Pharmaceutical shares – what to look for

One of the most important parts of investing is understanding what a company does and the risks to their business. Profits and cashflow are key metrics to watch out for with any business, but there are often sector-specific metrics too. This can be particularly tricky when it comes to pharmaceutical companies. On top of the medical jargon, it’s often difficult to decipher the value of a group’s drug portfolio.

Cash flow – what is it and why does it matter?

Every investment comes with some degree of risk and pharmaceutical stocks are no exception. However, we think the information below should help with the decision-making process.

This article isn’t personal advice. If you’re not sure if an investment is right for you, seek advice. Ratios and measures shouldn’t be looked at in isolation, you should look at the bigger picture. All investments and any income they produce can fall as well as rise in value, so you could get back less than you invest. Past performance is not a guide to the future.

Size matters

It’s expensive being a drug maker. Enormous research and development costs go into each new therapy, and many never make it to pharmacy shelves.

Only about 10% of newly developed drugs will make it through the rigorous trial process. Even in the later stages of the approval process, there’s a better chance a drug will be tossed out than made available. Just over 58% of drugs in phase three clinical trials (the final stage) will be rejected.

A bird in the hand is worth three in the bush, as they say, and in the case of drug makers, that certainly applies. Having drugs already on the market generating the cash needed to support the expensive development process is a big bonus. For that reason, the industry’s largest, best funded, players tend to be safer than some of the upstart biotech stocks that frequently make headlines.

In the US, Johnson & Johnson (JNJ) is an example of one such behemoth. Over the last quarter alone, the group’s pharmaceutical division brought in $13bn. JNJ has several patented, cash-generating treatments already on the shelves, which account for roughly 20% of overall group sales. For these drugs, competition is limited, and revenue is relatively secure.

As a whole its pharmaceutical arm brings in just over half of its revenue. The rest comes from a host of other goods like medical devices and consumer products, adding a layer of diversification. The group plans to spin off its consumer goods business, which will weight the portfolio more toward pharmaceuticals. But the fact remains that JNJ is more diversified than some of its smaller peers.

Johnson & Johnson revenue breakdown

Johnson & Johnson Pharmaceutical revenue breakdown

Source: Johnson & Johnson 2020 annual report.

From a security standpoint, this can be good because one failed drug isn’t going to sink the ship. But on the other side of the coin, one new treatment isn’t going to move the needle much either. That’s clear when you look at JNJ’s price to earnings ratio.

While there’ve been several big developments for JNJ, like the Covid-19 vaccine and subsequent boosters, investors are willing to pay $16 for each $1 of expected profit – roughly in line with the group’s ten-year average.

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Patent protection

The size of a drug maker helps smooth the ups and downs that go with the drug approval process. But patent protection is what keeps their current arsenal of treatments profitable while they work on new therapies. When a new drug is created it’s patented, keeping low-cost generic versions from muscling in and starting a price-war.

But the rights to a particular drug don’t last forever. For the most part, after 20 years, they’ll expire. With the exception of a few brief extensions, you can expect generics to crowd the market soon after, cutting profitability considerably.

With that in mind, patent expiry is another key way to evaluate revenue. If a large percentage of a company’s sales are at risk over the next few years, it’s important that their pipeline is relatively advanced with several drugs on the way to being approved.

Take AstraZeneca, for example. US sales make up about a third of overall revenue. Beginning in 2029, a significant portion of those revenues will be at risk of decline as its patents start to expire.

Percentage of AZN US revenue at risk due to patent expiry

Scroll across to see the full chart.

Source: AstraZeneca 2020 annual report.

However, the group has 171 projects in its pipeline. Of those, more than half are in the later stages of the approval process. This doesn’t guarantee the revenue will be replaced. But it does mean there’s a better shot at having new revenue streams in place before the old ones dry up.

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Dividend potential

The large drug makers are generally well-known for dividend payments. While it’s always nice to have the added benefits of a dividend payment, there are some things to consider.

The first is budget. A drug company that’s returning too much to shareholders will struggle to invest in their pipeline. That could leave them exposed when their existing patents expire.

On the other hand, investors will expect some degree of compensation if they’re to stick around through the uncertain approval process. With most of the sector’s biggest names returning cash to shareholders, it’s an important consideration.

Just because a company’s paying dividends today doesn’t mean it will be tomorrow. We suggest looking at dividend cover to get an idea as to how secure a dividend payment is – but remember dividend yields are variable and no dividend is guaranteed. They are not a reliable indicator of future income.

GlaxoSmithKline, for example, has recently trimmed its dividend and is now expected to offer a prospective dividend yield of 3.5%. That represents nearly 70% of the group’s earnings, leaving behind 30% to invest in growth and pay off debt. While this isn’t a huge cushion, it’s enough to suggest there’s no immediate need for further cuts.

Rarely does one metric tell the whole story, though and that’s why it is important to consider the bigger picture. Lots of companies opt to funnel cash away from investors to pay down debt if it starts to become expensive. With a potential interest rate hike on the horizon, companies with lots of debt could start to prioritise their financial obligations.

GSK finds itself in such a position. The group’s planning to execute a demerger that will see its debt offloaded to its consumer arm in the year ahead. But if it doesn’t go as planned, the dividend could be on the chopping block.

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The bottom line

Demystifying drug portfolios and understanding how drug companies run their businesses takes time and effort, but all this information can be found in their annual reports. If wading through a mountain of drug data isn’t your cup of tea, we cover research updates on more than 100 stocks, including a few in the pharmaceutical sector.

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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.