We Buy, Sell, and Praise

This week, investing is not the first thing on people's minds. We plan to spend time with our loved ones on Wednesday, and we hope you do, too.  

But we do keep the wheels turning at the Rule Breaker Portfolio, having spent the last two weeks reviewing our holdings (see tables at the bottom of the column) according to our sell criteria. Now it's time to act.

First, some terrific news about one holding we won't be selling today. We were dee-lighted Monday to read that our latest long addition, LendingTree (Nasdaq: TREE), bucked the crowd. The company released the happy news that it would reach GAAP (as opposed to the dreaded pro forma) profitability in the current quarter, a quarter earlier than planned. And not only that, but to the tune of $0.06 a share, versus the previously projected loss of a penny.

In a prepared statement, CEO Doug Lebda attributed the good news to mortgage refinancing activity (surprise), as well as increased lender capacity and conversions across all loan categories. We're glad the business model is working. The company is not a lender, but an online lending exchange that earns money when a site visitor's inquiry passes a lender's screening criteria and is referred to that lender. If the referral results in a loan closing, LendingTree earns much more money.

Our view of the investing opportunity from LendingTree (recently analyzed in depth in The Motley Fool Select) is that explosive returns -- if they do come -- won't stem from interest-rate sensitive lending activity, which fluctuates, but from growth in market share. We purchased shares this past June and are happy so far. The stock jumped over 13% on the news to close at $15.85, but gave back about half today.   

Profits now more distant
Our last two columns (you can find every one in our archive) explained why one of our risky holdings, Human Genome Sciences (Nasdaq: HGSI), may be successful in the future but offers less opportunity for excellent returns in the next five years than other companies.

This business has excellent management. Several of us on the Rule Breaker Portfolio team have personally met all the top execs. Their accomplishments with the fledgling, revolutionary company are superb. CEO William Haseltine is a visionary. He, his excellent CFO, and top management team did exactly what smart companies did during the 1999-2000 boom, when investors drove stocks of anything genomic to the moon (Alice!): They raised as much money as possible on the best terms available. Smart, smart, smart.

But however much Human Genome Sciences (HGS) has going for it -- and it's a lot -- no one should forget that's mere speculation. As such, the company must provide us the opportunity for explosive returns -- a tradeoff we capture in the handy acronym 10x/5y. That is, we want the opportunity to earn 10 times our investment in the next five years. Give or take a few times, give or take a few years, but that's the idea.

When we bought HGS in September 2000, we wrote:

HGS is our most risky investment to date. It has virtually no revenue. The revenue it hopes to generate in the future depends on the approval of its drugs, the protection of its patents, the acceptance of its technology, and other uncertain factors. Even in the best-case scenario, HGS won't see revenue from its first drug for three to five years. It may make money from its data in the meantime, but that's not its business. Thus, significant revenue is years away, and actual profit some years beyond that, since HGS will spend heavily on research during that time.

It's not currently profitable, revenues are declining:

Period     Revenues 
Trailing 
 12 months  $3.4 mil. (gulp!)   
2001        12.8
2000        22.1
1999        24.5
1998        29.6
1997        25.6
1996        36.5
1995         5.0            

If HGS's future profitability is the Golden Gate Bridge, we are sitting on a deck across the San Francisco Bay with so much fog between us that the Bridge might as well be gone. Potential for 10x/5y? All but kaput.

The three- to five-year horizon we saw in Sept. 2000 is still three to five years -- but from now. HGS hasn't moved a drug into Phase 3 in the two years we've owned it. In drug development time, two years is nothing, but it's two more years we wait. If we had bought an established drug company, we would expect that in a full pipeline of drug candidates in human trials, many would not produce enough data to justify a company laying out years of staff time and scarce cash for more than Phase 1 or Phase 2 trials.

Management has trumpeted the genomic data -- its bio IP -- as a revenue source, and that freedom from prior agreements with big drug makers allow it to strike new deals. The deals haven't come, though they may. But the key for dramatic investor returns will be drugs.

We didn't buy an established drug company. We invested in a speculative business run by visionary leaders with a shot at super returns, if Phase 2 candidates moved quickly and were approved in the next three to five years. Not happening. The business has not played out as hoped.

So we will sell our 590 shares of HGS within the next five business days. At yesterday's close, our loss -- including our original buy, sale for tax purposes, and repurchase, was in the range of 80%. Ouch. 

A better place for our money
We have watched management of another risky biotech drug-maker holding make excellent moves to reduce the downside risk for investors, while it, too, pursues risky candidates through human trials. Since the time we invested in Millennium Pharmaceuticals (Nasdaq: MLNM), it paid a reasonable price for COR Therapeutics and earned its blockbuster drug, Integrilin, a cardiovascular drug candidate pipeline and sales staff.

Its lead drug Velcade, formerly MLNM-341, received fast-track status from the FDA in June. The indication is multiple myeloma, a severe cancer but not a huge market, but Velcade is in trials for solid tumors.

Millennium has been criticized because none of its own drugs has come to market -- only those from its Leuko-Site acquisition. And the company sold its interest in the first of the drugs, anemic-selling leukemia treatment CAMPATH, to partner ILEX Oncology (Nasdaq: ILXO). A clinical oncologist tells me CAMPATH is the last choice among options because of its nasty side effects. Velcade is another Leuko-Site product.

Meanwhile, Millennium's vaunted discovery engine churns out leads for partners, such as Bayer and Abbott, and earns over $200 million a year in revenue:

Period       Revenues 
Trailing 
  12 months  $297.3 mil.* 
2001          246.2
2000          196.3
1999          183.7
1998          133.7
1997           89.9
1996           31.8
1995           22.9
*Includes revenues from COR Therapeutics.   
           

For big returns to investors, Millennium must produce top-selling drugs and earn more than royalties. It made a smart move to use cash and equity to purchase Leuko-Site and COR Therapeutics, cushioning the downside for investors while it ramps up its research and development machine, but Velcade and others must be approved and succeed in the marketplace. And management must watch stock option grants and other shareholder dilution.

As individual investors, we must be ruthless. HGS may have a great future ahead, but it does not fit our strategy now. Not executing, it will be executed. Millennium offers us the better prospects for returns over the next five years, but it entails great risk, too. If in the next several years, Velcade's solid-tumor trials disappoint, and no other drug with similar potential is on the way, Millennium will likely join HGS in the sold column. Under certain valuation models, one could also argue that Velcade's success is priced into the stock today. I'm not convinced of that right now but will keep an open mind.

Therefore, when we sell HGS shares, we will reinvest the proceeds in Millennium, also within the next five business days (in accordance with our trading policy). And we're looking for more places for our available money. Please add your suggestions on the RB Companies discussion board. Readers are split on what to do with AOL Time Warner (NYSE: AOL) -- 38% say sell it all; 35% to sell half and keep half; and 27% say keep it. Please add your vote! 

Have a most Foolish week, and we'll be thinking of you on Wednesday. Updated portfolio returns below. We're ahead of the S&P 500 and Naz for the week and month, but in between them for the year.

Tom Jacobs (TMF Tom9) is a senior analyst at The Motley Fool. At press time, he owned shares of Millennium Pharmaceuticals. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.

Rule Breaker Portfolio Returns as of 9/09/02 Market Close:

            RB        S&P     S&P 500
            Port      500      DA*    Nasdaq
Week      +2.96%**   -1.43%   --      -0.73%
Month     +5.17%**   -0.95%   --      -1.78%
Year     -25.19%**  -21.35%   --     -33.11%
CAGR 
 using IRR***
 since 
 8/4/94  +21.24%     +8.37%  +10.68%  +7.61%