When we buy top dogs and first movers in important, emerging industries, we hope they will prosper and become the leaders -- the powers -- in those sectors. But we know that many -- if not most -- of our risky investments will not achieve rule-the-world status: Our Rule Breakers may not become Rule Makers.

Take our drug makers: Amgen (Nasdaq: AMGN) and Human Genome Sciences (Nasdaq: HGSI). Each dreams of being a Pfizer (NYSE: PFE), Johnson & Johnson (NYSE: JNJ), or GlaxoSmithKline (NYSE: GSK). If they enter that big drug maker club, breathe that rarified air, earn those huge profits and steady shareholder returns -- they (and we) ring the bell. If they can't make it up the hill, weighed down by competition or any other failure to capitalize on their early advantages, they wither and twitch, afflicted with the tweener death rattle.

Who needs professional wrestling? We have another exciting game. With an eye to their valuations relative to the big drug makers, let's check the scorecard for Amgen and HGS!

Evaluating drug makers
Our portfolio's two drug makers are at very different stages of their development. Amgen is a first-generation biotech drug maker, one that in the 1980s began using genetic engineering advances to create new drugs. Its ambition? No less than to overthrow the dominant large drug makers -- join 'em and beat 'em. HGS is part of the next rule-breaking world, second-generation companies using even newer advances in both computing capability and molecular biology -- genomics and proteomics -- to turn drug making on its head and vault into the leadership.

The landscape for drug makers is this:  

  • big pharma (e.g., Pfizer, Johnson & Johnson, GlaxoSmithKline, Merck (NYSE: MRK), and more)
  • the first-generation biotech drug makers (e.g., Amgen, Genentech (NYSE: DNA), and Biogen (Nasdaq: BGEN)) You can learn all about them in May's issue of The Motley Fool Select.
  • second-generation unprofitable drug makers, relying on more recent biotech advances to build new drug companies basically from the ground up (e.g., HGS, Millennium Pharmaceuticals (Nasdaq: MLNM), Vertex Pharmaceuticals (Nasdaq: VRTX), CuraGen (Nasdaq: CRGN))     

We know when we buy top dogs and first movers in important, emerging industries, that we invest in early Darwin. Only the strong survive in upsetting the established order. But if we can own a company that makes it -- against huge odds and in a world strewn with corporate corpses -- there's gold in them thar hills. It's a very risky strategy, and one that should not be more than a small part of most people's portfolio.

Big pharma
The large drug makers are very profitable companies that sell products for high margins. The marquee big pharma names have years of making both prescription drugs and over-the-counter health products that are parts of our everyday lives. Many of us -- myself included -- are guilty of painting these companies as prescription drug makers, when large parts of their businesses depend on using their massively powerful consumer brands to sell consumer products. This does not mean they are not good investments. On the contrary, they have the power to make a lot of money off of low cost items -- think Tylenol or baby shampoo -- due to the brand.

Here's a quick look at the big pharma world: 

                      Market  Sales    P/E  Div. 
                        cap                 yield
1. Pfizer              $271B $29,151M  49   0.98%
2. GlaxoSmithKline      176   27,791   31   1.01   
3. Merck                158   42,858   25   1.83
4. Johnson & Johnson    145   29,611   30   1.36
5. Bristol-Myers Squibb 106   18,354   26   1.99
6. Novartis             103   35,805   22   1.37
7. AstraZeneca           87   17,49    30   2.09
8. Eli Lilly & Co.       86   11,216   28   1.43
9. Abbott Labs           81   13,751   44   1.58 
10. American Home Prod.  80   13,375   N/A  1.48
11. Pharmacia            64   18,488   48   1.05 
12. Schering-Plough      56    9,746   25   1.58

Big pharmas have worldwide sales and marketing organizations. They also have huge research and development programs that spend billions per year. But they can't move as quickly as a smaller company to take advantage of changes. Elementary: A tank moves and turns more slowly than a Mazda Miata.

First-generation biotech whizzes
Early biotech advances led a first generation of companies to explode in the 1980s. Genentech (NYSE: DNA) cloned the first genetically engineered drug, human insulin, sold by Eli Lilly (NYSE: LLY) as Humulin. But Amgen (Nasdaq: AMGN) eventually rammed forward with two blockbusters -- Epogen and Neupogen -- and leads the group today in sales and market cap. The seven drug makers in this group are all profitable:

         Market  Trailing-12-   P/S      
          cap     month sales   ratio*
Amgen    $66.7B  $3,720M        17.9
Genentech 28.9    1,890         15.3
Genzyme   10.4      804         12.9
Chiron     9.8    1,010          9.7
MedImmune  9.7      587         16.5
Immunex    9.1      901         10.1
Biogen     8.2      947          8.7
*price-to-sales

Scooped by the second-generation wonders?
Biotechnology has changed as rapidly as the computing industry. Technologies change, and new products and companies emerge. In the late 1980s, two more things rattled the landscape and created new biotechnologies and openings for creative new companies: The dramatic increase in computing capability at lower cost, and genomics approaching from the horizon. The second generation of biotech drug makers was born.

What makes four of them stand out is the big money deals from big pharmas -- deals that provide money for drug development and the promise of sales and marketing clout but do not give away too much of future profits. We've written about the major deals that have helped put four companies into contention to be big drug makers of tomorrow: HGS, Millennium, Vertex Pharmaceuticals, and CuraGen. The first two companies have received a lot of words in our columns. You can see that they have lower market caps than companies in the first two groups, but investor enthusiasm for their futures gives them richer valuations, using the price-to-sales ratio: 

         Market  Trailing-12-  P/S      
          cap     month sales  ratio
HGS       $7.4B     $22M        336
Millennium 6.9      199         34.7
Vertex     2.6       89         29
CuraGen    1.8       21         85.7

Looking it all over
It may help to line the numbers up, using price-to-sales (not the only tool we recommend for valuing stocks -- far from it! -- but one that helps make a point).

                          Market  Trailing-12- P/S      
                           cap    month sales  ratio
1. big pharma: Pfizer       $267B  $29,151M    9.2
2. big ph: GlaxoSmithKline   172    27,791     6.15    
3. big ph: Merck             158    42,858     3.69  
4. big ph: Johnson & Johnson 145    29,611     4.89
5. 1st gen: Amgen             66.7   3,720    17.9
6. big ph: Pharmacia          64    18,488     3.46 
7. big ph: Schering-Plough    56     9,746     5.77              
8. 1st gen: Genentech         28.9   1,890    15.3
9. 1st gen: Genzyme           10.4     804    12.9
10. 1st gen: Chiron            9.8   1,010     9.7
11. 1st gen: MedImmune         9.7     587    16.5
12. 1st gen: Immunex           9.1     901    10.1
13. 1st gen: Biogen            8.2     947     8.7
14. 2nd gen: HGS               7.4      22   336
15. 2nd gen: Millennium        6.9     199    34.7
16. 2nd gen: Vertex            2.6      89    29
17. 2nd gen: CuraGen           1.8      21    85.7

This shows that as a company goes from promising and sexy, to somewhat proven, to a mature large pharma, the market apparently assigns a lower market cap as a multiple of sales. Of course, we don't want average companies. With Amgen and HGS, we think we've invested in companies that are the leaders in game-changing industries. But it's obvious that in the average world, as Amgen grows, it faces a valuation more like a big pharma. And HGS will need to produce a lot of revenues to maintain its current valuation.

I've written that Amgen's drug candidate pipeline and own management's statements mean that the growth will probably slow down to that of a large drug maker. Investors may expect slower returns -- maybe even flat returns -- for a few years. We will watch Amgen to see if it will join the big pharma leagues and provide us with exceptional returns.

HGS is a much bigger risk. Investors currently are willing to pay a very large premium for its shares -- in fact, to value the company about 10% less than Biogen, a company with close to $1 billion a year in sales! HGS will have to stuff its pipeline and bring big sellers to market to justify this valuation. But one blockbuster can produce $1 billion, and the drugs in HGS' pipeline are all targeted to markets with $1 billion seller potential. We'll watch their progress in human trials carefully   

I'll be back Friday to focus on a company in the second-generation group that we haven't spent much time with, but that appears more and more interesting with each look. See you then! 

Tom Jacobs (TMF Tom9) wishes he had a biotechnology crystal ball. At press time, he owned no shares of companies mentioned in this article. To see his stock holdings (and chortle), view his profile, and check out The Motley Fool's disclosure policy.