Big Pharma at a Discount

These five drug stocks should produce healthy returns.

It's plain to see why nobody loves Big Pharma these days. The brand-name-drug companies are barreling toward a "patent cliff" as more than $130 billion in products go generic over the next few years. Washington is rumbling about slapping new taxes on drug makers. ObamaCare, thought to be on its deathbed after Republican Scott Brown's stunning victory in the race for a U.S. Senate seat from Massachusetts, has been resuscitated. As for the shares themselves, the sector trailed Standard & Poor's 500-stock index by 25 percentage points over the past year.

It's that very unpopularity, though, that captures the attention of contrarian-minded investors. The drug sector is certainly cheap. On average, the stocks trade at 11 times estimated 2010 earnings, 18% less than the overall market's price-earnings ratio. Analysts expect earnings for the industry to rise an average of 8% this year. Plus, Wall Street isn't all that worried about health-care reform. The industry has already made a deal with the Obama administration to offer modest discounts in exchange for expanded coverage. The impact of reforms, says Barclays Capital analyst Anthony Butler, should be "limited and manageable."

Other pluses. Several mega mergers last year restocked the pipelines of the largest firms and helped them diversify with biotech drugs and other medicines with longer patent lives. Companies are also slashing billions from their cost structures and outsourcing more testing and manufacturing to offset slowing sales. And although the era of blockbuster drugs may never return, many firms are finding new revenue streams in niche products, vaccines and licensing deals.

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With the durability of the economic recovery still in question, investors may view drug stocks as relative safe havens. And even if drug shares go nowhere, investors can at least pocket some dividend income, with most of the stocks yielding better than 3%. Our picks for healthy gains (all prices are as of March 12):

Johnson & Johnson (JNJ): $64

Shoppers may know Johnson & Johnson for its Band-Aids and baby shampoo. But consumer products made up only one-fourth of J&J's 2009 sales of $61.9 billion. Medical devices and pharmaceuticals round out the pie, and analysts expect sales in the drug division to accelerate, thanks to a robust pipeline of new products and scant additional competition from generics through 2014. Drugs in advanced stages of development include new treatments for HIV/AIDS, hepatitis C and epilepsy. And J&J has made deals with biotech firms to develop treatments for cancer and Alzheimer's disease, as well as a genetically engineered "universal" flu vaccine that could work against all strains of the virus.

Wall Street expects J&J's earnings to grow 6%, to $4.92 a share, this year. That gives the stock a P/E of 13 -- an attractive price for a company with such impeccable finances. J&J is one of only four nonfinancial U.S. companies with a coveted triple-A credit rating, and the $14.5 billion on the firm's balance sheet gives it a lot of flexibility to make acquisitions, buy back shares or hike its annual dividend of $1.96 per share, which gives the stock a yield of 3.1%.

Merck (MRK): $37

Merck was plodding along with average growth prospects before it hooked up with Schering-Plough in a $41-billion deal last year. But the new Merck has a much stronger pipeline, with drugs in development that could add $10 billion a year to the company's top line by 2015, says Credit Suisse analyst Catherine Arnold. With more than 20 drugs in late-stage development, Merck should easily be able to offset losses from big sellers, such as Singulair, an asthma drug that goes generic in 2012. Schering also has several biotech drugs in the works, including a new fertility treatment. And Merck is targeting $3.5 billion in merger-related cost savings by 2012.

Merck faces risks, of course, and the stock could drop if studies of its blockbuster cholesterol drugs, Vytorin and Zetia, produce unfavorable results. But even with dwindling sales from those products, Merck should generate earnings growth of nearly 9% a year, on average, through 2015, says Arnold. Her estimates are on the high side of Wall Street's forecasts, but with a P/E of 11, the stock still looks underpriced.

Roche (RHHBY.PK): $41

Investors may think of Roche as a maker of brand-name drugs. But thanks to its 2009 acquisition of Genentech, Roche is now a biotech giant. The $46.8-billion deal gave Roche, based in Basel, Switzerland, full rights to three top biotech cancer drugs: Avastin, Herceptin and Rituxan. Roche also makes Tamiflu, which flew off the shelves during the H1N1 pandemic, and just received U.S. regulatory approval for Actemra, a new rheumatoid-arthritis drug. Roche is also working on a promising diabetes medicine and is exploring new uses for its oncology drugs.

Roche's American depositary receipts, which trade on the pink sheets, go for 13 times forecasted 2010 earnings of $3.17 per ADR. That's a premium to the industry's P/E. But Roche's product line is heavy with biologic drugs that have long patent lives. And operating-profit margins in the pharmaceutical division, at more than 39%, are near the top of the industry. All told, earnings should rise an average of 12% a year through 2014, says Jefferies analyst Jeffrey Holford.

Novartis (NVS): $55

Novartis, which is also headquartered in Basel, takes a more varied approach to growth. A health-care conglomerate with $44.3 billion in sales last year, it's a major player in brand-name drugs, generics and vaccines. And it will become a dominant force in eye care once it completes the purchase, for $39 billion, of the shares of Switzerland-based Alcon that it doesn't already own. Novartis faces some key patent losses, including its top-selling drug, Diovan, which goes generic in 2012 and accounted for 21% of Novartis's $28.5 billion in pharmaceutical sales last year. But Novartis's pipeline is consistently ranked as one of the strongest in the industry, with 28 new drugs in late-stage development, and upcoming products should easily plug the patent hole, says Morningstar analyst Damien Conover.

Analysts see Novartis producing annual profit growth of about 5% after 2011, which is midrange for the industry. But that doesn't include much of the merger-related savings, says Holford. New chief executive Joe Jimenez is expected to focus on boosting Novartis's profit margins. And despite Novartis's exceptional pipeline, the stock trades at only 11 times estimated earnings of $4.78 per American depositary share, about the same P/E as its peers.

Teva Pharmaceutical Industries (TEVA): $61

While makers of brand-name drugs dread the patent cliff, Teva Pharmaceutical Industries, the world's largest maker of generic drugs, approaches it gleefully. The Israeli company expects the global generics market to grow from $80 billion to at least $135 billion by 2015. Over that period, it plans to double its annual sales, to $31 billion. And it aims to increase its brand-name drug business, now 30% of sales.

You might expect to pay a steep price for Teva, one of the fastest growers in the industry. But while the stock has climbed 40% over the past year, it trades at just 13 times estimated 2010 earnings of $4.55 a share. And with profits climbing 15% to 20% annually, the shares look like they have plenty of room to run.