10 Drug Stocks with Healthy Prospects

Jim Jubak Founder and Editor, JubakPicks.com

Pharmaceuticals have gotten interesting again as battles shape up for the latest drugs to treat diabetes, hepatitis, and obesity. But which ones are the best bets? MoneyShow’s Jim Jubak, also of Jubak’s Picks, explores the current state of the industry.

It’s been a long time coming, that’s for sure. For what seems like a geologic epoch, investing in drug stocks has been about finding an attractive dividend and avoiding getting killed when the patent on a best-selling drug expires.

Growth? Forget about it.

But that looks like it’s changing—for some parts of the sector, anyway. For some drug companies, these are actually exciting times.

And given that some of the sectors that led the market upward in the first quarter look they might have problems in the second quarter, the excitement couldn’t come at a more welcome time for investors.

Exciting? Drug stocks? Absolutely.

3 Battles A-Brewing
Big dog Novo Nordisk (NVO), traded as NOVOB.DC in Copenhagen, and upstart Amylin Pharmaceuticals (AMLN) are in a pitched battle to see who will take the biggest share of growth in the market for diabetes drugs.

At the end of February, a panel of advisors at the US Food and Drug Administration voted 20 to 2 that the benefits of Qnexa, a weight-loss drug from Vivus (VVUS), outweigh the risks. An approval of Qnexa or competing drugs from Orexigen Therapeutics (OREX) and Arena Pharmaceuticals (ARNA) could put the first new weight-loss drug on the market in 13 years.

A new class of hepatitis-fighting drugs introduced by Merck (MRK) and Vertex Pharmaceuticals (VRTX) only last year is already looking at a challenge from a new group of therapies from Bristol-Myers Squibb (BMY), Gilead Sciences (GILD), and Johnson & Johnson (JNJ).

You might notice that the three potential drug opportunities that I’ve just mentioned have three things in common:

  • First, they target chronic (rather than acute) conditions. People with diabetes or hepatitis don’t die immediately after getting the disease. Like people who live with obesity, they struggle to manage their condition and to extend their healthy lives.
  • Second, the market for each of these groups of therapies is huge. The National Institutes of Health calculates that 18.8 million people in the United States have been diagnosed with diabetes. (An additional 7 million have the disease but haven’t been diagnosed, the Institutes of Health estimates.) As many as 1.4 million people in the United States live with chronic hepatitis B, according to the Centers for Disease Control and Prevention. An additional 3.2 million have hepatitis C. The World Health Organization estimates that 170 million people worldwide are chronically infected with hepatitis C.
  • And third, in each case a treatment does exist, but it’s either extremely expensive, difficult to administer, or ineffective—and sometimes all three.

Let me use the diabetes story to sketch in why I think the drug sector is interesting again. It’s an especially good example, because it also ties in directly with the weight-loss drug story. (I’ll have to leave hepatitis to another day.)

The Insulin Opportunity
Denmark’s Novo Nordisk is the big dog in diabetes drugs. The company has been in the commercial insulin market since 1923, and it controls about 24% of the market by value. Annual 2011 sales came to $11.7 billion.

The growth story at Novo Nordisk has been fueled by what’s been called a global epidemic of diabetes and a new generation of modern insulins. In a 2008 study, the CDC estimated that the incidence of diabetes in the United States had climbed by 90% between 1995 to 1997 and 2005 to 2007.

The increase, the study posited, was a result of an aging population—since diabetes incidence increases with age—and increasing obesity. Those demographic trends aren’t limited to the United States, and the World Health Organization estimates that there are now 350 million people in the world with diabetes.

Add those demographic trends, which don’t look like they’re about to reverse any time soon, to a market shift toward modern insulin analogs that replace human insulin with greater efficacy, safety, and convenience. You now have quite a growth story—especially if modern insulin costs roughly the same to produce as human insulin but sells for roughly 150% as much.

Novo Nordisk saw sales climb 11% in 2011, with operating profit up 18% and earnings per share growing 22%. The stock trades at a price-to-earnings ratio of 23 on projected 2012 earnings. The company has an extremely conservative balance sheet, with $2.84 billion in cash and cash equivalents on hand against just $390 million in short- and long-term debt.

Right now, the company’s payout ratio—the amount of profit paid out to shareholders—is about 45%, and the shares pay a 1.7% dividend yield. For 2012, the company has authorized $2.1 billion to repurchase shares.

But markets that provide companies with 34% operating margins (in 2011, this was actually up from the 29% average for 2007 to 2011) attract competition. Novo Nordisk is facing a potentially hard charge from a small biotech, Amylin Pharmaceuticals, and its product Bydureon.

The newly introduced drug is the first in the GLP-1 diabetes drug category available in a weekly injection. Novo Nordisk’s Victoza, Bydureon’s main competition, requires daily injection.

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The potential for Bydureon led Bristol-Myers Squibb to put in a $3.5 billion bid to buy Amylin last month. Not a bad price, you might think, for a company with $651 million in 2011 revenue that has yet to show a profit. But the San Diego company turned down the bid, saying it was too low.

The bid and the news that Amylin had turned down $3.5 billion were almost immediately leaked to Bloomberg by anonymous sources. One theory—and this makes sense to me—is that a big investor in Amylin leaked the information in an attempt to make sure that the company sells to someone.

It would be very hard now, the theory goes, for Amylin to strike a deal in which it kept US marketing rights to Bydureon for itself, because such a deal would bring in so much less than $3.5 billion that the stock would tank on the news. That would put the board in the awkward position of justifying a decision that cost shareholders big bucks.

The Medical Technology Stock Letter, which has recommended Amylin since it was a $12 stock, notes that this theory makes sense, given that activist investor Carl Icahn owns 10% of Amylin and has been vocally critical of the board for turning down the Bristol-Myers Squibb offer.

The Medical Technology Stock Letter suggests that a $30 offer—from Bristol-Myers or some other big drug company—would get the deal done.

But Novo Nordisk didn’t get to be where it is in the diabetes market by rolling over whenever a challenger made a move. The company has grown its share of the diabetes market (by value) from about 18% in 2001 to 24% today. (Nothing like growing share in a growth market.)

On April 2, Novo Nordisk played a classic "freeze-the-market" move by announcing that it would decide whether to develop a once-a-week version of Victoza (or some other candidate in its pipeline) by August. Yes, you got it right: Novo Nordisk would decide by August.

Think announcements like that are silly? It wiped 5.4% off Amylin’s share price on April 2.

A Weighty Competition
That’s not the last arrow Novo Nordisk has in its quiver.

One of the reasons Victoza has been able to gain share in the diabetes market so fast—159% sales growth in 2011—is that it helps control obesity in diabetes patients taking the drug for that disease. (This is a property of all GLP-1 diabetes drugs, including Victoza and Bydureon.)

Why not, then, Novo Nordisk management thought, submit Victoza for approval as a weight-loss drug?

That has put Novo Nordisk smack in the midst of a race with drug companies such as Vivus, Orexigen Therapeutics, and Arena Pharmaceuticals to get the first FDA-approved weight-loss drug to market in 13 years. In 1997, the FDA forced the withdrawal of the fen-phen diet drug after research showed links to heart damage and strokes.

The race hit an unexpected speed bump when, on March 29, an FDA advisory panel recommended by a 17-6 vote that companies developing weight-loss therapies for the US market do trials to assess heart risks.

Before that vote, Vivus was expecting word from the FDA on Qnexa by April 17. Now no one is quite sure what the schedule might be: The panel recommended post-approval tests for heart risks, so that wouldn’t delay a decision on Qnexa.

After the panel’s vote, an FDA spokesperson said that the decision wouldn’t affect applications already filed. Vivus competitor Arena is expecting that its drug Lorcaserin will go before an advisory panel on May 10, with an FDA decision by June 27.

Positive FDA action on either drug would create a big pop in the affected stock, since the company would become an immediate candidate for a buyout bid from a big drug-maker. For example, Cowen values a post-approval Vivus at $40 a share. (The stock was one of the few to buck the downward market trend on April 4, closing the day at $22.37.)

But while Novo Nordisk trails when it comes to a schedule for approval—the company expects to submit Victoza for approval as a weight-loss drug by the end of the year—it has two critical advantages that may make it the effective leader when 2013 comes around.

First, Novo Nordisk already agreed when Victoza was approved by the FDA in 2009 to do cardiovascular-outcome trials. The company is in a position to be the first to produce actual data that indicate its drug is heart-safe.

Novo Nordisk thinks the outcome of its post-approval cardiovascular trials might come out with an even better result. There are indications, the company says, that GLP-1 drugs are beneficial to the heart. That has not been proved, the company notes, but that could be an outcome of the post-approval trials.

(The GLP-1 story is extremely odd—involving, as it does, proteins found in Gila monster saliva. Look it up, if that kind of thing is your cup of, well, Gila monster saliva.)

Like all the other targets Wall Street is projecting for these stocks, take this one with a grain of salt. But Citigroup has projected that approval of Victoza as a weight-loss drug could be worth $5 billion in US sales alone to Novo Nordisk by 2017.

I don’t need that projection to get me excited about this drug stock—and indeed the whole diabetes and weight-loss area. Yes, for me, excitement is back in the drug sector, or at least this part of it.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Polypore International as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio here.