Cliff Diving

Top High Tech Companies To Buy Right Now

The so-called "patent cliff" is an issue that's been dogging the pharmaceutical industry for several years, but it really came to the fore in 2012 when drugs generating more than $35 billion in annual sales lost patent protection. That year, real per-capital drug spending fell by 3.5 percent thanks to the effect of generics flooding the market, the first year the US drug market actually shrank in terms of value.

The cliff hasn't figured quite as largely in the pharmaceutical calculus over the past couple of years, with only about $18.5 billion in sales going off patent last year and only about $16 billion at risk this year. But pharmaceutical companies will be base jumping next year when they run up on the cliff again, as $33.5 billion in annual sales are at risk of losing their protections.

However, many pharmaceutical companies actually have a usable parachute this time around. With the clear visibility of the looming precipice, most have invested heavily in research and development and built up drug pipelines to help cushion their fall. There are also few blockbuster drugs—those with $1 billion or more in annual sales—losing their patent protections, softening the blow. And while new drug approvals totaled just 27 last year, 39 were improved in 2012, setting a 15-year high.

Despite the better industry fundamentals, some drug markets are still better situated than others, making 2014 an ideal time to buy into a pair of Big Pharma players: Merck & Co (NYSE: MRK) and Pfizer (NYSE: PFE).

When Merck released its fourth quarter results two weeks ago, it reported a 14 percent decline in profit for the quarter on a year-over-year basis. Worldwide sales were down by 4 percent largely thanks to the expiration of its Singulair patent, causing a 38 pe! rcent decline in sales of that drug. Sales of diabetes treatment Januvia and HPV vaccine Gardasil were also off, though revenue from cholesterol fighter Zetia rose 6 percent and the arthritis drug Remicade saw 13 percent growth.

With the weaker sales and the inclusion of acquisition and restructuring costs, earnings per share (EPS) for the quarter totaled $0.26, down from $0.30 in the year-ago quarter. Excluding those one-times, adjusted EPS came in at $0.88 versus $0.83 in the same period last year.

On a full-year basis, worldwide sales were down 7 percent to just more than $44 billion, well off 2012 sales of $47.3 billion. EPS totaled $1.47 for the year, missing the prior year's earnings of $2.00.

For this year, Merck expects earnings to come in between $2.15 and $2.47, with adjusted EPS falling in the range of $3.35 to $3.53. The company's patent troubles aren't quite over either, with Nasonex, Temodar, Integrilin and three other drugs all expected to lose protections. But only Nasonex produces annual sales anywhere near $1 billion, though Temodar is a close second and the rest of the drugs produce only negligible revenue. In all, about $3 billion in annual sales are at risk.

The company faces even fewer expirations in 2015 and has an attractive pipeline with 20 phase II programs and 13 phase II programs currently running. Many of those programs are focused on unmet medical needs, improving the odds of approval since they face less competition and have better pricing power in the market.

Merck has also entered into collaborative agreements with three other drug companies—Pfizer, Amgen (NSDQ: AMGN) and Incyte (NSDQ: INCY)—to test the safety and efficacy of MK-3475 (formerly known as lambrolizumab) in combination with partner compounds. MK-3475 is an immuno-oncology drug and Merck is interested in establishing if it will produce better results when combined with other drugs.

The beauty of this approach is that different indications are being studied, ! so the po! tential uses for MK-3475 can be quickly expanded through the collaboration.

Merck can also unlock additional value by selling of its Animal Health and Consumer divisions, following the ongoing industry trend of refocusing on its core therapeutics business.

While it is currently trading near its 52-week high, less patent exposure and an attractive pipeline makes Merck a buy up to 60.

Pfizer falls at the opposite end of the spectrum in terms of patent expirations.

Lyrica, a treatment for nerve and muscle pain as well as partial-onset seizures in adults, is a mega-seller with annual sales of about $4 billion. Along with Detrol, the drug is facing expiration this year for a total of about $4.5 billion of sales at risk.

While that's a huge chunk of sales, Pfizer saw the writing on the wall several years ago and has been aggressively building out its pipeline. While it has 31 phase I projects underway which are still years from market, it has 24 phase II and 20 phase III trials currently underway. It also has 6 drug programs in registration, essentially waiting for action by the Food and Drug Administration. That represents an investment of more than $40 billion on research and development over the past five years.

That's one of the most attractive pipelines among the major pharmaceutical companies.

Nonetheless, the company is getting relatively little respect from investors who are still gun shy after a tidal wave of expirations over the past several years. But in addition to its pipeline, management has aggressively cut costs and has sold off its nutritional business and spun out its animal health division.

The company could unlock further value by splitting off other operational units. But right now, the company is trading at just 13.1 times forward earnings, the lowest valuation of the drug majors.

For 2014, the company said that it expects revenue to fall between $49.2 billion to $51.2 billion, essentially in line with this year's $51.6! billion ! in full-year revenue. It looks for EPS of between $2.20 and $2.30, slightly better than this year's $2.22.

I suspect both management and the markets are underselling the company, with its potential blockbuster breast cancer treatment palbociclib likely to be approved before year's end. It also has a number of partnership-development deals coming to fruition soon which are also showing strong promise.

Pfizer is undervalued and a good buy up to 37.