Investors can still find health stock gems

Low price doesn't reflect long-term prospects for several companies

Dollars & Sense

May 05, 2002|By Pat Dorsey | Pat Dorsey,MORNINGSTAR.COM

Being a value investor means wading in when the news is bad. Earnings coming in below expectations? Great! Negative articles on the front page of The Wall Street Journal? Bring 'em on! Stocks hitting 52-week lows? Fantastic!

Simply buying beaten-down stocks isn't enough, however, because stocks can fall a long way and still be expensive if they were high-priced to begin with and the fundamental picture gets considerably worse. The trick is to be reasonably sure that the stock price has fallen more than the business value, in other words that the long-term picture is still bright even though the short-term picture is ugly.

This description, I think, fits a lot of health-care stocks now. Pipelines for a lot of large pharmaceutical companies are drying up, biotechs are getting crushed after overpromising and underdelivering for the umpteenth time, and everybody loves to hate HMOs.

As an example of how things have changed, look at genomics leader Celera Genomics, whose stock has fallen from $120 or so in mid-2000 to about $20 today. The current share price is roughly equal to the value of its database business and the net cash on the balance sheet, which means the market is assigning essentially no value to its drug-development business. Selling database subscriptions was recently switched to Celera parent Applera Corp.

We think the market is valuing Celera appropriately, because it's uncertain whether the drug-development business will ever generate cash. Even if it does, those cash flows won't show up until many years from now. (The current value of a stream of cash flows lessens as those cash flows get pushed further into the future.)

However, there are more than a few pharmaceutical and health-related companies that we think the market is undervaluing, and I polled Morningstar's four health-care analysts about their favorites.

Schering-Plough: We like this stock so much that we recently purchased a little bit for one of the portfolios we track in Morningstar StockInvestor, our monthly stocks newsletter. Wall Street is tightly focused on the loss of revenue from the blockbuster antihistamine Claritin when the drug loses patent protection in the near future, but we think the drop in the stock price more than compensates for the loss in expected cash flows.

Trading at about 20 times next year's earnings - which is very cheap for a drug stock - we think the stock is substantially undervalued. The stock trades for about $31, and our discounted cash flow analysis places fair value closer to $39.

Bristol-Myers Squibb: Although management has made mistakes recently, Bristol still generates a ton of cash flow and yields a hefty 3.5 percent. Moreover, the company has more than a few drugs that are chugging along just fine, and Bristol's finances are rock-solid. This one likely will require some patience, and things certainly could get worse before they get better, but the stock is too cheap to ignore. If nothing else, Bristol's an attractive takeover candidate.

ICOS: Moving even further out along the risk spectrum, we come to this rarest of creatures: an undervalued biotech. ICOS' future is tied to Cialis, essentially a much-improved version of Viagra that ICOS will be co-marketing with Eli Lilly. If Cialis is approved within the next few months - which seems likely - we think it can generate enough cash over the next several years to make ICOS worth $65, which is a long way above the current $42 share price.

Before you get too tempted, however, remember that this is a classic biotech: If Cialis doesn't get approved, or if it gets delayed long enough for competing products to hit the market first, ICOS shares will be hit very hard. This one's appropriate for only a very small portion of your portfolio.

First Health Group: There's more to health care than drugs and biotechs. First Health runs the nation's largest preferred-provider organization, which is becoming more popular among employers than traditional HMOs. HMOs can get whacked by rising health-care costs if they don't negotiate sufficient premium increases from employers; PPOs just pass the costs along to consumers.

However, PPOs are still able to give consumers cheaper access to health care than they could gain on their own, which encourages employers to sign up with them. First Health also enjoys fat margins and just won a giant contract that will increase its growth rate quite a bit over the next few years.

We think the shares are worth about 25 percent more than their current price. The big risk is that HMOs are able to start up their own PPO networks and take customers away from First Health.

Waters: This company is one of the largest manufacturers of equipment used in drug-research areas such as proteomics and genomics, so it shouldn't be a surprise that the shares had a huge run during the late 1990s mania for anything gene-related.

Even though spending on drug research has slowed, the long-term trends are pretty good, and Waters still has a strong market share in some of the fastest-growing areas of the market.

Although competition has increased quite a bit in the past couple of years and the company recently lost a patent dispute, Waters has a strong record of keeping costs under control and of introducing products, both of which bode well.

The stock isn't as cheap as some of the others mentioned above, but the price is reasonable for what you're getting. If it falls back to the mid-20s, it would be quite attractive.

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