Is this a once-in-a-market-cycle chance to load up on drug stocks at great prices?
$60 billion bid for
certainly has touched off a tsunami of speculation. What company will be next? How do investors pick up a quick buck in the acquisition frenzy that's about to explode?
Well, before you jump in, consider what my study of the price-to-sales ratios of drug stocks indicates: Pfizer has snapped up the only stock, Pharmacia, that looks like a bargain at current prices. The rest of the sector looks fairly valued at best.
No doubt about it, drug stocks have taken a beating this year. Safe-haven stocks such as Pfizer,
Johnson & Johnson
are down 19%, 22% and 15%, respectively for 2002. Second-tier but usually reliable pharmaceutical holdings such as
have plunged even further, falling 40%, 54% and 36%, respectively. Damage to the sector hasn't been limited to U.S. stocks either, with Pharmacia down 23% and
down 21% for the year.
More Room to Fall?
But compared to the average stock, are drug stocks now cheap? At first glance, it certainly doesn't look like it. In fact, an initial look at the sector suggests that prices have a lot further to fall.
The price-to-sales ratio for the Standard & Poor's 500 stock index is 1.4. (That is, the index as a whole sells for a price that's 1.4 times the revenue of the 500 companies that make up the index.) The price-to-sales ratio for Pfizer, even after the punishment of recent months, is still a whopping 6.5; J&J, 4.9; Eli Lilly, 5.2; GlaxoSmithKline, 4.2; Abbott Labs, 3.5. Only Merck at 2.3 and Bristol-Myers at 2.6, two of the most savagely-pummeled stocks in the sector, manage to come in with ratios under 2.8.
Every other drug stock is selling at a price-to-sales multiple at least two times higher than the big-cap market (that's the best way to describe the S&P 500 stocks). And Pfizer, Eli Lilly and J&J are selling at price-to-sales ratios roughly five, four and three times the index.
All things being equal, at these price-to-sales ratios, drug stocks deserve a loud "sell" right now.
The Drug-Stock Premium
But, of course, all things are never equal. In any market, some stocks should trade at a higher ratio, whether the ratio in question is based on earnings or sales or book value. For example, when it comes to price-to-earnings ratios, the market pays more for stocks that are growing earnings at a higher annual rate. An investor is buying a stream of future earnings and not just one quarter or one year's profits.
For price-to-sales ratios, the key to earning a higher multiple is profit margin. Companies that earn high margins sell for higher price-to-sales ratios. That, too, stands to reason, because a higher profit margin means that the company reinvests more of its sales (the profits from the sales) into its future business -- and earns more on those reinvested sales, too.
So a drug company such as Pfizer, which is in a profit-margin business, ought to sell for a higher price-to-sales ratio than a company such as
, which is in the low-margin discount retail business. Pfizer's net profit margin in the last 12 months is a whopping 25%; Wal-Mart's is just 3%. On average, over the last five years, Pfizer has recorded a net profit margin of 20% to Wal-Mart's 3%. No wonder Pfizer commands a higher price-to-sales ratio than Wal-Mart's current 1.1.
Historically, because drug companies do business in a high-profit-margin industry, they have shown high price-to-sales ratios.
So to determine how over- or undervalued the drug sector is, you first need to do a historical comparison of current ratios with past figures.
My 10-Stock Index
I've created my own 10-stock drug index to use to compare the price-to-sales ratio of drug stocks as a sector to the multiple of the market as a whole. Today, the price-to-sales ratio for these 10 stocks is an average of 4.1 in comparison to the 1.6 multiple for the Russell 1000 index. That's a premium of 160%. (The 10 stocks are Abbott Labs, Pfizer, Merck, Bristol-Myers, Johnson & Johnson, Lilly, Pharmacia, GlaxoSmithKline,
Going back to 1996, the year before the beginning of the big run-up in price-to-sales multiples in the drug sector, I get an average 3.7 price-to-sales multiple for my drug-stock universe. That compares to a price-to-sales ratio that year of 1.4 on the Russell 1000. The premium then was 157%. The sector isn't noticeably cheaper now. In fact, it's just a bit more expensive than it was in 1996, but the difference amounts to just 3%.
All that the selloff in drug stocks has done is to reduce the sector as a whole to a historically reasonable valuation. It has deflated the bubble in the sector, but it hasn't created a whopping sectorwide bargain. The drug sector as a whole is now fairly priced -- no more, no less.
But you have to take this kind of historical comparison with its own grain of salt. Using past price-to-sales ratios to value stocks in the present and future assumes that the profitability of the businesses in the sector in the future will resemble historical levels of profit.
The Profitability Picture
For example, some Wall Street analysts currently argue that the drug industry will be significantly less profitable in the future than it has been in the past. Drug companies are seeing large numbers of very profitable drugs come off patent. One example: The loss of patent protection for Prozac has cut deeply into Eli Lilly's profits. And thanks to what seems to be a genuine increase in the scientific difficulty of finding new blockbuster drugs, companies have been slower than expected to replace those blockbusters.
Of course, a slowdown in new-drug approval at the Food and Drug Administration hasn't helped any. And we also seem to be in one of those election-cycle periods when politicians rediscover the shockingly high cost of drugs and make gestures at controlling costs.
My own take is that these problems are less serious than analysts believe. Some of the problems are largely rhetorical, such as the efforts to cap drug prices. And others are important in the short-term but largely irrelevant in the long run, such as the turmoil at the FDA. Even taken as a whole, they do not add up to a serious change in the extraordinary future profitability of this industry. The U.S. population continues to age; people will put off almost any other spending to buy drugs that promise better health (or at least less discomfort); and the government and insurance companies that pay a good part of the bills haven't found a way to cap costs.
Past price-to-sales ratios provide a good floor for future stock values in this sector. But let me show you what happens to the logic of price-to-sales ratios when the ground shifts under a company's feet.
Behind the Merck Numbers
Merck, for example, showed a 4.8 price-to-sales ratio in 1996 (before the market bubble really filled with gas) and a 4.1 price-to-sales ratio in 1993.
In comparison to those past multiples, Merck seems cheap right now at its current price-to-sales ratio of 2.3.
But Merck's case isn't what it seems. If you look at the 10-year summary of Merck's key financial ratios, you see a clear pattern of falling profitability that stretches back to the early 1990s. In 1992, Merck's net profit margin was 25%. By 1995 it was down to 20%, and then it continued to decline, hitting 17% in 2000 and 15% in 2001. (Merck's return on equity deceptively kept climbing all these years because the company was leveraging its capital structure by adding debt. You can that see in the climbing of the debt-to-equity ratio from 10% in 1992 to 30% in 2001.)
The steep climb in price-to-sales multiples that began in 1996 was irrational in light of this falling profitability and constituted Merck's own individual stock bubble. That bubble began to burst in 1999 when worries about Merck's future product pipeline began to roil the market.
This kind of shift in a company's business can also change a seemingly fairly priced stock into a bargain. Take a look at Pharmacia, for example. With a price-to-sales ratio of just 2.8 recently, the stock trades at almost the same multiple that it earned from the market in 1996.
But the company's profit margins are substantially higher now than they were in 1996. That year, the company earned a paltry net profit of 4%, among the worst in the sector. By 2001, that figure was up to 9%, and the current 12-month trailing figure is a tad over 10%.
Pharmacia does indeed deserve a price-to-sales ratio below that of a profit-master such as Pfizer, but the improving profit picture at the company argues that this stock is significantly undervalued. And that's especially true if you agree with the argument of those analysts who see Pharmacia's profitability continuing to increase as the company exploits its market position in next-generation painkillers such as Celebrex (at the expense of Merck, by the way), and as it completes its spinoff of its
agricultural subsidiary this year.
This, of course, is precisely why Pfizer wants to buy Pharmacia and not Bristol-Myers or Abbott.
This kind of analysis isn't just useful for Merck and Pharmacia and the drug sector as a whole. The same questions confront any investor thinking about buying a fallen growth star in any sector. Investors considering
now know exactly what I mean: Sure, the stock is cheaper, but is it cheaper because the market has unfairly marked down the company's prospects, or because the market is accurately reflecting a decline in the company's business?
Historical price-to-sales ratios won't magically give you an effortless answer to that question. But they do provide a way to start answering what I'd call the toughest question facing long-term growth investors trying to figure out what to do about this market now.
At the time of publication, Jubak owned or controlled shares in the following equities mentioned in this column: Eli Lilly, Pfizer and Johnson & Johnson.