The broad-based S&P 500 may have swooned a bit over the past week, but yesterday's substantial market gains pushed the number of new 52-week highs relative to 52-week lows to a ratio of nearly eight-to-one. For skeptics like me, that's an opportunity to see whether companies have earned their current valuations.
Keep in mind that some companies deserve their current valuations. Take Tata Motors (NYSE:TTM) as a shining example. In February, India's largest automaker reported a near-tripling in its net income as its Jaguar Land Rover unit continued to outperform with profits more than doubling. What's really amazing is that Tata achieved these results on the heels of weak truck sales in India due to higher gas prices and reduced demand. Despite these concerns, at a mere eight times forward earnings, Tata Motors shares seem to have much more upside than downside.
Still, other companies might deserve a kick in the pants. Here's a look at three that could be worth selling.
Patent cliff dilemma
The allure of large pharmaceutical companies is that they boast huge margins on their branded drugs, which leads to healthy profits and substantial dividends. However, the downside to branded drugs is their finite patent exclusivity of just 20 years (usually 10 years once they reach the market). As such, many big pharmas are now dealing with their own versions of a patent cliff. None, though, appears to be in worse shape than Eli Lilly (NYSE:LLY), which nonetheless finds itself at a 52-week high.
As far as drug development goes, Eli Lilly has been a veritable disaster over the last two years. Lilly saw Alzheimer's treatment solanezumab fail to meet its primary endpoint in a late-stage study in 2012, although it's still being studied over the long term in an international investigator-sponsored trial. In 2013, lymphoma hopeful enzastaurin also failed to meet its primary endpoint in a phase 3 study, eventually causing the drug to be scrapped. Finally, gastric cancer therapy ramucirumab was fast-tracked by the Food and Drug Administration for possible approval, even though its median overall survival improved relative to the placebo by just 1.4 months -- a disappointment, considering how much hype surrounded the drug prior to its late-stage study.
Not only is Lilly failing to develop new blockbusters, but it's also seeing previous blockbusters eaten alive by generic competition. The New York Times reported that about three-quarters of Lilly's pipeline will lose patent protection between 2010 and 2017, which leaves no room for error.
Wall Street is forecasting a 15% revenue decline for Lilly in 2014, with a marginal low-single-digit climb in 2015. That hardly seems befitting of a company that trades at 19 times forward earnings and whose pipeline is anything but certain. I recommend taking this gift that Wall Street has bestowed upon investors and running for the exit.
Back to reality
Sticking with the health care sector, the second company on my sell radar this week is Kindred Healthcare (NYSE:KND).
Kindred is a provider of transitional-care hospitals, long-term care facilities, rehabilitation services, and home health and hospice care within the U.S. The obvious attraction to Kindred is the combination of Obamacare -- which should reduce the number of uninsured patients in the U.S. and remove some uncertainty regarding its ability to collect on services rendered -- and an aging baby boomer population that will likely lead to an increase in home health demand in the coming two decades.
But there's also a flip side to this perfect picture on paper. Obamacare may reduce some of the payment uncertainty, but it's also a health care reform law designed to reduce businesses' reliance on government-sponsored aid (i.e., Medicare). What this means is that the Centers for Medicare and Medicaid Services, the agency that helps set Medicare rates, will recommend pushing reimbursement rates lower over the coming years and make it very difficult for Kindred to grow its business without relying on acquisitions.
We're already seeing the reality of this slowdown in Medicare reimbursements, with Wall Street projecting top-line growth of just 3.5% next year. It also doesn't help that Kindred has missed the Street's earnings-per-share projections in two of the past three quarters.
At 19 times forward earnings, Kindred isn't overly expensive or poorly run, but there's much more downside potential than upside, in my opinion.
Finally, continuing our theme of decent companies whose business models aren't broken but whose valuations don't make sense, we have solar panel manufacturer First Solar (NASDAQ:FSLR).
I already know what you're thinking: "Blasphemy! Solar is the future!" I'm not disagreeing with you that alternative energies will be instrumental in lowering carbon emissions and producing sustainable energy (at lower cost) over the long run.
My concern here is twofold. First, First Solar's sales are somewhat dependent on energy tax credits for businesses and consumers. But a number of tax breaks are in danger of not being renewed for 2014. Thankfully, solar credits aren't set to expire for residential customers until 2016, but given Congress' propensity to sit on things in recent years, there's no guarantee that this beneficial break will continue beyond that year, removing a big incentive to use solar energy.
Second, I worry about further commoditization of the industry as China props up its domestic solar industry. It had looked as if a few of the larger China-based solar companies would go belly-up, ultimately restoring some semblance of production balance to the rest of the world. However, with China's government stepping in and pledging to order 35 gigawatts of solar power through 2015, First Solar will likely have plenty of competition around the globe, and perhaps even in the U.S., despite potential anti-dumping measures.
I wouldn't deny optimists their moment in the sun (pun fully intended) after First Solar boosted its EPS forecast dramatically in March, but given a single-digit growth rate that's slowing every year, as well as the expectation of lower EPS in 2016, I find it to be an easily avoidable stock.