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Healthy, Wealthy, and Wide

With the stock market on a tear, finding undervalued stocks with large margins of safety is becoming increasingly difficult.

RJ Towner, 05/04/2011

This article first appeared in the April/May 2011 issue of Morningstar Advisor magazine. Get your free subscription today!

Health care, specifically large-cap pharmaceuticals, have lagged behind consumer goods and basic materials, however. Fears of weak pipelines and patent cliffs have prevented shares from participating in the rally, but Morningstar's analysts think that several great companies in the sector still look undervalued.

Sector = Health care

We begin the screen by focusing in on health-care companies. Firms in the health-care sector range from small speculative biotechnology stocks to long-established titans of business.

And Morningstar Rating > 3

Our goal is to focus on companies with large margins of safety, so our screen will focus on companies rated at least 4 stars, which implies a fairly significant discount to Morningstar analysts' fair value estimates.

And Economic Moat = Wide

The next step is to focus on companies that have sustainable competitive advantages, which can range from patents, to brands, to sheer size and scale. Wide moats are generally an assurance that the business is unlikely to fail anytime soon.

And Dividend Yld % Current > 3

In addition to finding discounted stocks, we can limit the screen to companies that will provide solid income while the uncertainty surrounding these companies clears up.

And Free Cash Flow Year 1 > 3%

Free cash flow is quite literally the amount of cash left over after everyone, including shareholders, is paid off. A company generating significant free cash flow can provide returns to shareholders via dividend increases, share buybacks, or strategic acquisitions.

On Feb. 24, this screen, performed in Morningstar Principia, left us with seven companies. Here are a few that are particularly compelling:

Abbott Laboratories ABT
On the foundation of a wide lineup of patent-protected drugs, a leading diagnostics business, a strong nutritional division, and a top-tier vascular group, Abbott Laboratories has dug a wide economic moat. We expect that these operating lines will continue to generate strong returns and drive growth. Further, the company's skills at partnerships and acquisitions probably will add to internal growth.

In addition to strong internal operating lines, Abbott has a successful record of acquisitions and partnerships. The favorable acquisitions of Knoll and Kos Pharmaceuticals brought in Humira and Niaspan along with pipeline products. The acquisition of Guidant's vascular business opened the door to a new operating segment and Xience, a drug-eluting stent superior to an in-house stent. Additionally, the recent acquisitions of Advanced Medical Optics and the drug units from Solvay and Piramal should add value over the long term. The strong record and ample cash flow raise our confidence that external growth opportunities will probably augment internal growth.

Eli Lilly and Company LLY
Eli Lilly's innovative culture and strong financial commitment to developing the next generation of drugs set the company apart from its peers and fuel its long-term growth. However, while the next several quarters should see strong demand for its currently marketed drugs, Lilly faces one of the steepest patent cliffs in the pharmaceutical industry between 2011 and 2013, with more than 40% of its current sales encountering generic competition.

Lilly's internal pipeline should also mitigate the patent losses over the next decade. The company tends to spend about 20% of its sales on financing the development efforts of new drugs; this is much higher than the midteens industry average. Further, the company will probably increase this percentage to 25% during the next few years. A result of Lilly's robust pipeline is a testament to its strong commitment to research.

GlaxoSmithKline GSK
As one of the world's largest pharmaceutical companies, GlaxoSmithKline has used its vast resources to create the next generation of medicines. The company's innovative new product lineup and expansive list of patent- protected drugs create a wide economic moat, in our opinion. Glaxo's diverse operating platform should more than offset patent expirations for respiratory drug Advair and antiviral drug Valtrex.

Glaxo's size ranks in the top tier of the pharmaceutical industry. This enormous bulk creates economies of scale in developing new drugs. In the highly uncertain race to drug development, the company's vast resources have created multiple opportunities for new blockbuster drugs. Glaxo's deep pockets have funded more than 10 major drugs in Phase III development. Further, the company has compiled more than 100 early-stage compounds in its pipeline. Recently approved cancer drug Tykerb and bleeding-disorder treatment Promacta should go on to develop into blockbusters.

We believe that the diverse platform of Glaxo's operations can withstand generic competition and declining Avandia sales. Additionally, the firm should generate close to GBP 7 billion annually in operating cash flow, which could be used for external growth opportunities.

Johnson & Johnson JNJ
Johnson & Johnson stands alone as a leader across the major health-care industries. The company maintains a diverse revenue base, a robust research pipeline, and exceptional cash-flow generation that together create a wide economic moat. Patent losses on antipsychotic Risperdal and neuroscience drug Topamax have weighed on recent performance, but we remain confident that the company's breadth can overcome these issues.

Diverse operating segments and expected new products insulate Johnson & Johnson from the patent cliff facing the pharmaceutical group. Also, in contrast with most of its peers, Johnson & Johnson faces relatively modest patent losses during the next few years. While the company still faces more than $2 billion (3% of sales) in patent exposure through 2012, we project strong growth from the remaining business lines to offset these losses and yield steady growth during the next five years.

Sanofi-Aventis SNY
Sanofi-Aventis' wide lineup of branded drugs and vaccines and a robust pipeline create strong cash flows and a wide economic moat. Growth of existing products and new product launches should help offset patent losses for cancer treatments Eloxatin and Taxotere as well as anti-clotting agent Plavix.

A history of acquisitions and robust cash flow from operations means that Sanofi could take advantage of further growth opportunities through external collaborations. We expect that Sanofi will continue to make acquisitions in the branded pharmaceutical and biotechnology market. However, we also believe the company will go further down its diversification path by adding more generic drug businesses, particularity in emerging countries. As the company generates more than EUR 8 billion in operating cash flow, it creates plenty of capital for acquisitions.

RJ Towner is a research analyst with Morningstar.

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