Pharma's Newest Acquisition Targets

Valentine's Day may be over, but much of the pharma industry is still in love. The object of its affection? Itself.

Pfizer (NYSE: PFE  ) announced this month an additional $5 billion in share repurchases, bringing the total the board has allotted to $9 billion. AstraZeneca (NYSE: AZN  ) doubled its buyback program to $4 billion. And everyone expects GlaxoSmithKline's (NYSE: GSK  ) sale of its shares in Quest Diagnostics (NYSE: DGX  ) to be put toward a share buyback. Even big biotech Biogen Idec (Nasdaq: BIIB  ) had gotten in on the act, setting aside enough cash to repurchase 20 million shares to offset shares issued to employees.

That may sound like good news. But it's not good for everyone.

This should scare biotech investors
First, small drug developers count on large pharmaceutical companies to fund large phase 3 trials, and biotech investors count on the potential for a takeout. Without pharma's cash, biotech will suffer.

Second, business development folks at the pharma companies have a lot of experience in valuing assets and usually get more access to data about biotech companies' pipelines than the average investor. If they're not willing to make acquisitions or partnerships, that suggests biotechs' pipelines aren't worth all that much.

I'm less worried about the second one because this is all relative. The share repurchases aren't so much a sign that biotech is expensive as that pharma is extremely cheap.

A little math (just a little)
To figure out if a company's share buybacks are going to have a positive impact on EPS, you have to look at the earnings yield, the inverse of the P/E, and compare it to the rate of return the company could get by hording the cash in a bank account.

Company

Low End of 2011 Earnings Yield Estimate

Pfizer 11.4%
AstraZeneca 13.4%
Biogen 8.4%
GlaxoSmithKline 9.1%*

Source: Company releases. *Based on lowest analyst estimate from Yahoo! Finance.

By this measure, the shares of these companies are insanely cheap. Many are facing patent cliffs that will likely decrease earnings in the years ahead, but repurchasing shares should have an immediate effect on EPS. There's no way the companies can get those kinds of guaranteed return by sitting on their cash.

The share buybacks will also have an immediate effect on cash flows for drug companies that offer dividends, since the company doesn't have to pay a dividend on shares it's repurchased. With Glaxo's trailing dividend yield at 5.3%, for instance, and bank interest rates as low as they are, the buyback likely increases the return even if Glaxo's earnings fell to zero.

Not solving the problem
Unfortunately, the long-term problem is still there. Repurchasing shares may have a one-time payoff, but there's no opportunity to grow the investment. That's why I prefer companies like Merck (NYSE: MRK  ) and Eli Lilly (NYSE: LLY  ) that are willing to compromise short-term gains by spending on research and development in order to develop their pipelines for the long run.

The buybacks may help solidify the share price, but they don't offer much in the way of accelerated long-term growth.

Back to biotech
With cash going elsewhere, what are smaller drug developers going to do? They can always raise capital themselves through secondary offerings. Issuing shares dilutes shareholders, but as long as the companies' pipelines are progressing, investors are getting a smaller portion of a bigger pie.

There will also be some money available for partnerships. It's not like the pharma industry is completely narcissistic, throwing every last free dollar into buybacks. I would expect that the average value of a drug deal may go down until pharma sees more value in investing in other drugs than it does in buying back its own shares.

The biggest sacrifice that biotechs will likely have to give up is upfront cash in drug deals. The pharma industry will want biotechs to take on much of the risk of failure, tying the rewards to milestone payments that are only available if the drugs succeed. Considering that the share buybacks offer a guaranteed return, biotech can't expect anything else.

Looking for more dividend plays? Here are 13 more high-yielding stocks you can buy today.

Motley Fool Rule Breakers is always on the hunt for hot drug stocks and other cutting-edge picks. Click here to see all of our latest discoveries with a free 30-day trial subscription.

Fool contributor Brian Orelli, Ph.D., doesn't own shares of any company mentioned in this article. Quest Diagnostics and Pfizer are Motley Fool Inside Value recommendations. The Fool owns shares of GlaxoSmithKline, which is a Motley Fool Global Gains recommendation. Motley Fool Alpha owns shares of Quest Diagnostics. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.


Read/Post Comments (1) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 28, 2011, at 7:57 PM, stemcellanalyst wrote:

    Not to say that there aren't big deals out there. Cephalon just spent 1.7B last December on Australian startup Mesoblast in the largest stem cell deal ever. In the recent earnings call, new CEO Kevin Buchi told one of the hungry analysts that he didn't see that many more such amazing buying opps out there, but to bring him any deals where there was real value to be had. Interestingly, in the Mesoblast deal, Cephalon will fund the PIII trials in exchange for exclusive licensing rights, so this will likely be a continue to be a common paradigm. Given the stunning PII results for Revascor published in this month's Nature, Cephalon just scored a trillion dollar lottery ticket. http://bit.ly/i1pYmr

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1449742, ~/Articles/ArticleHandler.aspx, 8/28/2014 5:23:00 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement