My favourite stock in the Big Pharma sector

Pfizer’s bid for AstraZeneca is the big headline-grabbing story of the moment.

But it isn’t the only thing happening in the healthcare sector. In fact, from an investment point of view, it’s not even the most important thing.

We’re also seeing some significant deals in the ‘over the counter’ medicine market. This market comprises products where you don’t need a prescription – things such as hayfever pills and cough drops.

Some of the big pharmaceutical companies want to expand their businesses in this area, while others don’t want to play at all. Indeed, the US giant, Merck (NYSE: MRK), has just sold its consumer business this week for a very fancy price.

However, regardless of the price, I think Merck is making a mistake. I’d much rather invest in a pharma giant that also has a consumer drugs wing.

Let me explain why.

Drug companies are fetching high prices for their consumer divisions

Bayer, the German company that owns the Aspirin brand, is paying $14.2bn to buy Merck’s consumer health division.

Bayer will now be one of the world’s largest consumer health businesses, while Merck will focus on innovative, patent-protected, prescription drugs.

Merck isn’t the only drugs giant to follow this approach. Roche, Eli Lilly and Bristol Myers Squibb all focus solely on prescription drugs.

The rationale is that the company and management won’t spread themselves too thinly. They’ll just focus on one business area and won’t get distracted.

On top of that, buyers seem to be willing to pay handsomely for consumer health businesses at the moment. Bayer is paying 21 times ‘Ebitda’ for the Merck consumer business. Ebitda is a measure of profits that is normally much larger than other kinds of profit, so 21 is a very high multiple indeed.

The price was driven so high because Bayer wasn’t only competing against other drugs companies for the deal. Consumer goods giant Reckitt Benckiser (LSE: RB) also wanted to buy the Merck business, and that pushed up the price.

Why it makes sense to diversify

You can see why big drug companies might want to flog off their consumer units. Selling branded painkillers and hayfever pills is a very different business to inventing innovative new drugs for killer diseases. Focusing on one or the other makes things clearer for both management and investors.

The manufacturing costs for most prescription drugs are also very low, while prices are high. So the profit margins are potentially very high – assuming the drug makes it past the costly development and regulatory approval stages, that is.

But I’m not convinced by this ‘pure play’ argument. You see, consumer drug brands such as hayfever treatment Claritin (which is included in the Bayer/Merck deal) are very strong, and will probably continue to generate significant revenues for many years to come.

If a drugs giant owns some of these consumer brands, I believe it reduces the risk for investors. They provide a nice reliable income stream.

The problem with prescription drugs is that they are always a bit of a gamble. During the development process, you never know whether they’ll get regulatory approval for launch. And even when they do launch, you can never be sure of how well they’ll sell.

There’s also the issue that in most countries, you’re beholden to indebted public sector health systems that want to drive down prescription drug prices. So those high margins are always under threat.

Prescription drugs are a very exciting area for investors, no doubt about it. New technology means plenty of opportunities for breakthroughs, and ageing populations mean demand will continue to rise. But it’s risky.

Given these risks, I’m happier if a drugs company also has a reliable over-the-counter, consumer business to stabilise things – especially as the drugs company may be able to move some of its older products to the over-the-counter division at some point.

Which pharma giants are in consumer?

Apart from Bayer, GlaxoSmithKline (LSE: GSK), Pfizer, Novartis and Sanofi all have sizeable consumer units.

Indeed Glaxo and Novartis recently did a deal where they merged their consumer divisions into one jointly-owned business. To me, this shows that both companies are still committed to consumer drugs – they just want to cut costs and boost the impact of their sales force, in which case running a joint venture makes sense.

Of these companies, I’m still drawn most to Glaxo. On the downside, Glaxo is being hit by the decline in sales for its respiratory drug, Advair, but its development pipeline still looks promising.

What’s more, Glaxo trades on a reasonable price/earnings ratio of 15 and the yield is a decent 4.8%. So with a nice consumer division as well, I’m very happy to hold on to my shares in Glaxo.

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