Seeking Alpha
Special situations, growth at reasonable price, value, micro-cap
Profile| Send Message|
( followers)  

Summary

  • Celgene has been one of the great growth stocks of our era.
  • The company has a bulging pipeline on which it is overtly bullish, and management has earned respect.
  • Based on prospective earnings by 2017, the stock is undervalued.
  • In addition, CELG could be an attractive takeover target.

Background: The pharmaceutical space has seen healthy takeover activity. Monday, Merck (NYSE:MRK) announced that it is going to acquire the development-stage biopharma company Idenix (NASDAQ:IDIX) for nearly $4 B. Actavis (NYSE:ACT) is acquiring fallen angel Forest Labs (NYSE:FRX) at a high valuation. Amongst the giants, most of us are aware of Pfizer's (NYSE:PFE) failed attempt to acquire a smaller giant, AstraZeneca (NYSE:AZN).

I'd like to explain why Celgene (NASDAQ:CELG) could be a super-charged stock because of its healthy operations as well as its appeal to an acquirer. A note to newbies to Celgene: Despite its name, it is not a genetic engineering company, at least not yet.

Introduction: CELG has been one of the great stocks of our era. It takes its name from the company that spun it off, Celanese (NYSE:CE). The stock sat for years until 1998. It traded around 67 cents in the fall of 1998, and in the intervening time has risen to a current $160.

Celgene's core competency has revolved around intracellular protein homeostasis (i.e., maintenance of a steady state) that influences immunomodulatory functions. It calls drugs derived from this expertise as IMiDs. The first IMiD was Thalomid (emphasis added), launched for complications of leprosy. It later gained first-line status for treatment of the blood cancer known as multiple myeloma. The active ingredient in Thalomid is thalidomide, which is notorious in medical history for having been marketed to treat pregnant women's morning sickness and leading to large numbers of deformed children.

In order to reduce Thalomid's many side effects and to improve efficacy, Celgene later introduced its current blockbuster and main product, Revlimid (note the "-imid" again in the name). The active drug in Revlimid is lenalidomide, which is chemically analogous to thalidomide. Revlimid is on a steep growth path. Recently, yet another thalidomide analogue has come to market. It is called Pomalyst in the U.S. and Imnovid (i.e., "new IMiD") in Europe. All these IMiDs treat multiple myeloma, a blood cancer in which the cancerous blood cell type is one known as plasma cells. In the U.S., multiple myeloma is the second most common hematological malignancy after non-Hodgkin lymphomas and accounts for about 1% of all cancers.

Celgene has disclosed in its latest annual report that it has identified an intracellular protein, cereblon, as key to the actions of IMiDs. Research involving cereblon is driving at least two pipeline drugs, CC-122 and C-220.

Celgene has two other important products on the market. The internally-generated one is Otezla, an oral treatment for psoriatic arthitis that is also expected to be approved for psoriasis itself. The company reports that sales of Otezla are strong. Studies in other diseases are underway, but Otezla failed in a rheumatoid arthritis study. Otezla could become a blockbuster. Prior to its approval for psoriatic arthritis, with approval for psoriasis without (or with) arthritis still pending, Stifel wrote:

We are increasing our 2014 and 2017 Otezla sales estimates from $129M to $148M and $1,340M to $1,613M. Management provided 2017 Otezla sales guidance of $1.5-2.0B.

Whether these sales estimates are for the psoriasis indications only is not clear yet to me. Celgene's pipeline may be accessed readily, and any potential investors in CELG may wish to review it carefully.

The other major marketed product is Abraxane, which is an intravenous formulation for various common cancers. Abraxane uses a known anti-cancer drug, paclitaxel (Taxol), but eliminates the infusion reactions that older versions often caused by its unique formulation. Abraxane sales are growing; the product has substantial potential. In the same report linked to above, Stifel models $1.7 B in worldwide sales for Abraxane in 2017.

Financials: Celgene reports both in GAAP and non-GAAP format. This can make for confusing numbers. For example, Q1 had three subtractions from GAAP that are commonly used when reporting EPS. One is imputed options expense, and a second is amortization of intangibles and goodwill. For Q1, these totaled $0.60 and $0.61 per share, respectively. Omitting those, CELG earned $0.66 per share, down from $0.89 a year earlier - but this year, there were large licensing payments. If one excludes that "bad stuff," then EPS was $1.67. On that basis, consensus EPS for 2014 and 2015 are $7.32 and $9.64.

More important, the company is looking for adjusted EPS to reach at least $15 in 2017. The major fuel for this is achievement of first line indication for myeloma for Revlimid as well as longer duration of treatment. Important other fuels are growth of the products listed above.

The company has been shareholder-friendly in the past in that it shrank shares outstanding from 470 million in 2010 to a projected 400 million this year.

Celgene has a strong and diverse pipeline of small molecules (oral drugs) in development, but is moving to a 50-50 split to biotech in its pipeline. As it evolves from a biopharmaceutical company more toward a true biotech company, its shares might gain a higher valuation.

A note on valuing R&D-heavy companies applies to CELG. According to Value Line, R&D has occupied an enormous 34% of sales. CELG has been trading in the 8-9X sales range. Given its enormous R&D spend, P/S is a useful metric for this company. Even with that spending, its insignificant production costs for its lead products versus selling price means that its adjusted P/E is quite reasonable.

Pipeline: This is such a complex topic that it is best that interested parties review such material as Celgene's annual report. The company's sales are focused on hematological malignancies, but between Abraxane and the pipeline, Celgene is aiming to be a broad-based oncology company without limitation to one type of malignancy. The other focus is on immunology and inflammation, such as autoimmune diseases including psoriasis and Crohn's disease.

The latter is worth discussing for more than one reason. This quarter, Celgene announced a major product acquisition. This oral antisense product is going to enter Phase III studies for Crohn's disease and has promise for other indications. Nogra Pharmaceuticals will receive an upfront payment of $710 million, plus other payments as milestones plus royalties. This product could be a blockbuster, perhaps in the 2017 time frame for its FDA approval. So, it's a positive. The accounting for this product is an issue. If CELG has 400 MM shares outstanding, this cash payment of $710 million (pre-tax) will put its quarterly numbers into a loss situation.

We should think about how investors deal with large lump sum costs such as this one.

The impact of successive large licensing deals on assessing Celgene's profitability is difficult to assess, but this is not close to being a serious enough issue to affect my ownership of this stock.

Competition: Branded pharmaceuticals is one of the least competitive industries in terms of price, in contrast to generics, which are reasonably cut-throat, though even generics have high margins compared to most Old Economy industries. At the cutting edge of its sector, Celgene products have enormous gross margins. For many of them, the cost of production may be 1% or less of selling price. (If Celgene is successful in moving into true biotech products, margins will drop.) So it makes sense for Celgene to sacrifice current profits to win the race for new treatments where it will leverage its scientific, regulatory and marketing strengths. Within its current niches, Celgene is doing very well on all fronts so far as we can tell.

Let's discuss how to value CELG.

Valuation: A large cap stock, CELG is well-studied by analysts. However, it is so R&D-oriented that the resultant high P/E and uncertainties, plus the lack of a cash dividend, restrict the pool of shareholders. This is a good thing if you have an open mind, as it likely has led to some degree of undervaluation.

S&P Capital IQ is a major independent stock rating service. As a subsidiary of Standard and Poor's, it is not given to habitual over enthusiasm. With CELG recently at $161, it provided two ratings. Its 12-month target price is $208; and, the stock receives its highest, 5 Star rating. Separately, it uses a proprietary method to assess "fair value." On this count, CELG rates a super-high 5+, with an estimated fair value of $251 per share, more than 50% above the current trading price. Riskiness is deemed average, which means that overall, CELG is considered to have a well-above average risk-reward ratio by S&P. Of course, they can be wrong, but they are independent, so I give their assessments some credence.

The importance of trying to assess fair value, which is of course an educated guess, is of great importance with CELG, in large part specifically because of both the lumpiness of its cash flows and EPS, as was discussed above; plus, the huge percentage of its cash flows that go into R&D.

Why CELG is a buy for me: When the CEO of a successful company provides prepared words that are strongly bullish, I tend to believe it and in fact think that often the Street is a bit too skeptical. Here is Celgene CEO Robert Hugin speaking at a conference last week, per the Seeking Alpha transcript:

"We are very excited about where we are today. We think we have tremendous operating momentum in our core businesses which is critical because that's really what creates the opportunity for the future. And we are much as excited about where we are headed but we really see increased opportunities to accelerate what we are doing. Even the operating side -- I was in New Jersey, the headquarter on Monday, we had sort of semi annual portfolio review. And even in the near-term drivers we are seeing some good areas where we think we can accelerate things in the existing portfolio above and beyond the very exciting trajectory that we have. And we spent a lot of time on the pipeline as to where we are headed, what we invested in and we are just more energized about the potential the pipeline, both our internal pipeline and our external pipeline, and we really do believe over the next 12 to 24 months, we have the potential for multiple, multiple approve of concepts and new disruptive technology."

In our litigious age, legal departments vet these sorts of statements very carefully. CEOs only say things as ebullient as the above when they believe it to be true.

If we look forward a few years, the above CEO comments provide good reasons to anticipate upside surprises to the $15 EPS (at a minimum) the company projects for 2017. Depending on such factors as degree of R&D spending, I think we can look at a high P/E being given to these much enhanced earnings.

As a small individual investor, it is not necessary to guess at a proper P/E, simply to think that a larger CELG can readily carry a 15-20X P/E, or higher, off of the much higher EPS base it expects to achieve a few years hence.

There are not many companies that are non-cyclical, high-growth, and prospectively are trading around 10X EPS in only 3 years, with the reasonable expectation that the P/E at the time would likely be much higher than 10X.

Be long, then sit tight and be right appears to be a good strategy from my standpoint for CELG.

Of course, there are other ways to value CELG; that's what makes markets.

Celgene as takeover target: CELG has a current market cap of $64 B. Given the modest debt, and considering options outstanding, a few majors could consider a $100 B takeover offer. Two of several attractions of Celgene to a large multinational pharma company include the ability to cut R&D expenses to the degree needed for the deal to pencil in on P&L and stock price metrics, and the ability as a major to not have to work out partnership deals with small companies as Celgene is forced for financial reasons to do. (Of course, the major company might want to partner for any of several reasons, anyway.) Insider ownership at Celgene is small. At current minuscule interest rates, a projected P/E of, say, 13X would likely be attractive to a major, and its abilities to cut R&D expenses and other overhead at Celgene could increase profitability notably.

I have heard no rumors about Celgene being acquired, though.

Risks: Research is inherently risky. An example was just released by Celgene. It has just announced a positive trend for its azacitibine anti-cancer drug in a leukemia trial. Because of a small possibility that the positive survival and other findings could have been by chance, the trial did not succeed. So, even though on its face, the drug works for the disease studied, regulators would not likely approve it for this indication.

This quasi-failure of research is an extreme example; of course, sometimes a drug simply does not work, or does more harm than good.

In addition to the possibility of R&D failures, CELG stock tends to be volatile, and general market moves may move it more than its own fundamentals would suggest.

Among other notable risks are the prospects for Revlimid, its flagship product that accounts for more than half its sales and that has substantial growth expectations. There is a well-publicized patent case ongoing regarding it, one that I would refer interested parties to bone up on in Celgene's SEC disclosures and through other sources. Medically, Revlimid would suffer if an improved competitive product were developed, as well as if other indications beyond the current ones were not granted by regulatory agencies.

Summary: CELG has a lumpy expense stream which makes quarter-to-quarter and yoy comparisons difficult, but that's really a representation of how the real world functions and is not a problem for yours truly. In its devotion to R&D, it pushes current profitability down. Given the company's track record of success both with internally developed products and acquisitions (e.g. Abraxane), and many positive pending catalysts, I believe CELG to be an attractive stock that has set an aggressive and achievable growth course.

I also believe that CELG could be an attractive acquisition for the largest multinational pharmaceutical companies.

Understanding the several risks of the company's business and of CELG shares, I have recently taken advantage of the sell-off in the biotech sphere to initiate a position in CELG with a multi-year investment horizon. Note that as this article was making it to print, the stock has jumped 4%. To me, given the long-term prospects for CELG, the stock remains attractive to new money, but short-term trading considerations may come into play now for some investors, especially traders.

Source: Why This Physician Is Bullish On Celgene

Additional disclosure: Not investment advice. I am not an investment adviser.