Damien Conover: When we look at the pharmaceutical landscape over the last few years, we've seen valuations improve significantly. A lot of this is being driven by three key areas. The first of which is the end of the patent cliff, which really peaked in the 2012 time period. The second point is the growing importance of emerging markets, which are offering a new channel of demand for pharmaceutical products. The third reason has to do with increased productivity in the pipelines, which will bring forward next-generation drugs at a much faster rate than what we have seen for some time.
Wally Forbes: Sounds like a powerful combination.
Conover: Absolutely. And that has driven the P/E multiple for the group up to close to 18 times earnings. That’s up from a multiple that was closer to 12 times just a few years earlier. This massive valuation increase over the last two years was largely driven by those three factors.
At the end of the patent cliff, there were a lot of major blockbuster items losing exclusivity in 2012. Now going forward over the next five years, the patent expirations are much, much less. So pharmaceutical firms don't need to cut cost as much. They can focus on research and development, and they can focus on growth going forward, which is something that they couldn't really do in the 2011 and 2012 time period.
Forbes: That is a major change, isn't it?
Conover: A major shift. The other piece here is the increasing importance of emerging markets. If you go back a decade, emerging markets contributed very little to the overall growth of the pharmaceutical industry. In around the 2000 time frame, you were looking at emerging markets contributing much less than 10% of overall sales.
If you fast forward to today, you're looking at emerging markets contributing close to 20% -- or over 20% -- of top-line sales. That growth rate should continue to accelerate as the wealth creation in emerging markets continues and more disposable money comes to folks and to governments to use for drugs.
Forbes: Again, a powerful combination.
Conover: Yes, absolutely. And then the third point has to do with the increased productivity of the pipelines. This is probably the most important of the three trends. What we're seeing here is pharmaceutical firms shifting the strategy toward drug development in areas of unmet medical need.
What that means is opening areas of opportunity where there's not a lot of good drug treatment currently available. A good example there would be oncology. There are not a lot of good drugs to treat cancer. So the pharmaceutical firms have really pushed forward new treatment options in oncology, and I think that they will bring forth a next generation of drugs that have strong pricing power and will be in high demand by patients and physicians.
Forbes: That would make a very powerful background for them.
Conover: But summing all this up and then translating it into valuation and what kind of valuations we think are appropriate, we don't see a lot of opportunity in undervalued stocks with the exception of Sanofi (NYSE: SNY). We still think that it is significantly undervalued and offers a pretty good opportunity for investors going forward.
One of the nice things about Sanofi is it plays well into these different themes. It has very little patent exposure going forward; it has a strong entrenchment in emerging markets; and it has a pipeline that has a lot of focus on areas of unmet medical need.
Forbes: Why do you suppose this is hitting Sanofi differently than many others in the sense that it's not being recognized?
Conover: I think there are two factors. One, while it is focusing on some unmet medical needs, it lacks any major blockbusters that has drawn investors' attention. So I think one factor is that the pipeline, while it is good, it's not a spectacular pipeline that has certain products that can be mega blockbusters.
I think that’s the reason that it isn't grabbing investors' attention. And the second factor is that one of their key products is Lantus, which will likely face increasing competition over the next two to three years. Lantus is one of the key drugs for Sanofi. It's a long-acting insulin that is pretty differentiated right now. It represents just under 20% of total sales.
Forbes: It's coming up to expiration?
Conover: It's coming up to increasing competition. Both competition from different branded products and likely bio-similar competition. It's not going to be generic competition, but bio-similar competition from another insulin player -- with Eli Lilly being of most concern.
So that does weigh on the stock and does compress its multiple. But nevertheless, the growth prospects for Sanofi look very, very robust and it looks like a stock that is undervalued in our analysis.
One other stock that we think is still undervalued -- not to the same magnitude of Sanofi -- is Merck (NYSE: MRK). Merck has one of those products that could become a mega blockbuster. It's a PD-1 drug. PD-1 is a type of drug that helps the immune system fight cancer.
The drug's efficacy in early-stage studies suggests a major paradigm shift in cancer treatment -- particularly in lung cancer -- which is a $20 billion opportunity where this drug could take part of that market share. Something of that size can really move the needle for a company even as large as Merck, which we think is slightly undervalued. The management there is also a key reason why we think the stock is undervalued.
Forbes: Great. Those are interesting suggestions.
Conover: Yes, absolutely.
Forbes: Once again, thank you very much, Damien, for sharing your thoughts with us.
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