Employer Mandate: A Pharma Bump in the Road
by William Smead, Smead Capital Management
As long-duration value investors, we at Smead Capital Management have been very attracted to the conservative accounting, shareholder friendly dividends/buybacks and bright pipeline futures of major pharmaceutical/biotech companies like Merck (MRK), Pfizer (PFE) and Amgen (AMGN). Lately, there has been weakness in these shares and we’d like to review our best theory for recent fears and price weakness, while reviewing the merit of these high quality shares.
One of the more significant deals made by President Obama to get his healthcare plan enacted into law was the one cut with the major pharmaceutical companies. They agreed to give huge price breaks to seniors on prescriptions (fill the donut hole) in hopes of taking less of a beating in the court of public rhetoric and by gaining a huge number of newly insured potential customers. One of the keys to these new customers was the employee mandate. It has been postponed for at least one year out of fear that businesses would postpone hiring or lay off workers. This fear seems to us to be the cause of recent weakness in the prices of major pharmaceutical companies.
To understand the conservative accounting of pharmaceutical companies, you only have to look at their R&D budgets as a percentage of revenue. This R&D investment bears long-term fruit and is expensed, artificially hiding the incredible profitability of these companies. Most companies capitalize and depreciate long-term investments. Despite their ultra-conservative income statements these businesses generate high returns on equity (ROE) without leverage.
|R & D as a percent of sales||ROE|
Source: Thomson Reuters: Baseline
Merck pays a 3.6% dividend, recently added $5 billion to an existing buyback authorization and trades around 12.6 times earnings looking forward (P/E 2014). Pfizer pays a 3.4% dividend, boosted its buyback authority last week by $10 billion and trades at around 12.0 P/E forward. Amgen pays a 1.9% dividend, is in a $12 billion stock buyback and has publicly stated that the company would return 60% of adjusted net income to shareholders via dividends and buybacks. It trades at a forward year multiple of 11.8 P/E.