The Boring Portfolio

<THE BORING PORTFOLIO>
Boring Biotech?
Yeah, Right.

By Alex Schay (TMF Nexus6)

ALEXANDRIA, VA (March 26, 1999) -- While it's easy to make fun of the investment-world equivalent of "swinging for the fences" -- and I myself hurl an occasional barb at the business -- there is no doubt that the economics of a succesful biotech firm are strong (thanks in no small part to excellent returns on marginal capital).

Just to get me out of the curmudgeon camp -- when I recommended Amgen (Nasdaq: AMGN) in the 1998 Motley Fool Industry Focus, it was the firm's stellar return on invested capital profile (33%), 42% trailing pre-tax margins, and roughly $500 million in annual cash flow that piqued my initial interest from a valuation standpoint. Unfortunately, most of the real valuation work for biotech companies requires a medical degree rather than a CFA.

In case you've missed it in the past, here's the standard boilerplate language for investing in biotech:

"While the ultimate goal of a biotech firm is to market a product, it must subject itself to the U.S. Drug Development & Approval Process. This is probably the most rigorous new drug approval system in the world and, on average, costs $350 million and takes anywhere from 12 to 15 years to complete (from "lab to medicine chest"). The most important consideration for individual investors interested in biotech stocks is the reality of the drug discovery and development process. Only 5 out of 5000 compounds entering pre-clinical testing ever make it to human testing, and only 1 out of 5 of those is ever approved by the Food and Drug Administration (FDA)."

Today's announcement by Sepracor (Nasdaq: SEPR) that it had received final approval from the FDA to market Xopenex had me thinking about some of the well-regarded Phase III biotech firms (the favored risk management investments), as well as those companies currently in that shadowy netherworld between "biotech" and "pharmaceutical." Some firms that qualify include Centocor (Nasdaq: CNTO), Amgen (Nadaq: AMGN), Biogen (Nasdaq: BGEN) Immunex (Nasdaq: IMNX), MedImmune (Nasdaq: MEDI), BioChem (Nasdaq: BCHE), IDEC Pharmaceutical (Nasdaq: IDPH), and Genzyme (Nasdaq: GENZ).

In the process of updating some of the above "biotech" spreadsheets, I came across an interesting company with a connection to Genzyme. The firm is GelTex Pharmaceutical (Nasdaq: GELX), and it bills itself as a developer of "non-absorbed, polymer-based pharmaceuticals that selectively bind to and eliminate target substances from the intestinal tract." Without getting into any of the gory details, the "non-absorbed" element of the drug technology deals with the fact that it does its business in the intestinal tract itself, as opposed to getting absorbed through the intestinal wall and into the bloodstream (minimizing adverse effects). Here's a Scientific American article detailing the sponge-like action of polymers as they travel through the digestive system. Don't be scared by the title. By the way, an informative source for pharmaceutical research in general is BioResearchOnline.

The big GelTex drug currently under development is CholestaGel, a cholesterol-lowering agent that just recently yielded some positive Phase III results. In its second double-blinded placebo-controlled Phase III trial (that's really what it's called), one hundred patients with hypercholesterolemia (high cholesterol for short) were shunted through a six-week diet and then on to either a six-week placebo or CholestaGel regime. Merrill Lynch recently published the results:

Dosing Arm # Patients %LDL Cholesterol
Placebo 24 +1%
3.8 grams (1 a.m dose) 26 -19%
3.8 grams (1 p.m. dose) 22 -16%
1.9 grams (split dose) 24 -15%

The market for lipid lowering drugs is rather large considering the American propensity to sit around at the job for 12 hours a day and eat cheeseburgers. I know, I know, it's really genetic. In any event, the market opportunity is on the order of 6-8 million people, which by some estimates gives GelTex $100 million in revenues by the Year 2002 assuming U.S. approval by mid-year 2000 and slightly less than 2% penetration of the market. I don't care to comment about these estimates, except to observe that any decent understanding of human nature would lead to the conclusion that people would much rather lean on the crutch provided by a pill than exercise and decrease their intake of cholesterol. Yes, doctors will prescribe a comprehensive regime, but I'm pretty sure that of the three health improvement strategies, the easiest one to stick with will be the pills.

I like what I'm hearing about the efficacy of the drug from the two sources in the medical community that I have contacted -- although one is currently in residency, so some of the conclusions are highly suspect (I hope she's not reading this). The small, multi-trial approach that the company has chosen to engage in has also been lauded as a means of minimizing nasty surprises on the side-effects front. As well, the company has engaged in a smart partnership with Genzyme to sell its RenaGel drug for patients with chronic kidney failure. As it turns out, without the $25 million milestone payment from Genzyme, GelTex would have reported a net loss in the fourth quarter of 1998 of 0.69 per share, as opposed to the $0.77 per share profit that it did come in with.

So what does all this matter to the "value" Borefolio? Can a biotech firm really be of potential interest? Sure, if it's trading at a significant discount to its intrinsic value. And there are some signs that GelTex has been a bit oversold recently in response to slowing sales of RenaGel (the large amount of shorts and Lipitor fans would disagree). Let's recap Dale's thoughts about our philosophy from last time:

"The one thing you need to know about us is that we like companies that can generate a large amount of earnings from a small amount of capital. The second thing you need to know is that we prefer companies that have the ability to retain those earnings and reinvest them in similarly high-return projects."

Biotech and pharmaceutical companies in general, and GelTex in particular, have a better shot than most of fulfilling these citeria. I am highlighting GelTex less because it's an actual contender for our capital, but rather to make the point that investors should focus on the expectations inherent in the stock price, and then use their knowledge to detect any possible future divergence (if expectations are currently too low). With two very positive Phase III trials under its belt, GelTex currently presents less operational risk than is priced into the issue (in my opinion) for investors with a two-year time horizon.

Let's take a brief look again at IT consulting firm Complete Business Solutions (Nasdaq: CBSI), which I mentioned in last Friday's report. Since that time, CBSI has taken another plunge to $17 1/4 from its close last Friday of $20 1/8. The firm is currently trading at 14.8 times 1999 EPS estimates of $1.16 (close to the lowest in its history as a public firm). Excluding trailing first and third quarter charges, this represents roughly 33% growth over 1998 numbers. Now, this would give CBSI a "PEG" of 0.44... I mean an "ASI" of 0.44. What's an ASI you might ask? Well, in the Schay Lexicon it's the same thing as the PEG except that it's called the Analysts' Sentiment Index (ASI).

Over the last two weeks the market has been saying to CBSI, "I think you might not make your first quarter numbers, and you will most certainly miss for the full year."

In response to this not-so-subtle message from the market, CBSI's riposte came in the form of an announcement that it had secured the website development business for Medsite.com. "E-commerce solutions such as this, which are a recent initiative for us, are becoming an increasing part of our future growth. This evolution -- and the fact that we have such a diversified service mix -- are part of why we are comfortable with analysts' earnings estimates for this first quarter and remain optimistic about the rest of the year."

Take a look at the trailing numbers (Q4 had a rebound):

Company:CBSI
(Numbers in 000s except per share amounts)

Market Cap...$629,590.50
Enterprise Value...$629,590.50
EV/Revenues...1.67
EV/Invested Capital...6.86
EV/Assets...3.30
Price/Book Value...4.46
PSR...1.67
EPS...$0.18
P/E...94.10
EV/Operating...45.79
EV/Net Income...94.10
EV/FCF...5671.99
EV/NCFO...54.90
Diluted Sharecount...36,498.00

ROIC...10.30%
Boring Ratio...1.50%
Working Capital...108,767.00
Capital Turnover...4.35
Days Sales Outstanding...69.80
Days in Payables...17.41
Cash Conversion Cycle...52.38
Asset Turnover...2.11
Assets/Equity...1.33
PP&E Turnover...22.80
Net Margin...1.78%
ROA...3.74%
ROE...4.96%

Cash/Share...$1.66
Current Ratio...3.30
LT Debt/Equity...0.00%
Debt/Total Capital...0.00%

Begin Invested Capital...$81,335.00
End Invested Capital...$91,796.00
YOY IC Growth...12.86%
Avg. Invested Capital...$86,565.50
Invested Capital Turnover...4.35
ATOI...$8,914.13
Tax Rate...35.17%

Income Statement

Trailing Revenues...$376,567.00
Salary, contract, dep...$249,099.00
SG&A...$85,468.00
Operating Earnings...$13,750.00
Net Income...$6,691.00
Gross Margin...33.85%
Operating Margin...3.65%
SG&A/Sales...22.70%
Net Margin...1.78%

Balance Sheet

Cash & Equivalents...$60,732.00
Receivables...$72,007.00
Last Yr receivables...$54,445.00
Payables...$11,885.00
Current Assets...$156,016.00
Current Liabilities...$47,249.00
Long-Term Debt...$0.00
Shareholder's Equity...$141,155.00
Last Yr Shareholder's Eq...$128,675.00
Total Assets...$191,045.00
Last Year Assets...$166,501.00
PP&E...$17,846.00
Last Year PP&E...$15,186.00
Avg. Assets...$178,773.00
Average receivables...$63,226.00
Average Assets...$178,773.00
Average share equity...$134,915.00

Cap Ex...$11,357.00
Working Capital Change...$15,671.00
Net Op. Cash Ex. WC Change...$27,139.00
Net Cash from Operations...$11,468.00
NCFO/Reported Earnings...171.39%
Cap Ex/NCFO...99.03%
Cap Ex/Begin Invested Capital...12.37%
FCF...$111.00

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Stock  Change    Bid
BRKb  -     28  2400.00
CSL   -  11/16    41.19
CSCO  -  2 1/4   105.19
GTW   +1 13/16    65.63

                   Day    Month   Year  History
        BORING   -1.04%   1.69%  -2.70%  30.65%
        S&P:     -0.56%   3.59%   4.68% 113.71%
        NASDAQ:  -0.64%   5.73%  10.33% 132.40%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96    105.19   339.10%
  8/13/96  200 Carlisle C    26.32     41.19    56.46%
 12/31/98    8 Berkshire   2244.00   2400.00     6.95%
   2/9/99  100 Gateway 20    72.38     65.63    -9.33%


    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  23667.19 $18277.20
  8/13/96  200 Carlisle C  5264.99   8237.50  $2972.51
 12/31/98    8 Berkshire  17952.00  19200.00  $1248.00
   2/9/99  100 Gateway 20  7237.50   6562.50  -$675.00


                             CASH   $7658.52
                            TOTAL  $65325.71