all those years ago.

Credit goes to several factors, most notably the absence of any new imminent blockbuster-drug patent expirations, and an industrywide focus on shareholder-friendly moves such as share buybacks and dividend hikes.



Ironically, the rising share prices have overwhelmed the impact of many of the dividend boosts. Rising prices of stocks such as Merck (MRK), Pfizer (PFE) and Bristol-Myers Squibb (BMY) have moved their dividend yields down from the 5% to 6% range to the 3% to 4% range.

To be sure, a rising tide has lifted all boats, as just about every major drug company has a stock chart like the one you see above. Yet as we move ahead, a pair of factors may benefit only a select group of companies. Simply put, many drug stocks have now seen their best gains already take root, and investors should focus on stock-picking instead of just owning the sector.

The asset unlock
Over the past few years, some of these companies have realized they are valuable on a sum-of-the-parts basis and have moved to unlock the value of the various parts. In the past five years, three major spin-offs have occurred.

"All three of these were ultimately well received by the market as it appears that the sum of the parts was greater than the whole in all cases," said analysts at Jefferies Group.

For example, AbbVie (ABBV) has risen nearly 25% since it began trading at the start of the year. Shares of Zoetis (ZTS) haven't risen as robustly, but the deal was so hotly anticipated that the offering price was boosted from $22 to $26 just before the IPO, enriching Pfizer's coffers in the process. Mead Johnson (MJN), for its part, has risen roughly 200% since its February 2009 debut, more than twice the gain of the S&P 500 in that time.

Thanks to those gains, look for more value-enhancing spin-off announcements in the next year or two. Analysts at Jefferies looked at the business structures of all of the leading drugmakers and focused on companies that have the most diversified revenue bases and are thus the likeliest candidates to pursue a spin-off. Looking at these companies on a sum-of-the-parts (SOTP) basis, the firm sees the biggest upside for:

Abbott (ABT), which still might spin out its nutrition, diagnostics and medical devices businesses, has 30% upside to its $48 SOTP assessment.

Germany's Bayer (BAYRY), with a fast-growing crop sciences division, has 35% upside to the $145 SOTP value.

Novartis (NVS) might look to spin off its vaccines or animal health businesses and could unload its one-third stake in Roche Holding (RHHBY). Such moves would yield 20% upside to Jefferies' $85 SOTP assessment.

Watch the pipelines
The other key trend for Big Pharma is a shift away from patent expirations toward potential new blockbuster drug launches. Analysts have been scrubbing the drug pipelines at the major players and found that a few companies are poised for robust new drug launches over the next few years.

One of the big developments in drug research is the use of antibodies to boost the immune system against cancerous tumors. Several companies are testing drugs in clinical trials, and Bristol-Myers Squibb may be in a position to take a leading role by combining a pair of drugs, Nivolumab and Yervoy.

At the recent American Society of Clinical Oncology annual meeting, this drug combination "stole the show," according to Morgan Stanley's analysts, citing a high degree of rapid efficacy for the drug combo. The niche could represent a $2.5 billion annual revenue opportunity for Bristol-Myers by 2020, according to these analysts. Goldman Sachs concurs with the bullish view of Bristol-Myers citing "the best pipeline story of the group."

Analysts at Citigroup are partial to Novartis (NVS), thanks to a new drug platform called CART-19, which has the promise of treating a wide variety of cancers and might one day make up what Citi calls a "mega-blockbuster pipeline." Those analysts think CART-19 could be useful in fighting "refractory solid tumors (including ovarian and pancreas) as well as earlier-stage disease and non-oncologic indications, such as viral infections and autoimmune disease. These indications represent significant potential upside risk to our estimates."

Merrill Lynch analysts highlight Eli Lilly (LLY) as a top pick, noting that "Several promising late-stage pipeline assets are underappreciated, in our view, and could be transformative to Eli Lilly's growth trajectory." They see shares rising from a recent $52 to $65.

Risks to consider: Big Pharma stocks have risen handily over the past 12 months, but the companies that lack pipeline or merger and acquisition catalysts may be ripe for profit-taking, especially as they no longer offer highly enticing yields and are poised for anemic growth in the years ahead. 

Action to take: While investors scored with virtually all drug stocks in the past 12 months, only stocks with catalysts have a path to further upside. Novartis and Bristol-Myers Squibb appear to be best-positioned for further gains at this juncture.

David Sterman does not personally hold positions in any securities mentioned in this article. 

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