In the early and late stages of product development, the upside for a biotechnology company can be figured quite easily. The upside is based on the amount of sales that are possible relative to the company's market capitalization. In determining the amount of upside that exists, using sales compared to valuation is an overlooked tool that makes figuring upside quite easy.
Why Are Sales So Important?
Once a company gets into the stages of marketing its product and is producing sales, the most important valuing metrics might change, as margins can then be identified. But until then, we have absolutely no way of knowing what margins will be created from a product while it is in Phase 2 or 3 development.
Sure, a company can guide and estimate, but there is really no way to know with any levels of certainty. This fact is the primary reason that Dendreon (DNDN) had a market capitalization over $6 billion in 2011. Yet, once the market realized the manufacturing woes associated with the drug, its valuation quickly responded and was no longer valued on sales potential alone. Until that time comes, the only metric we have is peak sales potential.
Then, we have mountains of clinical data and it becomes our responsibility to sort through the information and determine a product's likelihood of success, and its upside relative to sales. Thus, I am looking at three different examples: Overvalued, Fairly Valued, and Undervalued as it compares to sales alone. I will show how valuation in the clinical setting leaves either massive room for gains, limited room to trade higher, or in some cases, is completely priced into the valuation, and why this information is important to you as a retail investor.
Overvaluation At Its Worst
To me, Osiris Therapeutics (OSIR) has completely priced in all of the upside potential for its lead candidate, Prochymal, but is yet to see any revenue from sales.
The company operates in two segments: Biosurgery and Therapeutics. The Biosurgery segment consists of the products Grafix and Ovation. Its Therapeutics segment consists of Prochymal, the first ever approved cell therapy product with stem cells as the main component. It is approved in Canada and in New Zealand for the treatment of graft-vs-host disease (GvHD) in children.
The company's Biosurgery segment is expected to generate close to $15 million this year, and the success of Prochymal is yet to be determined. However, it is Prochymal that is responsible for the company's market capitalization of $334 million; its stock has doubled since before Prochymal's Canadian approval. As it stands now, Osiris Therapeutics trades with a price/2013's sales of 22, which is far greater than that of Orphan companies Alexion Pharmaceuticals or Regeneron Pharmaceuticals.
The reason is because Osiris management has in some way sold the idea of immense potential for Prochymal. The drug treats a rare disease, one that affects about one in every 100,000 people. Combined, New Zealand and Canada have about 37 million people, meaning that GvHD might be found in 400 people. Then, once you narrow down this population even smaller to only children and those unresponsive to steroids, Prochymal has a targeted population of a few dozen patients.
Prochymal has been designated by the FDA as both an Orphan Drug and a Fast Track product. Hence, while it may be approved, a peak patient population of only a few hundred patients is still relatively small. So far, Prochymal hasn't produced any sales in either New Zealand or Canada, and strangely, peak sales potential cannot be found anywhere. However, it doesn't take much to crunch the numbers and to see that the drug's upside is very limited, as of now.
According to recent studies, GvHD in children is about 20%, which gives Osiris a tough task in finding patients to treat. In addition, Prochymal is only used on those patients who don't respond to steroids, making its share much less than 20% of total GvHD cases. At $10,000 per treatment cycle, I find the math very difficult to figure how the company could create substantial sales. In fact, I see no scenario where peak sales, under the best of circumstances, could exceed $50 million annually.
Osiris bulls might say that the upside lies in Prochymal's ability to treat Crohn's disease, diabetes, and other illnesses. But let's not forget that this is a 20-year-old company, whose track record and prior studies have been unfavorable to say the least. With that said, I am not necessarily saying that Osiris is a horrible company, but rather that all upside is priced into its stock. With a $334 million market cap - if we assume peak global sales of $50 million - then Osiris is trading at more than 6.5 times peak sales of Prochymal. This is simply way too expensive!
Fair Value With A Rising Stock Price
There are a lot of examples that I could use for fair value in the biotechnology space, as more times than not, the market values companies correctly. But for the sake of this topic, I think ACADIA Pharmaceuticals (ACAD) is an interesting selection.
You might look at ACADIA Pharmaceuticals' one-year 900% return and assume that it is now expensive. Because after all, Osiris has traded flat over the last year and the company is still overvalued. However, this is the point where price performance is really irrelevant, as it tells you nothing about potential and valuation.
ACADIA Pharmaceuticals has posted a 900% gain for three reasons:
1) Very few expected Pimavanserin at 40mg to emerge as the leader in the antipsychotic pipeline.
2) Prior to data in November 2012, the company's valuation was not accounting for Pimavanserin's potential success.
3) The peak sales estimate has consistently been modified higher with new data.
In my opinion, Pimavanserin will see an accelerated approval and will be FDA approved sometime next year, following the FDA's decision that Pimavanserin does not need Phase 3 testing. The drug will treat Parkinson's disease psychosis (PDP), an indication with no other FDA approved drug. In the past, other drugs have treated this disease off-label; but with Pimavanserin showing excellent results, it will control the market, and many believe it will also steal much of the off-label antipsychotic market.
Prior to Phase 2 data, ACADIA traded with a market cap of just $160 million. This represented a price/peak sales of just 0.50 for this particular indication. Pimavanserin is also being tested to treat schizophrenia and Alzheimer's disease psychosis (ADP). Over the last several months, analysts have adjusted their sales targets, saying that because of its success in treating PDP, physicians might view Pimavanserin as the best option for these other two indications as well. Thus, peak sales potential has abruptly risen from $300 million, to $1 billion, and now sits at $2 billion annually.
For a thorough explanation of its rising sales target, click here
Now that Pimavanserin's peak sales estimate has risen from $300 million to $2 billion you might see why the stock has rallied. Back in November, it traded at 0.50 times peak sales, but now with a $1.4 billion market capitalization it trades at 0.7 times peak sales. For a company whose outlook and future has drastically changed, a 0.7 times peak sales premium is quite attractive.
With all things considered, ACADIA is now priced at a level to where its valuation can rise with fundamental gains. Far too often, biotech stocks price all their upside prior to a drug launch, and investors are then left disappointed. This is not the case with ACADIA. It is one of the few stocks that has appreciated with developments, and is priced appropriately (borderline cheap) prior to its launch.
A Cheap Company and Sales Potential Explained
There are a number of reasons that a company might trade at a deep discount to its potential sales. Perhaps, the stock is deeply diluted or the company is relatively unknown. Maybe it is the most logical reason of all: Investors don't expect its lead product to succeed.
Let's look at NeoStem (NBS). This is a $110 million company with three catalysts:
1) The development of very-small embryonic-like cells (VSELs) with several of the most prestigious universities and The Vatican. If successful, this would lead to the development of therapies to treat diseases where there are no options.
2) The company's PCT cell manufacturing business is growing fast. In the last 12 months, the company posted revenue of $13 million, growing 99% year-over-year. The company has signed three new clients in the first six months of 2013.
3) The Phase 2 development of AMR-001 to prevent deterioration of the heart following an acute myocardial infarction.
To explain value relative to sales, let's just look at #3, the development of AMR-001. Most expect data within the year, and hope that recent history of nothing but positive news from AMR-001 continues.
A couple of weeks ago, Aegis Capital upgraded shares of the company to "Buy" saying that a successful study could lead to a partnership with Baxter. The two companies have very similar late-stage cell therapy products that treat cardiovascular diseases, and NeoStem's PCT division manufactures Baxter's product.
According to the company, AMR-001 has peak sales potential of $1.2 billion, which means that NeoStem is trading at 0.09 times peak sales. According to analyst Vernon Bernardino, none of AMR-001's upside is being priced into the stock. Bernardino said he believes investors are in a "wait and see" mode, and that NeoStem's current valuation reflects the growth and fundamentals of its PCT segment.
Therefore, NeoStem definitely fits into my category as being undervalued. The company has already shown reasons to believe the product will be a success. Those reasons include finding a threshold dose and no patient experiencing a deterioration of heart muscle function when treated with the threshold dose, which is the primary goal.
At 0.09 times peak sales, if data is good, a 0.5 times peak sales valuation shouldn't be unrealistic for a blockbuster product. This would represent Aegis' price target, and with expectations low, it does appear that risks are valued into the stock. Therefore, NeoStem is the quintessential high value stock, but value in biotechnology is only present if data leads to an FDA approval. Hence, while its valuation might suggest high upside relative to sales, the company still must produce the clinical results in order to see its value appreciate; much like ACADIA last year.
Using Peak Sales With Your Investment Outlook
When you invest in the biotechnology space, you have to ask yourself three questions: 1) What is the main product's (that's responsible for the valuation) likelihood of success? 2) What is the peak sales potential of that product? 3) How much upside exists at a stock's current valuation?
According to data from NYU, as of January 2013, the drug industry itself traded with a price/sales ratio of 3.0. This shows the "average" for large and established companies, and is the standard for fair value. This fact is important in assessing risk vs reward in the clinical space, and is the first step in answering the three questions above as it relates to upside potential and sales.
If the "standard" is 3.0 times peak sales, then you don't want to invest in a company that already trades above that range. The reason is because upside would be limited yet the risks associated with an FDA approval and clinical data still exist. Hence, a company such as Osiris Therapeutics, which still must earn an FDA approval, lacks the upside needed to make an investment beneficial.
A company such as ACADIA trading at 0.7 times peak sales is attractive for the mere fact that significant upside still exists, which might outweigh the possibility that its lead product does not earn an FDA approval. In theory, a biotechnology stock that is more expensive compared to peak sales while in the clinical stage has a greater shot at approval. But in the case of ACADIA (and other under and fairly valued stocks), its upside is also tied to the fact that its expectations were so low in November 2012, when its company changing data was released. Hence, investors are still rushing to buy, which means that its investment outlook remains strong, with significant upside still present.
Lastly, if you take a glance through the biotechnology space, you might find that many stocks fall in the undervalued category. The problem is that not many will go on to earn an FDA approval. Therefore, despite this "undervalued" space, trading below 0.5 times sales -- and has great upside -- that upside also comes with a price of potentially losing most of your investment. Personally, I chose NeoStem, because it does fit into the category and I like its chances of success due to early data and the exceptional results that have been produced from Baxter's Phase 3 cell therapy product. However, in this space, your assessment of clinical data must be superb, as not many that are "truly" undervalued exist; those that will eventually earn an FDA approval.
So, as you sort through a space that is full of opinions, always be sure to look at upside potential relative to sales, and to not spend too much time looking at the stock's past performance. To many, this is hard, as it requires changing an investment behavior from "what has the stock done" to "what could the stock do".
Above, I have given you three different examples of stocks that I believe fit into each category. These are stocks that have been valued according to expectations, with both the under and overvalued sections showing stocks that are valued incorrectly. In the case of ACADIA Pharmaceuticals, investors who buy now have the luxury of enjoying gains from a stock that should grow with fundamentals; assuming peak sales are reached.
While this article alone does not answer all of the biotech questions regarding outcomes of clinical data, the information herein should be used as a tool for you to utilize. It is a valuation tool, a tool that should allow you to determine upside "if" a product is successful and earns an FDA approval. In short, it is an overlooked metric -- one that is rarely discussed -- but one that should be considered, measured, and utilized as you seek investments in this particular space.