The large cap pharmaceuticals sector — comprising some of the largest drugmakers of the world developing drugs for human and veterinary use — was off to a strong start in 2018. However, it struggled thereafter probably on U.S. market instability and a few negative updates on the pipeline and regulatory front. Importantly, a relatively weaker top-line performance by some of the bigwigs due to slower sales of older drugs has also hurt the industry’s performance this year so far. Meanwhile, concerns about the government’s move to check higher prices of drugs/medicines remain an overhang.
Nonetheless, an ace investor will know that the drug sector has been one of the best-performing industries in the U.S. stock market. It is widely expected that the sector will rebound in the second half of the year.
We believe that new product sales ramp up with rising demand, successful innovation and product line expansion, strong clinical study results and frequent FDA approvals may bring the sector back on track this year. Also, many of these companies have accelerated their cost-saving initiatives to enable investment in new products and defend existing products to optimize long- and short-term growth. Cost savings can drive an earnings upside.
Importantly, mergers and acquisitions (M&A) activity is ramping up with the tax reform in place. The new tax law, which cuts corporate tax rate from 35% to 21% and encourages companies to bring back huge cash held overseas at a one-time tax rate of 10%, is spurring merger activity this year.
However, headwinds that can put pressure on the sector are drug pricing scrutiny, pricing and competitive pressure, concerns regarding Amazon’s interest in entering the healthcare arena and major pipeline setbacks. Most importantly, a slowdown in sales of some of the most high-profile older drugs, courtesy of payers and competitive pressure from both branded and generic drugs is a concern for the sector.
Industry Lags on Shareholder Returns
The Zacks Large Cap Pharmaceuticals Industry, which is a 14-stock group within the broader Zacks Medical Sector, has underperformed the S&P 500 and the sector it belongs to on a year-to-date basis.
While the stocks in this industry have collectively declined 3.8%, the Zacks S&P 500 Composite and the Zacks Medical Sector have risen 4.1% and 0.2% year to date, respectively.
Year-to-Date Price Performance
Large Cap Pharma Stocks Trading Cheap
Thanks to the underperformance of the industry this year, the valuation looks really cheap now. One might get a good sense of the industry’s relative valuation by looking at its forward twelve months price-to-earnings ratio (P/E F12M), which is the most appropriate multiple for valuing large-drug companies.
The industry currently has a P/E F12M of 14.16, which is near the lowest level in the past year as well as the past five years. When compared with the highest level of 16.11 and median level of 15.69 over the past year, there is apparently some upside left.
The space also looks inexpensive when compared with the Medical market at large, as the current as well as median F12M P/E ratio for the Medical sector is 19.07 and 19.06, respectively.
Price-to-Earnings Forward Twelve Months (F12M)
Compared to the Zacks S&P 500 Composite too, the space looks cheap. The current F12M P/E ratio for the S&P 500 of 17.26 and the median level of 18.28 for the same period are above the Zacks Large Cap Pharmaceuticals industry’s respective ratios.
Price-to-Earnings Forward Twelve Months (F12M)
Earnings Outlook Appears Negative
While the above ratio analysis shows that there is a solid value-oriented path ahead, one should not really consider the current price levels as good entry points unless there are convincing reasons to predict a rebound in the near term.
One reliable measure that can help investors understand the industry’s prospects is the earnings outlook for its member companies. Empirical research shows that a company’s earnings outlook significantly influences the performance of its stock.
One could get a good sense of a company’s earnings outlook by comparing the consensus earnings expectation for the current financial year with the last year’s reported number. But an effective measure could be the magnitude and direction of the recent change in earnings estimates.
While the consensus earnings estimates for the Zacks Large Cap Pharmaceuticals Industry of $4.01 per share implies a decent year-over-year improvement, the trend in earnings estimate revisions has not been favorable lately.
Price and Consensus: Zacks Large Cap Pharmaceuticals industry
Looking at the aggregate earnings estimate revisions, it appears that analysts have begun to lose confidence in this group’s earnings potential.
The consensus EPS estimate for the current fiscal year has been revised 0.5% downward since May 31.
Current Fiscal Year EPS Estimate Revisions
Zacks Industry Rank Indicates Prospects for Improvement
The group’s Zacks Industry Rank is basically the average of the Zacks Rank of all the member stocks.
The Zacks Large Cap Pharmaceuticals industry currently carries a Zacks Industry Rank #208, which places it at the bottom 19% of more than 250 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.
However, our proprietary Heat Map shows that the industry’s rank was in the top 50% for the past six weeks and deteriorated only in the past two weeks.
Large Drugmakers Promise Long-Term Growth
The long-term (3-5 years) EPS growth estimate for the Zacks Large Cap Pharmaceuticals industry appears promising. The group’s mean estimate of long-term EPS growth rate has been increasing since January 2018 to reach the current level of 8.3%. Though this compares unfavorably with 9.8% for the Zacks S&P 500 composite, it is the highest level in the past year.
Mean Estimate of Long-Term EPS Growth Rate
In fact, the basis of this long-terms EPS growth could be the recovery in the top line that these large drugmakers have been showing since the beginning of 2016.
Revenues – Large Cap Pharmaceuticals Market
In fact, growing demand for drugs particularly targeted or personalized therapies; increases in the incidence of chronic diseases and technological advancements, evolving treatment regimens, an aging population and increased health care spending are some of the factors that should keep the sector on track in the long term. A faster drug approval process and the proposed removal of outdated regulations that drive up costs and slowdown in innovation should also provide benefits.
Another important indication of solid long-term prospect is the improvement in the group’s return on equity (ROE), which is a key metric for evaluating large cap drug stocks.
Return on Equity – Large Cap Pharmaceuticals Market
Succeeding in a shifting global market and evolving healthcare landscape will require pharmaceutical companies to adopt innovative business models, invest in new technologies, increase investments in personalized medicines and seek external partners and collaborators for complementary strengths.
The sector may face some volatility due to the drug pricing issue, pricing/re-imbursement pressure, increasing competition, slowdown in legacy product sales, loss of patent exclusivity of some key drugs and pipeline related setbacks.
However, pipeline success in innovative and important therapeutic areas, cost cutting, share buybacks, new product launches, increased M&A activity and appropriate utilization of cash may bring the sector back on track this year.
In the Large Cap Pharmaceuticals universe, only one stock currently sports a Zacks Rank #1 (Strong Buy), while another has a Zacks Rank #2 (Buy). Both these companies have witnessed positive earnings estimate revisions.
(You can see the complete list of today’s Zacks #1 Rank stocks here.)
H. Lundbeck A/S (HLUYY - Free Report) : Shares of this Danish drugmaker have gained 41.3% this year so far. The Zacks Consensus Estimate for current-year EPS was revised 11.6% upward over the last 60 days. H. Lundbeck has a Zacks Rank #1.
Eli Lilly & Company (LLY - Free Report) : The stock of this Indianapolis, IN based drugmaker has risen 2.9% this year. The consensus EPS estimate for the current year was revised 5.7% upward over the last 60 days. Lilly has a Zacks Rank #2.
Price and Consensus: LLY
Stocks to Stay Away From
Due to the short-term concerns related to Large Cap Pharmaceuticals stocks, we suggest that you avoid two stocks as these have a Zacks Rank #4 (Sell). Both these stocks have witnessed negative earnings estimate revisions.
GlaxoSmithKline plc (GSK - Free Report) : The consensus EPS estimate for this Brentford, UK based drug and consumer giant moved 2.7% lower for the current fiscal year in the last 60 days.
Price and Consensus: GSK
Novartis AG (NVS - Free Report) : The consensus EPS estimate for this Swiss drug giant declined 0.8% for the current fiscal year over the last 60 days. The stock has declined 9.7% this year so far.
Price and Consensus: NVS
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