Competitive? We at The Motley Fool? You bet!

When we analysts put ourselves on the line last November with Stocks 2003, our annual explosion of stock ideas for the year ahead and beyond, many of us started an online tracking portfolio to engage in friendly competition. In trading today, Rex Moore's Expedia (NASDAQ:EXPE) is up 76%, closing in on my Ligand Pharmaceuticals (NASDAQ:LGND) with an almost 100% gain, but neither of us is cocky. That's because in the short term -- and six months is the short term, folks -- anything can happen, and usually does. We say up-front each year that our ideas may or may not be short-term winners, but that they are the best ideas we see at the time based on business quality and valuation.

And when Rex puts his lightning-fast fingers to the keyboard this morning? Superglue, baby. Expedia's too close for comfort.

The case for Ligand
When I selected Ligand, it wasn't for conservative portfolios. Biotech drug makers on one hand included the gold standard -- successful and wildly overvalued companies like Amgen (NASDAQ:AMGN) and Genentech (NYSE:DNA) selling at 50-70 times free cash flow. At the other extreme were lottery tickets like Human Genome Sciences (NASDAQ:HGSI) or Millennium Pharmaceuticals (NASDAQ:MLNM), years from profits and very speculative. Ligand stood in between, unprofitable but with drugs on the market and many in development. It stood on the cusp of profitability -- as it had for several years -- still risky, with potential and a valuation knocked down with the rest of the biotech herd.

The key for Ligand's near-term profitability? To introduce and ramp sales of painkiller Avinza, a sustained release opioid approved by the FDA in 2002 as a once-a-day treatment for chronic pain, a market estimated at $2.7 billion last year. But there was a problem. Like all newer biotech drug makers trying to turn research and development expertise into a full-fledged drug company, Ligand partnered with another drug maker whose stronger sales force could bring greater profits than Ligand alone. Unfortunately, that partner just happened to be (funeral dirge, please) Elan Pharmaceuticals (NYSE:ELN).

Élan lost its élan
After I warned investors off Elan in the February 2002 issue of The Motley Fool Select, explaining its Enron problem of off-balance-sheet partnership debt and the SEC investigation that concerned me more, things deteriorated. The board showed management the door and began selling off assets to satisfy parent company debt guarantees for those partnerships' debt. The possible value I saw in Elan -- if the investigation were resolved -- diminished.

And for Ligand, well, let's just say that Elan wasn't going to be doing much Avinza co-promotion. It had other problems. Ligand had to get out of its deal at a reasonable price and find other marketing muscle.

In November, Ligand agreed to pay $100 million to reduce Elan's Avinza royalty share from 30%-35% to 10%. Elan would still manufacture the drug, but forgo the option to co-promote in the U.S. and Canada. To pay for this and to buy back about 20% of Elan's Ligand shares at the then-premium price of $9.00, Ligand issued $135 million in convertible debt. Investors hated the deal and the stock dropped to the Stocks 2003 publication price of $5.16, giving aggressive investors the chance for a bargain price -- if they were willing to bet that Ligand would sign a reasonable deal to bring more Avinza revenues.

Enter Akzo and Organon
It took nerves to hang on as the stock dropped under $4.00, but the patient have so far been rewarded. On Feb. 24, the company announced a 10-year deal (with possible extension) with the Organon unit of the Netherlands-based pharmaceutical company, Akzo Nobel (NASDAQ:AKZOY). Ligand will pay Organon according to this schedule:

      Avinza Annual Revenues     % to Organon
    $0-$35 million              0% (2003 only)$0-$150 million            30% $150-$300 million          40% $300-$425 million          50%Greater than $425 million  45%

Akzo has a weak near-term drug pipeline and projects a 20% fall in profit this year, but this is all the more reason for the company to incentivize its sales force to sell Avinza. Some may criticize the choice of partner, but Ligand probably obtained a better deal from an Akzo in need of a drug to market than from a powerful marketer like Pfizer (NYSE:PFE) that's less needy and therefore a tougher negotiator.

Removing the Avinza marketing uncertainty undoubtedly strengthened Ligand's business, and its shares rose from $4.80 when the deal was announced to yesterday's $9.35 close, a rise of 95%.

Now what?
In November, I offered an intrinsic value range of $9.35 to $12.63, based on a discounted cash flow analysis (DCF) using a discount rate of 15% for years 1-20 and 11% for the terminal period. Value investors like to buy at a significant discount to their estimate of intrinsic value and sell if the stock reaches the high side of an intrinsic value range. For Ligand, that would counsel selling if and when the stock starts creeping over $10.00. But I think you could make a case that if Ligand actually produces a sustained GAAP profit in coming quarters and free cash flow starting in a later quarter this year or early next year, it deserves a lower discount rate and resulting in a higher intrinsic value. Using value principles -- admittedly suspect for a company not yet profitable -- I'm not interested in selling by a long shot.

I also used a valuation model estimating specific products revenues and free cash flow beginning this year or next through 2008, estimating that Ligand could return almost six times an investment at $5.16 by then. (I explain both this and the DCF valuation methods in A Buy and Two Sells.). Due to the price increase, the 5.5 times return possible from November 2002 levels is reduced to 3.5, but that's still a return anyone would embrace over five and a half years.

And the risks
The case for an investor to buy today is that even though the stock costs more, there is far less uncertainty about its major product than there was six months ago. But reduced uncertainty does not mean no risk. Far from it. Investors in biotech and drugs need to keep all the risks in mind, and opportunity comes with them.

Keep in mind that after being hammered, stocks of a lot of biotech drug makers have been lifted en masse with the market, without much of a change in their business prospects. Just as buyers at $5.16 probably thought they had a lemon when Ligand shares dropped below $4.00 and only the patient held on to enjoy current paper profits, a buyer today might well see the whims of the market knock the price down in the near term. Over the long term, the stock of better-performing companies may outperform the market, but in the short term -- you know the drill.

Not only that, but Avinza sales might not ramp sufficiently to meet the valuation model's revenue forecast of $300 million (meaning around $120 million to Ligand) in 2008. Or currently marketed drugs Ontak and Targretin might not expand sales through new indications. And drugs in development with partners -- Ligand has several in Phase 3 trials with partners Pfizer and Wyeth (NYSE:WYE) may not succeed in trials or receive FDA approval. In fact, odds are that most will fail. Ligand's sales momentum has fallen, too. After four quarters of 9%-46% year-over-year growth in sales, sales dropped over 6% in Q1. One quarter is no big deal, but it could continue.

Ligand has been on the cusp of profitability before and several times has snatched defeat from the jaws of victory. But for those comfortable understanding a drug maker and the drug development and approval process, willing to read quarterly and annual financial reports and accept the risks, Ligand -- even after recent gains -- still offers the potential for excellent returns over the next five years and beyond.

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Tom Jacobs (TMF Tom9) is a Motley Fool writer and senior analyst who specializes in biotechnology and drugs but takes opportunity wherever he finds it. You can read his research in The Motley Fool Select and in columns via his very own archive . Tom holds shares of Ligand Pharmaceuticals and other companies, which are listed in his profile . Motley Fool investment writers are investors writing for investors .