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Value hunting in drugs
Pfizer's trouble with Celebrex has stunned conservative investors--but bargain hunters are tempted.

Monday, December 20, 2004
By Michael Sivy, CNN/Money contributing columnist



NEW YORK (CNN/MONEY) - In retrospect, it seems inevitable that Merck's problems with Vioxx would eventually raise serious questions about Pfizer's Celebrex, another painkiller of the COX-2 inhibitor type.

After a clinical trial found that Celebrex appears to increase the risk of heart trouble among those who take large doses over long periods of time, Pfizer announced that it would stop advertising the drug to consumers. Pfizer will still allow doctors to prescribe Celebrex for certain patients.

These problems raises a number of serious questions about drug stocks. For starters, why is the industry running into so much trouble nowadays? Just a few years ago, pharmaceuticals were considered one of America's top growth areas, yet now the sector's compound earnings growth is projected at less than 10 percent annually over the next five years.

The main problem is that the industry is dependent on a relatively small number of billion-dollar drugs. Blockbusters produce big profits, but they also require huge investments in research. In addition, companies that rely on such high-cost products face enormous liabilities if something goes wrong.

The pharma giants have immense financial resources and are likely to recover after such setbacks. But it may take months or even years before the extent of the damage becomes clear enough to permit a rebound.


Searching for value


A few value investors and special situations analysts have begun to recommend Merck as a long-term value. But nearly three months have passed since the company pulled Vioxx from the market after a test showed that the drug caused an increase in cardiovascular risk among patients who took it for more than 18 months.

In the meantime, Merck has developed and vigorously publicized its post-Vioxx growth plan. The company has new products up for approval, it has outlined its legal defense against Vioxx class-action suits and it plans cost-cutting measures as well as stock buybacks.

Given that Merck's share price is down 67 percent from its 2001 high, some bargain hunters think the risk-reward ratio looks worthwhile.

Making any such decision about Pfizer seems premature. The company is still holding out hope that test results raising questions about Celebrex will turn out to be less serious than they first appeared. The increase in cardiovascular risk, although significant in percentage terms, is still low in absolute terms. And the patients affected in the test took the drug for longer than two years.

It's conceivable that Pfizer might be able to save the drug, at least for limited use, which would mean relatively low liability. If so, then Pfizer stock is already oversold.

On the other hand, Pfizer is taking a gamble by keeping Celebrex on the market, if it later emerges that the risks of the drug are greater than current data indicate. In addition, if evidence emerges that Pfizer had internal knowledge of any additional risks, the legal liability could be far greater than what the stock's decline to date has allowed for.

Quite frankly, it's impossible for investors to analyze this situation. Pfizer is not as cheap as Merck, and the Celebrex situation is more complex than that of Vioxx.

Given that Merck needed almost three months for the dust to settle, there's no rush to look at Pfizer until next spring (investors who already own the stock, of course, may want to hang on until something more concrete is known).

In fact, it's the uncertainty about the drug industry that is most striking. For a decade, stocks like Merck and Pfizer were considered totally safe choices with foolproof long-term growth potential. But as is now evident, there's no such thing as total safety in investing.

I suspect that the drug industry's long-term growth prospects are a lot better than 10 percent a year compounded. Biotech is advancing at a stunning rate and the enormous numbers of baby boomers are aging into their pill-taking years. Whether pharma giants develop drugs themselves or market boutique products, there's going to be a lot of business.

Nonetheless, the Merck and Pfizer nosedives serve as reminders that the real risks to your portfolio are usually impossible to anticipate. In addition, stocks that seem all the way down always seem to find a way to go lower.

The only protection is the fullest diversification possible. That doesn't only mean spreading the risk of high-flying stocks. It also means including deeply depressed industries that are likely to come back into favor at some point in the future. But as far as big pharma goes, you still have plenty of time to add Merck and Pfizer to your bargain bin. And for Pfizer in particular, it makes sense to wait three months or longer to see whether there's any further fallout.

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Takeover Targets: Pharma Bargains
Jody Yen, 12.17.04, 3:49 PM ET

The drug industry is under siege. Pfizer shares fell to a new 52-week low after the company said that one cancer study related to its drug Celebrex, which is used to treat pain and arthritis, uncovered cardiovascular risks.

Merck (nyse: MRK - news - people ) is embroiled in its own controversy over Vioxx, a similar painkiller, and other big pharma houses are facing patent expirations on some of their blockbuster drugs. The S&P index of pharmaceutical stocks is 11% lower than it was five years ago.

But bad headlines for an industry can often be good news for bargain hunters. The decline in share prices could spark a new round of consolidation and drug acquisitions.

In March 2004, Kos Pharmaceuticals (nasdaq: KOSP - news - people ) acquired asthma drug Azmacort from Aventis (nyse: AVE - news - people ), and with $200 million in cash on its balance sheet, Kos is well positioned to acquire more drugs. Then again, other suitors might see Kos as an attractive acquisition.

Kos has two other drugs, both of which are cholesterol treatments. Ninety-one percent of Kos Pharma's $434 million in latest 12-month revenues come from these two formulations.

While most cholesterol lowering drugs have focused on lowering LDL cholesterol (low-density lipoprotein), recent studies have begun to focus on the importance of raising the level of HDL cholesterol (high-density lipoprotein). While HDL's significance in cholesterol treatment is still being researched, the peak annual market for Niaspan and Advicor--Kos's two drugs that help raise HDL--could be $1 billion, according to SunTrust Robinson Humphrey analyst Robert Hazlett.

Kos has $100 million in operating earnings (profits before interest, taxes and depreciation), while its theoretical takeover price, or enterprise value (market value plus its debt minus cash) amounts to $1.3 billion. This gives Kos an enterprise multiple of 13. In contrast, its pharmaceutical peer group has an enterprise multiple of 24.

Measured by another metric, the PEG ratio (projected P/E divided by expected long-term earnings growth) Kos also looks attractive. Kos trades for 13 times its estimated profits for the next twelve months, while analysts reporting to Thomson First Call expect it to post 20% annualized earnings growth over the next three to five years. As such, Kos has a PEG of 0.7. Stocks with PEGs under 1.0 are generally considered to be undervalued.

One caveat: Kos's position in the cholesterol therapy market could be threatened by patent challenges, as Kos has filed a patent infringement lawsuit against Barr Pharmaceuticals (nyse: BRL - news - people ). A court decision isn't expected until late 2005.

Contrarian investing is usually a painful exercise because it involves betting against the crowd and the news often gets worse before it gets better. The following table lists four smaller pharmaceutical companies that look cheap on an enterprise multiple and PEG basis.

Assuming their drug offerings avoid the sort of problems that Pfizer (nyse: PFE - news - people ) and Merck are facing, the stocks on our list could turn out to be attractive acquisition targets. Even if they're not acquired, the market seems to be pricing in a lot of bad news: with the exception of Regeneron Pharmaceuticals (nasdaq: REGN - news - people ), these stocks have a PEG below 1.0. Regeneron Pharmaceuticals is not expected to be profitable in the next twelve months.

All of the companies below have sales below $1 billion and enterprise multiples below 15.

Pharmaceutical Takeover Targets
Company Price Year-To-Date Price Change Enterprise Value ($mil) Enterprise Multiple Latest 12-Month Sales ($mil)

Bradley Pharmaceuticals (nyse: BDY - news - people ) $19.75 -22% $374 9.6% $100

Cephalon (nasdaq: CEPH - news - people ) 48.06 -1 3,463 14.7 901

Kos Pharmaceuticals (nasdaq: KOSP - news - people ) 36.93 -14 1,304 13.1 434

Regeneron Pharmeceuticals (nasdaq: REGN - news - people ) 9.27 -37 612 12.9 148


Prices as of Dec. 16, 2004; Sources: FT Interactive Data and Thomson First Call via FactSet Research Systems


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