Why this battered pharma stock could be a top turnaround buy

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Hikma Pharmaceuticals

Pharmaceutical stocks have performed poorly against the market this year. Of the five largest UK-listed pharma stocks, only one -- ConvaTec -- has managed to beat the FTSE 100 in 2017.

The two biggest fallers in the top five are Hikma Pharmaceuticals (LSE: HIK) and Shire (LSE: SHP). They've fallen by 34% and 20% respectively this year.

Today I'm going to ask if either of these companies is now cheap enough to be a turnaround buy.

Competition hits profits

Shares of generic medicine specialist Hikma Pharmaceuticals have already bounced back by 14% from the low of 1,101p seen on 18 August. This group specialises in producing generic versions of medicines which have recently lost patent protection, but has experienced a series of setbacks over the last year.

The biggest was the company's failure in May to secure US approval for a generic copy of GlaxoSmithKline's Advair respiratory treatment. Hikma was then forced to cut its 2017 sales guidance again earlier in August, due to "increased competition on prices and volumes".

The overall effect of this flow of bad news means that 2017 earnings forecasts for the group have been cut from $1.60 per share one year ago, to just $1.04 per share today.

This could be the bottom

However, it is possible that we're nearing the bottom. When I wrote about this stock in August last year, I noted that on 26 times forecast earnings, "Hikma looks a little too expensive to me".

The subsequent collapse of the group's share price means that its valuation now looks more reasonable. The stock now trades on a 2017 forecast P/E of 15, falling to a P/E of 13 for 2018.

A lower share price means the dividend yield has also improved. The forecast yield for 2017 is now 1.9%, rising to 2.1% in 2018.

The risk for investors is that there's still more bad news in the pipeline. But the group's more modest valuation should reduce the risk of serious losses. In my view, Hikma Pharmaceuticals might be worth considering as a contrarian buy.

CEO "very confident"

Earnings per share are expected to increase fourfold this year at Shire, as the benefits of last year's acquisition of rare diseases group Baxalta kick in. Analysts expect adjusted earnings of $5 per share, putting the stock on a forecast P/E of just 9.5.

Despite this, Shire's share price has fallen by 20% so far this year. Investors just aren't buying the company's growth story. Why is this?

One reason is that the group had to load up with debt to finance the Baxalta deal. Net debt was $21bn at the end of June, representing a multiple of 4.6 times 2017 forecast net profit. That's a pretty high level of gearing, in my view.

Another downside is that despite the falling share price, the forecast dividend yield is still just 0.8%.

However, if the company delivers on its guidance, net debt should fall quite quickly. And there might be some chance of a dividend increase. Shire is considering whether to dispose of its neuroscience business, which specialises in ADHD treatments. Doing so could result in a cash or stock return to existing shareholders.

Overall, I'm wary about Shire. The level of debt involved makes this a more risky play for equity investors, in my opinion.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline. The Motley Fool UK has recommended Hikma Pharmaceuticals and 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