However, I still think that Shire has a lot of good qualities. So I’ve taken a fresh look following last week’s final results. Today I’ll explain why I’m now prepared to consider buying.
I’ll also highlight a smaller pharma stock I own that I believe could be a good dividend growth investment.
In October I flagged up two key risks that were keeping me away from Shire. The first was the challenge of integrating US pharma firm Baxalta, which was acquired for $32bn in 2016.
The second was the group’s net debt of $20.4bn. In my view, this mountain of obligations meant that the stock’s then-P/E ratio of 9.3 wasn’t as cheap as it might have seemed.
I’m pleased to report the Dublin-based firm has made good progress in both of these areas. A strong performance from Shire’s Immunology division plus good international growth helped lift product sales by 8% to $14.4bn last year. Adjusted earnings rose by 16% to $15.15 per share. The group’s net profit margin rose by 3% to an impressive 28%.
There was also a worthwhile reduction in debt. Thanks to a 63% increase in free cash flow, net debt fell by $3,370m to $19,069m, despite a $152m rise in capital expenditure.
Although borrowings are still slightly higher than I’d like to see, I believe the speed at which net debt is falling suggests that profit margins could rise steadily over the next couple of years.
With this in mind, I think Shire’s 2018 forecast P/E of 8.4 could be a good level at which to buy for a long-term position.
A specialist growth play
This specialist company buys up niche medicines and consumer healthcare products. These are then sold through retailers, pharmacies and the group’s own distribution network.
Activities such as manufacturing and warehousing are outsourced to keep capital expenditure to a minimum. The result is that Alliance is very profitable — the Wiltshire-based firm’s operating margin has averaged 28% since 2011.
This business model isn’t without risk. Many of the firm’s products are quite mature. In the future they may be replaced by more effective or cheaper alternatives. Relying on acquisitions for growth is also a risk. A few bad deals could cause profit margins to collapse.
A successful formula
But my assessment of Alliance Pharma’s track record suggests that the firm has found a successful formula and hasn’t tried to diversify too much.
Broker forecasts suggest earnings per share growth of 5% in 2017 and 13% in 2018. A forward dividend yield of 2.1% should be covered three times by earnings, suggesting plenty of scope for dividend growth.
The shares trade on a forecast P/E of 14.9 for 2018, with a PEG ratio of 1.3. I believe attractive gains should be possible from current levels. I continue to hold the shares.
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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended Shire. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.