The Low-Stress Way to Invest in Pharmaceuticals (PDLI, PFE, SGNT, MRK)

As long-term Pfizer Inc. (NYSE:PFE) and Merck & Co., Inc. (NYSE:MRK) investors can tell you, big blue-chip names - even iconic names - aren't guaranteed to be great investments.... particularly when you're talking about pharmaceutical stocks. Merck shares were trading around $55 per share ten years ago, but are currently at $44.45 (and pushing their luck at that level). Pfizer shares peaked at $49 in 2000, and are currently priced at $23.80 (and that's only thanks to the rebound from the multi-year low of $11.62 in early-2009.

The reason for the drubbing? The so-called patent cliff has a lot to do with it. Pfizer's Lipitor - the best-selling drug of all time - was en route to its patent expiration in November of last year. The drug makes up, or made up, about 16% of Pfizer's sales in 2011, but when drugs 'go generic', they can see a 70% to 90% dip in the revenue they generate. So, Pfizer was certainly going to lose a huge chunk of its top line... and it has.

Merck & Co. wasn't quite as exposed to the same degree of reliance on one drug for a big portion of its revenue; Singulair only contributes (contributed) about 11% of Merck's total revenue when it was under patent protection. Singulair's patent expires this month, meaning $3.2 billion worth of MRK annual sales are in jeopardy.

Yes, both companies are working on new therapies to replace the lost sales stemming from the expired patent, and both companies have won approvals for a few new drugs over the past year. Yet, there's no combination of new and still-protected drugs that will make PFE and MRK as investment-worthy as they were in their glory days.

With the problems of excessive reliance on one (or two) blockbuster drugs is finally coming home to roost, investors are finally primed to accept that consistency in sales is just as important - maybe more important - than being a category leader within the pharmaceuticals market. Enter PDL BioPharma Inc. (NASDAQ:PDLI) and Sagent Pharmaceuticals Inc. (NASDAQ:SGNT).

Odds are good many investors have only heard of PDL BioPharma in passing, and likely never heard of Sagent Pharmaceuticals Inc. That's because neither are anywhere near as big as Merck, Pfizer, or any of the other household pharma names. Yet, what SGNT and PDLI lack in size, they more than make up for in reliability.

In simplest terms, Sagent Pharmaceuticals and PDL BioPharma aren't swinging for the fences with a blockbuster drug, which may or may not pan out. These two organizations are deliberately looking for the low-hanging pharmaceutical fruit... income-driving drugs that may be low-margin, perhaps almost commodity-like, and therapies that may never exceed more than a few hundred million in annual sales. Yet, these are drugs that are also never going to stop being used, and these drugs - when combined with sales of other small-ish revenue drugs - may collectively be part of a surprisingly-big revenue machine.

For PDL BioPharma, the business model is a combination of generating royalty revenue from its patent portfolio, as well as producing other company-owned/developed therapies. Some of the patented drugs that generate royalty revenue for PDLI include herceptin and avastin. PDL will also generate royalties from bapineuzumab, if it's approved. J&J, Elan, and Pfizer are all developing the drug. PDLI isn't developing anything on its own, but has a finger on several things being developed by others. What's most interesting about PDL BioPharma is that it's designed from the ground up to pay dividends from its royalty income. The current yield is 8.5%.

As for Sagent Pharmaceuticals, it's being built from the ground up to mass produce lower-revenue drugs at a low cost... something the monster-sized pharma companies can't or don't want to bother doing. Specifically, SGNT is eyeing drugs or divisions of major companies that generate less than $100 million annually. That's not a lot of money, but when a $363 million company has a few of those under its belt, it's a big relative deal. Sagent can make it viable not because it's going to be selling any blockbuster drugs, but because it can effectively manage the manufacturing process by coordinating the activities of a few dozen different manufacturers and development labs.

Said another way, while Merck and Pfizer may be hoping to score big with three to five blockbuster therapies, Sagent and PDL BioPharma are hoping to piece together an ever-largening lineup of reliable-revenue producers. And given the struggle Merck and Pfizer have faced of late, investors are understandably interested.

The downside for PDLI is that a great deal of its patent portfolio will be expiring in 2014. It does have other drugs in the works, however, and with a trailing P/E of 5.5 and a forward-looking P/E ratio of 4.04, that risk may be fully priced in. Sagent isn't profitable on a trailing basis, but is expected to swing to a full-year profit in 2013. And, with the number of revenue-bearing products currently at 34 with 84 more pending ones in the backdrop, 2013's expected expected EPS of $0.69 is easily within reach.