Submitted by Mike Anthony as part of our contributors program.
Investors in biotechnology stocks normally have to take speculative risks ahead of FDA or regulatory approvals, so value investors typically steer clear of the entire sector. There are hundreds of rejections for every approval, and something called survivorship bias explains why pre-approval biotechs continue to attract undue attention. Some traders like gambling on companies and FDA decisions, but there is a way to approach the sector as a true value investor. This article will show some value investments — actual value, not just “likely to be approved” investments — trading completely under the radar in the biotech sector.
These value investments have no regulatory risk. They are operational, straightforward businesses that are generating revenues with approved products and can be analyzed using traditional metrics like DCF, P/B or EPV. Most of the time, biotechs that have achieved approval are simply trying to sell more of their product. Their task is akin to marketing televisions, clothing or tea; their products are more sophisticated, but the underlying concept is identical.
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This predictability is the basis of value investing. Of course, a post-approval biotech is no different than a fashion clothiers, at least on a fundamental basis. The only thing that particularly attracts a value investor is bargain pricing, and most biotech companies decline in price after receiving regulatory approval, as pre-approval speculators take profits and move along to their next wager. Excitement over FDA catalysts wanes, boredom sets in, share price declines, and the only thing left to say on a conference call is, “The focus is marketing.”
Value investors love this situation. They hate expensive, popular stocks. They love cheap, boring, forgotten stocks trading near liquidation value with a trump catalyst: earnings.
For example, on May 31, Depomed (DEPO) failed to receive approval of its menopause drug candidate Sefelsa. The FDA issued a Complete Response Letter, and the company abandoned the drug shortly thereafter. Shares had rallied to a 52-week high of $7.15 on anticipation of approval and promptly fell to $5.76 on the news. According to the CEO, Depomed is “now focused on its two marketed drugs, Gralise and Zipsor, a strong balance sheet and the potential to turn cash flow positive in the second half of this year.” Shares remains near the lows reached after the FDA’s letter.
The set-up is beautiful: disappointed FDA traders abandoning the stock, concluding drug trials, full acknowledgement by management that the focus has shifted to traditional marketing, and no popular headlines making the stock expensive.
Depomed’s Gralise (approved drug) sales for the first quarter 2013 were $6.1 million ($38.6 million estimated full year 2013 and $64.6 million by 2014) and Zipsor (another approved drug) sales for the first quarter 2013 were $3.0 million ($18 million estimated full year 2013 and up to $30 million by 2014). Depomed also earned $13.3 million from royalties and $3 million from licenses for the first quarter 2013. After all expenses, the company lost just $5.5 million in the first quarter 2013 and guides total revenues of $125-135 million for 2013. The CEO has stated that Depomed should be cash flow positive this year. That should catch the attention of a value investor.
With a market capitalization of $322 million on revenues of $125 million, Depomed has a very low P/S ratio of 2.6. Using estimated 2014 revenues of $173 million, P/S drops to 1.9. Depomed fits the bill: cheap, boring and no regulatory approval risk for future revenues. Right now, shares are in the middle of its 52-week range. Value investors would become very interested in Depomed the low $5s or high $4s where the current P/S ratio would drop below 2.0.
There are many other cheap biotechs. If Wall Street had to name the epitome of boredom in the biotech sector, Targacept (TRGT) would be the name. Down from $30 per share two years ago to $5.19 yesterday, the company’s drug candidates for mental disorders like ADHD and schizophrenia have repeatedly failed regulatory scrutiny, leaving the company with only its legacy products and an expired partnership with AztraZeneca (AZN). Revenues trickled in at $3.5 million for the first quarter 2013, yet the company is a cash cow, holding over $170 million with almost no debt. An astounding 100% of the company is book value, with cash almost equal to market capitalization.
The big problem with Targacept is that revenues are declining while the company continues burning cash on clinical studies and SG&A. Targacept lost $8.1 million in the first quarter 2013 and will likely continue losing money for the foreseeable future. Although it has some residual revenue, sales are not keeping the company afloat, and the only long-term hope for the company is its therapeutic pipeline. Although several of its candidates are undergoing Phase II trials, value investors are not speculative in nature. They would rather await the decision with their money at work elsewhere in the meantime. Nevertheless, Targacept is basically a net-net… although it does need a catalyst to propel shares higher.
The best opportunities for biotech bargain hunting reside overseas. By the time a company gets through FDA approval for its drug or device, it has likely attracted significant attention from U.S. investors. Value investors prefer things to be under the radar. Scanning through companies, it is difficult to find cheap U.S. listings but easy to find cheap foreign listings. An easy example is PLC Systems (OTC: PLCSF). It sells a CE-marked device that injects saline into the bloodstream while extracting equal parts urine. At $500 per procedure, this drug-free device flushes the body quickly to remove chemicals, dyes, toxins, or whatever else the kidneys would normally filter. Sales are ramping, even with no footprint in the U.S.: $0.6M in 2010, $0.7M in 2011, $1.1M in 2012, $1.6M in 2013 and $3.0M in 2014 (estimated). This gives the company a 2014 P/S ratio of 2.0 with profit margins of 49%. Many international biotechs are humming along like this with increasing sales, no regulatory risk, and no real catalysts aside from quarterly reports. PLC Systems is a textbook value investment with earnings catalysts that will propel shares higher over the next year.
Looking internationally at companies like PLC Systems is also prudent because, frankly, the U.S. stock market is becoming expensive. Existing investments are performing well, but bargains are becoming rare. The job of finding value investments in a bull market is difficult, but not every country’s stock market is rallying. Sales are sales, no matter from which country they are derived, and if a post-approval biotech company is selling well abroad with no domestic fanfare, all the better for value investors.