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Trough Valuations and Post-Bubble Malaise


by Jim Reddoch

The stock market has had a rough year, but the performance of the Nasdaq — down 15 percent — is downright enviable for biotech investors. The BTK stock average is down 28 percent for 2002 to date. Genomics stocks have largely tracked the BTK in ’02, but underperformed in 2001.

This column takes on the idea of “trough valuations,” or in other words, how low can they go?

The trough valuation is the historical nadir in the price of a stock, as measured by a criterion or ratio such as price or price relative to earnings. The concept is based on the fact that there are cycles in stock valuations such that the group will experience peaks and valleys, pinnacles and troughs.

The term usually refers back to a down cycle in valuations, although sometimes this is implied. For example, you sometimes hear that profitable biotechs haven’t traded at these price-to-earnings¯to-growth levels since the early ’90s. (The early ’90s, up to 1994, forms the basis of most trough valuation comparisons; it was the last really ugly down cycle for biotech stocks.)

All of us now recognize that we were living in a biotech bubble there for a while. Genomics companies were some of the highest fliers, and many investors have now sold out of these stocks because of the longer-than-expected horizon to profitability, for example. On the other hand, there’s a price for everything, isn’t there? Can these stocks go lower? Absolutely.

Might the current prices represent an attractive entry point for the long term? Possibly. After you consider company management, years of cash left, and general business prospects, see if the stock is trading at or below the historical low for the group, according to the following criteria. Is the P/E¯to-growth value less than 1.0? Is the market capitalization (i.e., stock price times shares out) less than two times cash? Is the technology value (i.e., market capitalization minus net cash) less than two to three times revenues?

Investing is about as scientific as the Oscars. Therefore, the approaches above should be used with care. Here are some of the problems with the above directives. First, few genomics companies are profitable (this valuation criteria is used more often with the profitable biotechs). One could project a future EPS and then “discount” it back to the present on a risk-adjusted basis, or one could just skip to the next question. The hitch with #2: after the one-of-a-kind financing window in 1999 to 2000, small pre-profitable biotech companies have higher levels of cash than in the last down cycle. The other hitch with #2: these companies have plans for that cash and the current level is possibly a lot higher than it will be in 2003. The problem with #3: if the revenue is from collaborations, it may taper off or decrease if the biotech does more R&D for its own account, as is happening more frequently at small biotechs with cash.

Are things really that bad valuation-wise? We don’t think valuations are that terrible for quality companies. After all, Millennium still sports a $4-billion-plus valuation, greater than the sum of the top five antibody companies. Excluding its $1.1 billion in net cash, Human Genome Sciences is currently approaching a valuation of $1 billion, and its latest-stage drug (of seven in the clinic) is only in Phase II. What are these two companies doing right? Successfully transitioning into product-based biotech companies and possessing the cash to pay for it.

Some investors say stocks are different from most goods we buy in that we want them when they’re high-priced and not when they’re on sale. However, the patient investor will take the current negative biotech sentiment in stride and purchase those genomics companies producing measurable assets.

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