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The One Stock to Own in this Troubled Sector

By: David Sterman
Posted: 1/27/2011 7:00:00 AM
Referenced Stocks: BAX;EPS;JNJ;RHHBY;SHPGY

The drug industry is staring at a $30 billion hole. That's the annual sales volume of major drugs that are set to lose patent protection in the next 18 months. Pfizer's (NYSE: PFE ) cholesterol reducer Lipitor,  Bristol-Myers Squibb's (NYSE: BMY ) blood-clot preventer Plavix, Merck's (NYSE: MRK ) asthma medication Singulair, and Abbott's (NYSE: ABT ) cholesterol reducer Tricor are all set to see a steep drop in sales once that happens. Ely Lilly (NYSE: LLY ) has the bad fortune of losing two major drugs -- Cymbalta and Zyprexa (both used in the treatment of mental illnesses) -- and it's unclear how these companies will make up for the loss.

The looming deadlines have been in focus for several years, and these firms have been scrambling to either develop or acquire new drugs to fill the hole. Trouble is, their research and development machines are generating more failures than winners, and analysts expect to see sales steadily decline for the next five years.

Even the firms that saw the patent nightmare looming and took action still can't escape the tidal wave of generics. Bristol-Myers Squibb appears to have a fairly impressive drug pipeline, but it will be hard pressed to make up for the loss of four drugs by 2015 that account for 49% of current sales.

To combat those top-line pressures, most of these firms have started to aggressively cut their workforces, which is temporarily helping to boost thebottom line . Most drug companies plan  deeper cuts in 2011, though analysts seem to doubt there is any fat left to cut and wonder if currentearnings forecasts for 2011 need to be reduced.

With such a gloomy outlook, the entire sector has lost the respect and attention of money managers. That's precisely why this is a good time to pay attention, because the drug sector has real pockets of strength, if you know where to look. Here's a short look at a few firms that actually have real growth prospects in this otherwise beleaguered industry.

Abbott Labs
Abbott's management saw this train wreck and started taking action a few years ago. They realized the importance of keeping many irons in the fire -- an approach that is now paying off. Whereas most drug firms bet the ranch on internal drug development or risky acquisitions, Abbott made sure that it also had exposure to diagnostic equipment, nutritional products and cardiovascular devices. That diversified approach has enabled Abbott to boost sales a likely 14% in 2010. As a result, Abbott is in a position to hike itsdividend for the 39th straight year in 2011.

But the real story here is pharmaceuticals. Abbott has been quietly building up an impressive pipeline of drugs, many of which are yielding very favorable results in clinical trials. These include ABT-450/r (treatment of hepatitis C), bardoxolone (treatment of chronic kidney disease), daclizumab (immunosuppressive), briakinumab (treatment of plaque psoriasis) and elagolix (reduces pain from endometriosis). The pipeline was bolstered by a 2010 acquisition of biotech firm Facet, which is pursuing a range of therapies in immunology and oncology.
 
Outside of drugs, Abbott remains as a one of the leading players in cardiac stents. A new stent being tested called ABSORB looks to have blockbuster potential. "If Abbott succeeds in proving the advantages of its dissolving stent over the existing stents, then it could be a major breakthrough for the company," noted analysts at First Global Securities in a recent report.


 

Shares of Abbott have drifted back toward the 52-week low in recent months as the company had to initiate a costly recall of its Similac baby formula from the market.The company more recently conceded that a promising psoriasis drug would be de-emphasized in the near-term.Shares now trade for about 10 times projected 2011 profits, a multiple that is in-line with its Big Pharma peers, but below diversified health care stocks such as Johnson & Johnson (NYSE: JNJ ) and Baxter International (NYSE: BAX ) .

Venturing abroad
Some suggest that European drug stocks hold the greatest growth prospects. Goldman Sachs, for example, recommends Roche Holdings (RHHBY.PK ) and Shire Pharma (Nasdaq: SHPGY ) , and eyes at least 30% upside in each name. Roche recently acquired Genentech, immediately transforming it into a biotech powerhouse with an impressive drug pipeline. Shire is growing at a solid clip thanks to increasing worldwide demand for its drugs that treat attentiondeficit hyperactivity disorder.

Eli Lilly
Perhaps no stock is more vulnerable than Eli Lilly, which stands to lose all three of its top drugs (Zyprexa, Cymbalta and Alimta) in the next 30 months. Were it not for a 2008 acquisition of oncology firm Imclone Systems, Lilly would be poised for sharp annual revenue drops. As it stands, sales are expected to drop 2% this year, around 5% in 2012 and perhaps more than 15% in 2013.

To help thebottom line , management is already halfway through a plan to shed 5,500 employees. Despite that, 2010 is increasingly looking like the peak year ofearnings for the firm.Earnings per share ( EPS ) are expected to fall by 7% in 2011 and perhaps at a double-digit rate in subsequent years. Don't be tempted by that juicy 5.6%dividend yield . Analysts increasingly suspect that Lilly will have to slash thedividend to preserve cash, a move that could trigger an exodus of income-oriented investors from the stock.

Action to Take --> Several years from now, Abbott Labs is bound to look far healthier than Eli Lilly, even though both firms have somewhat comparableearnings multiples. The firm should be a solid portfolio candidate for investors. The contrasting situation with these firms also sets up a nice potential pair trade for investors looking for a name on both the long and short side.


-- David Sterman

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Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.