Searching for Values in the Drug Stock Universe

December 6, 2006 by Douglas A. McIntyre

By Chad Brand of Peridot Capitalist

Not too long ago I wrote about pharmaceutical giant Pfizer (PFE) and how it trades at a seemingly steep discount to its peer group, and boasts a 3.9% dividend yield to boot. With the broad equity market having rallied sharply since August, investors looking to get a little more defensive can often find solid bets in the healthcare space. I decided to look at 12 of the larger drug companies to see if any other values are out there other than Pfizer. It appears there are.

I have actually been underweight healthcare stocks for some time. This had little to do with a lack of confidence in the macroeconomic outlook for the sector, and everything to do with the fact that I just couldn’t really find too many bargains. While many of the drug stocks still appear to be fully valued, sideways trading in several stocks in biotechnology has resulted in extreme price-earnings multiple compression.

Followers of the sector know very well that biotech stocks have traditionally traded at premiums to their big pharma counterparts, mainly due to the fact that they tend to be smaller, and therefore one big product breakthrough can have a dramatic effect on the company, and fuel substantially higher earnings growth. It appears in today’s market, however, that the two subsets of healthcare have converged as far as valuations go. As a result, I think there are opportunities for investors to capitalize.

Below you will see summaries of a dozen drug companies, sorted in ascending order of forward P/E ratio. Also included are current dividend yields and projected growth rates in 2007 for both sales and earnings. Grouping the names in this manner makes it a lot easier to spot the relative values.

In group “A” you will find the aforementioned Pfizer, which trades at a discount to its peers. Sanofi (SNY) is close, but yields about 50% less. Glaxo (GSK) rounds out the trio of below-market multiple stocks, but Pfizer still looks the best to me based on valuation and their dividend. Also, you may have read that the new CEO there recently decided to cut 20% of their salesforce. Further cost cutting is likely, and expect dividend increases to be consistent over time.

The second group of stocks (“B”) are those that trade around a market multiple. In this group, I highly favor Amgen (AMGN). I know they lack the 3-plus percent dividend of Eli Lilly (LLY) and Merck (MRK) but the double digit growth rates are very impressive, and AMGN has rarely traded at a sub-16 P/E.

Groups “C” and “D” are mostly biotechnology companies, but somehow both Bristol Myers (BMY) and Schering Plough (SGP) are trading at a premium to Genzyme (GENZ) and Biogen (BIIB) despite far less growth potential. Again, the fat dividend yields are a factor here, but I still believe there should be a valuation gap between biotechs growing at double digit rates and big pharma muddling around in the single digits.

Full Disclosure: Peridot owns shares of Pfizer and Amgen