Cost of Capital Key to Valuation

I have based a lot of my analysis on this blog around financial models, specifically rNPV, which I have talked about many times. However, after a discussion on ViroPharma's (VPHM) Yahoo! Finance message board, I noticed that I never mentioned a key component to valuation, which is a company's cost of capital.

Cost of capital (COC) is a firm's expected cost to finance its operations. It consists of a weighted average of a company's cost of equity (COE) and cost of debt (COD). COC is calculated with the following formula:

COC = [(Weight of Equity)*(COE)] + [(Weight of Debt)*(COD)]

For more information, Investopedia has several good articles that explain the components: Start with this one.

The estimate for COC is just as important as an estimate for a potential market for a drug when using rNPV. COC is the rate at which future cash flows are discounted back to the present, and underestimating COC can give you a rNPV number that would be too optimistic, and vice-versa. Present value calculations are very sensitive to changes in the discount rate.
This is why it is important for analysts to get the COC right, or at least caution on the high side.

Generally speaking, development-stage biotechs have a COC in the 20% range. While big-cap biotechs like Genentech (DNA) and Gilead (GILD) have COCs around 10-12%. The difference in COC has to do with the risk involved with investing. Genentech and Gilead have marketed products, with positive cash flows and profits and, therefore, less risk, so investors are willing to seek lower returns. However, development stage biotechs like GenVec or NeurogesX are highly risky, and investors want to be compensated for that risk.


Disclosure: I own shares of GILD and NGSX

What can we make of Amgen?

Amgen (AMGN) reported earnings last night and investors are giving the stock a 4% boost today. The stock, which is down some 36% in the past year, has struggled since mid-2005. The company's growth has slowed, and the company has a cloud over it with a pending FDA panel review of anemia drugs. The panel meets in March, and could place restrictions on drugs that treat anemia from chemotherapy, which could affect Amgen's Epogen and Aranesp.

Amgen's 2007 earnings were nothing to boast about, as the company posted $14.77 billion in revenues, only a 3.5% gain, and $4.8 billion in adjusted profit, a 4% gain over 2006. It must be noted, however, that Amgen did still grow despite a 25% drop-off in fourth quarter sales of Aranesp.

Looking forward, the picture is equally mixed, at least according to analysts. With the stock off nearly $30 from its highs, some analysts are calling Amgen the potential comeback story for 2008. Others aren't ready to join the stock.

The bulls say:

• Amgen's anemia drugs don't make up enough of the company's total sales to make too much of a difference.
• Cowen analyst Eric Schmidt: "We would expect the recovery to begin March 14." (The day after the FDA panel review.
• Positive results from a Phase III trial of osteoporosis drug Denosumanb will lead to a return of growth in 2009.
• Leerink Swann analyst Bill Tanner: "We believe investors will once again revisit AMGN shares by virtue of the valuation and better business prospects beyond 2008."

The bears say:

• Results of the FDA panel meeting could provide for more downside.
• Banc of America analyst William Sargent says Aranesp could lose at least 25% of its patients
• FBR analyst Jim Reddoch: "There is still downside potential if the (anemia drug) label is tightened."

There is a lot of opinion about Amgen out there. The stock seems cheap as it trades at less than 12x 2008 earnings (depending on the earnings estimate) and the company has a decent pipeline and enough resources to fund it and even add to it. However, there have been dark clouds over the stock for a while now and it could take some time for investors to return, especially with other big-cap biotechs thriving.

Read more:

1. http://biz.yahoo.com/ap/080125/amgen_ahead_of_the_bell.html?.v=1
2. http://www.cnbc.com/id/22841272/site/14081545

Disclosure: I do not have a position in AMGN

Gilead keeps impressing

Gilead Sciences (GILD) announced a record fourth quarter yesterday, as the company posted $1 billion in product sales for the quarter, the first time the company had broken the billion-dollar mark in product sales. Led again by its HIV franchise, Gilead beat Wall Street estimates, which led to an upgrade from Friedman Billings Ramsey, an outperform reiteration from Rodman & Renshaw and a price target increase from Standard & Poors.

Revenue growth was led by continued strength in HIV drug Truvada. Truvada sales increased 33% year-over-year to $449 million for the fourth quarter. Gilead's newest HIV drug Atripla came in with $260 million in revenues for the quarter, slightly under analyst estimates. However, there are expectations for Atripla to further pick up its growth this year as the EU approved the once-a-day treatment in December.

Europe is poised to be a strong contributor this year to Gilead's growth. The weak dollar continues to help the company; Atripla sales will pick up there; and the company expects a second quarter approval of Viread for the treatment of Hepatitis B. Furthermore, Letairis, which treats Pulmonary Arterial Hypertension, and is approved in the U.S., is expected to be approved in the EU soon.

While the majority of Gilead's growth will continue to come from the HIV franchise, the company's push into other areas has been a mostly positive result for shareholders, and will continue to supplement long-term growth. The company expects its cystic fibrosis drug Aztreonam Lysine to be approved by the FDA in the third quarter; Viread is also expected be to approved for HBV in the third quarter by the FDA; Letairis had $15 million in revenues in the fourth quarter after being approved in June; and Gilead has Phase III trials ongoing for Darusentan, which treats resistant hypertension, and a Phase II trial for GS 9450 in the treatment of Hepatitis C.

The growth continued for Gilead in the fourth quarter, and the 2008 outlook looks good again. Investors should be happy with the company's results, its pipeline, and the continued $3 billion buyback of shares.


Disclosure: I own shares of GILD

Correction and Clarification to Tysabri article

It has been brought to my attention that I made an error in my recent Tysabri article. The drug Remicade is owned by Johnson & Johnson, which it received in its purchase of Centocor, Inc. Schering-Plough markets the drug outside the United States. I apologize for the error.

Also, I want to clarify a few issues that have been brought up as well.

1) Tysabri was pulled due to links with PML, not necessarily because the drug causes PML. Since it has returned to market, there have been no other links to PML, which was stated in the article.

2) My analysis for the drug is based on its potential in the Crohn's market according to analysts views. I do not feel that the Crohn's market is the reason to buy these stocks. I did not do analysis for the MS market, since the Crohn's approval was the news. The MS market is very lucrative, and based on both company's views of Tysabri's potential growth, it could be a reason to buy either stocks.

3) Please refer to my disclosure statement at the bottom of my blog.


The article will re-run below with changes made:

The roller-coaster ride that the drug Tysabri has been on over the past several years hit another high this week as the FDA approved it to treat Crohn's Disease (CD). But this approval doesn't necessarily mean the roller-coaster ride will end for the drug, which is co-marketed by Elan (ELN) and Biogen Idec (BIIB) and also is approved to treat multiple sclerosis (MS).

Tysabri was originally approved for MS in 2004, but was pulled from the market in 2005 after there was a link to PML. The FDA allowed the drug to return to the market in 2006 with a risk-management plan, and there have been no complications with PML since. The drug will have a risk-management plan for Crohn's as well.

According to the companies, there are approximately 500,000 people in the U.S., which represents a market of approximately $800 million per year. However, analysts don't expect the drug to push for significant market share in CD. Tysabri is essentially a third-line therapy for Crohn's, behind Johnson & Johnson's (JNJ) Remicade and Abbott's (ABT) Humira. In my view, the drug's sales will be limited in CD because of these other treatments and because the EU rejected its approval for CD in November.

One analyst says that Tysabri could reach $182 million in peak sales for CD alone by 2013. Other estimates have the drug reaching $40 million by 2010. Total sales estimates for Tysabri, including both MS and CD, range from $400 million to $1.2 billion by 2010.

The addition of Crohn's to Tysabri's approval list shouldn't do much for either stock, in my view. Biogen's stock didn't react much to the news, trading up only 1% on the the day of the approval. Elan has more to gain from Crohn's since about 37% of its sales came from Tysabri in the third quarter 2007. But, investors didn't push the stock up any with the approval. Tysabri is not going to grab the market share in Crohn's to help these companies too much. The Crohn's market is not a good enough reason to invest in either Biogen or Elan. However, both do have other products and good pipelines that might be worth taking a look at if you are interested in these two firms.


Disclosure: I do not have positions in any of the stocks mentioned

Drug of the Week: Tysabri

The roller-coaster ride that the drug Tysabri has been on over the past several years hit another high this week as the FDA approved it to treat Crohn's Disease (CD). But this approval doesn't necessarily mean the roller-coaster ride will end for the drug, which is co-marketed by Elan (ELN) and Biogen Idec (BIIB) and also is approved to treat multiple sclerosis (MS).

Tysabri was originally approved for MS in 2004, but was pulled from the market in 2005 after two patients died after contracting PML. The FDA allowed the drug to return to the market in 2006 with a risk-management plan, and there have been no complications with PML since. The drug will have a risk-management plan for Crohn's as well.

There are approximately 500,000 people in the U.S. with CD according to the companies, which represents a market of approximately $800 million per year. However, analysts don't expect the drug to push for significant market share in CD. Tysabri is essentially a third-line therapy for Crohn's, behind Schering-Plough's (SGP) Remicade and Abbott's (ABT) Humira. Concerns about safety and the fact that the EU rejected its approval for CD in November will limit the drug's sales in my view.

One analyst says that Tysabri could reach $182 million in peak sales for CD alone by 2013. Other estimates have the drug reaching $40 million by 2010. Total sales estimates for Tysabri, including both MS and CD, range from $400 million to $670 million by 2010.

The addition of Crohn's to Tysabri's approval list shouldn't do much for either stock, in my view. Biogen's stock didn't react much to the news, trading up only 1% on the the day of the approval. Elan has more to gain from Crohn's since about 37% of its sales came from Tysabri in the third quarter 2007. But, investors didn't push the stock up any with the approval. I'm not overwhelmed either. Tysabri has been shown to be a high-risk drug and it isn't going to grab the market share in Crohn's to help these companies too much. Tysabri is not a good enough reason to invest in either Biogen or Elan. However, both do have other products and good pipelines that might be worth taking a look at if you are interested in these two firms.


Disclosure: I do not have positions in any of the stocks mentioned

Earnings Info Links

Here are a couple of links for more information on Genentech's and future biotech earnings.

1) CNBC's Mike Huckman announces DNA earnings.

2) TheStreet.com previews the earnings season.

Another disappointing quarter for Genentech

Genentech (DNA) reported full-year 2007 earnings today and, while the company beat on the bottom line and guided 2008 in-line, investors sent shares down again as its major drugs missed revenue estimates. Shares of DNA have traditionally traded on the company's revenues, and this time is no different.

Fourth quarter revenues for cancer drug Avastin came in at $603 million (a respectable 23% growth), but analysts expected sales of $616 million. Lymphoma drug Rituxan had sales of $596 million, but analysts expected $603 million. Same goes for breast cancer treatment Herceptin ($327 vs. an expected $332) and eye-disease drug Lucentis ($197 vs. $200).

DNA has been lost money for investors since 2005, when the stock hit an all-time high of $99.60. Now, 2008 may shape up as more of the same. The only thing that might save DNA shares is an FDA announcement in February on the approval of Avastin for breast cancer. However, an FDA panel already recommended to not approve Avastin for breast cancer last month. The final FDA decision is set for February 23. Investors might want to stay away from DNA, unless the FDA pulls a fast-one and goes against the panel's recommendation. I don't see that as likely.


Disclosure: I do not have a position in DNA.

Busy week comes to an end

Biotech's first busy week of the new year came to an end yesterday on a down note, as Cadence Pharma (CADX) announced that its IV pain drug failed to meet its main Phase III trial goal. The announcement sent shares down more than 60%. For more information read here.

I'll stay busy next week bringing you more information from the sector as earnings season gets underway. First up is Genentech (DNA) Monday after the bell. Stay tuned.

Stock of the week: ViroPharma

ViroPharma (VPHM) has had a big week with its stock climbing 20% after the company announced better-than-anticipated guidance for 2008 sales of its bacterial infection drug Vancocin. The company expects that 2007 sales of Vancocin were in the guided range of $202-208 million and that 2008 sales will fall in the range of $210-235 million. This guidance greatly out-paces what analysts were projecting. Consensus 2008 estimates had ViroPharma with $182 million in sales.

Analysts, for a couple of years now, have feared generic competition to Vancocin, which could eliminate 50% of the product's sales in the first year of an available generic. However, a generic form of Vancocin is not available yet, and it appears from ViroPharma's guidance that it does not feel one will be available this year.

However, that does not mean the threat of generic competition is gone. A generic form of Vancocin will be available at some point, and investors need to look beyond Vancocin to see if ViroPharma is a viable investment choice.

VPHM is a small ($700 million market cap), but highly profitable biotech. The company has a clean balance sheet; approximately $6 per share in cash and short-term investments; and has strong operating cash flows ($121 million in the trailing twelve months). These traits could give ViroPharma some room to seek acquisitions or partnerships. Or could make VPHM a strong buyout candidate.

For VPHM to be a buyout candidate, or for it to be a viable investment choice, we must look further and into the pipeline. ViroPharma currently has four projects that it or its partners are working on. However, I'm only accounting for one of those projects becoming financially viable at this point.

ViroPharma and Wyeth decided to discontinue Phase II dosing for HCV-796, a Hepatitis C drug because of safety concerns in August. The companies continue to pursue ways to use the drug, but I'm not counting on anything. VPHM also has a compound that could treat C. difficile-associated disease (CDAD), but it has not moved into human trials yet.

Lastly, I'm not accounting for pleconaril, a nasal spray to treat the common cold, which is being developed by Schering-Plough (SGP). Pleconaril has been a part of ViroPharma since the 1990s. The company filed an NDA for an oral form of the drug in 2001, but it was rejected by the FDA. SGP licensed the drug in 2003, and has been working on the nasal form since. ViroPharma is due to potentially receive another $65 million from SGP, as well as royalties if the drug makes it to market. However, the clinical trial process has been slow. The drug is currently in Phase II. And when I looked on Clinicaltrials.gov, it showed that a Phase II trial had been completed, but neither company has said anything about it. I would be willing to think that data from that trial should be expected sometime soon, but I have no definite time-table for that announcement. So, until we do hear something from that trial, I'm not going to account for pleconaril in ViroPharma's future earnings.

With all that said, ViroPharma does have one very promising drug, that could earn more in peak sales than Vancocin. Camvia (maribavir) is in Phase III trials for the treatment of cytomegalovirus (CMV). The company projects that a market is available for peak sales of $500 million. That would provide significant growth for VPHM. The company says it is on track for a 2009 NDA. Using my rNPV template, I feel that Camvia is worth $4.37 currently to the company. It would be worth around $8 to the company if Phase III trials are successful.

As I see it, there are two wildcards that are holding me back from calling ViroPharma a strong buy. First, what will happen with generic Vancocin. If the company can continue to get the FDA to hold back allowing a generic Vancocin, the drug should continue to grow its sales and I feel is worth at least $10 per share, which is slightly above the current trading price alone. However, if generic competition gets in as early as next year, I feel that Vancocin is only worth $5 going forward and the stock is probably fairly valued, at best. The second wildcard that I'm looking at is pleconaril. If Schering gets this drug moving, it has the potential to be a blockbuster, and ViroPharma would reap those benefits. However, there is currently no telling if that will happen, we'll just have to keep our eye out for news.

To conclude, I like ViroPharma. It is a good company, with a couple of good products. However, there is a lot of uncertainty here in 2008 and its long-term picture is a little blurry. My opinion is that this is a buy for the long-term, but I think a lot is riding on the Phase III trials of Camvia. Camvia should be able to replace Vancocin and keep the company growing for its shareholders. Although, this stock could really go places if the two wildcards fall into place for VPHM.


Disclosure: I have no position in any of the stocks mentioned.