For the benefit of readers who have not read any of my recent Celgene (NASDAQ:CELG) articles, most of my views on the company and the stock can be summarized this way:
- Great science, great products
- Great growth story
- Overspent on deals at the peak of the market last year
CELG has now officially reported the earnings forecast earlier in the month. There were no major surprises. The company disclosed that a modest portion of the sales gain in Q4 came from extra inventory stocking, but I think that was minor. Some of the headlines called the EPS a "miss" due to higher expenses than analysts expected, but in even a fair to good market and with the right valuation for CELG, I doubt this would have sent the stock down sharply to a multi-month low. CELG closed Thursday at $97.21, a price it first reached more than 15 months ago and when I was writing bullish articles about it.
However, when the stock soared to the $135 range on the news of its deal with Juno (NASDAQ:JUNO) last June, I sold my remaining CELG shares and began writing skeptically of its deal-making. Readers may remember that around then I was also beginning to call the stock market (NYSEARCA:SPY) "arguably bubbly" and to warn that a 1998-type vicious sell-off could well hit the biotech sector (with the hope for a 1999-type blow-off top if the Fed stepped in on the side of the bulls, which alas has not happened to-date).
Since then, I've been negative on CELG shares for that reason and because of my macro views on the market.
Just last week, after the company presented preliminary Q4 results and 2016 guidance, I wrote a more skeptical article, Could Celgene's PE Be Headed To The Dreaded Gilead Zone?. In this article, I laid out the possibility that as Revlimid went generic around the same time in the EU and the US in the 2022-3 time frame (along with other major current products also likely going generic), the P/E of CELG could shrink to the 8X range. I also pointed out that with the stock at $103 when I wrote the article, even a 12X multiple, which could be generous with the workhorse products facing near-extinction, total returns were still probably unattractive looking out to 2021.
More broadly, even when bullish on CELG, I have not been comfortable with the company providing guidance more than for the current year. I hold this view having written several bearish articles on IBM (NYSE:IBM) beginning in July 2013 and 2014 relating to the same topic. My thesis on IBM was that its already-manifest and worsening troubles were due in large part to a slavish devotion to meeting its 5-year plan EPS targets.
It is my evolving view that a similar problem may have been driving the frantic and overpriced deals that CELG did last year about which I complained in real time, and got out of the stock due to them and due to the market's frenzied reaction to the JUNO deal.
It is my further thought after reviewing the conference call transcript that analysts may be starting to adopt my view of the stock. I've been following CELG closely for almost two years, and the first question out of the gate in the Q&A was the first hostile or skeptical question I can remember. It went this way:
Congrats on all the continued progress, maybe a question for Peter, I haven't heard Celgene refer to the 2017 guidance in a while. I think the last update was $13 billion to $14 billion top line about $7.25 in non-GAAP EPS. Is that still intact?
Peter N. Kellogg
[First he beats around the bush, then says]:
That said, ForEx has been volatile since the time that guidance was issued in January 2013 and actually if you went from that time to today, we are probably seeing net of hedges about an $800 million impact on the top line. So we are calibrating on that and we do intend to provide an update as we get closer to 2017 based on where these ForEx rates, look like they are going to land in 2017.
Meaning, his answer is No.
Yet he more or less reaffirmed the projection for 2020 given in 2015.
How can any company not know what it's going to earn two years later but know what it will earn 5 years later?
Later in the Q&A, this topic was so important that a top-tier analyst returned to it skeptically:
Thanks. Just sort of following along on some of the prior questions about duration et cetera, I know there was growing and increase in confidence of operation, partly from the ASPIRE data and the AbbVie data as well as obviously the RVd data, but yet the 2020 guidance wasn't changed. I know there is a lot of dynamics moving along particularly FX, I mean do we just come away and take away the message that duration continues to get a lot better, but the FX was really a key issue in 2020. Maybe you just walk us through how the duration confidence is but yet 2020 wasn't really changed and things with that nature?
Mr. Kellogg reaffirmed that "we confirm out that 2020 guidance... we feel great about it."
But I think the damage was done.
The analysts are now realizing that even when using non-GAAP, heavy spending on R&D that's needed to create growth throughout the 2020's affects current profits and therefore wealth generation. Using GAAP shows the real truth (discussed below). For now, just on the next day after earnings, analysts are already joining the 2017 EPS markdown crowd, per Yahoo! Finance (NASDAQ:YHOO):
EPS Trends Current Qtr.
Current Estimate 1.29 1.42 5.71 7.23 7 Days Ago 1.30 1.39 5.70 7.32 30 Days Ago 1.30 1.39 5.71 7.27 60 Days Ago 1.29 1.37 5.71 7.27 90 Days Ago 1.34 1.41 5.96 7.48
In addition, the company refers repeatedly to their heavy investments in growth. This is definitely a preferable way to move the stock up than IBM's way not long ago to cost-cut its way to "growth." But expenses are expenses, and no analyst on any conference call with CELG is fooled in the slightest by its non-GAAP "accounting." It's basically only CNBC and Yahoo Finance that help the company promote the less-sophisticated retail investors to buy, those numbers. Every analyst knows that if CELG spends close to $10 B in half a year on deals, that's $10 B plus interest (plus loss of future opportunities) that has to be earned in the future just for shareholders to come out even on the deals, much less truly profit from them.
Furthermore, part of the equity value of CELG comes both from its shareholdings in a large number of junior biotechs as well as the assumed future profits from their products to which it has rights. These could be turning bad; I believe it's a subtle point that investors may wish to think about. For example, CELG proudly announced the major deal with JUNO, it spent about $1 B on JUNO shares at $93 per share. JUNO was around $46 on the day of the announcement; it's now $27.
CELG has significant stakes in Acceleron (NASDAQ:XLRN), and invested in its secondary offering two years ago around $50; the stock is around $30 now. Another very important junior biotech partner of CELG, namely Agios (NASDAQ:AGIO), has seen its stock utterly collapse from a high of $137 one year ago to $43.65 today.
It's not only the loss of implied equity value in affiliates that's negative, it's the loss of implied value of the products that the partners are developing that makes CELG sensitive to the share price of its partners. Thus when junior biotechs began to break down on the charts, I took it as a negative point for CELG.
(In contrast, this phenomenon is good for the congenital acquisition cheapskate of the industry, Gilead (NASDAQ:GILD). Between last year's debt raise and its copious free cash flow, GILD is, vastly more than CELG, able to seize on bargain deal-making opportunities that the biotech bear market may create.)
The force of Thursday's breakdown of CELG, which may have been the catalyst for the renewed breakdown of the entire biotech sector (NASDAQ:IBB), may have been related to analysts having updated their models and coming to the conclusion I came to in my most recent CELG article. To reiterate, the conclusion is that no matter how admirable and science-driven CELG is, it has paid top dollar to buy into JUNO and acquire Receptos, and now it has a substantial negative tangible book value despite so many years of strong profits and free cash flow, and despite never having paid a dividend (though it has bought back some stock). Thus shareholders in CELG are in deeper than some realize, partly, I think, because of management's and most of the Street's unrelenting focus on non-GAAP "earnings." The problem is, as the NYT now says, those "earnings" can be viewed as "fantasy numbers." The accuracy of that phrase may be seen by looking at the balance sheet rather than the (more easily manipulated) P&L presentations promoted by management. It is the balance sheet that tracks the cash outlays on deals, after all, no matter what "adjusted earnings" show.
That the above article was on a controversial company, Valeant (NYSE:VRX), and not a transformative leader such as CELG, does not change the accounting principles. Acquisitions and deals require actual expenses; non-GAAP numbers are specifically designed by management to hide those expenses while staying within the law. The non-GAAP numbers CELG uses would, if accepted by investors, mean that up-front costs of deals would never enter the P&L. CELG also excludes stock-based compensation, as with options for executives, from its non-GAAP numbers. But it's called "compensation" for a good reason.
In other words, perhaps markets are now doing with CELG shares what they always eventually do absent a takeover that retires the shares: revert to reality, or at least Mr. Market's ever-changing view of such.
So I and perhaps the Street now look askance when CELG insists as it did in the conference call that it can do it all, as the outgoing CEO Robert Hugin and Mr. Kellogg appear to have been implying in tag-team nature near the end of the Q&A:
Robert J. Hugin
And Chris, it's Bob Hugin. Just on the business development, so I think we've been incredibly sensitive and strategic for a very long time in terms of managing our intellectual property assets, our tax positioning so that we have a financial flexibility to execute any business development deal that we think is appropriate and promising for our long-term outlook and that's been the history to track record.
And as a part of that, our teams have been incredibly successful in terms of using offshore cash extensively on multiple transactions for a relatively long period of time. I think that strategy is one that's proven to be effective. We've never seen ourselves to be in a situation where we have some financial restriction that didn't allow us to do the kind of things that we want to do and our plan going forward anticipates that same kind of positioning, and I think Peter and his team is doing a great job in managing that.
Peter N. Kellogg
Thanks Bob. And the other thing I highlight is we really are not in a position where we're constrained in any particular manner in the U.S. In fact as you saw and I mentioned in my remarks, during 2015, we spent $3.3 billion on share repurchase. And where the market is today and where it's been recently, it's a great opportunity going forward. So, we will continue to see ourselves being particularly forceful in the share repurchase area, because we are in great shape on cash and we see the stock in this sector right now great value.
But no company can be everywhere and do whatever it wants, which is, to put it in condensed form, what they appear to be implying in the above comments.
I disagree with Mr. Kellogg: CELG is constrained in the US. It is constrained everywhere from doing future large deals, because it has numerous commitments to growth that cost a lot of money. Whatever it may have overpaid in deals last year is not close to fatal, but debt is way up, cash is down, and now that deal prices have almost certainly fallen and the cost of debt has risen, CELG is indeed constrained from buying what increasingly looks like an attractive set of junior biotech assets.
This is the updated balance sheet:
December 31, 2015 2014 Balance sheet items: Cash, cash equivalents & marketable securities $ 6,551.9 $ 7,546.7 Total assets 27,053.4 17,340.1 Short-term borrowings and current portion of long-term debt - 605.9 Long-term debt 14,250.4 6,265.7 Total stockholders' equity 5,919.0 6,524.8
Of that equity, as of 9/30/15 there was $15.5 B of goodwill and intangibles. So there is about $9.6 B of negative tangible equity that has been expended and has to be earned back plus some desired ROIC to justify the whole effort.
As with Amazon.com (NASDAQ:AMZN) falling 12% after-hours Thursday precisely because the economy is peaking and its profits (finally!) were not up to snuff, sometimes Mr. Market changes focus.
CELG cannot even stand by a 2017 forecast it made in 2015. Thus its analysts may have done what I did in my last article. They may have analyzed the deal with Natco and Allergan (NYSE:AGN) for generic Revlimid, gone to sources unknown to me regarding the possibility of one or more other challengers beyond them, and asked the question I asked: What P/E leads to what "equilibrium" price range for CELG 5 years hence? Then pick your interim discount rate and get today's "fair value" price.
Everyone in the pharma space is comfortable thinking in 5 year blocks, because more or less that is how every brand pharma company thinks. In their minds, it's already 2018 or something like that. So the analysts routinely look at a company's marketed products and the late-stage pipeline, project out 5 years, and then ask, what "E" deserves what "P" to give today's "buy" range.
In the case of CELG, it's no criticism of its operational excellence to say that if it earns its projected $4.50 per share this year (GAAP is the only accurate metric) and grows EPS at an outstanding 17% per year until EPS double, we will find ourselves looking backward at $9/share in April or July 2021. Now, among my many caveats is that I do not know what CELG will earn in 2020, but I'm unwilling right now to project a faster EPS growth rate than 17%.
At that point in 2021, CELG will as currently configured have a Gilead problem: it will be facing declines in Revlimid sales and soon will lose almost the entirety of them (by March 2025). And if another generic beyond Natco/AGN also comes to market (note that Natco's has not been approved yet), then matters could be far worse than I'm projecting.
With some or all of CELG's other current major products also facing patent expirations soon thereafter (the analysts have a better sense of this than I), I simply find it difficult to project more than a 10-12X P/E in 2021 on that projected $9/share in EPS. Of course, the SPY as a whole could be trading at a very high multiple and CELG would participate in that, but then it's not a CELG analysis we're doing, it's a market analysis. And I think that just depending on how successful the JUNO partnership is, how the Receptos product(s) is, how the antisense drug mongersen for IBD is, and how the rest of the pipeline does, a single digit P/E may be appropriate given how dominant Revlimid is fated to remain for the next 4-5 years within the CELG group of drugs.
As an important caveat, investors who have faith in CELG as a great product discovery engine may well want to project a 20X or higher P/E on those possible $9 EPS. That would target $180 only 5 years from now, or about a double. I'm not predicting how many changes of mood Mr. Market will have, but for whatever reason, since CELG made all its deals in H1 last year, I have focused more on the downside possibilities for the price than the upside. Plus, as regular readers know, I have gotten much more cautious about the market as a whole.
To summarize, I look at CELG now joining some of its also great biotech compatriots in setting 12-month lows as the stock succumbing to new market conditions in which biotechs are not getting the benefit of the doubt re future, almost limitless growth.
CELG shares can go from their recent 50X and higher EPS, double EPS, then double them again and yet it can then trade, after quadrupling EPS, a good deal lower than it is now. Again, that's with operational excellence as we are used to from this great growth company.
Given that scenario, and with current market conditions, I continue to see substantial downside risk to the stock even as the company continues to perform at its usual very high standards. If Mr. Market wants to look at a P/E of 10X on 2020-1 EPS of $9, or a $90 stock price in 2021, then the stock could be at or below $60 in a "bear" market. Of course, if it gets there, it could be a steal, but these things do happen unpredictably every now and then.
I'd like to be long CELG, as I'm a big fan of profitable science-driven growth biotech companies of which CELG is an exemplar, but this just looks like a time to stand aside if one's out of the stock and see how matters shake out. Of course, there are many loyal long-time holders of the shares who even if they happen to accept this analysis (which could easily be wrong) have a very long time frame and don't sweat the ups and downs of one of the great growth successes of our era.
Thanks for reading; all comments are appreciated.
Disclosure: I am/we are long GILD.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.