Rule Breaker Portfolio The Year Ahead for Rule Breakers

We look ahead for AOL Time Warner and our three development-stage biotech drug makers and wannabes. One's producing cash, the others spending it. We want more of the former and intelligence in the latter.

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By The Rule Breaker Team
January 15, 2002

Last week we took a quick look at our holdings in 2001. Today we examine our hopes and fears for two large parts of our holdings -- AOL Time Warner (NYSE: AOL) and three development-stage companies using biotechnology to revolutionize health care.

It's earnings season for our companies, too.

eBay (Nasdaq: EBAY) reports today after market close, and our community will be discussing the results on the eBay discussion board. Next Tuesday will see the words from Amazon (Nasdaq: AMZN) and Millennium Pharmaceuticals, followed by Amgen (Nasdaq: AMGN) and Celera Genomics (NYSE: CRA) on Wednesday, and Starbucks (Nasdaq: SBUX) on Thursday. No date yet from Human Genome Sciences (Nasdaq: HGSI).

AOL Time Warner: Due to Rebound? (Jeff Fischer -- TMF Jeff)
AOL Time Warner is operating in "the worst advertising market in memory," according to outgoing CEO Gerald Levin. It's so bad that not even the wizardry of The Lord of the Rings and Harry Potter, both AOL-TW blockbusters, helped enough.

The world's largest media monster lowered late-2001 and all 2002 expectations. After being aggressive last year and missing goals, the company is thankfully being conservative with 2002 estimates. Management is assuming that advertising and the overall economy will not turnaround, but will remain flat. (So let's just hope that it doesn't shrink.)

Assuming a flat economy, AOL Time Warner expects 2002 sales growth of a modest 5% to 8%. That sounds horrible, but 2001 revenue only grew about 5%, to $38 billion. Therefore, 2002's estimated sales growth could match or actually improve on last year's.

Free cash flow (which is cash from operations minus capital expenditures) rose more than 200% to $3 billion in 2001, putting the $133 billion market-capped company at 44 times free cash flow. That is about the multiple that Coca-Cola (NYSE: KO) carried the past five years with stagnant earnings. Free cash flow in 2002 should grow by double-digits, but by how much is the question.

Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is the preferred reporting metric of media giants. AOL Time Warner expects EBITDA to grow 12% to 18% in 2002 (but be flat the first quarter), after growing 18% in 2001 to nearly $10 billion ($11 billion was expected).

Currently, consensus estimates call for $1.09 in earnings per share this year, after $1.17 in 2001 earnings. Those results would put the $30 stock at 25.6 times trailing earnings and 27.3 times 2002 earnings. That's slightly less than the S&P 500's average P/E.

What to expect for 2002? It sounds like we'll see water treading from the company -- at least until the advertising market improves. When it does, AOL Time Warner should be one of the largest beneficiaries. The question is, "How soon?" Meanwhile, the stock trades at only 13.5 times 2001 EBITDA. That's much lower than the approximate 20 multiple that most assumed it would carry for several years. Perhaps it will get back up there before the year is out.

Biotech: Where to Stash the Cash? (Tom Jacobs -- TMF Tom9)
We own three unprofitable companies whose goals are to use biotechnology to revolutionize health care, and they are sitting on K2's of cash: Millennium Pharmaceuticals, Human Genome Sciences (HGS), and Celera Genomics. All three grabbed the gold while the getting was good -- when the stock market favored their shares and allowed them to issue stock or low-rate convertible debt to fund research and development. This is the way of the biotech world, where a decade or more of cash burn precedes profits, if any.

What great cash positions for these companies to be in:

        cash &    LT          TTM        TTM 
        ST inv.  Debt      Cash Burn   Revenues
MLNM  $1,527 mil $ 83 mil  $-150 mil  $246 mil
CORR*    633      600       -  9       126
HGSI   1,659      504       -121        12
CRA**    968       23       -126        97

[source: SEC Form 10-Q for quartering ending 9/30/01]

*Millennium has proposed to buy COR Therapeutics, maker of the cardiovascular drug, Integrilin, for $2 billion in stock and cash.

**Don't rely on anything but the SEC filing for Celera's numbers, and remember to find its own breakdown in the SEC filings that include parent Applera Corp. and sibling Applied Biosystems (NYSE: ABI). Yahoo Finance didn't -- it uses Applera numbers for CRA.

Millennium has one drug on the market, Campath, producing negligible revenue. Its MLN-341 may well be a blockbuster cancer drug, but it's still in Phase 2 trials, several years away from possible Phase 3 trials, Food & Drug Administration approval, and marketing -- in the best of all possible worlds. The company decided to beef up its already significant partnering revenues (revenues produced through collaborations with large pharmaceutical companies) with a $2 billion stock-and-cash purchase of COR Therapeutics (Nasdaq: CORR). Millennium gains COR's injectable anti-platelet (anti-clotting) drug Integrilin, which will add an estimated $150 million a year in revenues, and a cardiovascular drug sales force.

Whither Celera and HGS?
Both Celera and HGS have similar drug-making ambitions to Millennium, but far smaller revenues and similar cash burn. Celera last year changed its focus from its genomic and proteomic data business to drug discovery and development, and it at least has revenue from its bioinformatics products to help fund its future. HGS has much smaller current revenues but is way farther along with a fattening pipeline and newly built manufacturing facilities, despite a very serious setback with disappointing human test results for its Phase 2 drug, repifermin.

Both companies have virtual pipelines -- drugs being developed by other companies for which our holdings will receive royalty payments if and when the drugs hit the market and earn money -- but HGS is leading here, too. CEO William Haseltine has often boasted that most of drug giant's GlaxoSmithKline's (NYSE: GSK) pipeline is filled with HGS-partnered drugs. I have enormous respect for Haseltine's vision, leadership, and experience, but there's a lot of boasting going on at HGS for a company with $12.2 million in trailing-12-months revenue and a market cap of -- gulp! -- $3.81 billion. Celera's $126 million in trailing revenues support a market cap of only $1.62 billion.

Both HGS and Celera can do what Millennium did: buy revenue streams to improve their financials, business prospects, and, yes, stock prices in the long run. HGS also is in a position of relative financial strength to strike a good deal for one of its pipeline drugs (getting a 50-50 split instead of royalties), or -- my personal favorite wild card -- contract out their new manufacturing facility to another drug maker that is short of capacity. Capacity is a worldwide problem, reportedly causing Immunex (Nasdaq: IMNX) to forego some Enbrel revenues.

Whatever happens, we don't want HGS and Celera to spend willy-nilly. We want them to make the best investments. Millennium, HGS, and Celera all had short-term (less than five years) valuation risk due to the disparity between their market capitalizations and revenue and profit prospects. Millennium reduced its risk substantially with its COR Therapeutics purchase, but if the long term dictates different short-term moves for HGS and Celera, that's fine. We'll be watching closely. 

And one more thing: Spare us the hype!
Readers of this column know that we've been down on the spin machines from these three companies. But Celera just plain went over the top this week when it trumpeted a payment -- amount not disclosed -- from Aventis (NYSE: AVE). Getta load of this: 

"The most recent milestone payment recognizes selection of Celera Cathepsin S inhibitor compounds as Early Development Candidates (EDC) for inflammation and autoimmune diseases. At Aventis, EDC nomination is the final step prior to the initiation of preclinical development activities."

Hold the presses -- not! A candidate to be a candidate for the "final step" before starting preclinical testing? This is worth spending shareholder money for a press release? The thing isn't even entering human trials, at which point it would have on average a 10% chance of FDA approval and marketing five to seven years later. It's bad enough when a company issues a press release when it files with the FDA for a preclinical candidate to enter Phase 1 human trials, but this takes the cake for absurdity. 

If these companies think that press releases will do more for their stock price in the long term than deploying their cash intelligently to boost their revenues, earnings, and cash flow, we'd like the opportunity to set them -- and their boards -- straight. The first thing we'd do is send Millennium's Mark Levin, HGS's Haseltine, and Celera's Venter and Applera's Tony White to Warren Buffett's letters to shareholders. 'Nuff said. 

Have a most Foolish earnings season!

Rule Breaker co-managers Jeff Fischer (TMF Jeff) and Tom Jacobs (TMF Tom9) have not had their DNA sequenced by Celera Genomics. At press time, Jeff owned shares of Millennium Pharmaceuticals, and Tom owned stubs of Millennium and Celera Genomics. Check out profiles for Jeff and Tom, and also The Motley Fool's disclosure policy.

Rule Breaker Portfolio

We are currently changing providers for our portfolio data. During the transition, we won't be able to show updates of our overall returns. We present the total gain and percentage returns of the individual stocks in the portfolio below, but it currently does not reflect the realized gains in existing positions. We have realized gains of about $70,776 from AOL and $35,307 in Amazon, and realized losses of $27,062 in Human Genome Sciences. Other past realized gains are also not reflected in the cost basis for the portfolio. We hope to have the problem rectified soon. Thank you for your patience.
 Ticker Company Price
 Change
 Daily Price
 % Change
 Price 
 AMZN AMAZON.COM, INC. 0.18 1.78% 10.29 
 AOL AOL TIME WARNER INC. 0.13 0.43% 30.03 
 CRA APPLERA CORPORATION - CELERA GENOMICS GROUP (0.07) (0.29%) 23.93 
 EBAY EBAY INC 0.87 1.38% 64.03 
 MLNM MILLENNIUM PHARMACEUTICALS INC (0.44) (2.03%) 21.26 
 SBUX STARBUCKS CORP 0.01 0.05% 21.91 
 AMGN AMGEN INC 0.76 1.37% 56.26 
 HGSI HUMAN GENOME SCIENCES INC 0.04 0.14% 28.54 
      
 Trade Date # Shares Ticker Cost/Share Price  Total % Ret  
09/09/97 1320 AMZN 3.18 10.29  225.20%
08/05/94 4020 AOL 0.45 30.03  6,732.20%
12/17/99 1260 CRA 39.76 23.93  -39.80%
02/26/99 1145 EBAY 46.54 64.03  38.59%
09/27/01 1560 MLNM 16.06 21.26  32.46%
07/02/98 940 SBUX 13.98 21.91  56.85%
12/16/98 1160 AMGN 21.44 56.26  162.44%
10/29/01 590 HGSI 43.06 28.54  -33.70%
      
 Trade Date # Shares Ticker Total Cost Current Value  Total Gain  
09/09/97 1320 AMZN 4,204.20 13,582.80  9,378.60 
08/05/94 4020 AOL 1,816.43 120,720.60  118,904.17 
12/17/99 1260 CRA 50,093.00 30,151.80  -19,941.20 
02/26/99 1145 EBAY 53,294.44 73,314.35  20,019.91 
09/27/01 1560 MLNM 25,051.00 33,165.60  8,114.60 
07/02/98 940 SBUX 13,138.62 20,595.40  7,456.78 
12/16/98 1160 AMGN 24,875.50 65,261.60  40,386.10 
10/29/01 590 HGSI 25,405.60 16,838.60  -8,567.00 
Cash:95.48 
Total:373,726.23 


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Note
The Fool Portfolio was launched on August 5, 1994, with $50,000. It was renamed the Rule Breaker Portfolio in October 1998. The investing strategy began with the first investments of the Fool Port and has evolved with time and experience. In July 2001, the portfolio began adding $12,500 each quarter (We missed Jan. 2002, so we added $25,000 in April 2002). We skip a quarter if we have enough uninvested cash or cash available in stocks we would prefer to sell to make new investments. All transactions are shared and explained publicly before being made, and returns are compared in each week's column to the S&P 500 (including dividends where noted) and the Nasdaq composite. For a history of all transactions, please click here.