Are Drug Stocks Too Expensive?

Big pharmaceutical companies have endured their share of knocks over the past few years as high-profile drugs have lost patent protection, forcing cost cuts and a reimagining of research and development.

As pipelines mature and patent expiration turns more into a hill than a cliff, you may be wondering if the industry has more opportunity for upside.

The Food and Drug Administration approved 39 new drugs in 2012, above the 30 and 21 approved in 2011 and 2010, respectively -- marking the largest number of approvals in sixteen years. The pickup continues this year, with 13 new drugs getting approved in the first half of the year, a similar number to the first half of 2012.

While the FDA may not be able to match 2012's breakneck pace through year's end, it signals a shift may be under way as research partnerships and technology breakthroughs translate into new revenue for the industry.

The cheapest big pharmaceutical stocks
One of my favorite ways to quickly and simply consider whether companies are cheap is to compare the historical price-to-earnings highs and lows to the forward price-to-earnings ratio.

If the forward P/E ratio is near the high end of the five-year P/E range, I typically view the company as richly valued. If it's near the low, there may be an opportunity to move higher.

Using this analysis across a universe of the biggest drugmakers shows that only Teva Pharmaceuticals (NYSE: TEVA  )  has a forward P/E ratio below its five-year P/E low.

Teva Pharmaceuticals has struggled this past year ahead of the high-profile patent expiration for its blockbuster $4 billion a year multiple sclerosis drug Copaxone. Shares have slid from a peak of $65 in 2010 to near $40, and earnings estimates for next year have dropped from $5.41 to $5.17 in the past 90 days.

As a result of the headwinds, Teva has embarked on a major restructuring that includes cutting 10% of its payroll in a bid to shave up to $2 billion in annual costs by 2017. Teva hopes those cost cuts can help strengthen its balance sheet, which was weakened by a slate of high-profile acquisitions including the $6 billion acquisition of Cephalon in 2011. But, cost cuts can only go so far. For Teva to truly prove cheap, it will need new products, too. For investors, some of that potential will come from Teva's market leading position in generic drugs. As of January, the company had 147 product registrations awaiting FDA approval.

TEVA Chart

TEVA data by YCharts.

Four other drug stocks are also trading at less than 1.5 times their five-year P/E lows: Merck  (NYSE: MRK  ) , Johnson & Johnson  (NYSE: JNJ  ) , Pfizer  (NYSE: PFE  )  and GlaxoSmithKline  (NYSE: GSK  ) . Each has a ratio below the median 1.54 times for the industry.

Source: Yahoo! Finance.

Ramping activity boosts pipelines, offsetting high profile patent expiration
Merck has 13 drugs in phase 3 clinical trials. In May, Merck gained approval for cholesterol-lowering drug Liptruzet. That drug combines Merck's Zetia with a generic version of Pfizer's Lipitor, and you'll want to watch third-quarter earnings to see if the new combo therapy gained traction with doctors. The company hopes to rejuvenate its drug program, hiring former Amgen R&D executive Roger Permutter this past spring. And, much like Teva, Merck is embarking on a significant cost savings plan that will cut 8,500 jobs, or 20% of the company's workers. That move is expected to save $1 billion next year and $2.5 billion by 2015.

Johnson & Johnson's recent success is tied in part to Zytiga, a fast-growing prostate cancer treatment that notched sales of $464 million in third quarter -- an increase of 75% from last year. The company has similar hope for its hepatitis C treatment simeprevir. Earlier this month, J&J reported preliminary phase 3 results for simeprevir showing that it met efficacy and safety endpoints ahead of the Thursday's scheduled FDA review panel and the drug's November PDUFA date.

Over at Pfizer, the company has high hopes Xeljanz can capture market share from blockbusters Enbrel and Humira in the autoimmune category. Pfizer's Xeljanz generated sales of just $33 million in the first six months of this year after receiving FDA approval late last year. But Pfizer has a range of studies evaluating the drug across autoimmune disease that could help propel revenue higher. In addition, the FDA approved Duavee for hot flashes and post menopause osteoporosis earlier this month and Pfizer has 17 more drugs in phase 3 trials, suggesting that additional sales and earnings opportunities may be coming.

GlaxoSmithKline is counting on oncology sales, which grew 20% year-over-year in the first half, to help drive future growth. Glaxo's Tafinlar and Mekinst gained approval from the FDA earlier this year and in the EU in September for melanoma. Those drugs will likely provide tailwind growth through 2014. Glaxo has a solid oncology drug pipeline, with ongoing phase 3 trials for breast cancer, head and neck cancer, gastric cancer, kidney cancer, and ovarian cancer.

This Fool's final take
In buying any of these five companies, an investor would be paying near the low end for forward earnings compared to what investors have paid for earnings in the past. All five have catalysts tied to cost cutting or new drug pipelines that could move the needle on profits and earnings per share.

However, drug development is risky. Any number of potential pitfalls could derail drug pipelines, forcing analysts to adjust earnings forecasts. As a result, you should keep a close eye on earnings reports, trial data and FDA news flow for changes. Regardless, considering the forward P/E to historical P/E ratio gives you a good starting point and suggests that these five pharmaceutical companies may offer upside.

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