The term ‘value trap’ is often banded about by financial journalists and investors alike. It means a company whose shares appear to offer good value but, for any number of reasons, is fatally flawed and, as such, is not a wise investment.
Indeed, AstraZeneca (LSE: AZN) (NYSE.AZN.US) is often considered a value trap, having an exceptionally low price-to-earnings (P/E) ratio and a relatively high yield. With shares currently priced at 3147p at the time of writing, AstraZeneca yields 5.6% and has a P/E of just 7.8. This compares well to the healthcare sector which has a P/E of 15.8 and to the FTSE 100 whose P/E is 12.5.
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Doomsayers, however, claim that AstraZeneca is a value trap because it is currently experiencing a patent cliff, where many of its biggest selling and highest profile drugs are coming off patent. This means that generic drugs can be manufactured and prices undercut, equating to huge falls in both revenue and profitability for AstraZeneca.
However, I believe that the present situation presents a golden opportunity for investors.
Since the company replaced its CEO in October 2012 it has stepped-up its acquisition spree, recently purchasing a 100% stake in California-based Pearl Therapeutics. It has also ceased its share buyback programme, announced a partnership deal with Roche and plans to increase research and development spending in future years. It certainly has the financial muscle to do so, with debt levels being manageable (the debt/equity ratio is around 43%) and cash flow being impressive too.
Furthermore, dividends per share remain well covered and it is unlikely that they will have to be cut should forecasts prove to be correct and earnings fall over the next few years. However, with a new CEO, the financial clout to pursue an aggressive acquisition strategy, sector-leading R&D facilities as well as partnerships offering significant potential, AstraZeneca’s patent cliff may be somewhat offset by gains made elsewhere.
In that case, a P/E ratio of 7.8 suddenly looks good value, rather than a value-trap, and presents investors with a golden opportunity to buy a high-yielding healthcare company on the cheap.
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> Peter owns shares in AstraZeneca.