Our investing advice is the same as it has always been: Own pieces of companies that produce things of real value, with capable leadership, whose shares are undervalued; own as much stock as you can yet still sleep well at night, yet hold some cash in reserve to buy when opportunities arise, notes Bruce Kaser, editor of Cabot Undervalued Stocks Advisor.
Here's a look at two drug makers that we recommend in our Growth & Income Portfolio. The stocks in this portfolio are generally higher-quality, larger-cap companies that have fallen out of favor.
They usually have some combination of attractive earnings growth and an above-average dividend yield. Risk levels tend to be relatively moderate, with reasonable debt levels and modest share valuations.
Bristol Myers Squibb Company (BMY) shares sell at a low valuation due to worries over patent expirations for Revlimid (starting in 2022) and Opdivo and Eliquis (starting in 2026).
However, the company is working to replace the eventual revenue losses by developing its robust product pipeline while also acquiring new treatments (notably with its acquisitions of Celgene and MyoKardia), and by signing agreements with generics competitors to forestall their competitive entry.
The likely worst-case scenario is flat revenues over the next 3-5 years. Bristol should continue to generate vast free cash flow, has a solid, investment-grade balance sheet, and trades at a sizeable discount to its peers.
Valuation remains low at 8.7x estimated 2022 earnings, compared to 11x or better for its major peer companies. The stock’s 8.2x EV/EBITDA multiple is similarly cheap, compared to 9-10x or better for peers. Assuming an average of $15 billion/year in free cash flow, the shares trade at a 10% free cash flow yield.
Either we are completely wrong about the company’s fundamental strength, or the market must eventually recognize Bristol’s earnings stability and power. We believe the earning power, low valuation and 3.2% dividend yield that is well covered by enormous free cash flow make a compelling story.
Merck (MRK) shares are also undervalued as investors worry about Keytruda, a blockbuster oncology treatment (about 30% of revenues) which faces generic competition in late 2028. Also, its Januvia diabetes treatment may see generic competition next year, and like all pharmaceuticals it is at-risk from possible government price controls.
Yet, Keytruda is an impressive franchise that is growing at a 20% rate and will produce solid cash flow for nearly seven more years, providing the company with considerable time to replace the potential revenue loss. Merck’s new CEO, previously the CFO, is accelerating Merck’s acquisition program, which adds return potential and risks to the story.
The company is highly profitable and has a solid balance sheet. It spun-off its Organon business last June and we think it will divest its animal health segment sometime in the next five years.
In Merck’s recent 10-K filing, the company showed a net debt balance of $25.0 billion, up about $1.5 billion from a year ago. Higher profits and the $9 billion in proceeds from the Organon & Co. (OGN) spin-off were more than offset by its Acceleron Pharma and Pandion Therapeutics acquisitions, as well as its $6.6 billion in dividends.
In essence, Merck traded Organon for two higher-risk, higher-potential-return companies. Separately, Merck said it is donating 135,000 courses of its Covid anti-viral treatment to Ukraine.
Merck has a strong commitment to its dividend (3.6% yield) which it backs up with generous free cash flow, although its shift to a more acquisition-driven strategy will slow the pace of dividend increases.
