The Best Drug Stock for 2007: Endo Pharmaceuticals

Drug stocks that get beaten down over competitive threats or other concerns that turn out to be overly exaggerated often make for great investments. After having fallen over 13% back in October on concerns that its lead product might face generic competition sooner than expected, Endo Pharmaceuticals (NASDAQ:ENDP) fits this mold exactly.

The cause of last year's calamity with shares of Endo were worries that its top drug, the pain patch Lidoderm, could face generic competition sooner than 2015, when the last of the patents covering the drug expire. Without Lidoderm, Endo's top and bottom lines would be in major trouble, as the drug accounts for over 60% of revenues and is still experiencing rapid sales growth.

The concern over generic competition against Lidoderm arriving any time soon is way overblown, however. Endo has five patents on the patch, and the earliest patents don't expire until 2009. Furthermore, even if another drug company files an application to market a generic version of Lidoderm, Endo will be able to delay the FDA from approving the marketing application for up to 30 months as it defends its patents in court. Endo has also made arguments to the FDA's generic drug division that any future generic versions of the drug need to be tested more thoroughly than regular drugs since the active ingredients are delivered with a patch. This all means that any generic competition is years away, coming no earlier than late 2009.

Last week Endo gave financial guidance for 2007. Initially, its expected year-over-year revenue and earnings growth of roughly 15% and 10%, respectively, looks quite unappetizing. But these comparisons are hurt by Endo's agreement to stop selling its generic version of Purdue Pharmaceuticals' OxyContin at the end of 2006 as part of a patent dispute settlement.

Leaving out generic OxyContin sales from 2006 makes comparisons between the years look much more respectable, with sales and earnings expected to both be up at least 20% in 2007 versus 2006. Normally I don't like stripping out earnings streams with generic drug companies, but in the first three quarters of 2006 Endo's generic business accounted for only 15% of sales. Thankfully its generic sales are becoming a much smaller portion of overall revenues, since the consolidation that occurred in the generics industry last year means Endo is facing competitors like Barr (NYSE:BRL) and Teva Pharmaceuticals (NASDAQ:TEVA) with many more resources to put into fighting for the sought after first-to-file generic exclusivity periods on drug going off patent.

Besides Lidoderm, there is still plenty of other opportunity for top-line growth. Late last year, Endo launched the pain drug Opana, and it's already expected to account for nearly 10% of revenues (almost $100 million) in barely a year on the market. Endo is also making progress on its moderately sized drug pipeline and has two more pain treatments in phase 3 trials. The nice thing about these drugs is that investors won't have to wait years for any FDA verdicts on them, since Endo expects to file new drug applications for both in the first half of 2008.

Shares of Endo aren't exactly expensive right now, trading at only 17 times its expected 2007 adjusted $1.68-$1.72 in earnings per share. Another goodie is that Endo has almost $700 million in cash and investments sitting on its balance sheet (about 18% of its market cap), so investors need not fear any excessive share dilution from financings that so commonly occur with drug stocks.

Well-run companies like Endo, whose shares have fallen due to a wall of worry that might never materialize, often rebound dramatically as investors regain confidence in the stock and slowly discount the competitive threat over time. This doesn't necessarily mean that the generic threat that Endo is facing with Lidoderm will turn out to be untrue, but rather that the market has been overreacting to a threat that is still years away at the earliest.

I'm not the only one that thinks Endo might make a fine investment for 2007. In our Motley Fool CAPS database, Endo has been picked by 48 other players to outperform the market compared to only five underperform calls. Whether or not you agree that Endo will be the best drug stock for 2007, come on over to CAPS and rate it yourself. CAPS is free and you just might pick up an investing idea or two. Click here to get started.

Discover our other Foolish candidates for the best drug stock for 2007.

Fool contributor Brian Lawler does not own shares of any company mentioned in this article. The Fool has a disclosure policy.