Betting on Biotech: The Mispriced and Fiscally Fit

When AtheroGenics  declared bankruptcy earlier this month--an event that Morningstar analyst Bill Buhr saw coming  last November--investors were reminded that the business of developing new drugs is fraught with uncertainty. According to the Tufts Center for the Study of Drug Development analysis, it costs $1.2 billion to bring a biologic drug to the market--factoring in the cost of failures along the way and the time value of the money poured into R&D. Management teams are often forced to make a big bet on the future of a single drug candidate, and if trials don't go as planned, the firm's investment in research and development becomes virtually worthless. These costs are looking even more onerous for some cash-strapped biotechs today, with liquidity proving difficult to come by and uncertainty riding high in the broader stock market.

Biotechs: Tough Under Pressure
Until recently, biotechs as a group had been holding their own in the broader market storm. The Amex Biotechnology Index, or BTK, was roughly flat for the year through Sept. 30, a remarkable achievement considering the challenges that most corners of the market have seen over the past few months--challenges that brought the S&P 500 Index down about 19% through this same period. However, for the first nine days of October, fear appeared to be more equally distributed, with the BTK down 18% for the S&P 500's 22% drop.

Despite the recent wide-sweeping draw-downs of the overall market, we think this year-to-date performance shows that Mr. Market has a good intuition about biotechs. These stocks aren't vulnerable to the same macroeconomic factors that drive so many others. While an extended recession would no doubt have an impact on the sales of some drugs, as patients may struggle to afford copays and may choose to visit doctors less regularly, the biotech industry is not dependent on market gyrations at its core. Mortgage defaults have no bearing on the success or failure of a Phase III cancer drug.

Why Some Plummeting Share Prices Make Sense
But by all accounts, this is no ordinary recession. Equity and debt markets aren't operating efficiently, and management teams at any biotech companies that have yet to turn a profit are most likely counting their pennies in an effort to avoid any attempt at tapping either market--which would no doubt come at a steep price to current shareholders. We've adjusted the uncertainty ratings to Extreme for several drug companies with limited access to cash, expensive R&D efforts, or worrisome debt balances. To see an updated list of these stocks,  click here.

For biotechs with promising technologies but shrinking cash balances--such as  Exelixis (EXEL)--we think that prices can only swing so low. Large pharma firms could become even more hungry to acquire the pipelines of such biotechs, as the fact that most of these behemoths are flush with cash gives them that much more leverage in negotiations. And acquisitions are clearly still an option. On one of the worst days in recent stock market history,  Eli Lilly (LLY) announced a $6.5 billion acquisition of  Imclone --not dependent on financing.

...and Why These Firms Stand Out as Favorites
In addition to industry leaders  Amgen (AMGN) and  Biogen Idec (BIIB)--which we highlighted as two of our favorite health-care stocks in a recent Stock Strategist article--we think these four biotechs have been unfairly hit by market weakness. Their financial health, promising product portfolios, and innovative technologies make them very attractive at current prices.

 BioMarin Pharmaceutical  (BMRN)
Moat Rating: Narrow | Fair Value Uncertainty Rating: High | Morningstar Rating: 4 Stars
Rare-disease expert BioMarin sells three life-saving drugs via its own global salesforce and a partnership with  Genzyme . Due to the severity of the diseases it treats and the small number of affected patients globally, BioMarin is able to charge steep prices. BioMarin crept out of the red this year, and we think that this the firm could achieve operating margins north of 30% within the next several years. The steady nature of growth from rare-disease drug sales should continue to benefit BioMarin for the foreseeable future, and we expect 23% average annual revenue growth for the next 10 years. Its biologics are also difficult to manufacture and could be among the least likely to be plagued by competition after their patents expire, even if follow-on biologic legislation is passed. With $576 million in cash at the end of the second quarter--and $500 million in low-interest, convertible debt (which does not start to come due until 2013), we think that the firm is on solid financial footing.

 Novo Nordisk (NVO)
Moat Rating: Wide | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 5 Stars
Wide-moat Novo Nordisk is the world's premier diabetes drugmaker, with a 52% share of the global insulin market. Novo's operating margins exceed 20%, and it has more than $1 billion in cash with almost no debt. Insulin purchases are nondiscretionary, because failing to control blood sugar levels can lead to serious long-term complications like kidney and cardiovascular disease. Novo's stock has traded down on concerns that its lead pipeline drug--in the same class as Amylin's Byetta--could cause pancreatitis, although there has been no evidence that this is the case. In our opinion, Novo is well positioned to weather almost any economic head wind, and it may even benefit from the recent strength in the U.S. dollar.

 Alnylam Pharmaceuticals  (ALNY)
Moat Rating: None | Fair Value Uncertainty Rating: Very High | Morningstar Rating: 4 Stars
Alnylam's internal pipeline is at the earliest stage of all of the companies that we are profiling in this article--with no marketed products and its more advanced product candidate in Phase II of clinical testing, it will be years before Alnylam turns a steady profit from its drugs. However, the firm's innovative, RNA-based technology has proved to be a strong source of funding, as large pharmaceutical partners who want access to the firm's patented technology have pushed Alnylam's cash balance to $538 million as of the end of the second quarter. With no debt and the potential for more revenue from current and new partnerships in the future, we think that Alnylam has been mispriced by Mr. Market.

 Amylin Pharmaceuticals 
Moat Rating: None | Fair Value Uncertainty Rating: High | Morningstar Rating: 5 Stars
Concerns over the potential side effects of Amylin's lead diabetes drug, Byetta, sent this stock plummeting in August, and the broader market's fall has only served to make the firm even more undervalued, in our opinion. We think that pancreatitis concerns are overblown and that Amylin's lead drug candidate, Exenatide LAR--a long-acting version of Byetta--has the safety, convenience, and efficacy to become a billion-dollar drug if it enters the market on schedule by 2010. While Amylin has $900 million in debt, the vast majority of this balance is convertible debt that is not due until 2014, and Amylin's second-quarter cash balance of $891 million should be sufficient to carry the firm through additional trials and the launch of LAR. We think that 2008 will mark Amylin's biggest year of cash burn and that investors are underestimating the progress that Amylin is making with LAR and its obesity-focused pipeline.

Morningstar analyst Matthew Coffina contributed to this article.