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Summary

  • Valuations on profitless biotechs are difficult. One method puts R&D expenses back with operating profits in the numerator of ROC, and capitalizes them as an asset included in the denominator.
  • Amgen, Gilead and Pharmacyclics returns using R&D-adjusted ROE and ROC are presented along with ROIC data from New Constructs and from Morningstar.
  • Investors in a biotech with reliable returns on capital that exceed its cost, or that are rising rapidly, can ride out negative volatility with more confidence than speculators can.

In this article I make a case for placing valuations on biotech stocks, even profitless ones. I recommend investing in profitless biotechs only if revenue is increasing. Furthermore, I recommend investing in profitless biotechs only if returns on capital exceed its cost - with a possible adjustment - or if ROC is rapidly growing towards value creation.

Aswath Damodaran of Stern School of Business at NYU wrote a paper in 2007 that I consider important. Paraphrased, he teaches that R&D for a tech or biotech company should be amortizable just like PP&E is for an industrial. Damodaran in his article points out that the effects of capitalizing R&D "will vary from firm to firm, generally pushing down unreasonably high returns and pushing up sub-standard returns" at smaller but rapidly growing, research-intensive firms.

The following figures show trends in ROC adjusted for R&D expenses using Damodaran's method for biotech - he used Amgen for an example and so will I. This method of judging company performance will then be applied to two other profitable biotechs. ROIC data from Morningstar and from New Constructs are also provided. The ROC metric like ROIC is based on net operating profit after tax or NOPAT (the numerator). The denominator for ROC is capital which may be different than invested capital used in calculating ROIC. For R&D-adjusted ROC, capital is long-term debt + shareholder equity on the balance sheet (not market cap) + the unamortized R&D asset at the end of the preceding fiscal year.

If ROIC is greater than the approximately 10% weighted average cost of capital, value is created. The same should be true for R&D-adjusted ROC assuming the cost of capital for the R&D is about the same as WACC.

Amgen (NASDAQ:AMGN). R&D-adjusted NOPAT in the 6th row of the following table is computed from the items in preceding rows as: operating earnings x (1-tax rate) + R&D expense for the current year - sum of the amortization in the current year for prior year R&D expenses.

To capital (long-term debt + stockholder equity) is added the R&D asset on row 7, all derived from financial statements at the end of the prior year. Thus ROC = NOPAT/Capital with current R&D expense added to the numerator, and total 10-year unamortized R&D added as an asset to the denominator; the 10% of the R&D asset amortized in current year is subtracted from numerator.

AMGN

2009

2010

2011

2012

2013

Operating Earnings

$5,506

$5,545

$4,312

$5,577

$5,867

R&D Expense for current year

$2,864

$2,894

$3,167

$3,296

$3,929

R&D Assets Amortized current yr

$1,931

$2,135

$2,340

$2,570

$2,788

Adjusted Pre-tax Operating Earnings

$6,439

$6,304

$5,139

$6,303

$7,008

Effective Tax Rate

11.5%

13.0%

11.3%

13.3%

3.5%

R&D-adjusted NOPAT

$5,806

$5,583

$4,652

$5,561

$6,803

Total 10-yr unamortized R&D (asset)

$14,217

$14,976

$15,803

$16,529

$17,670

Stockholder equity (book)

$22,667

$23,944

$19,029

$19,060

$22,096

Long-term Debt

$10,601

$10,874

$21,344

$24,034

$29,623

Capital R&D-adjusted PRIOR YEAR

$32,267

$47,485

$49,794

$56,176

$59,623

ROE adjusted for R&D

15.7%

14.3%

12.0%

16.0%

19.1%

ROC adjusted for R&D

18.0%

11.8%

9.3%

9.9%

11.4%

ROIC unadjusted (Morningstar)

12.8%

11.6%

8.1%

8.0%

10.2%

ROIC (New Constructs)

16.0%

16.3%

15.8%

17.7%

16.2%

For AMGN R&D-adjusted ROC and ROE are shown in green and red,respectively; ROIC from Morningstar in blue; ROIC from New Constructs in orange:

Beginning in 2011 AMGN levered up its ROE with more debt (6th row from bottom of the table and in red $ on the figure). ROC adjusted for R&D and Morningstar ROIC both declined from 2009 to 2012 then trended upward in 2013. ROIC as computed by David Trainer (New Constructs) remained fairly constant between 15.8% and 17.7% for those years.

Gilead (NASDAQ:GILD) results are next. Again as recommended by Damodaran, returns on capital for one year are based on capital available at the end of the prior year.

GILD
2009
2010
2011
2012
2013
Operating Earnings
$3,529
$3,962
$3,790
$4,010
$4,524
R&D Expense for current year
$940
$1,073
$1,229
$1,760
$2,120
R&D Assets Amortized current yr
$292
$375
$469
$574
$736
Adjusted Pre-tax Operating Earnings
$4,177
$4,660
$4,550
$5,196
$5,908
Effective Tax Rate
25.0%
26.2%
23.6%
28.8%
27.35%
R&D-adjusted NOPAT
$3,294
$3,623
$3,655
$4,043
$4,670
Total 10-yr unamortized R&D (asset)
$2,765
$3,462
$4,222
$5,408
$6,792
Stockholder equity (book)
$6,367
$5,864
$6,739
$9,310
$11,369
Long-term Debt
$1,243
$2,946
$7,606
$7,055
$3,939
Capital R&D-adjusted PRIOR YEAR
$7,591
$10,375
$12,272
$18,567
$21,773
ROE adjusted for R&D
52.5%
39.7%
39.2%
36.9%
31.7%
ROC adjusted for R&D
43.4%
34.9%
29.8%
21.8%
21.5%
ROIC (Morningstar)
39.4%
33.1%
22.2%
14.7%
16.1%
ROIC (New Constructs)
42.1%
43.8%
37.0%
17.2%
17.4%

Even though GILD has grown revenue and earnings substantially for 5 consecutive years, the effect of rising capital (5th row from bottom row of the preceding table) has progressively depressed R&D-adjusted ROC and ROIC (Morningstar and New Constructs). In contrast, ROE was levered up by increasing the amount of debt shown by the $ figures in red.

High but, for most recent years, declining returns on capital makes GILD's future growth all the more important to investors. And its projected growth is high. This figure from F.A.S.T. Graphs is reassuring in that regard.

(click to enlarge)

Amgen's projected growth through 2015 is not as high.

Pharmacyclics (NASDAQ:PCYC) had through 2013 the highest 5-year stock price appreciation of any biotech of which I am aware, so I was interested in returns on this stock. For brevity and simplicity in reporting (see note below) I omit the table. Here is the chart. ROE is the same as ROC since PCYC carries no long-term debt.

PCYC returns have been steadily rising. ROIC just cleared cost of capital in 2012, but clearly added economic value for shareholders in 2013. While the rate of rise in R&D-adjusted ROC has been weighed down by its book capital which more than doubled between 2009 and 2013 (that's not the same as market capital which went up 240-fold), it approached 44% in 2013 (note: the data for PCYC are as of June 30 for years 2009 through 2012, then December 31 for 2013 after a change in reporting date; yearly income from operations was actually much higher for 2012 as of December 31 than as reported June 30, the data for which was used in the above computations).

Discussion. Most biotech investors are seeking rapid growth, some of us also seek value. David Trainer has argued that the distinction between growth and value is made irrelevant by correct valuations. He shows that P/E ratio is driven by ROIC and earnings growth forecasts in the following lookup chart:

Amgen. R&D-adjusted ROC data were not very different than ROIC data from Morningstar after fiscal year 2009, and were flat at about 10-12%. David Trainer adjusts NOPAT and invested capital based on line-by-line analysis of financial statements and shows ROIC nearly constant at about 16% for fiscal years 2009-2013. According to his lookup chart, a 16% ROIC and analysts' estimate of 7% earnings growth for 2014 would support a market average P/E of about 16. Adjusting ROC for R&D boosts AMGN's 2013 return by about 4%. However, unless you are confident that the drugs emerging from the AMGN pipeline will lead to higher earnings and returns, AMGN could be a value trap rather than the value stock many of us believe it to be.

Gilead returns on capital declined substantially between 2009-10 and 2012, then stabilized at about 15-17%. Earnings growth has been estimated at >100% for 2014. Even if we reduce that earnings estimate to 35%, GILD could still be awarded a triple-digit P/E on David Trainer's lookup chart. GILD has been a great creator of economic value for its shareholders, and will probably create a whole lot more, but as we have recently learned, politics and patent litigation do pose a threat.

Pharmacyclics ROIC trends and 2013 R&D-adjusted ROC are spectacular, but if analysts' negative EPS growth estimates for this year are correct, PCYC will not add economic value in 2014. Negative projected earnings puts PCYC off the top (negative direction) of David Trainer's lookup chart for P/E. On the other hand, if EPS growth is positive, PCYC will be off his chart in the winning direction. This shows what a potentially lucrative but risky business biotech investing is.

This article was not intended to provide a comprehensive analysis of any of the three companies presented. It was intended to extend Damodaran's use of R&D-adjusted ROC for biotechs to three well-known biotechs currently at various stages of maturity. PCYC, much smaller than the other two biotechs, had returns which were consistently boosted after adjusting for R&D. This is in accordance with Damodaran's predictions. In contrast, for large cap AMGN and GILD, R&D-adjustment had a less pronounced and less consistent effect on returns.

These return metrics surprised me. They make one of my value stocks look like its on the verge of being a value trap were it not for its strong pipeline. It depicts another as a strong creator of value but, were it not for its new miracle drugs, past its prime. For the third company, analysts' earnings estimates for this year and R&D-adjusted ROC gives me the mental picture of a shooting star that could fall back to earth - but this metaphor could be very wrong: over the past 5 years, PCYC has had the strongest and most consistent growth in ROIC and ROC.

Recommendation. Invest in a biotech with:

  1. Revenues that are increasing mostly from payments on its pipeline or platform, but also from sales of a product on the market.
  2. Market cap/revenue (or P/S) ratio <20.
  3. Returns on capital reliably > the 10% cost of capital, or rapidly heading in that direction. And don't use ROE as the primary valuation metric unless you consider debt a good way to create value.

Do the arithmetic. Drug pipeline should be an important but not the sole consideration in a biotech investment decision. Valuations are important to the decision as well. Biotech investors who speculate about how much their biotech pick's pipeline will grow profits, but who do not critically look at the track record of economic value creation can wake up to find their beloved pipeline was a pipedream. Finally, compare notes with value-oriented analysts like those at EVA Dimensions and Morningstar, or like David Trainer who explains on the New Constructs blog how to adjust financial statements for accounting distortions.

Source: Retail Investors Should Be Doing Valuations On Their Biotechs - The Market Is