Are Some of the Big Pharmaceuticals Undervalued?
by Charles Rotblut, CFA
Senior Analyst/Contributing Editor
Groupthink Mar 14 2000 2:00PM
Over the past several months a shift in investment dollars toward the biotech industry has reduced the market capitalizations of several large pharmaceutical companies. The reason for the shift is not surprising considering the publicity associated with gene therapies and the potential that exists for exponential gains in biotech stocks. Although some of these biotech companies will certainly realize their potentials, the reality is that many will not, thus leaving some investors with significant capital losses.
A safer, though less direct, way to play the biotech boom is to consider the big pharmaceutical companies. The reason is simple: distribution and marketing. None of the biotech companies control market share or have the networks that the major pharmaceutical companies do, and, therefore, almost all of the biotech companies will need to strike agreements with at least one of their larger brethren to bring the next generation of prescription drugs to market.
The large pharmaceutical companies are less risky for four reasons: their product lines are more diversified, they have a history of earnings, many of them pay dividends, and several of them are relatively undervalued. The rest of the this article will focus on this last point.
During the past several years, these companies have commanded P/E multiples above that of the S&P 500. Recently, however, this has not been the case as several of the large pharmaceutical companies are trading at P/E multiples that are below the multiple of the S&P 500, and even below the multiples that they have individually commanded over the past few years. Given that the industry outlook remains positive and that these companies remain fundamentally strong, investors may want to start asking themselves whether the large pharmaceutical companies are undervalued at their current prices.
To initiate this kind of comparison, it is useful to know the multiples at which the S&P 500 Index has traded over the past several years. Using year-end data, the broad composite index commanded a P/E multiple of 17.41 in 1995, 20.77 in 1996, 24.53 in 1997, 32.15 in 1998 and 32.53 in December of 1999. As of the market close last Friday, the S&P 500 traded at a P/E multiple of 29.35.
Secondly, a few additional comments should be noted to make the comparisons fair. All individual stock data is presented based on Friday's closing prices as well as year-end valuations that coincide with valuation information on the S&P 500. We excluded Pfizer {PFE}, Warner-Lambert Co. {WLA}, American Home Products {AHP}, Abbott Labs {ABT} and ALZA Corp {AZA} because of merger activity. ABT and AZA called off a joint merger last December.
Bristol-Myers Squib {BMY} is down 18.4 percent for the year, falling hard earlier this month because of an unfavorable ruling in a patent dispute over Taxol, an ovarian cancer medication. The stock has also been under downward pressure because of differing opinions among analysts concerning the level of future profitability and the strength of the company's sales pipeline. Combined, these factors explain why the stock trades with a P/E of 26.09, which is the lowest this figure has been since 1997.
Eli Lilly & Co. {LLY} is down 8.0 percent for the year and has been in a downward trend since last November. The stock is currently trading at a P/E of 26.83, which is below both its five-year average of 34.2 and the current P/E of the S&P 500. The fact that the stock is trading at discount to the S&P 500 is notable because, historically, LLY has traded at a premium to the composite index. Investors should also note that pullback to $55 resulted in the stock seeing its lowest price levels since September 1997.
Dow component Johnson & Johnson {JNJ} is off 24.0 percent this year. The decline is part of a downward trend that started last December after an analyst with S.G. Cowen in early December reduced his earnings estimates for Q4 of 1999. The company did meet the fourth quarter earnings estimate and has met or exceeded the consensus estimate during each of the past four quarters. Despite this ability to perform as expected, the stock is trading at a P/E of 23.47, which is well below that of both the S&P 500 and JNJ's three-year average P/E of 29.87.
Another Dow component, Merck & Co. {MRK}, is down 11.3 percent for the year with most of the declines occurring after the Wall Street Journal ran an article about patent expirations for five of the company's drugs. Historically, the company has had a history of performing well and is viewed by many as the blue chip stock of the drug industry. MRK is currently trading at 24.31 times trailing twelve-month earnings. To say that this P/E is low would be an understatement in light of the company's historic multiples: 24.31 in 1995, 25.52 in 1996, 28.42 in 1997, 34.31 in 1998, and 27.42 in 1999. Investors should also note that the stock has commanded a higher valuation multiple than the S&P 500 for every year except for 1999.
Schering-Plough {SGP} is down 11.6 percent for the year despite being the recipient of several recent analyst upgrades. The stock appears to be beleaguered because of lackluster industry sentiment, versus its fundamental value - particularly since the company has stated that it is on track to reach year 2000 earnings estimates. SGP's current P/E of 26.36 represents a discount to both the stock's five-year average of 29.5 and to that of the S&P 500.
Given these historically low P/E multiples, investors may want to consider further researching these stocks. This is not to say that there is not additional downside risk. With the prospect of health insurance being a point of contention in the presidential election, the stocks could, conceivably, head lower, but given the multiples at which these companies have traditionally traded, many of these pharmaceutical companies may in fact be undervalued relative to their future growth prospects.
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