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Investors who sold Affymetrix (NASDAQ:AFFX) after the earnings miss last week are missing something themselves: this Life Sciences biotech company is turning around. In 2013 AFFX more than doubled year-over-year its return on capital adjusted for research and development costs.

This article is not a comprehensive analysis of AFFX. That would include a detailed look at what it does, its assets, and its pipeline of products. The purpose of this article is to show that taking the financial analysis a few steps beyond earnings could help an investor avoid selling for the wrong reason.

In a paper discussing returns on capital and equity, Aswath Damodaran argues that research and development costs should be capitalized when analyzing returns for biotech companies. Just as a manufacturer of autos or aircraft relies heavily on amortizable, hard assets for its profits, the eventual profits of a biotech company are largely dependent on R&D as an asset, and this asset should be amortizable over a period of about 10 years. I will admit upfront that I do not know if this 10-year period should be applicable in the Life Sciences Industry, but this article makes that assumption.

For illustrative purposes, I first present the effect of capitalizing R&D on returns of two biotech paragons: Regeneron (NASDAQ:REGN) and Pharmacyclics (NASDAQ:PCYC). Both had large, negative returns on assets, equity and capital in 2011. However, both had large gains in market cap, and gained even more in the following two years. In the first three rows of the two tables below are the ROA, ROE, and ROIC by GAAP for REGN and PCYC (data source: morningstar.com). In the fourth rows are my computations of ROC adjusted for R&D as an amortizable capital expense using the method of Damodaran. In the fifth rows are the gains in market cap for each calendar year:

REGN

2011

2012

TTM (Sep13)

ROA

-11%

44%

37%

ROE

-44%

87%

64%

ROC

-30%

55%

44%

ROC adjusted for R&D

11%

27%

30%

Market Cap Gain

69%

203%

64%

PCYC

2011

2012

TTM (Sep13)

ROA

-36%

7%

49%

ROE

-42%

10%

66%

ROC

-42%

10%

66%

ROC adjusted for R&D

-2%

21%

35%

Market Cap Gain

143%

285%

88%

In 2011, ROC adjusted for R&D was 11% for REGN and -2% for PCYC, while ROC by GAAP was still hugely negative for both. This did not keep investors away, and in 2012 share prices surged as all negative return metrics turned positive.

I applied the Damodaran analysis to AFFX, and included in the table below the inputs for the R&D-adjusted ROE and ROC analysis over the past 5 years. R&D-adjusted returns are above zero. In contrast, GAAP returns have remained negative for six consecutive years as you can see at morningstar.com. In the figure that follows, R&D-adjusted ROE and ROC are plotted. I find the results for AFFX to be encouraging. Besides that, I like what AFFX does, and I like that it still sells for less than twice its book value, a rare finding in biotech. I am not trying to say AFFX is a biotech paragon like REGN or PCYC, but AFFX is recovering, and its returns are evidence.

AFFX ($M)

2009

2010

2011

2012

2013

Operating Earnings

$(33)

$(5.2)

$(17)

$(39)

$(12.6)

R&D Expense for current year

$77

$68

$64

$58

$48

R&D Assets Amortized

$8

$7

$6

$6

$4.8

Adjusted Pre-tax Operating Earnings

$37

$56

$41

$13

$30

Effective Tax Rate

0.0%

0.0%

0.0%

0.0%

0%

R&D-adjusted NOPAT

$37

$56

$41

$13

$30

Total 10-yr unamortized R&D (asset)

$422

$416

$406

$390

$365

Stockholder equity (book)

$298

$294

$275

$277

$258

Long-term Debt

$247

$95

$95

$166

$156

Capital

$545

$389

$370

$443

$414

ROE adjusted for R&D

5.1%

7.9%

6.0%

1.9%

4.9%

ROC adjusted for R&D

3.8%

6.9%

5.2%

1.6%

3.9%

Source: Be Glad You Didn't Sell Affymetrix's Earnings Miss. Its Returns Are Evidence Of Its Recovery