Dendreon Is No Dot-Com Story ... Yet

We're a motley group here at The Motley Fool. There's no party line, and analysts often have widely different views on the same company. Heck, we even duel sometimes.

In an article yesterday, fellow Fool Daniel Harrison concluded that investors should stay away from Dendreon (NASDAQ:DNDN). For those who disagree -- and, from the comments, it seems there are a few of you -- I'm here to ride to the rescue. But only a little.

Daniel is right. (Hold your fire and let me finish.) Investors looking for more of the quick, triple-digit returns that Dendreon has given investors over the last few months should look elsewhere.

The question then becomes: Is Dendreon a bad buy at today's prices? And my conclusion is: Not if it gets cancer treatment Provenge approved. And there's the risk. More on this in a bit.

The easiest way to figure out if a development-stage drugmaker is a good investment is to figure out how much you think the company will be worth in a few years and then decide if the risk is worth the potential return. To ballpark it, here are a few companies that already have drugs on the market:

Source: Capital IQ.
*Sales of Nexavar as reported by partner Bayer. TTM = trailing 12 months.

The first three all have marketing partners for their major drugs, which cuts down on their value. Dendreon, without a partner, will likely command a price-to-sales ratio more like Abraxis', possibly 5 or more. That might even be conservative, considering that higher sales of Provenge, compared to Abraxis' Abraxane, will increase operating margins, thus resulting in higher earnings. Earnings and cash flow are ultimately what companies are valued on.

Figuring out potential sales for Provenge, however, is a little difficult, because we don't know how much Dendreon will charge for the treatment. But it's not difficult to imagine annual sales hitting $1 billion in a few years. At a price-to-sales ratio of five, the market cap would then be $5 billion, about double what it is today.

Assuming it takes five years to hit that goal, that translates to roughly a 15% compounded annual growth rate from here. With conservative valuation models, I'm not sure that investors in large companies like Johnson & Johnson (NYSE:JNJ), Procter & Gamble (NYSE:PG), or even Coca-Cola (NYSE:KO) could expect returns like that over the next five years.

Of course, Dendreon isn't without risk. Provenge is not approved yet. Let me repeat that. Provenge is not approved yet, and investors who remember the spring of 2007 should have that burned into their brain. Having said that, however, with safety and efficacy data looking good, and the Food and Drug Administration having signed off on the clinical trial design, the risk of not getting an approval is fairly slim at this point.

The bigger risk might be that the company burns cash as a slow FDA takes awhile to approve the drug, but Dendreon has a couple of things working in its favor. First, the FDA had already looked at most of the data when it decided that the company needed more data to get approval in 2007. Second, and more importantly, metastatic prostate cancer is a debilitating disease that has few treatment options. I'm no lover of the FDA, but the agency is generally pretty good about getting decisions out in a timely manner when the drug treats a disease with few options.

Daniel wrote, "Buyers today should be making a serious long-term commitment," and I think he's right. In the short term, the stock market is a popularity contest, remember. With any approval for Provenge still at least nine months away by my estimate, it wouldn't surprise me to see the stock trade sideways for quite a while.

Where I think we disagree is in the view that "the uncertainty is still too high." Some people, Buffett included, think biotechs are scary. While I can point out the monster returns as justification to take the risk, ultimately each investor needs to make his or her own decision about risk tolerance.