Celgene (CELG) is a great company with wonderful drugs and excellent future prospects. However, I have a few problems with its stock valuation.
Many investors don't "look under the hood" 
of the companies they purchase and are often blind-sided later on due to a lack of due diligence. Looking under the hood of Celgene's financial reports, I have found some points that bother me:
- GAAP vs. non-GAAP reporting.
- Share compensation.
Below, I will detail the above points and compare Celgene to Gilead (GILD) on these issues. Why Gilead? That company is highly successful and has the highest market cap of any biotech; I consider Gilead to be a "gold standard" in many ways, including financial reporting.
GAAP vs. Non-GAAP
Just about every company reports "adjusted" or non-GAAP earnings using the justification that it better represents the underlying business. And, if used judiciously, that is fine. However, if abused, the non-GAAP figures can be highly misleading.
I'm not sure if I would go so far as to say that Celgene is "abusing" the non-GAAP figures, but the company's practices certainly raise a red flag with me and a simple look at the recent numbers will tell the tale. Below is a table of Celgene's GAAP and non-GAAP earnings per share numbers for that last three quarters:
| Period | GAAP EPS | Non-GAAP EPS |
|---|---|---|
| Q1 2014 | $0.66 | $1.67 |
| Q2 2014 | $0.72 | $0.90 |
| Q3 2014 | $0.61 | $0.97 |
All of the above figures can be found on Celgene's website. For example, here is the link to the Q1 results.
The difference in reporting is obviously significant. While Celgene's GAAP earnings through nine months in 2014 amount to $1.99 per share, the adjusted earnings add onto that figure and drive it up to $3.54 per share, an increase of 78%. That kind of increase is outside the norm, in my experience.
Let's see how Gilead reports:
| Period | GAAP EPS | Non-GAAP EPS |
|---|---|---|
| Q1 2014 | $1.33 | $1.48 |
| Q2 2014 | $2.20 | $2.36 |
| Q3 2014 | $1.67 | $1.84 |
Gilead's website has a great page that I used for the above figures. It is very clear and is even titled "GAAP to Non-GAAP Reconciliation".
Gilead's GAAP EPS for 2014 amounts to $5.18, while the adjusted EPS amounts to $5.67, an increase of 9%. That sort of difference is well within the bounds of normalcy, in my experience.
Management is Paid Rather Well
One of the major sources of differences between GAAP and non-GAAP reporting comes in the form of paying the top brass with stock and derivatives. This so-called "share-based compensation" must be included in the GAAP reporting but it is not included in the non-GAAP adjusted figures.
For the nine months of January through September, Celgene recorded a share-based compensation expense of $319 million. In that same time period, the company's net income was $1.386 billion -- thus, share-based compensation ate up a hefty 23% of the company income.
For the nine months of January through September, Gilead recorded a share-based compensation expense of $265 million. In that time period, the company's net income was $8.597 billion -- thus, share-based compensation ate up a relatively measly 3% of the company income.
Just for fun, let's have a look at Coca-Cola (KO) and share-based compensation at that company. Back in April 2014, there was a flurry of excitement over Coke's new compensation plan. The company since reversed gears and is going forward with a plan that Warren Buffett says "makes great, great sense".
For the nine months of January through September, Coke recorded a share-based compensation expense of $143 million. In that time period, the company's net income was $6.353 billion -- thus, share-based compensation cut into a little over 2% of the company income.
Conclusion
Celgene's reporting makes the stock look more attractive than it actually is. Taking a look at the average analyst estimates, we can see that in 2014 the company should earn around $3.69 per share and in 2015 the estimates call for $4.88. Those figures are non-GAAP (adjusted) EPS, of course. However, people see those figures and say things like "Celgene is trading at 25x forward earnings". Statements like that are not accurate.
As I've shown above, for a company such as Gilead, an investor can pretty much ignore the difference between GAAP and non-GAAP figures. One cannot ignore the difference for Celgene. GAAP earnings per share for Celgene will be more like $2.70 in 2014 and I estimate $3.60 in 2015. Thus on a GAAP basis, the company is trading at approximately 45x 2014 earnings and 34x 2015 earnings.
Celgene sports a pretty high premium and that adds valuation risk to the stock. Furthermore, the compensation package looks, quite frankly, excessive. I love the company and I'm confident that strong growth will be had for the next several years. However, investors should be cognizant of what goes on "under the hood" and Celgene might want to make itself a bit more like Gilead in that respect.
I currently rate Gilead a strong buy and Celgene a hold.
