The Biotech Judgment Call

Well, I’m going to be doing something a bit differently today. Normally, I take a look at one stock at a time. Normally, it’s a simple dividend growth stock, one we’ve all seen before. Companies like Genuine Parts (GPC), Wal-Mart (WMT), and Hormel (HRL) are all still on my list to analyze. All told, I have ~50 companies I still want to write reports for.

But therein lies a bit of a problem. Already, I have 34 companies in my portfolio. And even worse, I still have ~24 companies on my immediate will-buy watchlist. Assuming I buy all of my watchlist, and nothing is added or removed from either, that’s 58 companies I’ll end up with in my portfolio. That’s a lot honestly. At that point, I’d be getting uncomfortable adding new things, as my portfolio would be getting more difficult to manage. And it’s not my goal to replace my current job as a software developer with a job as a portfolio manager, you know? I have a good seed portfolio, and it’s time I start moving from stock selection to direct accumulation in stocks I already own.

Hence, we’re gonna be seeing a few changes:

1) My focus is going to be almost exclusively on dividend growth stocks. If it’s a tech/biotech/whatever growth stock, and it’s already not on my watchlist, I most likely will not consider it as an investment after today. I’ll analyze it, sure, but more out of curiosity than anything.

2) I am going to implement a new criterion – a hard limit on a dividend yield. I know, me of all people?! I never liked hard limits on yields for several reasons. Most of them are personal, not really worth going into. One concern was they fluctuate too much for me to make a judgment on them. Another one was that I wanted to get a good balance of low-yield-high-growth and high-yield-low-growth, and a dividend yield restriction didn’t really help out there as much as the Chowder number. But I’ve got a blend I am generally comfortable with, and honestly, it’s a bit too biased to the former for true comfort. By instituting a minimum yield requirement, I can shift my portfolio’s balance to a more even split. Of course, this doesn’t apply to my current watchlist, only to companies I have yet to analyze. And that criterion is … 2.25%. High enough to allow for faster compounding, low enough hat I’m not disregarding all that many solid faster-growth stocks.

So before these changes take effect, I want to look at one last chunk of growth stocks: the biotechs. There are three companies I’ve had my eye on, but none fall into the dividend growth category. But like I said, I have enough stocks on my watchlist. I only get to add one, if any. So let’s take a quick look at them, and see who’s the best!

The contenders are …

Celgene Corporation (CELG) – Spun off of Celanese Corp (CE) in 1986. Based in Summit, New Jersey, USA. Specializes in cancer and immune-inflammatory diseases. Main products include Thalomid (thalidomide) for erythema nodosum leprosum and Revlimid (lenalidomide) for multiple myeloma. (Link)

Biogen Inc (BIIB) – Formerly known as Biogen Idec. Created in 2003 as a merger of Geneva-based Biogen (founded by several Nobel Prize laureates) and San Diego-based IDEC Pharmaceuticals (founded by two respected biotech pioneers). Focuses on neurodegenerative and hematologic disorders. Company products include AVONEX, FAMPYRA, and TYSABRI for multiple sclerosis, as well as other drugs for leukemia and hemophilia. (Link)

Jazz Pharmaceuticals Plc (JAZZ) – Founded in 2005, IPOed in 2007. Focuses on varied orphan drugs. Released drugs include Xyrem (sodium oxybate) for narcolepsy and FazaClo (clozapine) for schizophrenia. (Link)

An investment of $10,000 in December 2000 for BIIB would be worth $63,574.62 today. This yields an annual rate of return of 13.8%. For CELG, the total value is $292,209.41 (an AROR of 26.6%). For JAZZ, which is a younger company, the same amount invested in June 2007 is worth $118,387.50 (37.1%). All three of these crushed the S&P 500 during this time frame. (Source: FAST Graphs)

Investment Criteria:

Since all three companies are growth stocks, we’ll use our growth stock screening criteria:

Celgene:

• I may only invest in companies in sub-sectors I understand: Iffy
• The company must have a ‘narrow’ or better economic moat, based on Morningstar’s judgment: Yes (Narrow)
• The company must have a quality rating of ‘B’ or better (‘A’ or better preferred), according to S&P’s credit ratings: Yes (B)
• Earnings must be on a consistent and significant uptrend: Yes
• FAST Graphs must show undervaluation based on the Normal P/E ratio (the blue line): Yes
• Expected return is 8% or more over the next few years, according to FAST Graphs: Yes (3,310.34%*)

Biogen:

• I may only invest in companies in sub-sectors I understand: Iffy
• The company must have a ‘narrow’ or better economic moat, based on Morningstar’s judgment: Yes (Wide)
• The company must have a quality rating of ‘B’ or better (‘A’ or better preferred), according to S&P’s credit ratings: Yes (B+)
• Earnings must be on a consistent and significant uptrend: Yes
• FAST Graphs must show undervaluation based on the Normal P/E ratio (the blue line): Yes
• Expected return is 8% or more over the next few years, according to FAST Graphs: Yes (447.86%*)

Jazz:

• I may only invest in companies in sub-sectors I understand: Iffy
• The company must have a ‘narrow’ or better economic moat, based on Morningstar’s judgment: Yes (Narrow)
• The company must have a quality rating of ‘B’ or better (‘A’ or better preferred), according to S&P’s credit ratings: Unknown (Not Rated)
• Earnings must be on a consistent and significant uptrend: Yes
• FAST Graphs must show undervaluation based on the Normal P/E ratio (the blue line): No
• Expected return is 8% or more over the next few years, according to FAST Graphs: Yes (207.82%*)

* Total return by 2020, if projecting the historical CAGR forward.

Well, this is easy. Since I can’t ballpark JAZZ’s quality ranking, and since it is overvalued, I will remove it from consideration right now. That leaves us with CELG and BIIB.

Other Bonus Ratings:

Celgene:

• S&P Capital IQ: 5-star Strong Buy
  • Scale is 1-5, 1 being ‘strong sell’, 5 being ‘strong buy’
• Thompson Reuters StockReport: 8 (optimized score of 5)
  • Scale is 1-10, 10 being best, 1 being worst
  • Optimized scores weight insider trading and price momentum heavier than other criteria
• Value Line: 2 for safety; 3 for timeliness
  • Scale is 1-5, 1 being best, 5 being worst
• Morningstar:
  • Economic moat: Narrow
  • Stewardship: Standard

Biogen:

• S&P Capital IQ: 4-star Buy
  • Scale is 1-5, 1 being ‘strong sell’, 5 being ‘strong buy’
• Thompson Reuters StockReport: 7 (optimized score of 6)
  • Scale is 1-10, 10 being best, 1 being worst
  • Optimized scores weight insider trading and price momentum heavier than other criteria
• Value Line: 3 for safety; 3 for timeliness
  • Scale is 1-5, 1 being best, 5 being worst
• Morningstar:
  • Economic moat: Wide
  • Stewardship: Standard

Financial Overview:

Shareholder wealth creation

Since neither CELG or BIIB pay a dividend, it’s clearly not worth analyzing that. Nor do they intend to, according to their annual reports.

• CELG: “We have never declared or paid any cash dividends on our common stock and have no present intention to pay a cash dividend on our common stock.”
• BIIB:  “[W]e historically have not paid cash dividends and do not have a current intention to pay cash dividends”.

What is a bit more important is share buybacks. It’s pretty well-known that for biotechs, an investor’s primary method of return is capital appreciation. And something else that’s a bit tricky is that growth-stage biotechs usually raise capital by issuing shares. Now I don’t like dilution. I’m greedy; I want the same or more share of a company’s earnings over time. Thankfully, profitable biotechs don’t really need dilution to fund drug development, and as a result, can be expected to gobble up shares. So let’s see how they do

• CELG: 909.77 million in July 2008, 800.59 million at the end of February 2015
• BIIB: 290.25 million in July 2008, 235.23 million as of April 2015

I used the same general timeframe for both for ease of comparison. CELG decreased their shares outstanding by 12.00% over the past 7 years, meaning shares decreased by 1.71% annually. BIIB has decreased their shares outstanding by 18.95% during this time frame, which translates to a 2.71% decrease annually. BIIB clearly has eaten more shares since 2008. However, we have data back to 2005, which says that BIIB had 338.34 million shares outstanding. Using this number, we get a total decrease of 30.48%, translating to an annual 3.05% decrease, a very solid number. These numbers even account for the 2014 2:1 split CELG had. BIIB hasn’t split since 2000. Winner: BIIB

Debt and interest coverage

• CELG: Total debt/equity ratio of 1.053. Has been steadily increasing from 0.2 in 2010, which is discouraging. Total long term debt of $6.265 billion is high, especially when compared to shareholder’s equity of $6.524 billion. However, the interest coverage ratio of 14.22 is healthy. Quarterly free cash flows of $779.40 million are also healthy, and cover the annual interest expense of $176.1 million easily. Cash and cash equivalents sit at $7.546 billion which also easily takes care of debt.
• BIIB: Total debt/equity ratio of 0.05. Decreased steadily from ratio of 0.191 in 2008. Total long term debt of $582.06 million compares favorably to $10.8 billion in shareholder’s equity. Quarterly free cash flow is $635.21 million, which tells me that the company could easily be debt-free in one single quarter. Company also has $1.845 billion in cash and cash equivalents, so even if FCF turns negative for a few quarters, like what happened in mid-2013, the debt is well taken care of.

Although CELG has higher cash flow and more liquid cash on its books, I really like how BIIB is very close to debt-free. I value that financial security in market downturns or if earnings plummet. Close call overall. Winner: BIIB

Earnings growth and margins

• CELG:
  • P/E ratio: 47.4
  • One year forward P/E ratio: 17.8
  • Gross margin: 94.97%
  • Operating margin: 32.79%
  • Net profit margin: 26.07%
  • Return on assets: 13.02%
  • Return on equity: 33.02%
• BIIB:
  • P/E ratio: 27.0
  • One year forward P/E ratio: 23.1
  • Gross margin: 88.11%
  • Operating margin: 43.63%
  • Net profit margin: 32.49%
  • Return on assets: 23.97%
  • Return on equity: 31.51%

Close call once again. CELG has a higher chance of earnings growth, a higher gross margin, and a higher return on equity. BIIB has higher operating margins, profit margins, and return on assets. Plues, judging solely by current P/E ratio, BIIB is cheaper. Since BIIB’s margins are better, I vote for it. Winner: BIIB.

Pipeline

I’m not going to lie. This is a tougher section for me. I would advise you to do your own research. Thankfully, I have a few people in my personal network with medical and science backgrounds who can advise me on the basics of stuff like this. However, I am not a doctor, just your everyday code monkey. So rather than give you incorrect information, I’m deferring to the professionals to explain it for you. So like I said, read my links, read the excellent contributors on SeekingAlpha, and do your own research.

• CELG pipeline listing
• BIIB pipeline listing
• Analysis for CELG: (1), (2), (Morningstar)
• Analysis for BIIB: (1), (2), (3), (4), (Morningstar)

Future projections

I don’t really find much use for projecting total returns forward. I usually only care about dividend income. Even in situations where I’d rely on share price appreciation – like this – I don’t find it all that useful. Hence, I won’t be calculating it anymore. It’s even worse with biotech, since earnings are more of a crapshoot. It’s harder to project earnings out more than one year. So what’s the point in projecting the historical compound annual growth rate 5 years out if the numbers aren’t guaranteed to be right anyway?

Risk Factors:

These are more for biotech in general, but worth noting:

• Few biotechs pay dividends. Even if you are wrong with purchase points on most dividend growth stocks, the dividend help soften the blow. Without dividends, it gets that much more important to be sure you’re entering at a low valuation, or are purchasing small chunks of stock consistently to average out your purchase price.
• Clinical trials are expensive, long, and can fail. If one fails, that means a lot of money was wasted. So if no products in the pipeline make it to approval, both CELG and BIIB will really be up shit’s creek.
• Biotech is just generally risky. Investors seem to love biotech right now, but if that changes, a crash could happen. You need to really believe in your positions to want to add to them on declines, instead of just following the herd.
• Competition from generic drug makers
• Pricing pushback from governments and insurers

Final Conclusion:

Both stocks meet my criteria, and therefore both are a buy. It basically comes down to what you are looking for. CELG offers higher growth, but higher risk. It also appears cheaper via FAST Graphs, but more expensive via your standard P/E ratio. BIIB is close to debt-free, gobbles up more shares, and has higher margins. While I feel it will grow less than CELG, I feel that management are good stewards of capital, and they are being conservative while still growing profits. Plus, 65% of CELG’s sales are from one drug, Revlimid, while BIIB has four major drugs to drive profits. I prefer Biogen, and will add it to my watchlist for further monitoring.

There’s just one thing that keeps me from adding it to my portfolio immediately. While reading more on the drug pipelines, I came across this quote by a SeekingAlpha contributor, DoctoRx: “Biotech investing is for people who know what they’re doing”. With a company like BIIB, you need to be damn careful you aren’t just buying the stock because LOL why not. Although I like to think I have an understanding of biotechs and how they operate, my knowledge of the pipeline is not amazing. While this hasn’t stopped me from investing in companies like Johnson & Johnson (JNJ), Gilead (GILD), and Baxter (BAX), I feel a bit more research on my end is necessary. Once I feel really comfortable understanding what BIIB’s pipeline really means, I’ll initiate a position. Until them, I”ll keep reading and watching.

What do you think of my choice to add a dividend yield cutoff criteria?  Do you use one? Would you ever invest in BIIB?

Disclosure: Long BAX, GILD, JNJ

All data is accurate as of market close, 04/27/2015. My stock analysis archive page has been updated accordingly. Please read my disclaimer here before choosing to invest. Company logos are property of their respective companies. Data source is FAST Graphs, Scottrade Research, or company materials, unless otherwise indicated.

Tags: BIIB, Biogen Idec Inc, Biogen Inc, biotech, CELG, Celgene Corp, growth-stock-analysis, investment-philosophy, JAZZ, Jazz Pharmaceuticals PLC