Investors eager to take on high risk in exchange for potentially high reward know that they face many failures, which they hope will be dwarfed by the occasional Jolly Green Giant success. For the Rule Breaker portfolio strategy, we ask that a stock offer the chance to return ten times today's investment in the next five years. We use the shorthand 10x/5y. Does Amgen (Nasdaq: AMGN) measure up?
When the portfolio purchased Amgen in December 1998, there was no explicit 10x/5y criterion for a stock. But if we'd applied the 10x/5y test at the time, would Amgen have offered enough potential reward when we bought it? And now that we own it, should we hold?
Amgen's Q1
First, let's look at where Amgen stands today. It's a solidly profitable biotechnology drug maker with two important drugs selling billions a year, and a pipeline of excellent product candidates to maintain and increase future profitability. The company reported Q1 2001 earnings after market on Thursday, and the news was steady and solid. A 14% year-over-year increase in product revenues, a 10.6% rise in total sales, and a 12% climb in EPS from $0.25 to $0.28.
The company said that some factors would slow near-term growth from the mid-teens to the low double-digits. Among these are that it has taken longer than estimated for regulatory review and approval of Aranesp (a less-frequent dosage form of Epogen, Amgen's recombinant DNA version of the human hormone erythropoeitin, which stimulates red blood cells production). U.S. and European Union approvals are expected soon. Also, the company now sees lower-than-planned growth in the kidney dialysis patient population, key for Epogen/Aranesp sales.
Still, CEO Kevin Sharer sees future growth that most companies would envy. He said in a prepared statement and on the earnings conference call that he remained "confident in our long-term guidance of compound annual growth rate for sales and EPS of low 20s for the 2001-2005 period and sales between $8 billion and $9 billion in 2005," from $3.2 billion today.
Sounds good. Excellent, actually. So what's my problem? Am I looking a gift horse in the mouth? (I have a dear old friend who advises me to dare to be trite.)
Would we have bought Amgen?
Genentech (NYSE: DNA) was really the top dog and first mover in recombinant DNA drug making. But Amgen caught up and passed Genentech in sales and market cap ($22 billion) at the time of our December 1998 buy. Amgen stock has rewarded investors handsomely since then, just about tripling -- from $21.44 to Friday's $59.88 -- in two and one-third years, for a startling compound annual growth rate of 54.3%.
But that $22 billion market cap really offered no chance to provide 10x/5y returns, which would have meant a market capitalization of $220 billion by December 2003. For comparison, look at the competition among the world's top 12 drug makers, whose leaders all sported many more products and fatter drug pipelines than Amgen at the time of our purchase:
market cap
Pfizer (NYSE: PFE) $272 billion Merck (NYSE: MRK) 174
GlaxoSmithKline (NYSE: GSK) 166 Johnson & Johnson (NYSE: JNJ) 133 Bristol-Myers Squibb (NYSE: BMY) 113 Novartis (NYSE: NVS) 103 Eli Lilly & Co. (NYSE: LLY) 93 AstraZeneca (NYSE: AZN) 85 American Home Products (NYSE: AHP) 76 Abbott Labs (NYSE: ABT) 71
Pharmacia (NYSE: PHA) 68
Amgen 62
Schering-Plough (NYSE: SGP) 57
Before you say, "well, these were all smaller then," in fact, with a few exceptions, these haven't changed much since December 1998. Applying 10x/5y, we might well have passed on Amgen in December 1998. A great company, but with the potential for Rule Maker -- not Rule Breaker -- returns.
Where will Amgen be in 2005?
Let's try to project some possible returns for Amgen through 2005. We can use CEO Kevin Sharer's projected $8 billion to $9 billion in product sales for FY 2005 (not counting another 10% to12% a year earned from corporate partners and from royalties), figuring an average of $8.5 billion, and extrapolate from today's price-to-earnings ratio.
Amgen rang up FY 2000 product sales of $3.2 billion, yielding EPS of $1.05 and a P/E ratio of 55 based on Friday's close. Year 2005 product sales of $8.5 billion would suggest that, assuming that Amgen's net profit margins remain the same and it continues to have negligible share dilution, its 2005 EPS would likely be $2.86 a share. At its current P/E, that prices shares at $157. However, with estimated percent annual compound EPS growth in the low 20s, it's hard to see how the stock could sustain a P/E of 55 for long. At a healthy 30 -- more than similarly growing Johnson & Johnson, which currently carries a P/E of 27 -- Amgen's stock price would likely be about $86.
I also did the math using a price to free cash flow (P/FCF) multiple, because cash flow tells you more about how successful a business really is at generating money. But because the numbers come out almost identical to those for P/E -- Amgen currently has a P/FCF multiple of 51.8 using FY 2000 figures -- the P/E analysis tells us the same story. For those interested, I've posted the P/FCF calculations on the Rule Breaker strategies board.
Here's an estimate of our potential results holding Amgen until the end of 2005:
'05 12/16/05 from 4/27/01 from 12/16/98 P/E price %gain CAGR* %gain CAGR**
20 $57 -5% -1% 166% 15% 30 86 44% 8% 301% 22% 55 157 162% 23% 632% 33% *compound annual growth rate for 4.67 years **for the seven years from purchase
In a perfect world, the stock in 2005 will have provided a healthy 632% return from our 1998 purchase for 33% CAGR over seven years, with a 162% return and 23% CAGR from today. Darn good. But if Amgen's P/E or P/FCF multiple trends back to historical averages of 20, if management falls short of its sales goals, and/or if the Food & Drug Administration (FDA) delays approval or doesn't approve any drug candidate -- all good possibilities -- our holding may decline 5% by 2005, with a total return of 166% over seven years and a CAGR of 15%. These would be fine results for the Rule Maker Portfolio, which seeks 2x/5y returns based on less risk, but not for the Rule Breaker.
Conclusion? We should watch Amgen closely. If we find a Rule Breaker we really want to invest in, I vote that we take cash from Amgen to do so. What do you think? Please share your views on the Rule Breaker discussion board, and Fool on!
Tom Jacobs (TMF Tom9) worked in a pharmacy in high school and read the drug company bottle inserts for fun. He doesn't own shares of any company mentioned in this column. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.
