A Hearteningly Cheap Rule Breaker

Rule Breaker investing is all about finding innovative growth stocks, like medical-robotics manufacturer Intuitive Surgical (Nasdaq: ISRG  ) or Internet search-ad giant Google (Nasdaq: GOOG  ) . But while many of these stocks are known for their steadily climbing prices, every once in a while, a Rule Breaker-type pick goes on sale.

One such stock may currently offer investors excellent future growth prospects at a garage-sale share price. Since its June 2005 addition to the Rule Breakers portfolio, specialty pharmaceutical firm CV Therapeutics (Nasdaq: CVTX  ) has terribly underperformed the market, with shares down more than 66% versus the S&P 500.

Times may be changing for the better, though. CVT is holding onto some seriously undervalued assets that could become a little more loved later on this year. Let's try to make the case that shares of CVT are a steal at today's $8-and-change share price.

Choosing a valuation metric
There are many tools investors can use to value young specialty pharmaceutical companies like CVT. Enterprise value lends itself particularly well to gauging whether a potential investment in a drugmaker deserves further investigation.

Finding a company's enterprise value essentially tells you what value the stock market is placing on its assets, aside from its net cash. By removing a company's cash and debt from the equation, you can see what value the market assigns to a company's other assets.

If you think a drugmaker's other non-cash assets, like its pipeline and marketed drugs, are worth more than what its enterprise value says they are, its shares are probably undervalued. (Give yourself a suitable margin of safety, of course.) On the flip side, if its enterprise value seems bloated relative to its assets, its shares are probably overvalued.

CVT's assets at a glance
CVT's most valuable assets are its two approved drugs, Ranexa and Lexiscan.

Ranexa was approved for marketing in the U.S. in 2006. It's since become a modest success as a fallback treatment for angina patients who respond poorly to more common generic medications.

Sales of Ranexa will total roughly $100 million in 2008 with its current marketing label, but CVT has three applications awaiting review at the FDA that could significantly expand the drug's opportunities, potentially giving it a nice sales boost. Ranexa also won preliminary approval in the European Union earlier in the year, with final EU approval expected in the next month or so.

CVT's other top compound, Lexiscan, is a heart-imaging diagnostic aid. It was approved by the FDA in April and will be sold by CVT's North American marketing partner, Astellas. CVT stands to gain royalties on all of Astellas' Lexiscan sales, but it sold off half of its rights to these royalties for $185 million two months ago.

CVT also has a drug pipeline consisting of some very early preclinical and clinical-stage compounds, and another drug partnered with Biogen Idec (Nasdaq: BIIB  ) . It also has some tax-related operating-loss carryforwards that have value, and hard assets like equipment. But besides the aforementioned Ranexa and Lexiscan compounds, its only other major asset is the cash on its balance sheet.

After accounting for the sale of half the Lexiscan royalties, a cash milestone payment received from Astellas after Lexiscan's approval, and my estimate of roughly $30 million in cash burn in the second quarter this year, CVT should end the second quarter with about $315 million in cash and equivalents on its balance sheet.

CVT's debt is conservatively valued at nearly $450 million, mostly from long-term convertible notes. At market close Monday, its market capitalization was approximately $500 million.

Finding CVT's EV
Enterprise value equals market capitalization minus cash, plus debt. Using the figures we derived in the previous section, that makes CVT's enterprise value:

$500 million - $315 million + $450 million = $635 million

Thus, investors should ask themselves whether CVT's aforementioned two top drugs, Ranexa and Lexiscan, are worth at least the $635 million value that the stock market is largely ascribing to them.

At the very least, CVT's stake in Lexiscan seems fairly valued. Considering that CVT just received $185 million for half of its future Lexiscan North American royalty payments, it's not unreasonable to assume that the other half of Lexiscan's North American royalties are worth another $185 million today.

In that case, then Ranexa needs to be worth at least $450 million ($635 million minus Lexiscan's $185 million) for CVT's shares to even be considered fairly valued with this simplistic enterprise valuation.

Ending on a cliffhanger
I don't have enough room in this article to start working up an estimate of Ranexa's risk-adjusted worth, given the many variables involved.

For example, CVT has three July 27 PDUFA dates scheduled with the FDA to review Ranexa's expanded marketing applications. Assuming that the glacially paced FDA actually does review those applications sometime this year, by the start of 2009, CVT could have Ranexa approved as a front-line angina treatment (approval likely) and a diabetes treatment (approval very uncertain), with anti-arrhythmic efficacy claims also added to its label.

Don't forget Ranexa's chances in Europe, either. CVT has previously given a range of hypothetical market-potential assumptions (not the same thing as sales forecasts) of anywhere from $324 million to $972 million, depending on different variables. CVT plans to find a marketing partner in Europe, if not the rest of the world. As a result, it will only get a portion of any sales Ranexa generates abroad, plus a likely up-front payment for giving away its marketing rights.

Ranexa is an appealing drug for big-pharma partners in both Europe and the United States. Because angina is such a common disorder, and because Ranexa requires a monstrously large sales force to reach its full sales potential, it could be worth a lot more in the hands of a well-funded, large-cap pharmaceutical giant, like Pfizer (NYSE: PFE  ) , GlaxoSmithKline (NYSE: GSK  ) , or AstraZeneca (NYSE: AZN  ) .

Enterprise value is just one way to see whether a company deserves further research as a potential investment. Multiple other valuation techniques can also help gauge a company's intrinsic value; I generally use enterprise value as a jumping-off point before applying more complex and time-consuming valuation techniques like discounted cash flow analysis.

CVT's enterprise value estimate can be refined further by adding values for some of its lesser assets, such as its partnered drugs with Biogen Idec. Still, the thumbnail value I've worked up here should be a good starting place for further review.

If, like me, you believe that Ranexa is worth more than $450 million, then this rough calculation makes CVT's shares look seriously undervalued.

CV Therapeutics, Intuitive Surgical, and Google are active picks of our market-beating Rule Breakers newsletter. You can check out all our other recommendations, and get access to our message boards and exclusive content, with a 30-day free trial.

Pfizer is an active Inside Value pick. Pfizer and GlaxoSmithKline are active Income Investor picks. Biogen Idec is an active Stock Advisor pick.

Fool contributor Brian Lawler does not own shares of any company mentioned in this article. The Fool has an A+ disclosure policy.


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