Virtually every investor is quite familiar with the names of big pharmaceutical giants such as GlaxoSmithKline plc (ADR) (NYSE:GSK), Eli Lilly & Co. (NYSE:LLY), and Abbott Laboratories (NYSE:ABT) and the fortunes that have been made by investors in these enormously successful businesses. What many investors fail to spend time considering is that a much of the growth of these large businesses came from buyouts of smaller faster growing companies within the pharmaceutical industry that were priced cheaply in comparison to their larger brethren.
Special protection for special drugs
Certain drugs developed for the treatment of rare diseases (orphan drugs) are granted lower barriers for approval and/or extended patent protection as an incentive to manufacturers to produce them, thus limiting competition for market share. That is the upside; the downside is that the market for each drug is quite limited.
Mylan Inc. (NASDAQ:MYL) carries a debt to equity ratio of 2.18 and only generates enough cash to cover interest payments 4.3 times–not a tremendous cushion. In addition, its 5-year average returns on equity, assets, and capital have only been 7.1%, 2.8% and 3.4%, respectively, and its 5-year average net margin is a paltry 5.5%. These are not good numbers for any business outside of discount retail, but are very poor for the drug business.
Smaller and better, but more expensive
The company carries no long term debt, as well as $349 million in cash and short term investments on hand against total liabilities of only $210.32, placing it is on a solid financial footing. While the 2013 price to earnings ratio of 117.5 is quite a bit higher than I would normally like to see, based on 2014 projected earnings of $0.57/share, it will fall to 32.98 and be closely aligned with the estimated 5-year growth rate of 26.9%. While this projection is a very aggressive rate of growth, the volume of products in the company’s pipeline does seem to justify the expectation. The past 5-year returns on equity, assets, and capital of 23%, 13.1%, and 16.8%, reveal an efficiently-run business with an exceptional ability to allocate capital effectively.
The projected rapid earnings growth and extensive product offerings and pipeline give Impax Laboratories Inc (NASDAQ:IPXL) the potential to produce very attractive returns for investors due to the business’s growth could also attract the attention of one of the larger generic manufacturers looking to grow through strategic acquisitions.
The cheapest price and most limited product line
At the current price, Questcor Pharmaceuticals Inc (NASDAQ:QCOR) is trading for a puny 8.59 times estimated earnings of $4.06/share for 2013 and has a projected earnings growth rate of 22.50% for the next 5 years. Furthermore, management has produced spectacular returns on equity, assets, and capital for the past 5 years of 62.9%, 47.8%, and 63%, respectively. The dirt cheap valuation currently applied to shares of Questcor Pharmaceuticals Inc (NASDAQ:QCOR) reflects the inherent risk involved in placing investment capital in a business with essentially one product, and the movement of the share price has provided shareholders with a true rollercoaster ride over the past year. However, the failure of Aetna to attract any support among other major insurers for their reimbursement restrictions on Acthar Gel has given investors reason to be optimistic regarding future performance.
As of May 15, 2013, short sellers of Questcor Pharmaceuticals Inc (NASDAQ:QCOR) stock have a net position of almost 25 million shares and would have been experiencing quite a bit of pain on May 14th when the share price moved above $42/share. The short interest in Questcor Pharmaceuticals Inc (NASDAQ:QCOR) is almost equal to 9 days of average trading volume for the stock so a rising share price that caused the short sellers to begin covering could drive this stock violently higher very quickly.
Final thoughts and actions
Mylan Inc. (NASDAQ:MYL) carries a low valuation well-justified by the projected single digit growth projections and the debt level could prove to be problematic if the overall business does not go smoothly. Mylan Inc. (NASDAQ:MYL) and Questcor Pharmaceuticals Inc (NASDAQ:QCOR) both seem to offer exceptional opportunities for investors who understand the potential risks and rewards presented by each business. An equal allocation of capital between these two businesses would provide the opportunities for excellent long-term returns while spreading the risk between two alternatives. Both of these businesses would also make attractive acquisition targets for larger, more diversified companies within the industry, providing investors with two ways to make big gains in small pharma.
The article Two Stocks That Double Your Chances For Big Gains originally appeared on Fool.com and is written by Ken McGaha.
Ken McGaha has the following options: Short Jun 2013 $35 Puts on Questcor Pharmaceuticals. The Motley Fool has no position in any of the stocks mentioned. Ken is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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