Valentine's Day may be over, but much of the pharma industry is still in love. The object of its affection? Itself.
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.
Low End of 2011 Earnings Yield Estimate
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
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.
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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.