Profit in the biotech bust? You bet.
Last week, I wrote that the latest investing boom-and-bust cycle for newer, advanced life science companies might have left some promising companies selling at compelling valuations. Today, I present one with excellent prospects for a near-term double.
Finding the diamond in the rough
About 400 biotech companies trade on the major exchanges, and they fall roughly into two categories: laboratory research toolmakers (including so-called drug discovery companies), and biopharmaceutical companies. I designed a screen to eliminate the two extremes among them.
On one end, I wanted to screen out companies years away from products, profits, and free cash flow -- such as Human Genome Sciences
Easy criteria, tough to meet
These are the criteria I developed to accomplish this task:
- Sports a market capitalization over $100 million;
- Produced positive free cash flow (FCF) for last 12 months and each of last four quarters (FCF = net cash from operations minus capital expenditures);
- Increased FCF for most recent fiscal year versus prior, and for most recent two quarters versus same quarters a year ago;
- Has a current valuation below its rate of FCF growth. (Check out Rex Moore's recent look at how to use growth in FCF to your advantage.)
The market capitalization requirement sliced the universe of 400 companies in half to 198. The FCF positive criterion more than decimated (quintodecimated?) that 198 to only 13. The final two criteria, increasing FCF and current valuation below that growth rate, left but three.
I promised last week to share these three companies, but one stood out so starkly that it should be front and center. I'll turn to the others in future columns, only if second or third best becomes good enough.
QLT's numbers quilt
The company is Canada-based QLT Inc.
I looked at the company during the biotech boom several years ago, when it used to be QLT Phototherapeutics, after its then-primary research focus of light-activated drugs. The idea was interesting and perhaps rule breaking, but I had no shortage of companies with drugs on the market in which to invest and lose lots of money, thank you very much, and did!
I overlooked year 2000 approval of its lead drug and lost the opportunity. Or did I?
When the FDA approved QLT's lead phototherapeutic drug, Visudyne, for "wet," age-related macular degeneration (AMD), it provided new hope for many people. About 1.6 million Americans over age 50 have age-related macular degeneration, but 85% to 90% of the cases are "dry," and most affected do not become blind. The majority of the remaining cases of the wet form quickly progress to blindness. A profusion of small blood vessels develop under the retina, leak, break, and injure the macula -- the part of the retina that's involved in sharp vision.
The only prior treatment for the wet version was laser surgery, successful only in a minority of cases and destructive to nearby tissues. Now, a doctor can inject Visudyne into the arm or leg. The light-sensitive dye is specially designed to travel only to the eye's injured blood vessels, where exposure to a low-power laser beam makes the dye seal the blood vessels without troubling the neighbors. That advance combined with partner Novartis'
VISUDYNE SALES AND GROWTH
% Change 2002 Sales vs. Year-Ago Q4 $77.0 mil. 25% Q3 70.4 22%Q2 71.3 27%Q1 61.6 69% 2002 $287 mil. 27%2001 223 135%
NOTE: I suspect that 2002's four-quarters' sales don't equal
the annual total because I used each quarter's press
release, containing sales at the current exchange rate.
The company expects Visudyne revenues to grow 8% to 17% in 2003. It secures a larger share of these revenues than you would expect and, most importantly, turns more and more of it into free cash flow.
A sweet deal
Usually, an up-and-coming biopharmaceutical company reluctantly cedes its lead drug to a larger, cash-rich marketing partner in exchange for royalties most often between 10% and 20%. But QLT splits profits 50-50 with Novartis, which also reimburses QLT for manufacturing and certain other costs. QLT says its share of net profit amounted to 32% of Visudyne sales for Q4 of 2002 and 26% for the year 2002, excluding cost reimbursement. This is a very sweet deal.
QLT does not squander its riches, but instead converts its Visudyne revenues into free cash flow at a nice clip. Take a look:
% Change FCF FCF Vs. Year-Ago Margin Q4 02 $14.5 mil. 150% 41% Q3 02 12.7 32% 42%Q2 02 3.9 -56%Q1 02 10.2 1357%2002 41.4 355%2001 9.1 --
By comparison, Amgen's FCF margin last quarter was 31%; Pfizer's
Nor is this likely to be an isolated period of good news for QLT. It owns a substantial share of the top treatment for a condition affecting the fastest-growing segment of the population. Visudyne has a 70% market in the U.S. and is growing sales elsewhere, which will help it fend off any competition. (Once you're the standard of care, doctors are reluctant to switch.) Though competition can appear at any time, Visudyne's patent protection runs to 2015. And it's being tested for several other types of AMD (explained on its website) with significant patient populations.
The company funds increasing research and development for its drug-candidate pipeline out of revenues and still increases its cash pile. That balance was $222 million at the end of 2002, against not one penny of debt. QLT is spending less and less on advertising and marketing, while it also squeezes more cash out of revenues through working capital management: Its Flow Ratio declined over 20%, sequentially, each of the last two quarters.
Good news not yet priced in
Any much-vaunted biotech drug hopeful would kill for QLT's position, yet little of this is reflected in QLT's stock price. As of last Friday, QLT's enterprise value (market capitalization plus total debt minus cash) was $440 million. Divide that by 2002 FCF of $41.4 million, and you have an enterprise value/FCF of 10.7. Check it out: Free cash flow is growing at double- and triple-digit rates, but the market awards a multiple of only 10.7. Any other company with this business performance could easily command a multiple of 20 or more. That's the simple case for a double.
Yet now, when the company is at its most financially secure and revenues are growing, QLT stock has been thrown on the trash heap with the majority of biotech. On April 12, 2000, when the FDA approved Visudyne, QLT shares closed at $56.88. After hitting $80.00 the following August, it was downhill to its September 2002 low close of $7.57. Yesterday saw the first close over $10.00 since July 2002.
Does QLT fit in your portfolio?
Based on the case for a near-term double, I purchased a small QLT holding in January for the riskier part of my portfolio. No guarantees, of course. And while there may be potential for greater long-term returns as well, it would take at least another column or two to analyze the potential for QLT's research and development engine to yield approved and competitive drugs beyond Visudyne -- and to come up with a valuation based on that.
I would look more closely at management's history and ownership share, dig deeper into its assertion that no Visudyne competitor could be approved before 2004 or 2005, and look at QLT's entire pipeline for a long-range view of possible drug approvals, patient populations, and market shares (especially its Phase 3 drug, tariquidar, for multi-drug resistance in lung cancer patients). I would also evaluate the risk a loss in a pending patent lawsuit might mean in terms of royalty payments to the plaintiff.
Your mileage may vary, so why not drive over and blow your horn on our QLT and Biotechnology discussion boards? Our Fool discussion boards are consistently voted the best on the Web. With a painless free trial, it's easy to find out why.
Have a most Foolish week!
You can find more of Tom Jacobs' (TMF Tom9) columns in his archive, and those of any Motley Fool writer through our handy "Browse Stories By Author" drop-down menu on the Fool.com main page. Collect all Motley Fool author trading cards today! Tom owns shares of QLT and other companies, which are listed in his profile . Motley Fool investment writers are investors writing for investors .