3 Drug Stocks Investors Shouldn't Touch With a 10-Foot Pole in 2017

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Despite beginning the year on a rough note, the broad-based S&P 500 is up a solid 8% year to date. On the flip side, drug stock investors seemingly can't catch a break. The SPDR S&P Biotech ETF is off a little more than 7% year to date, while the VanEck Vectors Pharmaceuticals ETF has plunged 20% since the year began.

There were a number of factors that sacked drug stocks in 2016. We had what looked like a strong probability of Hillary Clinton winning the presidency and introducing prescription drug reforms that would have curbed drugmakers' margins and potentially shortened patent protection periods. Even though Clinton lost the presidency, drug stocks haven't recovered their losses for the year on account of President-elect Donald Trump also recognizing inherent issues with U.S. drug pricing.

Drugmakers also dealt with the possibility of multiple rate hikes being on the table earlier this year. Low interest rates are important to drug stocks since they provide a source of cheap capital for reinvestment, research, and mergers and acquisitions. If interest rates rise substantially, it could put the kibosh on M&A.

You could even say that biotech and pharmaceutical stocks suffered because they'd risen at a quicker pace than most other industries in recent years. Valuations had arguably gotten ahead of themselves, and profitable biotech stocks especially needed a cooling-off period.

Three drug stocks to avoid in 2017

With drug stocks down as much as they are in 2016, there's likely to be some bargain hunting ongoing in the industry in 2017. But by that same token, there are three drug stocks that might look like bargains at their current price, yet they shouldn't be touched with a 10-foot pole by investors in 2017, at least based on this Fool's opinion.

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Valeant Pharmaceuticals

Embattled drugmaker Valeant Pharmaceuticals (NYSE: VRX) may be down more than 83% for the year and trading at an adjusted P/E multiple of three, but I still wouldn't invest free money in Valeant now or in 2017.

To begin with, Valeant has legal woes to contend with. Front and center are the charges filed against former Valeant executive Gary Tanner and former CEO of Philidor Rx Services Andrew Davenport. Federal prosecutors have alleged that Tanner was steering a large amount of business to Philidor, a specialty drug distributor, and that Davenport was in turn kicking back money to Tanner. Additionally, Philidor may not have been disclosing the fact that it was a wholly owned entity of Valeant to insurers. While the legal woes could be confined just to these two former execs, it's also possible that Valeant could face fines or future sales restrictions.

Second, and perhaps more importantly, Valeant ended the third quarter with $30.4 billion in debt. This debt is crippling the company's financial flexibility, especially with its lenders cutting off any additional access to debt. Valeant's new management team, led by former PerrigoCEO Joseph Papa, will need to divest assets in order to pay down its debt and give itself some financial breathing room. However, Valeant is finding that selling its assets is tougher than expected. Its peers fully understand Valeant's plights and rightly aren't willing to pay a premium for its assets. Valeant may be able to take a significant bite out of its debt by selling its core assets (i.e. Bausch & Lomb or Salix Pharmaceuticals), but it would also likely cripple its future growth prospects in the process.

Even Valeant's flagship businesses are suffering. Prior to altering how it presents its results in the third quarter, dermatology sales had been down by more than 50% year over year. Some of this can be blamed on Valeant's poor PR and pricing issues, but we can also point to Valeant's new drug distribution deal with Walgreens Boots Allianceas a drain. Some of Valeant's prescriptions are being filled at a loss, and it could take multiple quarters for Valeant to fix its drug distribution issues.

This has all the makings of a drug stock to avoid in 2017.

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Another company that had a miserable year is vaccine maker Novavax (NASDAQ: NVAX). In 2016, Novavax shares have plunged by 84%, with almost the entirety of that loss coming on a single day back in mid-September.

Novavax's derailing came courtesy of its RESOLVE phase 3 trial not meeting the mark in preventing moderate to severe respiratory syncytial virus-associated lower respiratory tract disease in older adults ages 60 and up. Based on the results, vaccine efficacy was actually higher for the placebo, while a secondary endpoint demonstrated slight favorability, though nothing statistically significant, toward Novavax's RSV F vaccine. The only positive was that the vaccine was well tolerated.

Looking ahead, Novavax is sticking with its ongoing phase 3 study involving RSV F for infants as a form of maternal immunization. Although Novavax's phase 2 study in maternal immunization did show an increase in RSV-specific antibodies in the RSF V group compared to the placebo, there was no specific infection data provided. For added context, older adults also showed positive RSV-specific antibody increases in a phase 2 study. So, as my colleage Cory Renauerpointed out in September, it's possible Novavax could be barking up the same tree in its phase 3 trial for maternal immunization.

In response to this critical trial failure, Novavax announced a restructuring designed to reduce its cash burn between $70 million and $100 million annually. In total, 30% of its workforce was jettisoned. Yet, even with this expense reduction, Novavax could soon find itself struggling in the cash department.

Novavax ended the third quarter with $300 million in cash and cash equivalentsbut has burned through $194 million in cash through nine months of 2016 thus far. The implication here is that Novavax could still exhaust around $150 million in cash in 2017, putting it on track to run out of money perhaps by 2019. Furthermore, with very little in clinical studies beyond RSV F, it could be awhile before Novavax has a shot at recurring revenue if RSV F fails in maternal immunization.

Investors might like the downside protection of Novavax's $300 million in cash and cash equivalents, but I don't believe it'll last too long if RSV F disappoints in the infant indication. I'd suggest avoiding Novavax in 2017.

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PDL BioPharma

Finally, investors would be wise to resist the urge to invest in biotechnology royalty company PDL BioPharma (NASDAQ: PDLI), which is down 33% year to date.

PDL BioPharma, which has regularly paid a dividend yielding two or three times better than the average yield of the S&P 500, might seem like an attractive income option with exceptionally low overhead among drug stocks. Since PDL acquires royalty assets, it's able to maintain a small staff and relatively low overhead costs.

But there are two big problems here: PDL's dividend has been suspended and its key revenue driver is now gone.

PDL BioPharma's primary revenue driver are its Queen patents. At the end of 2014, PDL's Queen patents associated with select Genentech drugs expired. PDL was spared an immediate nosedive in revenue because it took more than 12 months for warehoused product to be sold down. However, with that time having passed, PDL is fully exposed to this lost revenue. In the third quarter, it generated just $53.6 million in revenue compared to $124.6 million in Q3 2015. In particular, it generated just $15 million from Queen patents tied to Tysabri compared to $119.2 million in Queen patents in Q3 2015. In response to its plunging profits, PDL suspended its dividend indefinitely, which essentially took away to main reason to own PDL BioPharma.

The only thing left for PDL BioPharma to do is start over. Unfortunately, it's going to take a long time before the company is able to replace the revenue it was generating from its Queen patents. PDL made a $107 million investment in Noden Pharma DAC and an affiliate in July in order to gain access to hypertension drug Tektuma (known as Rasilez outside the U.S.), but it'll need to do more to appease investors.

More recently, PDL issued $150 million in convertible senior notes in order to pay off $120 million in upcoming debt. It could also be argued that it issued debt in order to invest in new royalty assets. The key word here is that these notes are "convertible," meaning they could be turned into shares that ultimately dilute existing shareholders. Capital raises could become common as PDL attempts to rebuild its decimated royalty portfolio, and shareholders could be punished in the process.

With no dividend and a long road ahead, there's no reason for investors to be anywhere near PDL BioPharma in 2017.

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Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.

The Motley Fool owns shares of and recommends Valeant Pharmaceuticals. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.