Bursting Biotechs -- Are These Stocks Buys?

Biotech is a favorite sector for us to talk about here at The Motley Fool, and with the recent hits the market has taken, some of these companies are looking like a steal. But are they worth jumping on board with during this downturn, or should we let clinical trials play out before we go all in?

A full transcript follows the video.

Kristine Harjes: Bursting biotech, are these stocks buys? This is Industry Focus.

Hey, everyone! Welcome to Industry Focus, healthcare edition. I'm Kristine Harjes, your host, and I'm here with our wonderful healthcare contributor, Todd Campbell. Todd, how's it going?

Todd Campbell: It's going well. It's going to be an exciting show today.

Harjes: Absolutely. Ready to talk some biotech?

Campbell: Oh, yes!

Harjes: You're always ready. What we were thinking for today's episode, some stocks have been hit harder than others over the past four weeks. We wanted to take a look at some of biotech's worst performers over the past four weeks and just picked out a couple of interesting stories. We'll talk about what looks like a buy, what might look promising, but once you dig in it isn't, and have a chat about some stocks that are of pretty good size that have been hammered recently.

For our conversation today we lined up two stocks in the neighborhood of $2.5 billion market cap, and one Goliath at $150 billion. Any listeners already know who I'm getting at? I don't want to hold you in suspense for too long. We'll start with Gilead Sciences (GILD 0.91%). Gilead's shares are back down in the $100 range, which represents a 12% drop over the past month. Todd, what's going on here? Should we give up on Gilead?

Campbell: No. Anybody who has listened to us chat before knows that we like Gilead.

Harjes: Just a little bit.

Campbell: Just a little bit. Here's a company that is a market leader and a dominant player. I think the temptation is for investors to paint a broad brush stroke across the entire industry and say they don't want to have any risk, or own any of these companies. Gilead isn't like investing in a clinical-stage company. This is a company that's already the market share leader, and has been for a decade, in HIV treatment. It's the market share leader in the hepatitis C treatment, too.

This is a company that generates a tremendous amount of revenue and profit for shareholders, and it's trading at an even better valuation than it was a month ago. I would have argued a month ago it was still cheap.

Harjes: We were absolutely calling it cheap a month ago. Now, when you look at it, it's incredible how inexpensive this really awesome company looks. You're looking at a trailing P/E ratio of 11. Once you start looking forward you're at a forward P/E of under 9; single digits.

Campbell: Yeah. Everybody is betting that a competitor is going to come in. Last quarter they combined hepatitis C sales and they were running at an annualized rate of about $20 billion. People are saying if AbbVie launched its Viekira Pak -- which they did and it didn't really slow down Gilead much -- and Merck comes out with one, and Bristol-Myers is developing one, and J&J is working with people on one; what's going to happen to Gilead's market share in the future? It's going to shrink.

That's going to weigh down growth and profit, so why pay up for earnings.

Harjes: It makes sense that this is something that people are worried about. Gilead's got a 90% market share of all hepatitis C patients. This is a really big revenue driver for them. They treated 130,000 patients in the first half of 2015. It makes sense that if that were to disappear it would be a big threat to the company.

Campbell: Yeah. The problem with that thinking is that you're assuming that the pie is going to be the same size. You've got this 10" pie and it's not going to be a 20" or 30" pie. There's 150 million people globally with hepatitis C. There's 3 million here in the U.S. and we've treated 200,000 or 300,000 of them. This is an incredibly large patient population.

I think barriers to entry for patient treatment are falling, and will continue to fall, and that's going to create a much larger market opportunity that can then be split among the different players.

Harjes: With these new players, do you think anyone is going to come out with a better drug? I know Gilead is working on some new drugs, but I know there are also some other players that are looking to overtake Gilead and produce the best drug out there to treat hepatitis C patients.

Campbell: A lot of people thought the Viekira Pak was going to really put a dent into Harvoni's sales and genotype I. Viekira Pak is selling well, but it's really not getting the traction that people worried over. AbbVie has another pan genotype drug in trials; a two drug combination that its developing that it hopes will do better. Merck has an FDA decision pending for its hepatitis C drug, which I think could pose the biggest threat to the current generation of Gilead drugs.

Gilead isn't just sitting still. They're doing their own research and creating their own next-generation drug as well. Data from that should come out this quarter supporting the filing. If that goes well then it's going to have its next generation on the market next year, too.

I have a hard time believing that Gilead is not going to be the dominant player in this space a year or two from now.

Harjes: What about HIV? Do you think they'll continue to dominate that space just as much?

Campbell: This is a huge cash cow for the company. HIV is responsible for more than $10 billion in sales for Gilead each year. They've got five different drugs that are going to be more than $1 billion each, they're rolling out a new slate of drugs that include a reformulation of Viread, a very popular HIV drug that's losing patent protection in a couple years. That solidifies their patent portfolio now into the late 2020s.

HIV is going to remain an important part of their business, it's going to provide them with plenty of cash flow, you throw in hepatitis C on top of that and you've got a company that's got $14 billion in cash and growing every quarter. That gives you a lot of room for innovation.

Harjes: Yeah. Innovation and potentially acquisitions, too. This is another thing that I'd be remiss not to mention about Gilead Sciences; how smart they have been with their capital allocation in the past, and as shareholders we hope going forward as well. Their CEO, John Martin, is this huge intangible asset to the company given how smart he is about these acquisitions.

The one everybody always thinks of is the 2012 Pharmasset acquisition, which netted them Sovaldi; it seemed expensive at the time. It was $11 billion, but then Sovaldi sold $10.3 billion in its first year on the market. This was clearly a really smart move on the part of the company, particularly given that Sovaldi is a component of Harvoni, which sold $2.1 billion just in its first quarter on the market.

Even before that, if we go back into HIV, one of the key parts of Gilead's combo-HIV regimens, this drug was actually acquired in 2003 for only $464 million. It was acquired from a company called Triangle Pharmaceuticals. Since then drugs containing emtricitibine, which is this key component that they got form Triangle, have sold $50 billion in total.

Let me say that again: They bought Triangle for $464 million, and this drug has been part of combination regimens that have sold $50 billion since then. We can only imagine with Gilead sitting on all the cash that they have, they're going to do something pretty smart with it. I can't wait to see what it is.

Campbell: It may be something that we totally don't expect.

Harjes: Exactly. We could go on about Gilead forever, but we had a couple companies that we have lined up that we wanted to chat about today. Let's move over to a company called Insys (INSY). Todd, what are you thinking with Insys? They've gotten hammered recently. I think they're down 27% in the past four weeks. What do you think?

Campbell: One of the reasons I want to talk about this company is because it's a great example of how market hype gets a hold of a particular stock and it can send it to highs that may or may not be justifiable. The piper is being paid with the decline in Insys' shares. What I think is interesting about this company -- and I think you might slightly disagree with me on it -- I think that the hype surrounding the potential for this company to develop marijuana drugs is actually a side note; it's not really the reason why you should own, or consider buying these shares.

I think the selling in the company is getting overdone because of that. I think there is a lot more potential for upside because this isn't an ethical stage company that is counting on marijuana to drive its future growth. It already has one approved drug that's doing more than $200 million in sales annually. It's got another one awaiting FDA approval that will be targeting a market that's 150 million and growing, and it's got the potential to develop other drugs and launch other drugs in the next couple of years, too.

Harjes: I would agree with you. Of the companies that people might associate as marijuana stocks, this is definitely one of your best bets. It's trading on a reputable exchange. That's huge in the world of marijuana penny stocks, but I still think there's a lot of emotion at play here. There are a lot of people that are looking to invest on these "marijuana stocks" and they look at Insys and their research and think that this could be huge.

You're right though. The real story behind this company is not their marijuana research. One of the things that concerns me about it is how expensive it is. Even when you look at Subsys, this is a drug that's on the market and the company that's cash flow positive, but barely. I don't see how Subsys' relatively minor success can sustain this massive valuation.

Campbell: I would argue that the valuation isn't necessarily too out of whack relative to a GW farmer, which is a pure play in the marijuana space. Subsys' sales were up 40% in the second quarter. That gives you a $280 million run rate just for that one drug. If they can get $100 million from Oral Marinol, if that gets approved next year, then you're trading at less than 10x revenue.

Then if they can roll out any other drugs on top of that, you get a valuation that's going down to 5x to 7x sales. It's not cheap, but again, in the world of biotech, having a company that is generating any profit, and the potential to continue to grow profit that's debt free and is seeing its cash grow; for my money, I think that makes it an intriguing one.

Harjes: One more point that I want to bring up, and I want to get your thoughts of whether or not this is a concern to you; their short float is 62%. Do you think that represents a risk, an opportunity, or something to ignore? What are your thoughts there?

Campbell: Investors always overshoot. They overshoot on the upside when they get caught up in the hype behind marijuana, and similarly they're getting caught up in the hype on the downside as well. I think a lot of people who go out in short stocks think that marijuana plays are overdone. As a result, they've said that Insys' marijuana plant should be shorted.

Granted, that's not the only reason people are short. People are also short because they're worried that the FDA is cracking down on makers of opiate pain medicines like Insys' Subsys. If attorney generals from various states decide that Insys has been recommending these drugs off label -- which has been some concern -- that could result in some problems for the company, too.

I really think that when it comes to pain mediation, especially people who are dealing with cancer pain, or acute post-operative pain; these drugs are important. Yes, you want to get rid of the people who are abusing them and doctors who are prescribing to abusers, but you're not going to want to get rid of these drugs. The demand for them will remain and will probably continue to grow as an older population gets diagnosed with more cases of these diseases.

Harjes: I definitely see your point there. One thing I worry about in addition to these drugs being completely taken off the market is what I think will be the more likely case; there are going to be so many settlements with state attorney generals if these issues with doctors off labeling the drugs and potentially Insys marketing for this off label use continues.

Early in August the company settled with Oregon's attorney general for $1.1 million for marketing Subsys for non-caner neck and back pain, and things that the drug is not approved for. Total Oregon Subsys sales through the time of that investigation were only a little over $500,000. You're paying a fine of twice what the sales only ever were. I could see that potentially being a big problem for the company.

Campbell: It's absolutely a risk, but I think they'll be able to manage their way through it.

Harjes: Let's move on to our last company for today. This is an immune oncology company that holds a lot of intrigue, but maybe a couple of question marks, too. They're called Kite Pharmaceuticals (NASDAQ: KITE), and they are down 26% in the past four weeks. Todd, what do you think?

Campbell: We were just talking about media hype surrounding marijuana. Now, we're going to talk about media hype surrounding next-generation cancer cures. Kite Pharmaceuticals is one of the companies that's working on something called CAR-T cancer immunotherapy. Essentially they're withdrawing blood from a patient who has cancer, they're engineering the T cells that are part of the immune system to be able to recognize a protein that gets expressed by the cancer, and then they're putting those T cells back into the body to go after, find, and destroy those cancer cells.

Harjes: In theory, that's awesome. Any way that we can approach a novel way of treating cancer warrants a lot of excitement. We're reengineering the immune system to better fight and destroy cancer cells. What's the problem?

Campbell: You could not have imagined 20 years ago where we would have come in research on cancer. It's exciting. I really hope that these CAR-T developers succeed. I have some big concerns when it comes to going out and investing in them, even at these lower prices as they're falling.

Harjes: I agree with you there. Kite's most advanced drug is still in Phase I trials, and yet this company sports a $2.2 billion market cap. It's previously gone up to a valuation of 3.8, which is the highest that I've seen, but you have to remember, 90% of drugs entering Phase I never make it to market. Oncology is even less promising. 93% of these drugs will never end up making it onto pharmacy shelves.

Campbell: You have to worry about toxicity. Cancer is tough to treat, and you've got to kill cells in the body to do it. Unfortunately, when you're killing cells in the body, it's still very hard to make sure you're only killing the bad, unhealthy cells. Even though CAR-T therapies promise to be more accurate, we still don't fully understand the potential off targets that could be affected by patients receiving them.

So far, trials have shown really good response rates and that shouldn't be diminished. We're still years away from being able to have these things on the market though. The other concern I have with this stock is how competitive this whole marketplace is becoming. It's not like this is the only company that's developing a CAR-T therapy. There are a lot of other companies and researchers that are working on this technology.

I don't think a best-in-class has emerged yet. Because of that, it's hard for me to say, "I could go out and buy Kite at $2.2 billion and it will be a slam dunk."

Harjes: I totally agree. You've got Bellicum, Ziopharm, even Novartis has got their hands in them and if I were to personally put my money on CAR-T therapy I would put it in Juno. Juno is working on this new way of treating cancer, but the reason that I would say Juno would be your best bet out of all of them is because of this massive deal that they just struck with Celgene.

We've talked about Celgene on the show a lot. These guys know what they're doing. They recently paid $1 billion for a 10% stake in Juno, and access to Juno's pipeline, I think they also include an option to take up to 30% more stake in Juno; the point is, this is an indication that Juno is a very promising company if CAR-T is to work out as a whole.

There's a huge influx of cash, you've got so much marketing promise down the road if you're right there with Celgene to market these drugs. To me, I would say that is Celgene indicating to investors that Juno is the way to go in this field.

Campbell: What's also really interesting about that deal is the value of the shares that Celgene acquired breaks out to a share price in Juno that's somewhere around $90. Shares are now, what, $35?

Harjes: That's tricky math there. They paid $1 billion for it, but if you look at it, it's a 10% stake, and it's also what they're getting form the pipeline. Even though the press release stated that it's this many shares at this price, the bottom line is; they paid $1 billion for a 10% stake, plus a bunch of access to the pipeline. I think it's hard to derive an estimated share price from that.

Campbell: I understand. I think that's a good point. They're putting up a lot of money and the accounting of it can go in a lot of different ways. It could be for shares, or this, or that. You're right about the fact that they're taking the stake at all is probably more important than any price that's being awarded to the company.

I think when Celgene did the deal they said they could have their first drug in front of regulators from the deal around 2020. We're still a few years away from seeing any real results coming out of CAR-T that would be able to be used by patients. It's an intriguing space. I think it's one that we need to keep watching. I just think it's a little early in it and I would rather see some Phase II data, and some safety data across a larger patient pool before stepping in and buying any of them.

Harjes: I would agree. Of course, we want to keep our eye on this space just because that would be awesome to get these really effective drugs past all the trials and to the patients that need them the most. What I'm personally hoping is that the safety data stands up and ends up being better than anything else out there.

For now, as investors, it might not be the best way to throw your money into this indication with a whole ton of hype around it just yet.

Todd, thanks so much for weighing in here. Folks, you know where we see the opportunities, where we're seeing clear; what do you guys think? What companies are on your radar during this sell off? Let us know at [email protected].

Before we close off, I would like to make the reminder that we always have to say here: People on this program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against those stocks. So, don't buy or sell anything based solely on what Todd tells you to do or I suggest you do.

Do your own research. Have fun with it. It's a really intriguing space. There's a ton of great content on Fool.com, and, of course, we'll be back next week to chat more healthcare. Todd, thanks so much. Everyone, thanks for listening. Fool on!