4 big drug stocks; 4 ways to scope them out
Will pricey stocks like Eli Lilly, Warner-Lambert,
Merck and Pfizer keep beating the
expectations? Here's how I figure out whether
these companies have any "pleasant surprises"
that could tempt me to buy them.
By Jim Jubak
Roughly speaking, there are two schools of
thought on when to buy a stock. Momentum
investors buy when a stock is climbing on good
news, believing that many positive trends have
relatively long lives. Contrarian investors buy
when a stock is in the doghouse, believing that
investors always overreact to bad news and
send a stock's price too low.
Right now, big drug stocks like Merck (MRK)
and Pfizer (PFE) are pretty good examples of
momentum buys. On Jan. 21, I read a research
report on Pfizer from Prudential Securities that
called the stock a "hold" -- the Wall Street
equivalent of a "sell."
"At its present price of roughly $116, Pfizer sells
at 46.8 times our 1999 earnings estimates,
which anticipates all the good things that we
could conceivably imagine.” That was $26 a
share ago. On March 16, Pfizer closed at $142.
And you can't get much more contrarian than
oil-drilling and service stocks. Even after a
recent rally in the sector, Halliburton (HAL) is
down 39% from its 52-week high, Diamond
Offshore (DO) is down 52%, and Global Marine
(GLM) has slid 62%. And those are among the
healthiest companies in the sector. R&B Falcon
(FLC), a company that got Standard & Poor's
credit watch rating on Feb. 25, is down 80%
from its high.
Both sides of exceeding expectations
As different as momentum and contrarian buying
seem, however, they're actually both based on a
common foundation -- a company's ability to
exceed investor expectations. Momentum
investors believe that a company with the wind
at its back can manage to exceed even current
lofty predictions for earnings and growth, and
therefore send its stock climbing higher.
Contrarian investors are betting that a company
that everyone hates and that no one expects to
do much of anything can leap that rather modest
hurdle and send its stock scrambling off the
floor.
But while both schools of buying are built around
expectations, I believe the most important
questions for momentum and contrarian
investors to answer before deciding to buy are
very different. For the momentum investor, the
crucial question is "How?" How will this stock
manage to keep beating constantly rising
expectations? For the contrarian, the "How?" is
often pretty obvious. For this investor, the
burning question is “When?" When is the
turnaround going to happen?
In my next column, I'm going to look at the
"When?" for oil-drilling and service stocks.
Answering that question, I think, suggests a
strategy for building a position in the sector that
will maximize return and minimize the time a
contrarian investor has to wait for a reward.
In this column I'm going to look at the "How?" for
big drug stocks. My conclusion is that these
stocks aren't compelling buys right now. The
case for Pfizer, Merck, Eli Lilly (LLY) and
Warner-Lambert (WLA), the four stocks I'm
going to focus on in this piece, isn't convincing
enough to make me want to buy at current
prices -- as much as I'd like to own them, and
especially Pfizer, in the long run. (Pfizer is one
of my 50 Best Stocks in the World.) Here are
four steps toward answering the "How?"
question for these stocks.
First, get a general picture of current
projections for earnings and sales. At this
stage I'm not trying to do any original thinking.
Instead, all I want to do is get my arms around
the consensus wisdom about a company's
future. That consensus is, after all, what mostly
determines the current stock price.
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There's nothing here
that convinces me
that this company
can significantly
exceed
expectations.
Let's start with Eli Lilly. You'll find analyst
consensus projections for the company in
MoneyCentral's stock research area under
Analyst Info, Estimates, Earnings Estimates.
Right now, the consensus of the 30 analysts
who follow the stock (actually the mean of all
their projections) is that Lilly will earn $2.30 a
share in 1999. That would be an 18.6% increase
in earnings per share over 1998. On those
numbers, the stock looks pretty pricey
compared to the company's historic
price-to-earnings ratios -- on March 17, it traded
at about 50 times 1998 earnings per share and
about 39 times projected 1999 earnings. But in
this analysis I'm not too worried about that. The
price of the stock could well go up from here
despite that history, if Lilly can deliver results
that exceed current expectations.
The second step is to understand where the
company's recent growth has come from. An
investor can find these details in the most recent
quarterly and annual reports. In Lilly's case, in
the fourth quarter ended in December 1998,
much of the sales and earnings growth came
from four big products, Zyprexa, Prozac,
Gemzar and Evista. The first three showed 1998
sales increases of 98%, 10% and 86%
respectively over 1997. Evista, a new drug,
brought in $144 million in 1998 sales. High
selling prices and price increases for those
products (and the sale of the lower margin PCS
Health Systems business to Rite Aid) also
helped Lilly increase gross margins during 1998
to 77.9% in the fourth quarter, up from 75.1% a
year ago.
The third step is to see how the earnings
growth already assumed by consensus
projections is likely to be achieved. This is
tricky since companies generally don't issue
earnings projections by product category. But
usually you can make some educated guesses
based on past trends. For example, at Lilly the
four products cited above accounted for about
55% of sales in 1998, but almost all of the
growth in sales. By contrast, sales of the
antibiotic Ceclor were still almost $400 million in
1998, but that was a drop from $442 million in
1997. As a rough assumption, therefore, an
investor could assume that the bulk of sales
growth in 1999 would have to come from those
four products plus whatever new drugs are in the
pipeline.
The past also allows you to project sales trends
for 1999. Prozac's history demonstrates that a
hit drug shows big percentage increases in
sales as it grows from a tiny base and then
slows. If Prozac can match last year's 10%
growth, it would be a great showing, but 8% or
9% is more likely. Zyprexa should put up big
numbers next year, but the percentage increase
is likely to be down from last year's 98% gain
since sales of the drug in 1998 came to $1.4
billion. A 33% jump to almost $2 billion would be
impressive. Based on 1998 sales, Gemzar and
Evista look like solid products, but seem
unlikely to be in the same class as Zyprexa or
Prozac. Growth in the 50% to 60% range for the
two seems reasonable. Given the minor
slowdown in growth by the company's biggest
product -- Prozac accounted for about 33% of
1998 sales -- these trends point to overall sales
growth of about 13% in 1999, down from the
15% increase achieved in 1998.
How then do analysts get to the consensus
$2.30 a share, an 18.7% increase in earnings?
Well, Lilly's share buyback program helps. The
company bought $2 billion worth of its own stock
-- about 28 million shares -- in 1998, and plans
another $1 billion in purchases in 1999. Add in
some continued expansion of gross margin as
the company's big increases in selling, general
and administrative expenses moderate and you'll
get something like the earnings increase
projected by the consensus.
The fourth step is to look for potential
upside surprises. What could produce
bigger-than-expected sales or earnings at Lilly?
There's an awful lot of future good news already
included in the stock's price. Sales for Prozac,
for example, assume that the company will win
in court and be able to extend its patents on the
drug until 2004. Sales projections for Evista
seem to assume that Lilly will get approval to
make breast cancer safety claims for the
product. And I don't see any new blockbuster in
Lilly's pipeline that will hit the market full force in
1999. Actose, a new drug for diabetes, should
get approval this year, but Lilly will have to split
profits from that drug with Takeda, its developer.
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I wouldn't buy
Warner-Lambert
here but the stock is
worth watching and
could get interesting
if it pulled back.
My conclusion after all this? I think the
consensus already includes all the good news I
can see. There's nothing here that convinces me
that this company can significantly exceed
expectations. And without being able to identify
potential upside surprises, this stock doesn't
have the potential momentum I'm looking for.
How do Warner-Lambert, Merck and Pfizer
measure up on momentum?
Warner-Lambert's key product is Lipitor, the
leading cholesterol-reducing drug in the world.
Lipitor continues to gain market share -- a
process that helped make Warner-Lambert the
fastest-growing major drug company in 1998.
But that story is in the stock, I think.
Management has predicted 30% earnings
growth in 1999 -- and that is now the Wall Street
consensus -- largely on continued growth in
Lipitor sales and attendant increases in gross
margin. Warner-Lambert now trades at 37 times
1999 projected earnings.
Any surprises on the horizon? Not in 1999,
although 2000 might be promising. Analysts are
worried that earnings growth will slow drastically
to 23% from 30% as Lipitor and Neurontin, the
company's second-biggest seller, face
competition from generics in 2000 and 2001. I
certainly wouldn't want to own the stock if that
prediction comes true, but if investors start to
discount Warner-Lambert's stock price on those
worries, that could set it up for a nice positive
surprise or two. In summary: I wouldn't buy
Warner-Lambert here but the stock is worth
watching and could get interesting if it pulled
back.
Merck looks cheap if you compare it to its
peers. The stock is trading at 34 times 1999
estimates, and more importantly from a
momentum perspective, I can see a couple of
potential positive surprises in 1999.
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Merck is the drug
stock most likely to
deliver upside
surprises over the
next year.
Merck should get its COX 2 inhibitor, Vioxx, to
market in June. On the basis of extremely
strong sales for Celebrex, the first drug in this
class, I think it's likely that Vioxx sales could hit
$500 million in 2000. In the short run -- that is,
1999 -- Vioxx is likely to actually hurt Merck
earnings as the company plunges into an
expensive marketing war with Monsanto (MTC)
and Pfizer. But if sales ramp more quickly than
expected, or if Merck gets a significantly
stronger label from the Food and Drug
Administration, that would lead to upward
revisions for earnings in 2000 -- exactly the kind
of surprise a momentum investor likes to see.
Merck has a couple of other potential rabbits in
its hat. The stock took a beating when the
company announced that it would not pursue
compound MK-869 for depression, even though
the drug was in Phase 3 trials. After that
disappointment, good news on a second
generation drug for the same application that is
now in Phase 2B trials would qualify as a
positive surprise.
And finally, Merck trades at a lower P/E ratio
than its big drug peers because many of the
company's key products are due to come off
patent in 2000 and 2001. But I think this
pessimism might be overlooking one of Merck's
key strengths. No drug company knows more
about navigating the complex drug approval
process. I think Merck has a good chance of
getting approval to expand the uses of some of
these drugs, as it recently did with its
cholesterol-lowering medicine Mevacor.
And I wouldn't be surprised to see Merck pursue
some of the same patent-saving tactics that Lilly
has used to protect its Prozac franchise.
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A great company,
but right now at this
price -- no thanks
In summary: Merck is expensive on the
fundamentals and faces clear long-term
challenges to growth, but it is the drug stock
most likely to deliver upside surprises over the
next year.
And finally Pfizer. Is there any possible
combination of upside surprises that will enable
this stock to beat the current lofty expectations?
I think the answer is no. I can see potential
surprises with no problem. Pfizer now has the
biggest and best sales force in the drug
business and companies that were once
competitors are now knocking on Pfizer's door to
ask for help in selling their next blockbuster
drug. But I think the price already reflects the
likelihood of a steady stream of new products.
At 57 times projected 1999 earnings, the good
news is in this stock as far as the eye can see.
In summary: a great company, but right now at
this price -- no thanks.
Pfizer sums up the challenge in buying
momentum stocks. Is the price currently so high
that it discounts all probable good news? When I
deal with oil-drilling and service stocks in my
column next Tuesday, I'll be writing about
companies where investors clearly don't have to
worry about that problem.
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