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Pharmaceutical stock watch

Pharmaceutical stock watch
August 24
15:55 2017

Has a plunge in Hikma Pharmaceuticals (HIK) gone too far, accentuated by short selling? And, hence, is the FTSE 250 (MCX) stock due at least some technical rebound?

Or, like a (less savage) drop at FTSE 100 (UKX)-listed Shire (SHP), is it signalling a status change for pharmaceuticals away from “defensive growth”?

If forecasts are fair then, at about 3,770p, Shire trades on a forward price/earnings (PE) multiple of just over 9 times; at 1,170p, Hikma trades on about 13 times. Both have de-rated from historic annual average multiples over 20 times and both are projected to recover earnings this year.

I’ll focus in this piece on Hikma, which has just over 5% of its stock out on loan (versus none disclosed for Shire) as this may be contributing to a negative bias in pricing. With 41.5% owned by the chairman/chief executive and a pharma-major, the market in Hikma is relatively tight, hence it only needs an element of short closing to spur upside.

The difficulty is defining underlying value, as competition in drugs intensifies, and Hikma being significantly a generic distributor – than, say, GlaxoSmithKline (GSK) or AstraZeneca (AZN), which are investing in new drugs protected by patents. Thus, intrinsic value, quite like the stock, is a moving target.

58% plunge but a hopeful broker implies 92% upside

The five-year chart shows classic self-reinforcing trends. From 2013 to early 2015 the stock climbed from 750p to 2,574p as earnings expanded fast (see table). Then a tussle of opinion between roughly 1,800p and 2,600p was followed by a fall from 2,676p in August 2016 after those interims saw core earnings per share (EPS) down 21% in constant currencies.

Hikma’s story has improved but its latest results convey a stale group overall: 1% revenue growth or 5% in constant currencies, with guidance trimmed for the full year. Core profit is effectively flat, up just 3% in constant currencies.

The narrative is mixed: an improvement in generics and the injectables business resilient, albeit offset by weaker profits from branded drugs. Competition in the US is increasing and pricing pressure intensifying.

The PR tactic is to brand Hikma as “stable” but last June’s general election rephrased that in the British conscience as “lacking fresh ideas”.

An acquisitions strategy has also accumulated some £621 million net debt, the service cost of which clipped 16.5% of interim operating profit; not ideal but manageable with interim operating cash flow up from £77 million to £175 million.

Independent broker Peel Hunt has a 2,150p target that it “reiterates”, having forecast last May EPS of 87.1p this year and 103p in 2018. But its £285 million pre-tax profit target for 2017 as a whole looks rich considering Hikma’s interim performance and the industry becoming mercurial.

Hikma Pharmaceuticals – financial summary Consensus forecasts
year ended 31 Dec 2012 2013 2014 2015 2016 2017 2018
Turnover (£ million) 700 877 906 943 1,445
IFRS3 pre-tax profit (£m) 83.3 191 220 208 156
Normalised pre-tax profit (£m) 87.7 209 234 225 189 251 334
Operating margin (%) 14.3 25.6 26.9 26.6 15.4
IFRS3 earnings/share (p) 31.9 68.8 84.6 82.1 49.0
Normalised earnings/share (p) 34.2 77.6 91.6 90.2 63.3 83.2 104
Earnings per share growth (%) 12.4 127 18.1 -1.5 -29.8 31.5 25.1
Price/earnings multiple (x) 18.5 14.1 11.3
Historic annual average P/E (x) 28.7 20.5 23.8 23.4 27.7
Cash flow/share (p) 46.8 93.0 127 105 76.6
Capex/share (p) 28.3 24.1 35.6 34.9 52.5
Dividend per share (p) 8.3 11.1 12.0 16.8 22.9 26.1 28.1
Dividend yield (%) 2.0 2.2 2.4
Covered by earnings (x) 4.0 6.1 5.5 4.3 2.6 3.2 3.7
Net tangible assets per share (p) 125 175 192 248 227
Source: Company REFS

Will president Trump spoil the “US drugs party”?

A latest report, which may account for the stock rising about 50p to 1,170p, cites Hikma sharply increasing prices of six medicines in the US, including a diarrhoea treatment up 430%. It shows how generic drugs with scant competition can command high prices despite a wider deflationary environment; the US having no controls over what buyers must pay.

It also exemplifies why Donald Trump seized on “drugs companies treating the US like dummies” as part of his 2016 election campaign, promising that “outrageous prices will be coming way, way, way down”. But, like most Trump promises, his administration is struggling to progress an executive order on pricing or allowing cheaper imports.

Thus, US pharma stocks have lately enjoyed some reprieve. This hasn’t reached Shire or Hikma, though, despite both companies deriving about two-thirds of revenue from the US.

The president of Hikma’s US operation says price rises on a small number of products were needed for investment to become commercially viable. Most of these are in liquid form, however, where tablet alternatives are a more competitive market.

Estimates for the global prescription drug market vary but one was for $816 billion (£634 billion) in 2016 with underlying growth of 4.9%, the US being a key driver of growth up 5.6% to $320 billion.

Meanwhile, a PWC report, Pharma 2020, suggests the global market could be worth $1.6 trillion by 2020 as demand for medicines grows and the middle class expands; although mature markets are becoming more difficult as financial constraints limit healthcare spending despite demographics boosting demand.

Operating margins: Mixed but lower

The five-year table shows a drop to 15.4%, having achieved 26% to 27% over 2013-15; although Hikma’s 2016 results saw the core operating margin (excluding amortisation of intangible assets) down from 30.5% in 2015 to 5.8%, which was worrying.

Latest interims show a standard group operating margin of 12.6%, albeit a core margin of 19.7%; thus it would appear to be stabilising but doubtless the decline prompted fear about competition undermining some prices.

Hikma’s interim generics revenue is up 18.7% to £237 million helped by an acquisition, with organic performance undisclosed except to cite “revenue growth limited by the impact of increased competition on pricing and volumes, rationalisation of our product portfolio and a reduction in contract manufacturing revenue. We expect the tougher market conditions to remain in H2 2017, with continued price and volume erosion on our marketed portfolio”.

More positively, “we expect to more than offset this impact through increased demand for certain products, further portfolio optimisation and a small number of new product launches”. Thus, margins may at least have found a support level.

Takeover interest from 16.6% shareholder?

Bouhringer Ingelheim is one of the world’s 20 largest pharma companies and can’t be ignoring the drop in market value of its stake from £1.07 billion to £448 million.

The stake came about two years ago as a result of Hikma buying Bouhringer’s US generics side, the sale enabling it to focus on research and new products while retaining exposure to a market then seen as offering growth amid an ageing population and increased acceptance of generics.

But whether Bouhringer would seek to turn that logic on its head and re-purchase (plus a lot more) seems less likely. The stake may also complicate third-party bids, although Hikma’s strong cash flow profile could appeal to buyout financiers.

So, a takeover is possible if market sentiment festers although I wouldn’t bank on one.

Gaining support from a 1,120p low

The stock is enjoying some rebound, up to 1,170p. Quite likely there are traders/investors eyeing Hikma, if wary of catching a falling knife, until a support level is established.

Liquidity may not be enough to tempt institutional buyers, while private investors sit on their hands and the price has dropped. Yet the bounce shows a technical situation possibly over-sold, of interest to vigilant traders.

With the Trump administration increasingly on the ropes, the fear factor against pharma may be overdone. Add the technical situation of shorts needing to close in a tight market and Hikma could be a coiled spring.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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