FezHenry has a very interesting comment about my last post (valuing biotechs). I like (and agree with) several of his points - I have taken the liberty of copying the majority of it below, as I want to highlight the parts I agree with, and show why I think differently on others.
>>Thank you for taking the time to post such an in-depth response. The reason why I asked initially is because all of those biotech stocks you've mentioned have had zero positive free cash flow over the past ten years. This rate of cash burn has always been a reason why I have never personally invested in bio-tech's, because in my opinion, the majority of them just end up as giant cash-sucking research machines in the long run.
Yes, that giant sucking sound was not just jobs moving to Mexico - it is also biotechs (and nearly all early corporations) siphoning cash out of investors and giving them back lottery tickets. And you know what typically happens with lotteries...
I like how you've analyzed these stocks in such great detail, and you've obviously done some interesting modeling as well, but I'm somewhat concerned that you may be missing the investment forest for the bio-tech tree. For a company to be a proper investment, it needs to be able to generate more than just positive earnings...it has to be able to generate free cash flow.
Free cash flow (FCF) - or ANY kind of cash flow - is an attribute of a good company. And I agree FCF is something a typical investor will be looking for. Let's explore WHY that is.
Once a company is making more than it spends, on a real earnings basis, there are typically four things they can do with it. They can (i) pay a dividend (ii) retain earnings and reinvest in the company (usually better equipment to manufacture more quickly or more cheaply), (iii) reinvest in R&D for new or better products) or (iv) acquire other companies, with which they hope to make more or better products than it costs to acquire them.
But please note something about these choices:
Option i is perhaps the best from the investor's point of view (I can certainly spend extra money better than my favorite company can!) but note that the company then does not grow.
Option ii is wonderful up to a point, but you can make only so many widgets at a lesser price that people are willing to buy at any price.
Options iii and iv act just like what the company did when they themselves were the ones raising capital, through issuing more shares or debt. The difference of course is that they can pay for it as a going concern, but a couple products that don't make it from the lab to the shelf, or bad acquisitions, and that money is still sucked away.
My point is NOT to slam products, or making money via them. It is that companies making these profits will eventually have to revisit risk and invention. They have a far firmer foothold than pre-earnings corporations, but still have to allocate their capital in an intelligent way.
I think you may need to pay more heed towards how these companies are financing their revenues, and the impact on their profitability in the long term, otherwise you are just gambling that one of them will discover the next big thing.
Ah, but here's the thing. Even the next big thing is not a guarantee of a great company that is a good investment.
As example #1, I will pick on Tivo. I had a roommate who literally was probably one of the first 100 people to buy one. And the next day, he went and bought another (the larger storage one) for a second room. He LOVED A-V equipment and was a technophile. And he was right - everyone loved it. The problem is that the company made some poor choices with marketing and has been a dog for several years. Someone who waited for the sales to begin, measured them for a few quarters, projected them into the future, and was finally confident enough to buy, was the person who finally capitulated several years later for a loss.
Example #2 will be your choice of the financials over 2006 and 2007. Maybe Bear Stearns? Profitability up the yin-yang, darling of Wall Street, sweet credit ratings, and at the height amazing earnings that were projected to increase at astronomical multiples. Even though they did not make widgets, making deals can be just as profitable. But we all know how that ended up.
I am NOT dissing a company making actual profits. Many companies make great marketing decisions, and do not go charging into bubbles, as these two examples show. But simply having real FCF is not the only answer either.
I hope you don't think that I'm trying to rain on your parade, so to speak. I know that you have superior analytical skills from working with you @ CNB all of those years, but I just think you need to maybe take more of a fundamental view on some of these companies so you can properly estimate your risk. From a fundamental perspective, I personally wouldn't invest in any of these companies until they can at the very least, generate positive free cash flow and be able to stand on their own without financing their operations via shareholder dilution, or excessive leveraging...
Pre-earnings biotechs, as a category, are far riskier, as FezHenry notes, because to raise the funds necessary to maintain operation, they have to leverage debt, or sell more shares.
Note that I do not worry too much about the dilutative nature of issuing more shares (to a point!) - I may own 1.05 millionth of a company instead of 1 millionth but those existing shares then have $0.00001 more cash per share. And if I trust management enough to use that cash, I do not care if they raised it in a secondary or by achieving FCF.
Now here is the real difference, I believe, in the investing styles. I view fundamentals as more than just the metrics of cash per share, earnings per share, current ratios, and debt/equity. To me the fundamentals are "is what the company is doing, advancing its potential?" and "do I trust the management?"
... but I follow Warren Buffett's first two rules of investing:
1. Never lose money.
2. Never forget rule #1.
I think FezHenry and I are actually closer to each other than apart. I am a huge Buffett fan (I just finished Alice Schroeder's Snowball: Warren Buffett and the Business of Life and it is a fantastic telling of Buffett's life) but what you actually get out of it is that Buffett the investor is inhuman. I do not have the investing resources nor the time horizon of Buffett the investor. He can buy entire companies which gives him pricing power. He can sit on Coca Cola for 30 years. I freely admit I cannot.
But - there are a couple things I like to emulate him on. You do your research (due diligence), you talk to people, you fanatically find out every scrap of information you can, and when you get your fat pitch, you buy. Buffet talks of a punch card where you only make 20 investing decisions over your whole life. If you use 1/20 of your lifetime buys on Sangamo, you will want to make sure it is a great opportunity.
The other quality I have learned from Buffett, through Ben Graham, is that Mr. Market truly is insane. You can buy the same company for $20 a share one day and for $19 a share the next day. It is NOT 95% as good a company the second day, it is simply a function of fear, greed, reaction, hope, and maybe a little bit of the weather in New York. So if after my research I am in a company and I am convinced it is overvalued for the moment, I can sell some of my position without freaking out that I am breaking "Buffett's rules". The key for me from this second point is that you enter a position into a company you like with a core position, and can also trade around that position.
Please check out this post for an idea of what I am speaking of: http://www.fwallstreet.com/blog/31.htm
Done! And a good example of what you are leery of. However, I will point out that as a company, it may not be making money, but some investors had an amazing ride. Investing is a zero sum game - every share that gets bought means someone else has sold. The company really isn't more or less valuable - it is simply the relative pressure of the fear versus the greed.
I hope I haven't gone down too many rabbit holes and you are still with me. To close, my argument really boils down to my biotechs simply haven't started selling products yet. Once they do, the metrics you want to use (fundamentals) will either bear out the story, or they won't. You have different information available to you with the Buffetesque companies you choose to follow - actual sales information. I have to model out the potential sales before they happen with the companies I choose to follow. I do have to make the leap of faith that I have the next best thing, but you are making the implicit leap of faith that your competitors won't come out with the next, next, best thing.
As always, thanks for the thought provoking comments.
Regards,
Trond
Monday, November 9, 2009
Thursday, November 5, 2009
Valuing biotechs
FezHenry asks how I come up with the valuations for the biotechs I suggested. That is a fair question, and not an easy one to answer.
When you have companies that make products, have revenue, and (gasp) actual profits, then the task can be a bit easier. There are a number of metrics such as price-to-earnings (P/E), or price-to-sales, that you can use to compare a company against another within the industry and see which is a better deal. I am suspicious of these metrics, by the way, on the whole, because earnings are massaged quite a bit, and even sales can be "managed" from quarter to quarter. But at least there are real numbers to work with!
Biotechs that have no products available for sale yet are much trickier. Look at BioCryst (BCRX) which today announced its first order for the IV version of its swine flu drug peramivir. The pricing was MUCH more aggressive than the Street expected and the stock responded with a 15% gain on the day! At this point, forecasting more sales really depends on how much more the government will stockpile, whether doctors start prescribing it off its emergency-use label, if and when the other countries that have negotiated with the company (Israel, China, e.g.) start ordering, and perhaps most immediately important - whether Japan gives its emergency use authorization and they get an order for 500,00 to 1M doses. That would be a $1B order minimum, or $200M at its Shionogi royalty rate - one order alone that is half its market cap! Can you say hello $20s or $30s, from it's $11.39 today? (and yes, I have a little BCRX in my IRA - not a lot but I think this one, too, will do well in the next year)
Back to the actual question though.
Let's take Dendreon for an example, simply because I can do these numbers in my sleep. Provenge is not approved yet, so we have no real metrics. We don't even have a good price point on them - Dr. Gold has stated the one plant they have now, at full capacity, can produce $500M to $1B of sales. It however, is only 25% built out presently... and to complicate matters, they are planning two new plants, each of which will produce 3/4 of the NJ facility.
Now, you probably should also look at the number of patients a year who will get prostate cancer, at the phase at which this will be prescribed (post-androgen therapy) and make an estimate of the market penetration, and then figure the number of patients who actually get the drug multiplied by the cost per treatment. Suffice it to say I believe within 5 years, these three plants will all be at full capacity. (1+3/4+3/4) plants at $500M to $1B gives you a range of revenue of $1.25B to $2.5B ( you can usually also figure in modest price increases per year, but I'm ignoring that, for now). You can use the midpoint, but I like to assume the low point as a reality check. So $1.25B of sales is our first checkpoint.
Now you can apply some other metrics. Five-to-seven times sales is one rule of thumb for projected market cap. So using 5 * 1.25 gives us a $6.25B market cap, 5 years out. Our market cap now is about $3.2B so it's nearly a double - call it $55 from today's $27.78.
But wait!
We now need to discount back to the present, adjusting for risk. I have assumed approval and I have assumed revenues into the future (they will not be making $1.25B next year). At least I assumed the lower levels for the other choices! We can say there is a 10% risk that Provenge is not approved, or has a delay. There may be a 15% discount per year into the future revenue stream. All told that $55 in the future may only be worth $32 or so today. Still a nice 10 to 15% discount to today's price! And please note if I use the midpoints of revenue and times sales, we would arrive at a market cap of $11.25B - or a share price of $90 or so. Discounted that would be $60ish, compared to today's $27.78 - nice! I like to be conservative but I also like to see what might be in store.
You can also use the P/E ratio, once you estimate sales, to arrive at a price. At $1.25B (again, the low point in assumptions) in sales, the margins should be around 25% so there would be $312M in profit. I am going to assume they will issue more shares within 5 years and there will be 150M shares outstanding. That would be over $2 per share in earnings, and with an assumed x25 earnings multiple, we arrive at $50 per share - slightly less than my $55 from the times-sales estimate.
Note all these example all estimate ONLY United States revenue. Dendreon is actively seeking a rest-of-world partner - where they will collect a royalty on ex-US sales. These royalties will have an effect on the bottom line, perhaps as much as 20-25% of the US revenue.
They also have other immunotherapeutics in their pipeline that will follow Provenge, all based off the same method of action. They have learned HOW to construct trials for cancer vaccines, and their agents for breast, ovarian, kidney, colon, and lung cancers should move along more quickly through trials than Provenge did. This will become a growth stock once investors realize cancer may become a manageable disease through these immunotherapeutics.
Whew - lecture on Dendreon is now over. The take away from this lesson should be that there are a HUGE number of assumptions that go into any kind of estimate like this. Patient count, adoption rate, pricing, earnings, competition, production capacity - any of these could be off by factors of 50% or more! My usual method is to try to use the low points of most ranges to come up with a basement level price, and then start tweaking numbers, as not ALL categories will be at the lowest possible point. If the basement price looks attractive compared to today's price, though, you just may have a winner.
Too, the companies do not have to succeed in the end, for the stock to move in the next year or so. Each of these are "story stocks", where there is news coming out in a specific time frame. I actually think my 50-100% price rise will be accomplished BEFORE the actual news. I want to buy in to companies where there is some reason to believe the drugs work, let the pre-announcement excitement build, and then sell some-to-most of the position before the actual news. If GNVC hits $1.50 next spring, I will sell about half of my holdings and then let the rest ride into the interim results.
I have a lot more work to do on some of these models, but I will say that GNVC and SGMO look incredibly mispriced right now, based on potential sales. GNVC could be worth $30+, from today's $0.93 - but the trial itself still may go for 2 years, with a year plus from then for approval, and ramp up. Are you willing to buy $1,000 now, for $30,000 in seven years? SGMO could be a paradigm changer - where every company that wants to modify a single gene has to pay a royalty to Sangamo. In ten years, they may have 1,000 contracts for $10K to $50K each, as a yearly income stream along with their own drug sales from the trials they are running now.
Biotechs may be pie-in-the-sky, but several will pan out, into gold. There WILL be the next Amgen, the next Genentech... I think a couple of the names I've thrown out there may just be those companies.
Regards,
Trond
When you have companies that make products, have revenue, and (gasp) actual profits, then the task can be a bit easier. There are a number of metrics such as price-to-earnings (P/E), or price-to-sales, that you can use to compare a company against another within the industry and see which is a better deal. I am suspicious of these metrics, by the way, on the whole, because earnings are massaged quite a bit, and even sales can be "managed" from quarter to quarter. But at least there are real numbers to work with!
Biotechs that have no products available for sale yet are much trickier. Look at BioCryst (BCRX) which today announced its first order for the IV version of its swine flu drug peramivir. The pricing was MUCH more aggressive than the Street expected and the stock responded with a 15% gain on the day! At this point, forecasting more sales really depends on how much more the government will stockpile, whether doctors start prescribing it off its emergency-use label, if and when the other countries that have negotiated with the company (Israel, China, e.g.) start ordering, and perhaps most immediately important - whether Japan gives its emergency use authorization and they get an order for 500,00 to 1M doses. That would be a $1B order minimum, or $200M at its Shionogi royalty rate - one order alone that is half its market cap! Can you say hello $20s or $30s, from it's $11.39 today? (and yes, I have a little BCRX in my IRA - not a lot but I think this one, too, will do well in the next year)
Back to the actual question though.
Let's take Dendreon for an example, simply because I can do these numbers in my sleep. Provenge is not approved yet, so we have no real metrics. We don't even have a good price point on them - Dr. Gold has stated the one plant they have now, at full capacity, can produce $500M to $1B of sales. It however, is only 25% built out presently... and to complicate matters, they are planning two new plants, each of which will produce 3/4 of the NJ facility.
Now, you probably should also look at the number of patients a year who will get prostate cancer, at the phase at which this will be prescribed (post-androgen therapy) and make an estimate of the market penetration, and then figure the number of patients who actually get the drug multiplied by the cost per treatment. Suffice it to say I believe within 5 years, these three plants will all be at full capacity. (1+3/4+3/4) plants at $500M to $1B gives you a range of revenue of $1.25B to $2.5B ( you can usually also figure in modest price increases per year, but I'm ignoring that, for now). You can use the midpoint, but I like to assume the low point as a reality check. So $1.25B of sales is our first checkpoint.
Now you can apply some other metrics. Five-to-seven times sales is one rule of thumb for projected market cap. So using 5 * 1.25 gives us a $6.25B market cap, 5 years out. Our market cap now is about $3.2B so it's nearly a double - call it $55 from today's $27.78.
But wait!
We now need to discount back to the present, adjusting for risk. I have assumed approval and I have assumed revenues into the future (they will not be making $1.25B next year). At least I assumed the lower levels for the other choices! We can say there is a 10% risk that Provenge is not approved, or has a delay. There may be a 15% discount per year into the future revenue stream. All told that $55 in the future may only be worth $32 or so today. Still a nice 10 to 15% discount to today's price! And please note if I use the midpoints of revenue and times sales, we would arrive at a market cap of $11.25B - or a share price of $90 or so. Discounted that would be $60ish, compared to today's $27.78 - nice! I like to be conservative but I also like to see what might be in store.
You can also use the P/E ratio, once you estimate sales, to arrive at a price. At $1.25B (again, the low point in assumptions) in sales, the margins should be around 25% so there would be $312M in profit. I am going to assume they will issue more shares within 5 years and there will be 150M shares outstanding. That would be over $2 per share in earnings, and with an assumed x25 earnings multiple, we arrive at $50 per share - slightly less than my $55 from the times-sales estimate.
Note all these example all estimate ONLY United States revenue. Dendreon is actively seeking a rest-of-world partner - where they will collect a royalty on ex-US sales. These royalties will have an effect on the bottom line, perhaps as much as 20-25% of the US revenue.
They also have other immunotherapeutics in their pipeline that will follow Provenge, all based off the same method of action. They have learned HOW to construct trials for cancer vaccines, and their agents for breast, ovarian, kidney, colon, and lung cancers should move along more quickly through trials than Provenge did. This will become a growth stock once investors realize cancer may become a manageable disease through these immunotherapeutics.
Whew - lecture on Dendreon is now over. The take away from this lesson should be that there are a HUGE number of assumptions that go into any kind of estimate like this. Patient count, adoption rate, pricing, earnings, competition, production capacity - any of these could be off by factors of 50% or more! My usual method is to try to use the low points of most ranges to come up with a basement level price, and then start tweaking numbers, as not ALL categories will be at the lowest possible point. If the basement price looks attractive compared to today's price, though, you just may have a winner.
Too, the companies do not have to succeed in the end, for the stock to move in the next year or so. Each of these are "story stocks", where there is news coming out in a specific time frame. I actually think my 50-100% price rise will be accomplished BEFORE the actual news. I want to buy in to companies where there is some reason to believe the drugs work, let the pre-announcement excitement build, and then sell some-to-most of the position before the actual news. If GNVC hits $1.50 next spring, I will sell about half of my holdings and then let the rest ride into the interim results.
I have a lot more work to do on some of these models, but I will say that GNVC and SGMO look incredibly mispriced right now, based on potential sales. GNVC could be worth $30+, from today's $0.93 - but the trial itself still may go for 2 years, with a year plus from then for approval, and ramp up. Are you willing to buy $1,000 now, for $30,000 in seven years? SGMO could be a paradigm changer - where every company that wants to modify a single gene has to pay a royalty to Sangamo. In ten years, they may have 1,000 contracts for $10K to $50K each, as a yearly income stream along with their own drug sales from the trials they are running now.
Biotechs may be pie-in-the-sky, but several will pan out, into gold. There WILL be the next Amgen, the next Genentech... I think a couple of the names I've thrown out there may just be those companies.
Regards,
Trond
Watchlist
I desperately need to update my watchlist - I hope to have some time this weekend to do so.
I am very bullish on several stocks at this point - I'd have looked like a genius if I'd pointed out Sangamo yesterday ($6.30, up 16% today...) but there are a number of others too. SGMO, by the way, IS a watchlist stock and I will have an updated "buy under" price this weekend. I think it may give some back tomorrow, so I wouldn't just grab some today.
Allos (ALTH, $5.88 today) is one stock that I expect to be at or over $10 in the next 6 months or so. They have an approved drug, aggressive pricing, and a low number of shares outstanding (relatively). The worst case would be a buyout at a 10-20% premium.
Neurocrine (NBIX, $2.16 today) is another that SHOULD have news in the next 6 months that will propel it to at least a double and perhaps more. Several trials will yield news and a partnership awaits. I unfortunately have thought this for a few months now and have been buying steadily all the way down. Time will tell but this is rapidly becoming one of my larger stakes, just from the risk/reward.
GenVec (GNVC, $0.93 today) is the final one I will toss out - again, interim trial data expected within 6 months and the data should be really nice. Not good enough to file with the FDA immediately, but good enough to attract partners and/or suitors.
All of these (SGMO, ALTH, NBIX, and GNVC) should be 50% or higher in the next 6 months. I will make a note to revisit this post in May 2010 - I invite you to do some research on these companies and ask any questions you wish.
Regards,
Trond
I am very bullish on several stocks at this point - I'd have looked like a genius if I'd pointed out Sangamo yesterday ($6.30, up 16% today...) but there are a number of others too. SGMO, by the way, IS a watchlist stock and I will have an updated "buy under" price this weekend. I think it may give some back tomorrow, so I wouldn't just grab some today.
Allos (ALTH, $5.88 today) is one stock that I expect to be at or over $10 in the next 6 months or so. They have an approved drug, aggressive pricing, and a low number of shares outstanding (relatively). The worst case would be a buyout at a 10-20% premium.
Neurocrine (NBIX, $2.16 today) is another that SHOULD have news in the next 6 months that will propel it to at least a double and perhaps more. Several trials will yield news and a partnership awaits. I unfortunately have thought this for a few months now and have been buying steadily all the way down. Time will tell but this is rapidly becoming one of my larger stakes, just from the risk/reward.
GenVec (GNVC, $0.93 today) is the final one I will toss out - again, interim trial data expected within 6 months and the data should be really nice. Not good enough to file with the FDA immediately, but good enough to attract partners and/or suitors.
All of these (SGMO, ALTH, NBIX, and GNVC) should be 50% or higher in the next 6 months. I will make a note to revisit this post in May 2010 - I invite you to do some research on these companies and ask any questions you wish.
Regards,
Trond
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