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Generics will lead the ailing drug sector
Generic drug makers are expected to post strong earnings over the next couple of years, and their stocks trade at reasonable prices. With careful picking, theyre a better option than Big Pharma.
By Robert Walberg
If you own generic drug stocks, perhaps you can appreciate the cheap antidepressant prices. The group's average price decline this year is around 20%. The picture is even darker over the past 52 weeks, with the average decline a dismal 32%. And this comes from a sector accustomed to posting steady, if not spectacular, gains over the past several years.
But put aside the pills. For investors who want exposure to the drug sector, the generic group is the best place to turn, especially with big pharmaceutical companies having a tough time. Just look at what recently happened to Merck (MRK, news, msgs), which withdrew its blockbuster painkiller Vioxx because it can increase heart attack or stroke risk. Some expected Big Pharma competitor Pfizer (PFE, news, msgs) to benefit, but, as my colleague Jim Jubak has noted, it has its own problems.
Let's first look at why the generic group has seen a reversal of fortunes. One big reason was highlighted in Mondays "Heard on the Street" column in The Wall Street Journal -- the growing trend of "authorized generics." Here's how this new practice works.
Scoring a piece of the profits
Pharmaceutical companies get patents on their drugs, but those patents eventually expire. Generic drug makers then step in, most often quickly stealing business from the big drug makers. The first generic maker to market gets exclusive generic rights for six months, giving it a head start.
But with this new tactic, Big Pharma will take a drug about to lose its patent protection and allow another generic company or even a generic unit it owns to sell an authorized version of the drug. Either way, the big drug maker gets a piece of the profits. The "authorized" copy skirts the six-month rule and thus creates competition sooner than normal for the original generic, significantly reducing its profit potential.
Generics are also feeling the pressure from large wholesalers and retail drug chains to reduce their markups, again threatening margins and profit growth. In this case, however, the threat is relatively modest and not something that alone would trigger the type of price declines experienced over the past year.
But the intermediate- to long-term outlook for the generic drug sector is better than these issues would indicate. The aging of the population and the rising cost of medical care favor these companies. In addition, the sector is consolidating, which will reduce competition and enhance margins for the remaining players. Finally, the recent surge in new therapies and drugs, not to mention the booming backlog, bodes well for generics down the road.
In fact, Wall Street expects the sector to enjoy average annual earnings growth over the next five years of about 14%; with a few companies such as Andrx (ADRX, news, msgs), Ivax (IVX, news, msgs) and Teva Pharmaceutical (TEVA, news, msgs) projected to deliver annual growth of better than 20%. Now thats the kind of trouble I can live with.
Promising growth at reasonable prices
Valuations are reasonable, too. With the group under so much pressure recently, most of the stocks trade at discounts to the market, as well as to their long-term growth rates. This is a rarity for an industry projected to deliver profit growth of over 20% in each of the next two years.
Of course, if margins get squeezed more than expected, analysts might find themselves trimming future estimates. There have been, however, few earnings warnings or disappointments from the group to suggest a widespread trend. Over the past three quarters, only Mylan Laboratories (MYL, news, msgs) and Ivax have missed expectations, and even those were relatively minor misses.
Given the groups lousy stock performance this year, theres no big rush to swoop in and buy these stocks, especially not during the tax selling season. But as investors start to scout around for next years turnaround candidates, dont be surprised to see the generic industry make a nice run as the underlying growth story remains intact.
If you dont already own generic-drug shares and want to start nibbling in anticipation of a reversal, there are a few names that stand out from the crowd.
A powerful combination
First is Teva Pharmaceutical. With a market capitalization of more than $15 billion, this Israeli company is by far the biggest of the generics. Its relatively diverse portfolio of drugs, combined with its history of strong sales and earnings growth, makes it among the most conservative choices in the group. At 18 times 2004 projected earnings and 16 times projected 2005 earnings, the stock also is reasonably priced. Competitive profit margins and a modest dividend yield of 0.79% are added bonuses.
On a technical basis, Teva has had trouble getting above its 50-day moving average, $27.19, in recent months. Look for either a break above this ceiling or a retreat to major support in the $22-to-$20 area as long-term buying triggers, with a long-term price target of $33. (Support levels indicate where a stock has bottomed in the past.)
Ivax also is appealing on many fronts. Its operating margin and return on equity (ROE) of 13% and 15%, respectively, are among the best in the industry. Projected earnings growth over the next couple of years of around 100% and 23% is also the envy of the sector. Even so, the stock sports a forward price-to-earnings to long-term growth rate of 0.83. Traditionally this number, one measure of the stock's value, for the group is more than one.
Though the stock has taken a big hit over the past few weeks, it has held up relatively well over the past year, falling by only 14%. Typically, the stocks that hold up best during a broad sector retreat tend to play a leading role in any subsequent recovery. Ivax has strong support in the $17-to-$16 range, with a long-term price target of $26.
A cash hoard
Finally, lets take a look at Barr Laboratories (BRL, news, msgs). Though earnings growth in fiscal 2005 is projected to be a relatively pedestrian 10%, analysts are looking for an acceleration to a more respectable 17% in 2006. Long-term, growth is expected to average about 18%, which might be a bit optimistic but probably not too far off the mark. If so, the stock is a relative bargain at about 16 times and 13 times fiscal 2005 and 2006 estimates, respectively.
Valuations become even more attractive when you consider that Barr is sitting on nearly $4 per share in cash. The company also is generating free cash flow in excess of $200 million per year. Operating margins of 14.7% and a return on equity of 12.7% are also well above the industry average.
Though the stock is down 34% over the past year, it has bounced a bit in recent weeks suggesting that Barr is probing for a bottom. Near-term support can be found in the $36-to-$34 area. As long as the company delivers on growth expectations, look for the stock to move back above $50 a share.
For a closer look at generic drug stocks, check here.
You can look here to see how Big Pharmaceuticals have done.
At the time of publication, Robert Walberg neither owned nor controlled shares in any equities mentioned in this column.
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