Drug stocks offer an opportunity for investors in the wake of Thursday’s Supreme Court decision upholding much of the president’s health-care plan. They remain priced at sharp discounts to the broad market, and many of these companies stand more to gain than lose from the changes.
On one hand, the industry will have to pay an estimated $80 billion in fees and rebates over a decade to help pay for the plan. That’s a vast sum, but it’s dwarfed by the money drug companies make.
For the top six drug makers alone, assuming their revenues don’t grow at all over the next decade, the fees would amount to about 3% of revenues.
Wall Street expects drug revenues to decline in the near term, as patents expire on key drugs. Pfizer (PFE) is forecast to bring in revenues of $59.3 billion in 2014, down from $67.4 billion last year. For Merck, projected 2014 revenues are $46.5 billion, down from $48.0 billion last year.
But after 2014, revenues for most big drug makers are projected to resume growing. Companies launch new blockbuster drugs by then, but the larger opportunity lays with the tens of millions of Americans who will be prodded toward buying health insurance.
Anyone who has paid a $20 copay on a bottle of pills that would otherwise cost $200 knows that the insured are more likely to buy prescription pills than the uninsured.
Some companies, like Merck, are expected to return to today’s level of revenues within two years of the law taking effect. Others, like Pfizer, will lose such a large chunk of revenues from patent expirations on key drugs (in its case, Lipitor for cholesterol) that revenues are expected to take longer to bounce back.
But this “patent cliff” has long been discounted into drug stock valuations. Merck (MRK) sells for 10.7 times this year’s earnings forecast; Pfizer, 10.3 times; Eli Lilly, 13 times and Novartis, 10.4 times. The median for companies in the S&P 500 index is 15 times current-fiscal-year earnings forecasts.
One key for investors is that the costs imposed on drug companies from the new health-care law have already begun. The revenues won’t turn up until after 2014. That leaves these companies looking less attractive to investors now than they might in several years.
As a result, with share prices low, dividend yields are plump. Eli Lilly shares yield 4.7%; Pfizer 3.9%; Merck 4.1% and Novartis 4.5%. Two things investors have rushed into lately are companies that make staple goods, demand for which tends to hold up even in a down economy, and stocks with high dividend yields, because bond yields are near record lows. Drug stocks fulfill both of these demands, and yet remain relatively unloved.
That means buyers who scoop up these shares now stand to be rewarded with high income right away, and potential for growth in future years, once these companies learn to adapt to, and profit from, the new health care rules.
Mutual fund investors may prefer to stick with an exchange-traded fund that tracks a drug stock index. But yields on these are much lower, partly because of fees, but mostly because these funds have plenty of exposure to smaller drug companies that pay little or nothing in dividends.
The iShares Dow Jones U.S. Pharmaceuticals Index Fund (IHE) costs 0.47% a year and yields 1.4%. SPDR S&P Pharmaceuticals ETF, which weights companies equally, giving investors even more exposure to small firms, costs 0.35% a year and has a dividend yield of 0.8%.