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By Jeremy Glaser | 02-28-2011 11:56 AM

Better Days Ahead for Pharma Firms

Valuations for pharmaceutical companies should rebound once investors look past today's patent expirations to tomorrow's new drugs, says Morningstar's Damien Conover.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I am here today with Damien Conover. He is the Associate Director of Healthcare. We are going to take a look at fourth quarter pharmaceutical earnings, and see if there is any opportunities for investors today.

Damien, thanks for joining me.

Damien Conover: Thanks for having me Jeremy.

Glaser: So let's start off with some of the highlights of the quarter. Who really had results that exceed your expectations that showed a lot of positive momentum?

Conover: So, in general I would say the quarter largely came in as we expected. There were a couple of companies that put out some pretty interesting guidance and are doing somethings that are pretty unique that I think are positive surprises.

The company that I would probably point to the most in regards to this is Pfizer, ticker symbol PFE. Now this is a company that reported fourth quarter, they were largely in line. But what was important about the call was their new CEO decided to make a lot of different guidance and a lot of different strategy moves going forward. Particularly he is cutting R&D by about 25% and using a lot of the cash that's being generated at the company to do share buybacks.

So we are going to see an enormous amount of share buyback at Pfizer, $9 billion is targeted for the next two years which should be a good way to return cash to investors. And by cutting R&D, I think that could actually bode well for the company. A lot of investors are concerned that, the life blood of a pharmaceutical company are new drugs. Now Pfizer hasn't had the best track record by internally developing new drugs, so I think by cutting back those expenses, freeing up some cash for external deals, potentially acquisitions or licensing should bode quite well for the company.

Glaser: Now on the flip side, where there any companies that maybe you weren't so happy with after reading their results?

Conover: Yeah, on the flip side, Johnson & Johnson, ticker symbol JNJ, is a company that we think is well positioned for growth going forward, however the fourth quarter results came in a little bit lighter than we were anticipating. Subsequently we lowered the fair value on Johnson & Johnson to 75 from 77, not a major move but just kind of a tactical shift down.

And the main thing here that was a little surprising was weakness on the device side. J&J is finally coming out of their patent cliff, and their drug business is doing quite well. However the device segment is showing some signs of weakness and we ended up lowering our projections on some of the devices going out for the next 10 years. And also the consumer product, which has been plagued by recalls, continues to struggle. The problems they are taking a little bit longer than we anticipated. Both those things were a little bit surprising on the downside.

Glaser: Zooming out now at a bit from the actual quarter, there has been a lot of questions surrounding the pharma industry for a while, from healthcare reform to patent walls, to all sorts of questions. Where do you see the industry going for the rest of the year and beyond?

Conover: It's a really important question. 2011 marks the beginning of the steepest part of the patent cliff for the pharmaceutical industry. So you are really looking at really the darkest days. And I think in these days investors will finally begin to look beyond the patent cliff, look a couple of years out, when pharmaceutical firms will start to reemerge and start to post some pretty good growth. So since the industry has such a very, very low valuation, I think in time over this next year, as investors look out a little bit further, valuations will improve and I think some of the stock performers should be pretty good.

Glaser: Abbott Labs has been one of your top picks for a while, is that still where you would put new money today or do you think that there are other opportunities that are emerging?

Conover: Well, we like the pharmaceutical industry as a whole. We have several good picks here, but Abbott Laboratories remains our top pick. We think the company is very well positioned. In contrast to a lot of its peers, it does not face a major patent cliff. It does have some products that are losing exclusivity over the next five years. But really it is largely immune to the patent cliff that's facing the rest of the industry. Nevertheless the stock trades at an industry average multiple and our discounted cash flow suggests a much higher fair value than where the stock is currently trading. So I think the company is very well positioned with currently marketed products. It has got a decent pipeline. But most importantly, it just doesn't have the patent cliff that the rest of the industry faces.

Glaser: Damien thanks so much for talking with me today.

Conover: Thanks Jeremy.

Glaser: For Morningstar, I am Jeremy Glaser.

 

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