Bargains in biotech? Isn't that an awfully good example of an oxymoron?
Not according to a new study conducted by Richard Evans, a longtime Wall Street analyst. The study focuses on something that is inherently difficult: valuing a company's intellectual capital, and how valuation based on tangible assets can understate the true value of a company.
Several surprising conclusions can be drawn from the study that are of use to us ordinary folk who aren't afraid of the extreme volatility of biotech. Among the conclusions is that biotech's March meltdown, likely sparked by the political flap over Gilead Sciences' (NASDAQ: GILD) new hepatitis C drug, may have sent the stock of several biotech companies moving in the wrong direction.
While biotech companies never get to be value plays in the classic sense since almost all their value resides in future cash flows, Evans' thought-provoking research values pharmaceutical and biotech companies based on different metrics. The goal of the study was to take a close look at items like R&D productivity, number of patents per $1 million spent, and the average relative quality of a company's innovation.
Topping Evans' list of great companies was pharmaceutical giant Bristol-Myers Squibb. Biotech Celgene Corporation (NASDAQ:CELG) ranked second, and Gilead Sciences came in fourth. Vertex Pharmaceuticals (NASDAQ:VRTX), a biotech that has been moving in an outsized fashion lately, came in third.
Of course, on a traditional straight-up price-to-earnings basis, biotechs are still pricey and are likely to remain so. When you add profit growth estimates, though, the picture changes. On that basis, more than 20 NASDAQ biotech companies have forward 24-month PEG ratios below the 1.0 handle, including Gilead.
Let's look at these top three biotechs briefly in terms of whether optimism could be warranted.
Celgene: Avoiding the not-invented-here syndrome
Celgene uses an unusual model for research. The company finances scientific work at smaller companies, and then takes over the drugs' development as they move into clinical trials. The goal is to combine a smaller company's skills in researching new treatments with Celgene's skill in bringing them to market.
According to Evans, such a model makes R&D costs more predictable. He pointed out that most biotechs and pharmaceutical companies devote far too much of their research budget to internal work and are therefore becoming increasingly bureaucratic and lacking in true innovation.
What's keeping Celgene's stock depressed right now is the patent challenge to the company's lead drug Revlimid. There is another side to the equation, as Motley Fool contributor Stephen Simpson pointed out recently. Celgene is attempting label expansions for Otezla and Revlimid, so the Street could be overlooking some significant revenue opportunities if Celgene wins the patent fight.
Gilead Sciences: Pilloried for being successful
The flap surrounding Sovaldi (Gilead's hepatitis-C drug) shouldn't obscure the fact that the drug is on track to achieve the most successful launch in history. Other companies are scrambling for a share of Sovaldi's target market, however, which is expected to reach at least $20 billion in sales at the end of the decade. In addition, while Gilead is the world's leading maker of HIV medicine, many of those drugs face a patent cliff in 2017. A good question to pursue is whether Gilead's current numbers indicate that the market has already priced in the HIV cliff.
Vertex Phamaceuticals: Cystic fibrosis on its mind
Unlike Gilead and Celgene, Vertex suffers from weak fundamentals -- last quarter, the company reported a 64% year-over-year decline in revenue as management repositioned marketing away from hepatitis C drug Incivek in light of Sovaldi's superior profile. The stock also lost $0.65 per share, as opposed to a $0.03 profit in first quarter 2013.
The company's potential lies in new opportunities in the cystic fibrosis market, driven by Kalydeco and its pipeline product VX-661, which is currently in phase 2 trials. In R&D, Vertex is an unusual example of a biotech that focuses on a core competency, in this case understanding how drugs bind to receptors. Evans compares Vertex single-minded focus to Genentech when it was a stand-alone company.
The bottom line
Biotech is famous for its boom-and-bust cycles, and as long-term health care investors are aware, sell-offs often present classic buying opportunities. The big question is whether the pullback is over, or whether we're just taking a breather.
Evans' research has an ominous side that shouldn't be missed. Overall R&D productivity in biotechs is spiraling downward according to his report, with the top 10 pharma companies spending about $70 billion a year and getting nothing close to $70 billion in return. It used to be that biotechs did well if they were just average at R&D. When the dismal productivity numbers of the overall sector are taken into account, however, being average could be a disaster.
Cheryl Swanson owns shares of Gilead Sciences. The Motley Fool recommends Celgene, Gilead Sciences, and Vertex Pharmaceuticals. The Motley Fool owns shares of Gilead Sciences. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.