Biotech Weakness: Opportunity or Justified?

The weakness in the large-cap biotechs is back, but why? With the exception of Amgen, the financials and growth from these companies continue to amaze. Genentech has grown sales and earnings at a clip above 35% for the last three years; Gilead and Celgene have both grown greater than 60% per year over the past five years. These growths should continue in 2007, but after that, growths for Genentech and Gilead could slip below 20%. Should this cause investors to panic? Is this reasoning for the weakness?
An article in Investors Business Daily Friday outlined some other problems facing the industry. Investors are worrying about FDA delays, Congress, and potential competition from generics. Is this weakness justified? Or should we look at this as a buying opportunity?

Not to be neutral, but I think that it is both. The volatility in the overall market will make it tough for any one stock in the group to stand out, but I think that this is a stock-pickers market and you have to find stocks that will continue to be quality companies, deliver strong growth, and that will continue to be market leaders in their respective areas. Companies that possess these qualities will outperform the market and the industry in the long-run.
Investor concerns over the FDA, Congress, and generics are justified. The FDA has been more stringent in its review of drugs, but that poses more of a threat to the small biotechs. It has been unkind to Genentech recently, asking it to provide more information before approving Avastin to treat breast cancer. But, Gilead got its drug approved to treat hypertension without much trouble.
The article in IBD also outlines some newly passed measures from Congress that will allow generics to have a better chance in the future. But, biotechs still will have 12 years of exclusivity in the market, and with the large R&D budgets of these companies and the advancement of medical technology, most drugs will have competition within 12 years anyway.
I think this recent weakness is justified, but I also feel it is just a short-term hiccup. Most of the large biotech firms are growing too fast and have positions in their respective markets that are untouched. Genentech is expected to grow 30% this year and its cancer drugs are the best available, but the stock has given back 7.8% year-to-date. Gilead has had an impressive run, up 20% this year, but even it has given back 4% in the last month. Celgene's run has been tempered as well, giving back more than 9% in June.
As I've posted before, I'm a buyer of Gilead. I also like the weakness in Genentech and Celgene as buying opportunities, but the weakness will probably continue in the entire industry, especially with the overall market volatility. I don't see any reason to rush into a position right now, the momentum is pushing lower, so I would suggest doing the proper due diligence and taking your time to find the proper fit for your portfolio.

Valuing Biotechs

Valuing stocks can be a bit of an art and determining a value for biotech companies is even tougher, especially for biotechs without any products at market. So today I'll outline one of the methods I like to use when valuing companies. This method is called Risk-adjusted net present value, and it is fairly specific to the biotech industry.

Risk-adjusted net present value (rNPV) attempts to value a company by taking into account not only the future cash flows, but also the probabilities that those cash flows will even take place. This is especially useful for small biotechs that have not yet obtained FDA approval for a product. In using rNPV, we are able to find a company's value while taking into account significant events that could affect the stock price (like moving from Phase II to Phase III trials).

NPV is the same as a discounted cash flow analysis. It finds the present value of a firm's future cash flows. rNPV is similar. It is the present value of future cash flows, but those cash flows are adjusted by the probability of effect.
So, what are these cash flows? And, what are these probabilities?
These assumptions are crucial to our analysis of a small biotech.

1. Probabilities
Based on historical numbers, drugs in clinical trials have been approved by the FDA at the following rates:
Phase I: 20%
Phase II: 30%
Phase III: 67%
New Drug Application: 85%
(*These rates can differ +/- 5% based on differing types of drugs)
These percentages are the probabilities that we can use in finding rNPV. However, these percentages are the probabilities of a drug in each stage obtaining FDA approval. The percentage of drugs moving from one stage to another is the following:
Phase I to Phase II: 67%
Phase II to Phase III: 45%
Phase III to NDA: 79%
NDA to FDA Approval: 85%
These percentages are the probabilities that we use when a drug moves to a different stage.

2. Cash Flows
Determining a drug's cash flows can be very difficult. First, we must determine the costs. Secondly, we want to determine the potential revenues.

--Costs:
Costs tend to be determinate on the stage that a drug is in.
Phase I (1 year): $500,000 for animal testing + $12,000 per human subject (20-80 subjects)
Phase II (1.5 yrs): $1 mil for animals + $12,000 per human (100-300)
Phase III (3 yrs): $1.5 mil for animals + $6,000 per humna (1000-3000)
New Drug Application (1 yr): $1.8 million

--Revenues:
A peak sales estimate (which can usually be obtained about 3 years after FDA approval) can be determined by taking the market size and multiplying it by an estimated market share. Also, drugs tend to have a life of around 10 years. Revenues are usually assumed to ramp up, and ramp down with about 5-7 years of peak sales.


Alright, let's make sense of this information.

As an example, let's take Fictional Biotech, Inc. FBI has a drug in Phase II trials. This drug treats pancreatic cancer, which has a market of $2.6 billion. FBI's drug has an estimated market share of 8%, which leads to potential peak sales of approximately $200 million.
Now, let's take a look at some cash flows. For example purpose, we'll look at years 1, 3, and 10

Year 1: Costs: -$1.7 mil for phase II testing
Year 3: Costs: -$6.5 mil for phase III testing
Year 10: Costs: 60% of Revenue, Revenues: $200 mil

So, according to the rNPV method, these cash flows must be adjusted by the probability that they will occur.

Year 1: rNPV Cash Flow = (Costs x Probability) = (-$1,700,000 x 100%) This stock is already in phase II, so the probability is 100%
Year 3: rNPV CF = (Costs x Probability that drug will move to phase III testing) =
(-$6,500,000 x 45%)
Year 7: rNPV CF = (Revenues x Cost of Revenue x Probability that drug will obtain approval)
($200,000,000 x 40% x 30%)

To conclude this quick intro to rNPV, to get a value for the company, we find the net present value of all the cash flows that each drug in the pipeline could bring in. We discount at the company's weighted-average cost of capital, which is usually 20% or more for a small biotech firm.

For more information on rNPV (and a better example) check out: http://www.maricopa.edu/bwd/pdfs/biotechpb.pdf

Also, Brian at Baby Biotechs outlines a similar formula here: http://www.babybiotechs.com/investment-strategy/investing-in-small-biotechs

Coming Soon: GenVec

I have just completed my valuation of GenVec (GNVC) and will be posting my recommendation soon.

I plan to post recommendations on a weekly basis on all different sizes of biotechs that focus on many different areas.

Adam Feuerstein: Biotech Master

TheStreet.com's Adam Feuerstein covers the biotech industry in ways that are very convenient to individual investors. I appreciate that. He has provided tons of information in his columns that most individuals might not have information to. He has recently posted an FDA approval calendar, which is extremely convenient for investors looking to piggyback on those announcements. Also, his Biotech Mailbag provides weekly updates on several different realms of the biotech world.
For anyone looking for information on biotech, this is the guy to go to.

Gilead Splits

Gilead started trading post-split today. It announced back in May that it would split 2:1, so now it is trading around $39. That adjusts my target price to $45.
The company also annouced that Viread, one of its HIV drugs met its primary endpoint goal in Phase III trials to treat Hepatitis B. Gilead said it will file a marketing application with the FDA to allow Viread to treat Hep-B.
If Viread were to gain this approval, it would mostly have a cannabalizing effect for the company because Viread would just replace Gilead's Hepsera, which Viread was compared to (and performed better than) in trials.
None the less, it is always good to see a company improving its offering of products.

Gilead: A reason to welcome the recent sell-off

GILD
Recommendation: BUY
Target Price: $90
Disclosure: I am long shares of GILD

You should want to own the best company in the business. And the market has given us the chance again to do that. Gilead Sciences (GILD), a maker of the top HIV drugs on the market, has sold off and is prime to buy again.
GILD has had a brilliant run in 2007. It reached an all-time high of $84.47 in May; it just had a new drug approved; and its market share in HIV continues to increase from already great numbers.
What could be better??? Well, the market has sold off!! GILD is back down to $78.48.
I'm back in. You might want to be too. Net income is poised to grow at 15% this year and 18% next year. Sales should grow upward of 37% this year. It boasts returns on capital of 37% and returns on equity of 56%.
According to my valuations, its intrinsic value is about $82. However, my valuations have increased with each of the past three quarters and I believe this is why my target is above the current intrinsic value. Earnings are around the corner again and Gilead should post another superior quarter. Atripla sales have been outstanding; Letairis just got approved and some analysts believe it will lead the class of pulmonary arterial hypertenstion drugs, which could lead to sales of $500 million by 2011 (and put to rest bickering about the price Gilead paid in its buyout of Myogen).
Market headwinds currently exist, as the Dow and S&P have been very volatile recently. This could lead to another couple of dollars to the downside if the market continues its slide. But, I feel that would be it. The stock itself doesn't have much downside, especially since Letairis is now approved (and a competitor was denied). That should be great for investors.

Notice of Disclosure

This blog is meant for information purposes only. I am not a registered financial analyst or advisor. All recommendations should be viewed only as my personal opinion. There are risks associated with investing such as significant financial loss. I cannot be held responsible for losses from investing. Please do your own research and consult with a registered professional before investing.