It is a known fact that small companies are a great place to find big investment returns. This article discusses the outlook for small drug companies, which make medicines for both human and veterinary use. We have a separate industry outlook discussion for some of the largest drugmakers of the world. (Read more: Large Cap Pharma Stock Outlook: Short-Term Struggle Likely)
Most of these small drugmakers have a small portfolio of marketed drugs or possibly even no commercial-stage drugs at all. Some of these clinical stage drugmakers are dependent on just one pipeline candidate. Thus, the success or failure of their key pipeline candidates in clinical studies can significantly drive the stock’s price.
A partnership deal with a popular drug maker is a good sign about the potential of small pharma companies, especially when there is an equity investment included in the deal. For most of these companies, upfront or milestone payments from collaboration partners – in most cases their larger counterparts – are their only source of revenues. These companies therefore need ample free cash flow to fund their huge R&D costs.
For these smaller companies, succeeding in a shifting global market and evolving healthcare landscape requires them to adopt innovative business models, invest in new technologies, increase investments in personalized medicines and seek external partners and collaborators for complementary strengths.
These smaller innovative companies, in general, are having a rather poor year, the principle reason being pivotal study failures for key pipeline candidates. Other than that regulatory and pipeline delays are adding to their woes. Also M&A activity and collaboration deals have relatively dried up lately after a frenzy of announcements earlier in the year.
Industry Lags on Shareholder Returns
The broader medical sector has picked up in the past three months after struggling initially in the year. So, it makes sense to compare the performance of industries in this sector over this time period.
The Zacks Medical-Drugs, which is a huge 163-stock group within the broader Zacks Medical Sector, has underperformed both the S&P 500 and its own sector in the past three months. In fact it has also underperformed the Zacks Large Cap Pharma Industry, which is a 14-stock group.
While the stocks in the Medical-Drugs industry have collectively risen 2.8%, the Zacks S&P 500 Composite has risen 7.4%, the Zacks Medical Sector has risen 8.5% and the Zacks Large Cap Pharma Industry has gone up by 9.1% in the past three months.
Past Three Months Price Performance
Small Drugmakers’ Valuation Not Too Attractive
Despite the underperformance of the industry, the valuation looks hardly cheap now. One might get a good sense of the industry’s relative valuation by looking at its trailing twelve months price-to-sales ratio (P/S TTM), which is the most appropriate multiple for valuing small drug companies many of which are loss making companies.
The industry currently has a P/S TTM of 2.92, which is near the median for the past year. When compared with the highest level of 3.14 over the past year, there is apparently some upside left.
The space is also trading at a meagre discount to the Medical market at large, as the P/S TTM ratio for the Medical market is 3.00 and the median level is 3.03.
Price-to-Sales Trailing Twelve Months (TTM)
Even price-to-free cash flow is a good metric for evaluating small pharmaceutical firms that have to ensure consistent cash to meet their substantial capital investments and expenditures. They should be able to continue to function through times when the company is making substantial investments that are yet to pay off.
Using the price-to-free cash flow (adjusted) metric, the space looks slightly inexpensive compared with the Medical market at large, as the current price-to-free cash flow (adjusted) ratio for the Medical market is 11.29 while that for Medical-Drugs industry is 11.93.
Price-to-Free Cash Flow Adjusted
Underperformance May Continue Due to Bleak Earnings Outlook
Revenues of most of these drugmakers come from collaboration revenues, upfront and milestone payments or licensing fees and royalty payments from partners. Some of these drugmakers do earn some revenues from their marketed drugs. However, high R&D costs for pipeline development, investments behind product launches and rising competitive pressure can hurt profits.
But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. The earlier valuation discussion shows that market participants have been willing to pay up for these stocks already, potentially limiting further upside from current levels.
One reliable measure that can help investors understand the industry’s prospects for a solid price performance going forward is the industry's earnings outlook. Empirical research shows that earnings outlook for the industry, a reflection of the earnings revisions trend for the constituent companies, has a direct bearing on its stock market performance.
The Price & Consensus chart for the industry shows the market's evolving bottom-up earnings expectations for the industry and the industry's aggregate stock market performance. The red line in the chart represents the Zacks measure of consensus earnings expectations for 2019, while the light blue line represents the same for 2018.
Price and Consensus: Zacks Medical-Drugs industry
This becomes even clearer by focusing on the aggregate bottom-up EPS revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.
Current Fiscal Year EPS Estimate Revisions
Please note that the 24 cents EPS estimate for the industry for 2018 is not the actual bottom-up dollar EPS estimate for every company in the Zacks Medical-Drugs industry, but rather an illustrative aggregate number created by our proprietary analytics model. The key factor to keep in mind is not the dollar earnings of 24 cents per share of the industry for 2018, but how this dollar number has evolved recently.
As you can see here, the 24 cents EPS estimate for 2018 is significantly down from 32 cents at the end of June and 55 cents at the end of August last year. In other words, the sell-side analysts covering the companies in the Zacks Medical-Drugs industry have been consistently lowering their estimates.
Zacks Industry Rank Indicates Cloudy Prospects
The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates continued underperformance in the near term.
The Zacks Medical-Drugs industry currently carries a Zacks Industry Rank #155, which places it at the bottom 39% 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.
Our proprietary Heat Map shows that the industry’s rank was in the bottom 50% for the past four weeks.
Small Drugmakers Promise Long-Term Growth
The long-term (3-5 years) EPS growth estimate for the Zacks Medical-Drugs industry appears promising. The group’s mean estimate of long-term EPS growth rate has increased consistently to reach the current level of 13.14%, which compares favourably with 10.01% for the Zacks Medical Sector and 9.8% for the Zacks S&P 500 composite.
Mean Estimate of Long-Term EPS Growth Rate
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 slow down innovation should also provide long-term benefits.
Over the past few years, scientific and technological advancements have made it possible to develop therapies targeted at specific individual traits of a patient, which means personalizing it for the patient. Other than that, adoption and information exchange through meaningful use of health IT, developing therapies that improve overall patient outcomes and investing in developing and emerging markets are some of the new priorities for drug companies, both large and small.
Though smaller drugmakers are not doing too well lately, investment in the small- and mid-cap drugmakers may make more sense as sales at larger pharma companies are decelerating due to slowing product growth and increasing price pressure. However, the smaller companies also have their share of risk in the form of unstable cash flows. Also negative clinical outcome or regulatory obstacles can be huge setbacks for these smaller companies and significantly hurt their share prices.
In the Medical-Drugs universe, two stocks currently hold a Zacks Rank #1 (Strong Buy), while several stocks carry a Zacks Rank #2 (Buy). Most of these companies have witnessed positive earnings estimate revisions.
You can see the complete list of today’s Zacks #1 Rank stocks here.
Aerie Pharmaceuticals, Inc. (AERI - Free Report) : The stock of this Durham, NC-based ophthalmic pharmaceutical company has gained 15% this year so far. The Zacks Consensus Estimate for current-year loss per share has narrowed 2.8% over the last 60 days. The stock has a Zacks Rank #1.
Price and Consensus: AERI
Galmed Pharmaceuticals Ltd. (GLMD - Free Report) : This Tel Aviv, Israel-based small drugmaker focuses on making therapeutics for liver diseases. The consensus estimate for loss has improved 3.3% for the current fiscal year over the last 60 days. This Zacks #2 Ranked stock has risen 48% this year so far.
Price and Consensus: GLMD
RedHill Biopharma Ltd. (RDHL - Free Report) : The stock of this Tel Aviv, Israel-based small drugmaker making therapies for gastrointestinal diseaseshas risen 47.1% this year. The consensus estimate for current year loss has narrowed by 0.6% over the last 60 days. The stock has Zacks Rank #2 (Buy)
Price and Consensus: RDHL
ArQule, Inc.(ARQL - Free Report) : The stock of this Burlington, MA-based small drugmaker of cancer and rare disease medicines has risen 245.5% this year so far. The consensus estimate for current year loss has narrowed 40% over the last 60 days. The stock has Zacks Rank #2.
Price and Consensus: ARQL
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