After a tough 2016 due to political pressure, drug-makers looked to be having a good year. The SPDR S&P Pharmaceuticals ETF (NYSE: XPH) reached a 2017 high of $44.32 in late July, up nearly 14% on the year.

Even the hardest hit among the group were finding new life, such as when Valeant Pharmaceuticals (NYSE: VRX) (which had suffered from seemingly daily negative headlines) surged 96% from its April low through July.

But second-quarter earnings have not been kind. A chorus of poor earnings reports, especially in generics makers, has wiped 6.3% of the value off XPH in just 10 trading days.

New fears around increased competition and high levels of debt are dragging the entire industry lower.

At the same time, this is an industry with an immense amount of support from multiple demographics.

This could force government regulation that could start to clear the way for faster drug approvals.

That means a rebound could be in the making for the best names in the group — those pulled lower with the industry but with strong fundamentals and upside potential.

I’ve found three drug-makers trading at attractive valuations, without the debt that overhangs much of the group, and that could be ready to move higher.

Did Pharma’s Eyes Get Bigger Than Its Stomach?

Fears of government intervention in drug pricing have been calmed and it now looks like the new head of the Food & Drug Administration (FDA), Scott Gottlieb, might help speed approvals for sales in the United States.

The FDA announced a “Drug Competition Action Plan” in May, vowing to speed development of generics and clear approval bottlenecks within the industry. Increased competition may weigh on price growth but could be a boon for generic drug-makers and will take pressure off Washington to regulate prices across the industry.

Pricing fear has given way to another problem within the industry, sending pharmaceuticals sharply lower this month. Cheap interest rates and the need to refill pipelines with new drugs led to an acquisition boom across the industry. Drugmakers took on tens of billions in debt on the idea that strong sales growth would easily cover interest payments.

A few second-quarter earnings reports have shattered investor expectations and replaced regulatory headline risk with fears that some companies may have trouble servicing their debt.

Teva Pharmaceuticals (NYSE: TEVA), for example, said it would take a $6.1 billion goodwill impairment charge and cut its dividend by 75% to protect cash during its second quarter earnings call. The company took on more than $24 billion in net debt over the last year, increasing its leverage to $33.8 billion against just $28.0 billion in stockholders’ equity, to acquire the Actavis’ generics business.

Sales at Teva were flat last quarter while operating costs more than tripled from the same quarter last year. Faster drug approvals are helping the company get new products out but also mean tougher competition and higher marketing costs. Investors are now worried that the company can meet its debt covenants to maintain EBITDA of 4.25 times interest payments.

Shares of Teva plunged on its earnings report and continued to tumble in the days after, closing down 36% on the week.

Longer-Term Pharma Upside Is Still Intact

Against the negative sentiment in drugmaker fundamentals, we still have undeniable demographic support from an aging population. According to the Bureau of Labor Statistics, spending on drugs jumps 33% for the 65 to 74 age group versus those 55 to 64 years old.

More than 10,000 Baby Boomers turn 65 every day and will continue to do so until 2029. It’s a trend happening throughout the developed world and one that should drive volume for drug companies even if pricing remains weak.

The selloff in the industry has weighed on everyone, even the companies with relatively strong balance sheets. These companies did not leverage up to the extent that others did and could represent a buying opportunity.

Where debt levels are an issue, I like to use the enterprise-to-sales metric for valuation. Reducing the market capitalization by cash and then adding in long-term debt gives you a better idea of how much investors are paying for every dollar in sales compared to the simpler price-to-earnings measure.

Dr. Reddy’s Laboratories (NYSE: RDY) has no long-term debt and $229 million in balance sheet cash for an enterprise multiple of 2.5 times sales. For reference, shares of Teva trade at an enterprise multiple of 2.32 times sales even after last week’s crash.

Dr. Reddy’s Laboratories reported similar headwinds from competition but was still able to grow global generics revenue by 3% during the second quarter. Tax reform in India led to destocking, where pharmacies sell through their inventory without restocking from the company, but this could bring an upside surprise in sales through the rest of the year.

The company has a strong international presence, especially in emerging markets, with more than half (52%) of sales outside of North America.

Perrigo (NYSE: PRGO) has $4.6 billion in long-term debt but also $3.1 billion in balance sheet cash for an enterprise multiple of 2.2. The company is the largest store-brand, over-the-counter pharmaceutical and infant formula manufacturer globally, helping to smooth sales across prescription and OTC drugs.

Perrigo hasn’t been completely silent at the acquisition table, closing its €3.8 billion purchase of Omega Pharma in 2015, but it has been aggressive at paying down debt. Worries over the integration have weighed on the shares, down 23% over the last year, but the company’s balance sheet cash gives it all the financial flexibility it needs.

Mallinckrodt (NYSE: MNK) is slightly more leveraged with $5.7 billion in debt and $260 million in cash and an enterprise multiple of 2.8 times sales. The company settled with the Federal Trade Commission in January over antitrust complaints, removing the overhang of headline risk on the shares. Some restrictions have been removed from its lead drug, Achthar, which is approved for 19 indications and could see stronger sales growth for the rest of the year. Mallinckrodt’s sale of its nuclear imaging business last year could be followed by other asset sales to lower the debt level.

Risks To Consider: Headline risks around drug pricing could threaten gains in even the best-of-breed stocks in the sector, though it seems unlikely that regulators will take direct action against prices.

Action To Take: Avoid highly-leveraged companies in the specialty and generics drugmakers and take advantage of the recent selloff to position in companies with strong balance sheets and upside potential.

— Joseph Hogue

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Source: Street Authority