Are These 2 Biotech Value Plays Value Traps?

Two biotechs currently trading at deep discounts relative to forward earnings.

Mar 26, 2014 at 6:30PM

As biotechs continue to churn, investors need to carefully consider how much they are paying for a given stock. One way to do so is to look at a company's price to earnings ratio, or P/E. This classic valuation ratio allows you to get a feel for how much of a premium is built into a company's share price at current levels. Historically, biotechs have generally traded with a P/E of between 15 to 20, but the recent run-up has seen the average balloon into the 50s.

A perfunctory comparison of current to forward P/E ratios across the health care sector shows that some companies could be trading at substantial discounts relative to projected earnings (see table below). Yet, such a superficial analysis could lead you into a dreaded value-trap. In other words, there might be a very good reason(s) why these stocks are trading at discounts, relative to their forward earnings. With that in mind, let's take a closer look at why Gilead Sciences (NASDAQ:GILD) and Questcor Pharmaceuticals (NASDAQ:QCOR) appear to be "cheap" based on forward earnings.

CompanyP/E Fwd P/E 2015Difference
Gilead Sciences 40.1 12.8 -27.3
Questcor Pharmaceuticals 14.2 7.78 -6.42

Gilead might be undervalued because of uncertainty over Sovaldi
Gilead's new hepatitis C drug Sovaldi is one of the most closely watched stories in biotech this year. By all accounts, the drug is on pace to smash Vertex's (NASDAQ:VRTX) hepatitis C drug Incivek's record as the fastest drug launch ever, and analysts believe Sovaldi could double Gilead's 2014 initial revenue forecast of roughly $11 billion. As a refresher, Gilead's management decided not to include Sovaldi sales in 2014 guidance.

Although Gilead's P/E ratio will likely move lower as Sovaldi sales are factored into the company's valuation, the magnitude of the change is in question because of debate over Sovaldi's price and potential competition from AbbVie's (NYSE:ABBV) hepatitis C drug. In fact, the consensus among analysts suggests the P/E ratio will move significantly lower without a concomitant change in Gilead's share price, but uncertainty remains because of these issues (see above). 

Presently, U.S. patients are paying $84,000 for a 12 week course of treatment, which many public and private entities believe is too high. By comparison, Incivek is reportedly priced around $66,000 for a 12 week course of treatment, showing that Sovaldi is indeed priced at a premium compared to Incivek. Political pressure may thus drive a change in Sovaldi's current pricing structure, affecting total annual revenue for the drug. Moreover, AbbVie will likely launch its competing drug later this year, and it's largely unclear how competition will affect Sovaldi's commercial performance.  

Because of these outstanding issues, Gilead's 2014 earnings estimates are a moving target. That said, actual earnings will certainly be higher than the conservative estimates proffered by the company earlier this year. So, I believe Gilead should be viewed as a value stock at current levels.

Questcor is "cheap" because of lingering questions about Acthar Gel
Perhaps the biggest battleground stock in the health care sector is Questcor Pharmaceuticals. Despite Questcor growing earnings by over 150% year over year, shorts have still gobbled up 30% of outstanding shares. This extreme bearishness stands in stark contrast to a projected 5-year average earnings growth estimate of 29%. The foremost problem is that Questcor is under investigation for its marketing practices for Acthar Gel, its only commercial product to date. Adding fuel to the proverbial fire, Citron Research also recently raised questions about Acthar's chemical composition, essentially saying the product's contents do not match those stated on the label approved by the U.S. Food and Drug Administration.

Looking ahead, Questcor's P/E ratio could fall to a notable 7.8 based on 2014 estimates -- if shares do not move higher in the meantime. So, Questcor is most definitely a value stock from a fundamental perspective. Even so, the regulatory and legal issues cast a long shadow over the company's future prospects. Although I am skeptical about the recent controversy surrounding Acthar and the potential material impact of a fine arising from any marketing faux pas, it's tough to see how the stock can appreciate in such an acrid environment. In short, I believe Questcor straddles the line as more of a value trap than a bargain.

Foolish wrap-up
Bargains have been rare in the red-hot health care sector over the past two years, but the recent pullback could create more compelling buying opportunities. To separate the wheat from the chaff, you should consider a company's earnings moving forward, as well as its long-term stability. Gilead offers investors stellar earnings prospects, even under the most bearish scenarios for Sovaldi, and a stable of other strong commercial products. By contrast, Questcor is entirely dependent on a single product, whose future revenues are a question mark. As such, I believe Gilead is a bargain, whereas Questcor is better to be avoided at the current time.  

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George Budwell owns shares of Gilead Sciences. The Motley Fool recommends Gilead Sciences and Vertex 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.

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