THE INVESTMENT COLUMN : Chemistry right for drug shares

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The Independent Online
The pharmaceuticals sector has given investors a pretty rocky ride over the past five years as stock market sentiment has swung wildly. Currently the market is strongly in favour and yesterday's announcement that Glaxo had confirmed the validity of its patent protection for the world's best-selling drug Zantac was the latest good news.

Over the past year, the big pharmaceutical stocks have outperformed the FT-SE 100-share index by a sizeable 28 per cent, an impressive performance given the strength of the market as a whole this year. Drugs look like they are having an annus mirabilis to match their almost doubling in value in 1991, when looming recession sent investors scuttling to the perceived safety of the sector. Between the beginning of 1992 and the middle of last year, drugs lagged the market as investors worried about a tightening of the industry's ability to raise prices, but they are now back in fashion.

Within the sector, however, there are marked differences in value. Cheapest in relative terms appears to be SmithKline Beecham, where forecasts from Nikko Europe, the broker, predict growth in pre-tax profits from pounds 1.17bn to pounds 1.74bn between 1993 and 1997. Growth of 16 per cent in the last year of that period compares favourably with a prospective price/earnings ratio in the mid-teens.

Interestingly, the decline in US holdings of SB shares since the merger between SmithKline and Beecham has been reversed in the last year, and Nikko's target share price of 720-750p, compared with the current 655p for the A shares, looks achievable. An update will be provided tomorrow by the publication of nine-month figures.

Glaxo Wellcome, formed earlier this year by the UK's largest successful contested bid, also trades at a small discount to its European peers, and looks reasonable value, although less so than SB. Cost savings from the merger appear to have been much better than originally anticipated. That should allow the group to grow earnings at an average of 13 per cent a year over the next three years before a slowdown at the end of the decade as US patent expiries of ulcer drug Zantac and anti-viral Zovirax begin to take effect.

The settlement of the company's patent dispute with rival Genpharm yesterday, however, could encourage US investors, who have shunned the shares recently (see chart), to return. At 849p, up 52.5p after yesterday's good news, the shares could still have a way to run.

The drug major to have benefited most from bid speculation this year has been Zeneca, the former pharmaceuticals arm of ICI, which at 1183p has also received a boost from favourable developments in its new product pipeline. At that level, the company looks expensive in terms of its price/ earnings ratio, which even in 1997 is a demanding 16.5. Earnings growth that year will only be a market average 9 per cent.

Despite good fundamentals and strong management the shares look worse value than their peers, with too much speculative froth for most investors' comfort. A nine-month trading update today brings investors up to speed.

MY wraps up pretty package

The management team that was drafted in at packaging group MY Holdings five years ago must be pleased. Peripheral businesses such as a games division have long gone. Instead, MY concentrates on supplying the food and pharmaceuticals industries with plastic packs for ready-made meals and containers for pills and medicines.

Though these clients are tough taskmasters, the benefits are higher barriers to entry and fatter margins. The drugs companies, in particular, are willing to pay a higher price for packaging as hygiene and labelling standards are important.

The supermarket groups have been pruning supplier lists, choosing only those agile enough to deliver lower volumes on a just-in-time basis. Those that survive are in a better position to withstand supermarket pressure on supplier margins.

The benefit is evident in MY's results, which show a doubling of pre- tax profits to pounds 9.1m, on sales up 50 per cent to pounds 77m. This compares with a pounds 5m loss five years ago. The share price, which was languishing at 20p in 1991, has risen to 69p, up a further 4p yesterday. This is comfortably above January's 53p rights issue price.

MY's biggest problem this year has been the persistent rise in raw material prices that has dogged the sector. However, in spite of fearsome increases in both paperboard and plastic prices, MY has been able to pass most of these increases on.

Looking forward, MY should continue to benefit from the rationalisation of the packaging industry and this year should see an earnings contribution from the Propharmapak business acquired late last November. More deals are expected. House broker Albert E Sharp is forecasting profits of pounds 11m this year, which puts the shares on a forward rating of 12. They could have further to go.

Troubles mount at YJ Lovell

It is quite an achievement to turn a share worth the equivalent of pounds 31 in 1987 into one trading at just 14p yesterday but that is what a succession of management teams at construction, property and, until recently, housebuilding group YJ Lovell has managed.

Confirmation over the weekend that Robert Sellier, the latest chief executive, has decided to throw in the towel a year early opens the door for David Heppell from Lovell's American outpost to try his luck. Existing shareholders will have long since given up on the investment - the question is whether, at currently depressed levels, the shares are worth buying.

Catching the bottom of similar falls at distressed groups such as Next and Bluebird Toys has made fortunes for investors in recent years. It is far from apparent, however, that what remains at Lovell is a bargain even at this price but having sunk so low they do have attractions as a penny share punt - the 1p rise yesterday represented an 8 per cent increase.

Lovell's is a sad tale of over-confidence in good times (bidding for Higgs & Hill), over-optimism (failing to pay a dividend after promising one with a rights issue) and a massive swing from profit to loss. In 1989, pre-tax profits were pounds 33.4m, more than six times its latest market value, but between 1991 and 1993 it lost pounds 150m.

The company now risks falling into a black hole where investors lose track of what is going on and the shares are driven by unreliable whispers. One forecast yesterday predicted profits of pounds 1.3m for the year to September, putting the shares on a forward p/e ratio of about 10. Highly speculative.

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