Homely American Home Presenting a Potentially Pretty Pipeline

Drug stocks, suffering through a miserable year, have bounced back a bit in the past few days. But not American Home Products (AHP).

Most investors find the stock scary: The company faces unknown and potentially enormous liability from obesity-drug lawsuits. And, after several years of missteps, management credibility is at a low.

But a small collection of managers are picking up shares, thinking the Madison, N.J., company's new-drug pipeline will allow it to overcome those problems. Their belief rests on the notion that while the rest of the Street considers American Home's pipeline solid if unspectacular, AHP actually has at least one potential blockbuster on its hands.

One top New York buy-side specialist in health care, who prefers to speak off the record and whose firm is long the stock and accumulating more, says: "Everything looks great with American Home." After all, isn't it best to buy a stock when it's out of favor?

Certainly the American Home story isn't without its problems.

The company faces a collection of class-action lawsuits and about 4,000 individual suits, stemming from side effects associated with those Richard-Simmonses-in-a-pill, Redux and Pondimin. Most disturbing for investors is that it's impossible to even estimate the eventual cost of the suits. After a Texas jury on Aug. 6 returned a $23 million judgment against American Home, investors started to worry that the company's liability could balloon to between $5 billion and $10 billion. Most specialized health care investors expect the liability to amount to something like $1 billion to $2 billion, a range that falls roughly in line with some investors' estimates of American Home's insurance coverage for legal costs. The company declines to comment on the subject.

Down Home American Home's stock price in the last year

Liability isn't the only thing wrong at American Home. Along with the Redux and Pondimin withdrawals, the company in 1998 pulled painkiller Duract and more recently withdrew a rotavirus vaccine called Rotashield. (The company calls the latter withdrawal "temporary.") Last year two prospective mergers -- with Monsanto (MTC) and SmithKline Beecham (SBH) -- were called off. And then the company's agriculture business soured badly, leading American Home to miss earnings expectations last quarter. The company is "reviewing strategic alternatives" for the agriculture division. That's shorthand for "It's up for sale."

Such failures have hurt American Home's credibility. "I would agree that it's not the best-managed company," concedes the New York fund manager who specializes in health care.

American Home spokesman Lowell Weiner replies, "Our goal is to be among the world leaders in pharmaceutical revenue and earnings growth over the next few years."

American Home's stock doesn't reflect such lofty ambitions. At Monday's close of 40 13/16, the company is trading at 23 times 1999 estimated earnings of $1.77 a share (flat with last year). The stock trades at 20.3 times 2000 earnings estimates of $2.01 a share. Those estimates suggest Wall Street expects 14% earnings growth. Drug stocks typically sell at around twice their earnings growth rates.

According to data tracker Baseline, the company is trading at a discount to the S&P 500 P/E multiple for the first time since mid-1995. At its current stock price, American Home is trading at its lowest P/E multiple relative to the industry since late 1990.

Even at these levels, it'll be a long haul before investors climb aboard. Tom Malley of Janus, a major health-care portfolio manager, has been underweighting the drugs for about six months and expects the group to be unimpressive for the next 12 months or so. (He owns a reduced position in American Home.) If the Malleys of the world aren't tempted, you can bet that most generalist investors would rather watch 14 straight hours of intestinal surgery over the Net than let a drug-stock analyst into the office.

But American Home might be different. Barney Rosen, an analyst for the boutique firm Argus Research, which has no banking relationship with American Home, says, "Price and [the product] pipeline are the main thrusts of our buy recommendation, since we are no closer to measuring the final financial impact of litigation risk than we were in September 1997."

The company has five upcoming launches. The bulls contend that American Home's pipeline will yield a billion-dollar-a-year drug, countering the rap on American Home that only less-lucrative remedies are forthcoming.

There's Rapamune, an organ-transplant drug, and Flumist, an inhaled vaccine for the flu that the company developed with partner Aviron (AVIR). Both could bring in peak annual sales in the several-hundred-million-dollar range. Also, the Food and Drug Administration on Monday approved the sleeping pill Sonata. "We've been saying it could be a $500 million product," spokesman Weiner says.

The two potential jewels are Protonix, a proton-pump inhibitor for ulcers, and a pneumococcal vaccine for children's ear infections.

Evan Sturza, who heads up a boutique research shop bearing his name and manages a small hedge fund that's long American Home, contends that in Protonix "you're getting a billion-dollar drug that no one knows about." The other two medications in that class, AstraZeneca's (AZN) Prilosec and the Prevacid drug sold by a joint venture of Abbott (ABT) and Japan's Takeda, are multibillion-dollar drugs annually. Pointing to the antidepressant market, in which latecomers still manage to grab big sales, Sturza thinks that even a late entrant to this market will do well. Critics contend the market is saturated with competitors. Protonix should be launched in the fourth quarter.

Another billion-dollar product could be the pneumococcal vaccine. The New York money manager thinks that the drug has potential to report steady annual sales in the range of $600 million to $700 million, as most newborns get the shot. That's a bit higher than Wall Street believes. But he thinks the vaccine will have an unusual sales pattern that will boost American Home's stock. He contends that the drug will peak much more quickly than the Street expects, when not just newborns but also 1- and 2-year-olds get retroactively vaccinated. That will mean the drug could hit $1 billion in sales as soon as its second or third year on the market, and then fall back to its steady-state rate.

There may be disagreement on which drug will be the big one, but at American Home the cupboard isn't bare.

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