There are several ways good managers can return capital or increase shareholder value. Bio-Technology General's management doesn't appear to be focused on creating value for shareholders. In this case, a share buyback is the right prescription.

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By Zeke Ashton
August 19, 2002

I'm a shareholder of Bio-Technology General Corp (Nasdaq: BTGC), a biotech company that, as I wrote in a recent article, can't seem to shake its bad luck. Recently, I mentioned Bio-Technology General to a fund manager who's also a medical doctor. The argument that I gave for owning the stock is that Bio-Technology General has generated a total of $110.6 million in operating cash flow over the past five years, has over $100 million in net cash, eight marketed products, and a decent pipeline of drugs in clinical trials. At a recent market cap of under $250 million, this stock looks awfully cheap.

The find manager was intrigued and researched the company. "It's a good little company, and the management seems honest and hardworking, but none of that cash is likely to be returned to the shareholders," he said. Essentially, all the cash generated by operations will be reinvested in the business, and he has little confidence that it will find its way back to the shareholders in the form of a higher stock price. This got me wondering how to evaluate whether or not this is likely to happen.

Evaluating management effectiveness
In stock investing, a critical component of the process is judging whether the management team is ethical, competent, and shareholder-oriented. The manager of a company's first job is ensure business generates cash rather than consumes it. This seems obvious, but companies sold on our publicly traded markets have been consuming cash for decades. Until they generate cash, they're living on borrowed time.

Management's second job is to ensure the proper investments are made to maintain the business, so that it can continue to generate cash flow in the future. Some companies don't have excess cash available, beyond what's required for maintenance of the business, and therefore true value creation is quite difficult. For a consistently profitable company that generates cash above what's required to maintain the core business, the excess cash requires careful allocation by the management team. How this cash is used will determine whether per-share value increases.

This excess cash flow can generally be used to build value for shareholders in one of four ways:

• The company can invest the cash to grow the company's value organically. This could involve hiring new sales personnel or increasing advertising spending to grow sales of existing products, investing in research and development of new products, adding additional manufacturing capacity, or improving the company in any number of other ways.
  
  
• The company can make acquisitions, which will only add value if the company receives more than a dollar in value for each dollar they spend.
  
  
• The company can return the cash to the shareholder in the form of dividends, by either raising the dividend (for a company that already pays them) or by declaring a special dividend.
  
  
• The company may repurchase its stock. Note that this will only benefit ongoing shareholders if the price at which the company repurchases the shares represents a discount to a conservative estimate of the company's true value. The bigger the discount to a company's true value, the more economic value per share will be transferred to the loyal shareholders from the departing (or selling) shareholders.

Back to Bio-Technology General
Given the above, I decided to get out my collection of old Bio-Technology General annual reports and see if I could figure out how well the company has allocated the cash generated from operations. First of all, a certain amount of maintenance capital expenditures need to be deducted from the operating cash flow, which I'd estimate at about $5 million per year for Bio-Technology General. This may seem light, but remember that the company spends about 20% of revenues each year on research and development. This expense is already baked into operating cash flow. So I'll take that $110.6 million in operating cash flow and subtract five years of maintenance cap-ex at $5 million per year. That's $25 million, which leaves about $85.6 million left in excess cash. Where has this money gone? Here's what I found:

• In 1999, Bio-Technology General began constructing a new, state-of-the art manufacturing and research facility in Israel. According to the 2001 annual report, this facility is now operational at a total cost of approximately $40 million.
  
  
• In early 2001, Bio-Technology General acquired Myelos, a development stage company with a promising drug in Phase 2 clinical trials. The cost of the acquisition was $35 million.
  
  
• Also in early 2001, Bio-Technology General made a strategic investment in a company called Omrix Biopharmaceuticals. The total investment was $5 million. In the fourth quarter of the same year, Bio-Technology General wrote down the investment by $3 million.

That's a total of $80 million, which accounts for most of the last five year's worth of excess cash flow. Whether the company will get a decent return on its investment in the manufacturing facility is hard to say. But the stock market certainly isn't going to give it credit until the investment begins to translate into financial results. We likely won't be able to evaluate the acquisition of Myelos for some time -- though clearly this investment needs to result in a commercial product for Bio-Technology General to see a return. Again, the market isn't giving the company credit for this investment now. The Omrix investment has already been marked down to 40 cents on the dollar.

For 2002, Bio-Technology General announced it would increase R&D expense by about 40%, or $15 million. This will decrease operating cash flow by a like amount, and the results of this investment likewise won't be seen for a while. The company also noted it would be investing heavily to increase the sales force, thereby increasing selling and marketing expenses by about 20% over the previous year (or about $3.4 million.) This should result in increased sales of current products. We should be able to see short-term results here; management is already saying that prescription trends are improving.

A simple prescription
Clearly, the market shares the fund manager's skepticism that Bio-Technology General's cash flow will find its way back to shareholders, at least in the near future. The stock has spent much of this year trading below $5, a level last reached in 1999. More disturbing, despite obvious improvement in the business, the stock is trading at the same price it was back in 1992. There are two ways to view this: Either the stock is an incredible value now, or the company hasn't increased its per-share value much in 10 years.

On the most recent quarterly earnings call, CEO Sim Fass was asked why he'd recently purchased some 67,000 shares of company stock and whether the company would buy back some shares. Fass responded that the board will consider share buybacks. As for his own purchase, Fass noted that at the recent price, "I thought it was an eminently smart thing to do."

My prescription for Bio-Technology General is this: Management should take advantage of the current low valuation and buy back $10 or $20 million worth of shares. I believe the stock's undervalued, and that a repurchase would be the best use of the company's cash. Even a modest share buyback would send a strong message that management is determined to return cash to shareholders and increase the company's per-share intrinsic value. With over $100 million in cash sitting around, it certainly shouldn't affect the company's liquidity in any major way.

Now that would be eminently smart.

Zeke Ashton has been a long-time contributor to The Motley Fool. Zeke is also the managing partner of Centaur Capital Partners, LP, a money-management firm in Dallas, Texas. At the time of publication, Zeke owned shares of Bio-Technology General. Please send your feedback to zashton@centaurcapital.com. The Motley Fool is investors writing for investors.