Bullish
on Biotech
By Richard Moroney, editor
Dow Theory Forecasts
By George Wolff
As
the dust settles from the great dot-com and telecom debacle,
the bulls and bears are pitted against each other in a battle
over biotechnology. After all, who wouldn't be wary about investing
in profitless companies after the beating so many investors took
by betting on high-flying Internet, telecom and e-commerce companies?
That may be a sensible
concern, but it merits closer examination by investors considering
growth opportunities in biotechnology.
Let's hear from the
bears first and get all of the negatives on the table from the
outset. It's a plain fact that fewer than 30 biotechnology companies
are currently profitable; a strikingly low number in an industry
composed of more than 350 publicly traded companies. Even more
sobering is the fact that the biotech industry has been around
for a quarter of a century, yet it has annual revenues of only
$25 billion industry-wide to show for all the time and money
invested so far.
No bear would fail
to point out that biotech stocks are intensely volatile. Investors
who bought into the industry during peak periods are facing large
losses.
Looking to the fundamentals
of biotechnology companies, most of them are involved in drug
development, an inherently risky and time-consuming venture.
When a biotech company suffers a setback for a product in clinical
trials, the effect on share prices can be devastating.
The degree of risk
involved in biotech investing is clearly daunting, but let's
not declare the bears "winners" without a good fight.
The biotech sector has rebounded time and again from industry-wide
market setbacks. The reason is simple. Biotechnology offers extraordinary
growth potential.
The Bulls Fight Back
Nothing
illustrates more clearly the potential upside of biotech innovation
than the success of Amgen, currently America's premiere biotechnology
company. Ten years ago Amgen was a chronically unprofitable firm,
just beginning to rise from penny stock status. But in 1999 Amgen's
growth curve went exponential, shooting from the $20 range to
more than $70 a share. Based largely on the success of two successful
drugs, Epogen and Neupogen, Amgen now enjoys revenues in excess
of $3.5 billion a year and a market capitalization that usually
exceeds $60 billion.
Spectacular gains in
share prices are the norm among biotech companies that have successfully
brought important new drugs to market. MedImmune and Idec Pharmaceuticals
are two other frequently mentioned companies that have delivered
gains greater than 1,000% with successful drug launches. Success
on this scale is at the heart of the biotech industry's appeal
to investors.
Currently
the biotech industry has more than 350 drugs in development including
a remarkable 175 new medicines for cancer. Approximately 100
drugs are in the pivotal third Phase of clinical trials. The
revenue potential from this flood of innovation is staggering
and the industry's growth phase may well continue throughout
the entire 21st century. I have no argument with those who say
biotechnology is poised to become the world's largest industry.
In the past few years
the biotech industry entered a phase of hugely accelerated development,
an event marked by the mapping of the human genome in a span
of time most scientists had believed to be impossible. Supercomputers,
laboratory robots, lasers and "microarrays" (or laboratories
on a chip) have accelerated the process of developing new drugs
to the point where some industry executives complain of being
awash in new drug targetsa far cry from the predicament of pharmaceutical
companies that fretted about an "innovation deficit"
only a few years ago.
There seems little
doubt that a substantial number of biotechnology companies will
generate significant new revenue streams in coming years, just
as Amgen, IDEC and MedImmune did in the recent past. The investor's
challenge is to find the companies most likely to deliver returns
in the shortest possible time.
Picking the Winners
Before
getting down to specific criteria for stock picking, it's important
to learn about the tools of the trade. First, if I may say so,
I suggest you do some background reading, checking out excellent
books like "From Alchemy to IPO" by Cynthia
Robbins-Roth.
Most biotech investment
strategies begin by assigning companies of interest to three
tiers according to their market capitalization only.
In my book, "The
Biotech Investor's Bible," I have chosen to break
the industry down into four tiers, giving unique status to profitable
biotech firms. These Tier One companies are much easier to judge
by conventional stock-picking techniques because they exhibit
all of the familiar metrics such as P/E ratios. Unprofitable
firms require more specialized criteria.
The lower three tiers
are made up of biotech companies that have yet to turn a profit
and are broken down largely by market cap. Those with a market
capitalization of a billion dollars or more are generally among
the most promising contenders.
These Tier Two firms
are typically characterized by large research staffs, significant
pipelines of drugs in development and alliances with major pharmaceutical
companies worth hundreds of millions of dollars each. Major names
in this tier include Millennium Pharmaceuticals (MLNM), Human
Genome Sciences (HGSI), Protein Design Labs (PDLI) Abgenix (ABGX),
Affymetrix (AFFX) and Vertex Pharmaceuticals (VRTX).
Tier Three biotech
companies are valued between $500 million and $1 billion. Usually
these companies have at least one major drug approaching FDA
(U.S. Food and Drug Administration) approval. They are very risky
because they have typically been overvalued in anticipation of
FDA approval. Imclone (IMCL) appears to be the most recent victim
of over enthusiasm about unapproved drugs.
Companies in Tier Four
may have interesting products in their pipelines but they tend
to be in earlier stages of product development, hence their lower
market capitalization (usually well below $500 million). There
is a considerable risk of loss in this group, but, as a precaution,
investments in this inherently exciting arena should be kept
very small.
The time required to
bring a product to market is crucial in assessing biotech firms.
The three phases of clinical trials generally consume six or
more years and product failure is possible at any stage. Even
a drug that has made it through clinical trials to a company's
own satisfaction stands a chance of being rejected by the FDA.
The pharmaceutical
industry says that only one drug in five entering trials will
make it to market, therefore it stands to reason that a drug
which is in the pivotal Phase III testing is a better bet than
a drug in Phase I. That's the first key test of a biotech company's
viability.
Equally important is
the breadth of a company's product pipeline. Clearly a company
with only one product in the testing pipeline is a risky investment.
In the past year several biotech firms suffered 70% losses in
their stock values when a single drug failed during trials. A
broad product pipeline increases the chances of product approval
and lessens the financial impact on the investor if one product
does fail.
Alliances are another
key test of a biotech firm's viability. All of the companies
I named earlier in Tier 2 rose sharply in value when they struck
deals with major pharmaceutical firms. The top company in the
tier, Millennium Pharmaceuticals boasts of drug discovery alliances
with Lilly, American Home Products, Pfizer, and Monsanto. Although
Millennium has a somewhat smaller pipeline than its competitors,
its alliance profile indicates strong validation by leading pharmaceutical
scientists, backed up by hard cash commitments from its partners.
The company's alliances also have the potential to produce large
revenue streams well beyond Millennium's own pipeline through
royalties from successful products produced for its partners.
Millennium is also actively acquiring other biotech firms to
build the size of its pipeline.
Investors receiving
news of exciting scientific developments may also be blinded
to risk by the potential of a major discovery. Always keep in
mind when reading of scientific breakthroughs that many years
will pass before a fundamental discovery can be transformed into
a marketable product. The industry abounds with scientific achievement
but products and profits are still scarce. Invest accordingly.
Finally, a few words
about Tier One biotech firms, the names we are all familiar with
such as Amgen (AMGN), Biogen (BGEN) and Genentech (DNA): an investor
who checks the P/E ratios on such firms will often discover that
they are quite high by normal standards, even in a down market.
That's because investors are paying a premium for the profit
potential of drugs still in development.
Biotech P/E ratios
have been the focus of much debate but, in the wake of the tech-wreck,
this perspective is changing.
High PE? No PE?
Certainly
in the wake of the dotcom disaster investors and investment advisors
at every level profess an aversion to unprofitable companies.
Many of my clients in the financial planning industry now openly
scoff at the notion of investing in emerging companies that have
yet to turn a profit.
Typically, most investment
gurus still recommend widely known corporations, basing their
judgments of a company's future potential on ephemeral variables
including vague predictions about the state of the economy, interest
rate forecasts and changes in levels of consumer confidence.
This sort of speculation
still plays well in the financial media, appearing to be prudent
and conservative prognostication. But, permit me to ask the question,
how "conservative" are today's mainstream stock plays,
compared to biotechnology.
In search of perspective,
I reviewed the metrics of the top twenty stocks that are listed
as "Favorite Stocks" by the New York Times and the
Associated Press.
Surprise! There among
the top twenty companies were seven major firms sporting the
dreaded N/A symbol in their Price-to-Earnings ratios. Seven of
the top twenty companies are hemorrhaging money, but still they
retain remarkably high market capitalizations.
I compared these seven
unprofitable majors to seven top quality (unprofitable) biotechs.
The two tables below tell the story (See Table 1 and Table 2).
| Table 1: Favorite Stocks: New York Times & AP | |||||
| Company | P/E | Market Cap (Billions) |
Income/ Loss |
Cash | 52-week change in share price |
| Cisco Systems | N/A | $120 | -$2,290,000,000 | $7,500,000 | -16% |
| AOL-Time Warner | N/A | $109 | -$4,920,000,000 | $719,000,000 | -33% |
| AT&T Corporation | N/A | 56 | -$4,860,000,000 | $11,300,000 | -27% |
| EMC Corporation | N/A | $25 | -$507,000,000 | $2,500,000 | -68% |
| AT&T Wireless | N/A | $23 | -$91,000,000 | $0 | -51% |
| Lucent Technologies | N/A | $16 | -$13,000,000,000 | $3,000,000 | -56% |
| Avaya Inc. | N/A | $1.8 | -$415,000,000 | $252,000,000 | -44% |
| March 17, 2002 Data from Yahoo Finance, Multex, S&P, New York Times, AP | |||||
| Table 2: Leading (Unprofitable) Biotech Companies | |||||
| Company | P/E | Market Cap (Billions) |
Income | Cash | 52-week change in share price |
| Millennium
Pharmaceuticals |
N/A | $6.7 | -$192,000,000 | $1,470,000,000 | -3.8% |
| Human Genome Sciences | N/A | $2.9 | -$117,000,000 | $1,690,000,000 | -46% |
| Vertex
Pharmaceuticals |
N/A | $2.1 | -$68,000,000 | $0 | -7.3% |
| Abgenix, Inc. | N/A | $1.7 | -$60,000,000 | $557,000,000 | +11.7% |
| Affymetrix, Inc. | N/A | $1.6 | -$34,000,000 | $368,000,000 | +4.5% |
| Medarex | N/A | $1.3 | -$2,690,000 | $491,000,000 | +25%% |
| Ligand
Pharmaceuticals |
N/A | $1.2 | -$43,000,000 | $37,000,000 | +87% |
| March 17, 2002 Data from Yahoo Finance, Multex, S&P, New York Times, AP | |||||
In
terms of market performance (through the worst year in recent
market history) the biotechs have held up remarkably well. The
biotech firms compared to the "most popular" stocks
show better metrics in almost every other respect as well. Looking
at their losses compared to cash reserves, the biotechs generally
have a much better cash position to sustain their burn rates.
One obvious difference
is the past performance of the so-called favorite stocks. Many
of these once high-flying tech stocks were profitable
for a time and their continued popularity can only be explained
by a belief that an eventual return to profitability will also
restore their shares' once stellar prices.
Perhaps, but most financial
professionals I have interviewed say privately that they do not
expect the tech companies in Chart #1 to return to their previous
highs. Never.
Perhaps that is a bit
extreme, but keep in mind that at the height of the high-tech
speculation binge, companies like Cisco and Intel were briefly
valued on a par with General Electric. Clearly it is not rational
to expect these companies to regain such exaggerated values in
the foreseeable future. Many must show share price gains well
in excess of 100% to recover their former values
What about the biotechs?
Do they have exponential growth potential? Clearly I believe
they do. But, biotechnology companies that are engaged in drug
discovery may not have steady growth curves like those of conventional
companies
Sudden rises in the
values of profitable biotechs like Amgen, Medimmune and IDEC
are driven by the approval of major drugs after long and costly
periods of research and trials. Hundreds of companies worldwide
are currently engaged in promising research and there is every
reason to expect that a number of them will enjoy sudden gains
in share value as this research eventually brings products to
market.
Critics of investment
in profitable biotechs often cite the high P/E ratios of Tier
One companies. (I myself have indicated a preference for investment
in companies with greater growth potential in my book: "The
Biotech Investor's Bible.") Now, under current
market conditions, biotech P/E ratios are starting to look like
a bargain.
Here's a comparison.
The first table shows four tech stocks that do have positive
earnings from the same New York Times/AP list of 20 "Favorite
Stocks" They are compared to profitable biotechs. Many "favorite"
companies display remarkably high P/E's. (See Table 3)
| Table 3: Favorite Stocks, Profitable Tech Companies | ||||
| Company | P/E (Billions) |
Market
Cap (Billions) |
Income | 52-week stock performance |
| Microsoft Corporation | 56 | $332 | $6 | +13% |
| Intel Corporation | 167 | $210 | $1.3 | +9.5% |
| Verizon Communications | 224 | $127 | $.59 | +2 |
| Oracle Corporation | 31 | $72 | $2.4 | -15% |
| March 17, 2002 Data from Yahoo Finance, Multex, S&P, New York Times, AP | ||||
Compare those metrics to five profitable biotechs. (See Table 4)
| Table 4: Profitable Biotech Comparison | ||||
| Company | P/E (Billions) |
Market Cap (Billions) |
Income | 52-week stock performance |
| Amgen Corporation | 60 | $64 | $1.1 | +10% |
| Genentech | 184 | $28 | $.155 | +13% |
| Medimmune | 63 | $10.7 | $.149 | +27% |
| IDEC Pharmaceuticals | 116 | $10.6 | $.101 | +74% |
| Biogen | 28 | $7.4 | $.272 | -19% |
| March 17, 2002 Data from Yahoo Finance, Multex, S&P, New York Times, AP | ||||
The
high P/E ratios of profitable biotechs seem far less daunting
when compared to the so-called favorite stocks. And, in general,
the biotechs have also shown superior 52-week stock performance.
What are the high P/E
ratios of the large cap tech stocks based on? Largely on faith
that a recovering economy will boost profits so dramatically
that these companies will regain their former valuesno matter
how exaggerated they may have been at their peaks.
What are the high P/E
ratios of biotech stocks built on? Something much different.
They are based on the belief that sharp increases in come can
still be realized by these companies as their proven research
teams develop new blockbuster drugs and bring them to market.
Conclusion:
Biotech's Future
There
is no shortage of naysayers and prophets of doom among commentators
on biotech investments. Certainly this is a volatile and speculative
sector but it is nothing like the dot coms and telecoms of the
so-called "new economy." In the last two years, while
the new economy became old news, the biotech industry raised
an unprecedented $48 billion in capital and forged more than
400 corporate alliances. The majority of biotech companies have
enough cash in reserve to carry on for several years, a period
long enough to bring some extraordinary new products to market.
(Obviously investors should check corporate balance sheets to
make sure that a company isn't burning cash too quickly to bring
its products through the lengthy clinical testing and approvals
phase.)
Nevertheless, the fact
that the biotech industry has survived twenty-five years of financial
hardship remains a testament to its durability and to the widespread
belief in the industry's long-term profit potential. As hundreds
of new drugs from biotechnology begin saving lives and earning
revenues, investors will witness, and hopefully participate in
the emergence of many new "Amgens" and "Biogens."
We are now in the emergent
phase of a major industrial sector. In the coming century, biotechnology's
achievements will go well beyond the development of new drugs.
The industry is inventing entirely new technologies that will
likely affect every industry that has a role in the management
of living things. And that, if you take a moment to consider
the implications, is an industrial revolution in the making.
Good reason to be bullish.
Editor's Note: George
Wolff is an award-winning international journalist and currently
a professional speaker and business consultant to several firms
in the investment industry. He has addressed and reported on
more than 200 biotechnology companies, issuing a number of valuable
white papers charting the emergence of biotechnology. Strategies
to choose the quality companies and techniques to assess them
are set out in detail in George Wolff's book, The Biotech
Investor's Bible, $29.95, published by John Wiley & Sons
available at all major book stores June 22nd. Visit his web site
at www.biowolff.com.
