Big Pharma Battled the Pandemic. The Stocks Are Cheap. – Barron’s

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Illustration by Carl Wiens

Saving the world from Covid-19 doesn’t seem to count for much on Wall Street.

The global drug industry mobilized quickly to tackle the pandemic, and the results have been remarkable, with the rapid development of effective vaccines by companies like Pfizer (ticker: PFE) and Johnson & Johnson (JNJ).

Investors haven’t been in a celebratory mood, however. Most major U.S. drug stocks have badly trailed the overall market in the past year—the VanEck Vectors Pharmaceutical exchange-traded fund (PPH) is up 21%, compared with a 43% rise in the S&P 500 index.

Instead, investors have gravitated toward companies that stand to more directly benefit from a return to normal life and a reopening of the economy in the U.S. in the months to come.

As a result, drug stocks now look like one of the best pockets of value in a richly priced stock market. Major pharmaceutical companies trade for an average of 13 times projected 2021 earnings, against a price/earnings ratio of 22 for the S&P 500.

The drug P/E ratio is one of the lowest among any major industry group. Indeed, the stocks haven’t been so inexpensive relative to the S&P 500 in at least 20 years, according to J.P. Morgan analyst Chris Schott. Most yield 3% or more—double the 1.5% yield on the S&P 500—with Pfizer at 4.4% and AbbVie (ABBV) at 4.8%.

“It’s hard to believe the drug stocks are so cheap,” says Jon Boyar of the Boyar Value Group “The companies have built up so much goodwill.”

Bill Smead, manager of the Smead Value fund, which holds Merck (MRK), Amgen (AMGN), and Pfizer, argues that the group amounts to a “closet reopening play.” Many Americans put off going to the doctor in 2020 and didn’t get prescriptions for chronic conditions like osteoporosis, which hurt revenue. Merck has estimated that Covid-19 depressed sales by about 5% last year.

So, growth is coming. Schott says that the major drugmakers could average mid-single digit annual revenue growth and low-double digit earnings growth through 2025. That should stack up well versus most industries.

“There’s no reason to avoid the group,” he says. “We’re seeing drug pipelines strengthening, and core operations generally are exceeding expectations.”

One investor who is keen on drugmakers is Berkshire Hathaway CEO Warren Buffett. In the second half of last year, Berkshire (BRK.A, BRK.B) bought stakes of about $2 billion each in three drug stocks: AbbVie, Bristol Myers Squibb (BMY), and Merck.

Time to Take Drugs

Here’s how the big U.S. pharmaceutical companies and some industry-focused funds stack up.

E=Estimate. *Annualized

Sources: Bloomberg; Mizuho Securities; J.P. Morgan

The investment highlights Buffett’s value investing philosophy. The three stocks have some of the lowest P/E multiples in the pharmaceutical group. Investors can now buy Merck for below Buffett’s cost and Bristol Myers for about what he paid.

The drugmakers, Smead says, “are wonderful businesses,” echoing a Buffett phrase. “These companies have fantastic balances sheets, massive free cash flow, sustainable profit margins, and high returns on equity without using leverage,” he says. They’re socially responsible and have great governance.”

However, as with the language about potential side effects that accompany every drug commercial, there are a number of investing risks to be noted.

Most drugmakers are facing patent expirations on their top-selling drugs this decade. J.P. Morgan’s Schott, however, says the patent issue looks manageable, given a promising industry drug pipeline that is focused on oncology, immunology, diabetes, and Alzheimer’s disease.

“This is a totally different situation from the last time the sector was at a similar relative valuation,” in 2011 and 2012, Schott says. “Then, you had a more severe patent cliff and no pipeline to speak of.”

Another investor fear is the potential for drug-price controls now that the Democrats are in charge in Washington. Schott, again, is sanguine, saying that major healthcare reform will be “very difficult to enact in the near term,” thanks to razor-thin Senate control, differing policy views among Democrats, and more-pressing issues like the economy.

How to invest? Investors who want a basket approach can buy the VanEck Vectors Pharmaceutical ETF, which holds 25 global drug stocks including Eli Lilly (LLY) and Johnson & Johnson. The much larger Health Care Select SPDR (XLV) owns a broad spectrum of healthcare stocks in the S&P 500, with a weighting of about 45% in drug and biotechnology stocks.

A case can be made for all of the big drugmakers, from industry star Eli Lilly, which has the best projected earnings growth among its peers, to deep-value AbbVie and Bristol Myers. Both of those trade for under 10 times projected 2021 earnings, among the lowest P/E ratios for any large company in the S&P 500.

Then there is Pfizer. Its shares, now around $35, are little changed since November, when it reported positive results for its Covid-19 vaccine, developed with BioNTech (BNTX). Pfizer’s stock trades for little more than 10 times estimated 2021 earnings and yields 4.4%. Investors think that revenue from the Covid-19 vaccine will drop sharply after widespread global vaccinations in 2021 and 2022.

Yet the Covid-19 vaccine could prove more durable for Pfizer, with the potential for booster shots against new variants that could be priced for more than the $19.50 Covid-19 shot.

Pfizer does face more patent expirations this decade than its peers, including its breast cancer drug Ibrance. But its pipeline of drugs, like one for atopic dermatitis, is underappreciated, says Louise Chen, analyst at Cantor Fitzgerald. “The innovation at Pfizer is not being rewarded,” says Chen, who has an Overweight rating and a $53 price target on the stock.

Lilly is favored by ClearBridge Investments senior research analyst Marshall Gordon. He thinks the company is capable of high-single digit earnings growth and low-double digit earnings growth over the next five years, even without a contribution from its Alzheimer’s drug under development, Donanemab, which is a potential blockbuster.

That drug showed promise in an early-stage clinical trial in clearing plaque and improving cognitive function. More details are expected on Saturday morning. If successful, Donanemab could have potential sales of $10 billion a year, given that there is no currently effective drugs for Alzheimer’s disease.

Another of Lilly’s pipeline winners could be Tirzepatide, which looks like the best-in-class treatment for Type 2 diabetes and could hit $10 billion in annual sales following a potential launch in 2022 or 2023. Lilly’s stock, recently at $205, trades for 25 times projected 2021 earnings.

J.P. Morgan’s Schott says he is increasingly comfortable that AbbVie can get past the 2023 U.S. patent expiration of immunology blockbuster Humira, which accounted for over 40% of the company’s sales in 2020, without a big hit to earnings. His 2024 estimate of $13 is about equal to this year’s projection. He sees earnings growth of more than 10% annually from that 2024 base to 2030.

He points to AbbVie’s new immunology drugs, Skyrizi and Rinvoq, that are getting substituted for Humira, as well as the benefits of the 2020 deal for Allergan that brought the Botox franchise. AbbVie, at a recent $108, trades for only nine times projected 2021 earnings. Schott has an Overweight rating and a price target of $135 on the stock.

Like AbbVie, Bristol Myers faces major patent expirations in the coming years on two of its top drugs, Revlimid for cancer and Eliquis for strokes. Schott says investors aren’t giving Bristol Myers sufficient credit for an improving drug pipeline, including an oral psoriasis drug that has similar efficacy to injectable treatments. The company sees low- to mid-single digit revenue growth in the next five years.

The stock, at a recent $61, trades for eight times projected 2021 earnings and yields 3.2%. Schott has price target of $80 and an Overweight rating on the stock.

Merck has been the group’s worst performer in the past year. At $74, it trades for just 11 times estimated 2021 earnings and yields 3.5%. Investors worry about the 2028 patent expiration for oncology blockbuster Keytruda, which made up about 30% of Merck’s sales last year.

Bulls like Morgan Stanley analyst David Risinger argue that Merck has a good pipeline, including islatrivir for HIV, and a durable vaccine franchise led by Gardasil for cervical cancer that could be worth $100 billion. Risinger has an Overweight rating and a $90 price target on the stock.

Shares of Amgen, at $230, trade for 14 times projected 2021 earnings and yield over 3%. Risinger is positive on the stock, citing pipeline drugs for lung cancer and asthma as well a growing portfolio of biosimilars, which are the generic equivalent of bioengineered drugs like Humira.

Amgen also generates huge free cash flow—nearly $10 billion in 2020—resulting in a 7%-plus free-cash-flow yield on the stock. Amgen could buy back 3% of its stock this year. Risinger has an Overweight rating and a price target of $277 on the stock.

Johnson & Johnson is the bluest chip in healthcare. It has the largest market value (at over $400 billion), a rare triple-A credit rating, and a diversified revenue base of pharmaceuticals, medical devices, and consumer products.

Its shares, at about $160, aren’t expensive, trading for under 17 times projected 2021 earnings and carrying a secure 2.5% dividend yield. Cantor Fitzgerald’s Chen says the company’s quick delivery of a Covid-19 vaccine demonstrates J&J’s drug development expertise.

J&J, she says, has a “first-in-class” pipeline that isn’t well recognized and is focused on areas of unmet needs in immunology, oncology, and rare diseases. Chen has an Overweight rating and a price target of $200 on the stock.

The U.S. drug industry is in great shape, with an impressive pipeline of drugs and ample free cash flow. And their stocks have rarely been this cheap.

“People want to own all these disrupter stocks in technology, but not companies that are disrupting cancer,” Smead says. That could change in 2021, to the benefit of investors.

Write to Andrew Bary at andrew.bary@barrons.com

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