Two months back I wrote that shares of Express Scripts (ESRX), a leading pharmacy benefits manager, were bloated at $93 each. A P/E of 30 for the company was simply unsustainable. Today ESRX is down nearly $10 to $74 per share after issuing an in-line earnings report. Although I would not do a complete 180 and go long quite yet, I do think it is time for ESRX shorts to be covered for a 20% gain. Where should the money go? I'm interested in taking a look at Aetna (AET), which is down more than 20% today to $36 per share.
A Healthcare Opportunity For Investors?
If you look at the fundamental outlook for the healthcare industry over the next couple of decades you can't help but be impressed. After all, the demographic shifts our country is going to see as the baby boomers retire is quite compelling. From an investment perspective, leading companies serving our aging population stand to profit tremendously.
However, the current market climate for such stocks is quite interesting; healthcare stocks are getting hammered with investor interest lackluster at best. We know big pharma is facing severe headwinds. But insurance firms are down, as are medical device companies, not to mention the brutal sell-off in biotechnology in recent weeks.
It's true that any government-led reform to the healthcare sector could be negative for these companies to a certain degree. Right now, cost containment within Medicare and Medicaid is pretty much non-existent. If policy makers took firm action to bring costs down, pricing pressures would compress profit margins for essentially all healthcare firms.
However, how likely is such broad reform? And even if it does occur, will it completely cancel out all the incremental business gained from the aging boomer generation? I think these are important questions to ask when analyzing the sector and I suspect there are some excellent values beginning to surface, and prices could certainly continue falling in the short-term as governmental involvement is always more of a concern during election years.
Loyalties Aside, ESRX is Bloated
Shares of my former employer, Express Scripts (ESRX), a leading pharmacy benefits manager in the U.S., are going to fall a few points this morning. Earnings reported last night were 2 cents above expectations but the momentum traders wanted more.
Express Scripts had beaten estimates by a fairly wide margin in recent periods, and bulls were undoubtedly hoping for another "beat and raise" quarter. They got the "beat", but not the "raise".
Full year guidance remained at $3.10 to $3.22 per share in earnings. ESRX rarely misses guidance, so they will be fairly conservative. They don't raise guidance often, and when they do, it's usually only once per year.
At $93 per share, the stock was trading at 30 times 2006 earnings coming into the latest report, historically an astronomical multiple for a PBM company. It's true that accretive acquisitions are boosting growth rates above competitors like Medco (MHS) and Caremark (CMX), but 30 times earnings for ESRX is too rich, in my view.
As a result, profit taking is in order, and investors have already begun that process this morning.
Cramer Pump Sends NMTI Up 34% After Hours
Nothing really surprises me anymore, but today's action in NMT Medical (NMTI) is absolutely ludicrous. NMTI is a micro cap medical device company that closed today's regular session at $17 per share.
Tonight on CNBC's Mad Money show, Jim Cramer led off the hour-long episode by recommending NMTI, saying it could go to $100 if their new migrane product is approved. If the trials fail, his downside projection was $10 a share. Given the risk/reward he sees, Cramer pumps the stock for several minutes and the stock quickly jumps over 33%, or $6 per share, to $23 and change.
The reason I bring this up is because NMT Medical is one of 10 stocks featured on Peridot Capital's 2006 Select List, published earlier this month. Thanks to many individual investors who were silly enough to put in a market order to buy, simply based on Cramer's recommendation, I was able to sell a decent chunk of stock at between $23.09 and $23.75.
First of all, if you purchased our 2006 Select List and are lucky enough to be holding shares of NMTI right now, I strongly suggest taking some profits tonight in after-hours trading, or on Monday if the mark-up holds early next week. There is no fundamental reason for the stock to be up at all, let alone more than 30 percent.
It is true that the company's devices could be a huge hit if they prove effective, but human trials have not been completed. This stock is very speculative, as was noted in our report, and is not for every investor. In fact, we tabbed it the lone "speculative pick" in the group of 10 companies we profiled in the report. Please trade with caution, especially if you are a fan of Cramer's show. These are very dangerous waters for retail investors.
Another interesting twist is that NMT, not NMTI, spiked $5 during Cramer's show, as investors bought the wrong stock with a similar ticker symbol. NMT is a municipal bond fund that closed at $15, but some people paid $20+ for it in after-hours trading. Another example that if you're not careful, you can lose 25% of your money on a trade within minutes.
Genentech's Q3 Highlights Healthcare Cost Issues
There is little arguing that the rising cost of healthcare is one of the biggest issues hampering the U.S. economy. Next year, average health insurance premiums are expected to surpass $14,000 per family. That will represent one-third of the average household income in this country. The main reason for such staggering costs are prices for prescription drugs. Drug expenditures, which were $12 billion in 1980, hit $179 billion in 2003. That's an average increase of 12.5% per year, more than 4 times the historical rate of inflation.
Investors need look no further than the Genentech (DNA) Q3 earnings report to see exactly how crazy drug prices have gotten. Genentech's newest and second-best selling drug, Avastin, costs a whopping $140 for a day's supply. That equates to $4,400 per month and $53,000 per year. Should a drug for colon cancer really cost 20% more per year than the average household income in the United States? I bet very few could argue it should.
The argument for limiting the costs of prescription drugs centers around the idea that limited profit potential will result in less research and development, and therefore fewer novel therapies for the world's most lethal diseases. Without the ability to make a significant profit, proponents of a healthcare free market say, drug makers will lose the incentive to discover new drugs for cancer, heart desease, etc.
However, a simple analysis of Genentech's third quarter income statement shows that this theory, while it makes sense in economic terms, simply isn't true when you actually look at the numbers. Here are some key facts from DNA's latest earnings release:
* Genentech's drug mark-up (retail price versus manufacturing cost) is 662%
* Only 38% of the drug company's profit is reinvested into research and development, and net profit after tax actually surpasses total R&D expenditures
* Drug company net profit margins are nearly 20%, higher than any other major industry
And the one that is important to understand when hearing the debate on spiraling costs for prescription drugs:
* If retail prices for Genentech's drugs were reduced by 50% effective immediately, the company would still be able to spend the same amount it does today on R&D and would have more than $400 million left over in excess profit every year
BioCryst Rally Warrants Trepidation
Shares of biotech firm BioCryst Pharmaceuticals (BCRX) have caught fire lately after worries over a potential Avian Flu pandemic have flooded media outlets. The stock is up 80 percent to $17.65 already this month and has tripled in the last three months, giving the company a market cap of nearly half a billion dollars.
To say this violent move to the upside is based on speculation would be a dramatic understatement. The excitement over BCRX comes from a flu vaccine that the company actually scrapped in 2002 after it failed late stage clinical trials. However, with Avian Flu worries running rampant, the company has decided to bring back the drug and test it on bird flu. Early indications show it might have some kind of positive effect, but it's way too early to conclude the drug, Peramavir, would be successful in preventing the spread of Avian Flu.
Investors, though, haven't really focused on the downside (an ineffective drug brought back into testing only to get shelved again), but rather only on what it could do, become heavily useable in case a pandemic of Avian Bird Flu does sweep the globe. What happens if Avian Bird Flu goes the way of SARS, and in several months we never hear of it again? Or what happens if BioCryst's drug shows to not work, or not work any better than drugs that have already been approved by the FDA for the flu (TamiFlu from Gilead, for instance)?
There is no doubt that BCRX shares have momentum right now as individual retail investors gobble up shares while the media hypes the potential death toll from an Avian Flu pandemic. Such momentum could drive the stock higher in the short term, with $20 or $25 very feasible. However, for BCRX to maintain its current share price for the longer term, after the hype dies down, a lot of things need to go perfectly, most of which the company and investors can't control. If that doesn't happen, remember that BCRX was a $3 stock in April of this year.
Spiraling Healthcare Costs
I just got a notice in the mail from United Healthcare. My premium will be going up by 21 percent on November 1st. That's right... 21 percent in a single year. Although politicians campaigned on the issue, and Bush and Kerry continually pointed to the rising costs of healthcare as a grave concern during the 2004 presidential debates, nothing has been done about it. This is despite the fact that annual premium increases of 15 to 25 percent have been commonplace recently, with overall inflation only running 2-3 percent per year, and wages that have been flat for four years running.
All we can do really, aside from shopping around for better rates (which I'm doing), is try and make some of this money back via the healthcare portion of our investment portfolios. United Healthcare (UNH) will continue to grow earnings at double digit rates as long as Washington doesn't help us citizens out with healthcare reform. And that industry growth will persist regardless of whether gasoline is $1, $2, or $3 a gallon, or if Fed Funds are priced at 3%, 4%, or 5%.
Arbitrage Monday
For those of you out there who like to play the merger arbitrage game, take a look at today's merger announcement between OSI (OSIP) and EyeTech (EYET). OSI is paying $15 cash and 0.12275 shares for each EYET share in a deal expected to close by year-end. The current 5.6% discount on the deal represents a nearly 17% annualized return for arbitrageurs.
Big Pharma Has Tough Road Ahead
Texas Jury Finds Merck Liable in Death of Man Who Took Painkiller Vioxx, Awards Widow $253.4M
Big pharmaceutical companies like Merck (MRK) and Pfizer (PFE) are a lot riskier to own than many believe. Sure they have nice dividends and low P/E's, but a lack of new drugs to make up for patent expirations, and extreme legal uncertainties will make it tough for these companies to grow.
Before today's award, Merck was hoping its total Vioxx liability from the thousands of open cases would be no more than $10 billion. Well, the very first judgment against them today should raise some eyebrows.
Many people are recommending the big drug stocks for their fat yields and historically low multiples, but I have been taking the other side of the coin, and will continue to avoid these names.
Amgen Report Could Prompt Closing of Genentech Gap
The 2nd quarter earnings report from biotech giant Amgen (AMGN) issued Tuesday night was a blowout, no question about it. With much of the biotech acclaim going to Genentech (DNA) in recent years, AMGN has flown under the radar and now investors are clamoring to catch up. In fact, the stock is up $10 today to $80 per share. However, even with today's run-up does Amgen still represent relative value in the biotechnology sector?
I would have to answer "yes" to that question, even though I would wait for a dip before buying any shares. Genentech trades at 52 times 2006 earnings against just 22 times for Amgen. Not to say that these multiples should be identical, but such a discrepancy most likely reflects an overly optimistic view on DNA and fairly lackluster sentiment surrounding Amgen. I see no reason why Amgen should garner less than 25 times earnings given its strong drug pipeline and 15% growth rate.