Look around and you will easily find plenty of health care stocks with low price-to-earnings ratios. These stocks could present great values for investors. On the other hand, they could actually be value traps that deserve low P/E levels.
Both value stocks and value traps are cheap. Value stocks are cheap for a season -- while value traps are cheap for a reason. Let's look at three health care stocks to see to which category they belong.
Judging only on its historical share prices, big pharmaceutical company AstraZeneca (NYSE:AZN) doesn't appear to be significantly undervalued or overvalued. The stock is trading close to where it was at the beginning of 2008, 2010, 2011, and 2012. However, AstraZeneca's trailing P/E stands at 9.4 -- well below the industry average P/E of 19.5.
Why is AstraZeneca so cheap compared to others such as Merck (NYSE:MRK), which claims a P/E of 20? Take a look at the companies' products. AstraZeneca's top three products are Crestor, Atacand, and Seloken/Toprol-XL. These products combined for nearly 89% of the company's total revenue in 2011. However, two of the three saw decreased sales from the prior year.
On the other hand, Merck's top three products -- Singulair, Januvia, and Remicade -- combined for around 24% of the company's 2011 total revenue. Two of the three experienced strong sales growth from the prior year, with Remicade's sales slightly declining. Merck boasts several other products in its portfolio with strong annual sales growth.
When a company depends heavily on a few products, and sales for several of those products are going down, the company's stock is priced cheaply for a reason. AstraZeneca could still be a value, though, if these are only temporary conditions. Unfortunately, that doesn't appear to be the case.
The U.S. patent for Seloken/Toprol-XL has already expired. The patent for Atacand expires this year. Of AstraZeneca's current big three products, only Crestor retains patent protection in the U.S. past this year -- and its patent expires in 2016. Several other of the company's products also go off-patent by 2016.
AstraZeneca does have new products like Brilinta that could generate significant revenue. The company also has several drugs in late-stage clinical trials that hold some promise for the future. However, for now at least, this stock is cheap for a reason.
Dividend dead end?
Many investors salivate over the kinds of numbers achieved by PDL BioPharma (NASDAQ:PDLI). The company pays a super dividend yield of 7.9%. Shares are up more than 25% over the past year. And its trailing P/E is only 5.7. How could a stock that's priced so cheaply, growing so strongly, and paying such a terrific dividend even be included in a discussion of value traps?
As always, we have to dig into why the stock is trading so cheaply. PDL BioPharma is quite similar to AstraZeneca in one key respect: Both face expirations for key patents. However, AstraZeneca's outlook seems bright compared to that of PDL.
All of the products that currently generate significant revenue for PDL lose patent protection by the end of 2014. The company's CEO candidly admits that PDL will have to shut down in 2016 unless new revenue sources can be found.
PDL's management team is working to identify new opportunities to keep the company going strong. However, the challenges they face shouldn't be underestimated. Is PDL BioPharma cheap for a reason or just for a season? The way things stand now, we have to go with cheap for a reason.
Perception or reality?
Questcor Pharmaceuticals (NASDAQ:QCOR) traded above $40 a share for much of 2012 and nearly hit $59 in July. However, the current price stands below $27 per share. Why is Questcor priced so cheaply? The answer is grounded both in reality and perception.
Reality reared its head when Aetna (NYSE:AET) announced in September that it would limit reimbursement for Questcor's Acthar gel to only infantile spasms. Questcor receives much higher revenue from Acthar in treating multiple sclerosis, so this decision potentially portended bad news for the company.
The perception of the decision was even worse. Some speculated that other payers would follow Aetna's lead. Then the U.S. Attorney's Office for the Eastern District of Pennsylvania announced an investigation into Questcor's promotional practices. Short-sellers piled on.
So, do the lower share prices reflect only a temporary setback or is Questcor really a value trap? It depends on how you see things.
Those bullish on Questcor can point to the fact that Aetna only represents 5% of Acthar paid prescriptions. They can note that other insurers have not followed thus far with such a stringent move. If you're bearish, though, you can show that other insurers are becoming more restrictive about Acthar reimbursements even if they aren't clamping down yet like Aetna did.
Questcor could be a real biotech bargain -- or it could be a classic value trap. Quite honestly, it wouldn't surprise me if the stock soars 30% or sinks 30% over the next few months. We'll see.
Reason for the season
Some stocks can be priced cheaply for a reason and for a season. The reasons behind the cheap valuation can change, resulting in healthy share appreciation. This could happen for any of the stocks mentioned above.
In general, though, Foolish investors should avoid stocks that appear to be priced cheaply for a reason. Wait for the reason to be resolved. Then you can greet the stock's new season much more merrily.
Fool contributor Keith Speights has no positions in the stocks mentioned above. The Motley Fool owns shares of AstraZeneca plc (ADR). Motley Fool newsletter services recommend PDL BioPharma. 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 Motley Fool has a disclosure policy.