Democratic Victory and Healthcare-Think Positive!

With Democrats as "Masters of the House, " fear and trepidation seems to have swept the U.S. investment world.  Nancy Pelosi has promised legislation that would allow the government to negotiate directly with drug companies to purchase pharmaceuticals for Medicare, essentially equivalent to price controls in my view. Investors have headed for the hills...here are price changes in some of the major pharma companies since Tuesday's intraday highs:

Eli Lilly (LLY)                   -4.73%
Merck (MRK)                   -8.49%
Pfizer (PFE)                    -8.95%
Schering Plough (SGP)    -8.47%
Wyeth (WYE)                     -7.49%

I will have commentary regarding managed care and hospitals in a later post. One of the areas of great interest to Democrats has been drug safety, and rightfully so.

Senators Enzi (Republican-Wyoming) the Chairman of the Senate Health, Education, Labor, and Pensions Committee along with the Committee's ranking member, Senator Ted Kennedy (Democrat-Massachussetts) proposed a bill in August that would slow down the FDA approval process by implementing additional hurdles. New drugs and biologicals would have to undetake additional studies and clinical trials as part of a "risk evaluation strategy."

Here is Ted Kennedy's description of the bill.

Though delays in approval are clearly a negative for the pharma industry, there are other participants in healthcare that could benefit, namely the contract research organizations aka CRO's.

Examples of these companies and their performance since Tuesday are as follows:

Covance (CVD)   -3.21%
Parexel (PRXL)   -3.50%
Pharmaceutical Product Development (PPDI)   -5.90%

The potential for independent outsourcing of clinical trials at whatever phase seems to be enhanced by these proposed changes.

PPDI in particular is one that I like. It has generated free cash flow in six of the last seven years totalling $750 million
 of FCF. Over that time frame, capex has totalled only $315 million. Cash flow has been directed into reinvestment and why not, return on invested capital was 17.2% last year up from 15.4% and 9% in the last three years. On a TTM basis, ROIC is a healthy 15.7%. The company has not engaged in any share buybacks but has returned capital through its dividend of $0.10 annually. Last October, a special dividend of $0.525 was also paid out.

The five year revenue growth has been strong at 22.7%. Similarly, e.p.s. growth over that period was over 28%. FCF growth was 15%...strong numbers. On an EV/EBIT basis the company is trading at 17.6 times trailing twelve months EBIT.

PRXL trades at a slightly higher EV/EBIT at 19.25 times, has a spottier record of free cash flow generation and is generating ROIC of 10.9% on a TTM basis, up from its historical profitability but well below that of PPDI.

CVD, the largest and best known of the CRO's, has an ROIC of 15.1% similar to PPDI but sells at a fairly rich 19.3 times EBIT.

In adversity, one can often find bargain prices. In this case, it seems that the adversity is somewhat misplaced.

Disclaimer: I do not have a current position in any of the securities mentioned. Some clients have a current position in Covance and Pharmaceutical Product Development.