Examine phases before taking post-bubble biotech plunge

Dollars & Sense

October 27, 2002|By Jill Kiersky | Jill Kiersky,MORNINGSTAR.COM

Do the biotechnology stocks of 2002 really look like the Internet stocks of 2000? Biotech stock prices went through the roof from 1998 to 2001 as investors thought those companies were going to cure cancer any day.

They haven't, the so-called biotech bubble has burst, and company valuations have been slashed in half in the span of nine months. The two most watched biotech indexes, the Amex Biotech Index and the Nasdaq Biotech Index, are down nearly 50 percent this year.

Does that mean now is a good time to get into biotech stocks? It depends. As in all industries, companies in biotechnology go through phases, and each phase takes on a different risk and return profile.

Here's how we group the phases when we analyze any biotech company.

Young and speculative.

Typically reserved for companies formed within the past decade - which includes the majority of biotech companies - our speculative category is too risky for most investors who don't have a doctorate in cellular molecular biology. These are companies such as Rockville-based Human Genome Sciences and Dyax, which undoubtedly have interesting technology and could be extremely successful someday.

But real revenues from real products are many years away, and positive cash flow from operations is even further out. Compound that risk with the 20 percent chance that a drug in the first stage of human testing will reach the market, and we'd classify them as high-risk, no-moat stocks. That means we'd need a gargantuan margin of safety before we'd be willing to own them.

One example is Celera Genomics, also based in Rockville, which trades at a 35 percent discount to its net cash value of $12.80.

Surely, this company, founded by genome-sequencing star Craig Venter (who's no longer with the company), could someday discover a cure for cancer, but we think there's just as much potential to destroy shareholder value over the next decade, so we wouldn't even consider the stock unless it were trading closer to $5 a share. Even then, I think I'd rather earn a guaranteed 1 percent interest on my cash in a money market account.

A light at the end of the tunnel.

Many companies are further along, with a product on the market or within arm's length. Some are on the verge of breaking into the black, and others have demonstrated small but positive earnings. In other words, they've got more than a cell in a petri dish, but they still have a lot to prove. All of these companies have a high Morningstar Risk rating and a narrow moat or none at all, depending on competing products.

Cash is king during this stage, and many of these companies were able to build a large cash base during the high-valuation days of the past. But it's worth keeping a watchful eye on how quickly they are spending that cash, because the last phases of clinical trials are the most expensive, and preparing literally truckloads of documents for the Food and Drug Administration isn't cheap.

Giving up a chunk of the profits to big pharmaceutical and larger biotechnology companies isn't such a bad idea if it helps companies wend their way through drug commercialization.

Gilead Sciences and ICOS fit into this group. Gilead has two major approved products and should break even this year. ICOS is a different story. Its leading drug candidate, Cialis, treats erectile dysfunction and will have to compete with Viagra if approved next year.

The company has little beyond its single product, but we're placing it in this group rather than with the speculative companies because there's plenty of market share for several players in the multibillion-dollar erectile-dysfunction market. These stocks still entail a lot of risk because they are hit hardest when the probability chips fall on the wrong side of the table.

They made it!

Then, there are the bigwigs of biotech, the companies that have passed their age of innocence. These include the likes of Amgen, Genentech and Biogen, which have annual product revenues of more than $1 billion and market capitalizations beginning to rival those of big pharmaceutical companies.

They generate positive earnings and cash flow, and their drug development pipelines are large enough to sustain decent sales and earnings growth. As these companies become larger, their future cash flows become less risky. Biologically based therapies tend to mean more developmental uncertainty than big pharmaceutical companies' chemically based drugs - although the lines are blurring - so investors still require a higher premium for holding the stock.

Now that stock prices in this group have dropped 25 percent and more this year, many of them finally have an appealing risk and return profile - almost - for the majority of risk-averse investors.

Amgen, which trades at a 23 percent discount to our fair value estimate, throws off more than $1 billion in free cash flow (more than 20 percent of sales) and returns 36 percent on its invested capital (before its acquisition of Immunex).

The company has challenges ahead, but we're toying with the idea of lowering our risk rating from high to medium, which could turn the stock into a five-star holding. Besides, who wouldn't trust his money in Amgen's hands, with Kevin Sharer, a former nuclear-attack submarine officer, at the helm?

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