books about online stock trading, forex, futures, stock investing, market, trading systems
Hot Stock Biotechnology
Back to contents page

Although the best biotech companies can generate enormous free cash flow—biotech giant Amgen threw off more about $1.5 billion in free cash flow in 2OO2—most are too speculative for all but the most aggressive in­vestors. Picking successful firms requires a bit of skill, some understanding of the science, and a lot of luck.

Biotechnology firms are often thought of as younger, hipper, more in­novative, and faster growing than their pharmaceutical counterparts. They seek to discover new drug therapies using biologic—cellular and molecu­lar—processes rather than the chemical processes used by big pharma. Biotech firms are also on the cutting edge of developing novel therapeutic products, using groundbreaking technology platforms such as proteomics and genomlcs.

However, biotech drug development is still all about probabilities, but "with even more product risk because the therapies are often completely new forms of treatment. For example, Genentech has been developing a treat­ment that attempts to stop the body's mechanism for growing new blood vessels (a process called angiogenesis) on the theory that a cancerous tumor will die if it no longer receives blood. Although several companies are work­ing on similar therapies, none have been successful to date. Even if they are successful, the true size of these markets is anyone's guess. This adds another layer of uncertainty to the drug development process—as well as volatility in stock prices.

Think about biotech firms in three categories: established, up and coming, and speculative.

Established: These are the bigwigs of biotech and include companies such as Amgen, Genentech, and Biogen IDEC, which each have annual product rev­enues of more than $1 billion and market capitalizations beginning to rival those of big drug companies. They generate positive earnings and cash flow, and their drug development pipelines are large enough to sustain decent sales and earnings growth. As these firms become larger, their future cash flows become less risky.

In this category, look for:

Firms with a large number of drugs in late-stage clinical trials

Plenty of cash on hand, plus cash flow to cover several years of research

and development expenditures Firms that have built a salesforce of their own—so they no longer have

to pay another firm to market their products and can begin to build

relationships with physicians *- A stock price that provides a margin of safety of around 30 percent to

40 percent to its fair value

Up and Coming: Many biotech firms are on the cusp of success, either with a product on the market or within arm's length. Some are on the verge of break­ing into the black, while others have already demonstrated small but positive earnings. In other words, they've got more than a cell in a petri dish, but they still have a lot to prove. All of these firms hold lots of risk and typically have a narrow economic moat or none at all, depending on competing products.

Cash is king during this stage, and these companies are often able to raise capital during the market's periodic biotech booms. But it's worth keeping an eye on how quickly they are spending that cash because the last phases of clinical trials are the most expensive, and preparing literally truckloads of documents for the FDA isn't cheap. That's why it often makes sense for up-and-comers to form partnerships with bigger pharmaceutical or biotech firms. Although a partnership agreement means giving up a chunk of the profits, getting to market faster can be worth the cost.

Investors should ask the following questions to reduce their risk:

•  Does the company have enough cash to get through the final (and most
expensive) stages of testing? Compare the amount of cash on the balance
sheet to the amount of cash that the firm burns through in a typical year.
Phase III trials can cost tens of millions. Can the company write a check
for these trials, or will it have to go outside for capital?

•  Have larger biotechnology firms or pharmaceutical companies been will
ing to join forces with the firm? Partnerships can be a double-edged sword.
They often validate the viability of a bio tech's technology and provide
knowledge and sales expertise, but they also take a huge chunk of the prof­
its. Por example, Biogen IDEC's cancer drug Rituxan has gone gangbusters
since its 1997 approval, but because of the company's partnership with
Genentech, Biogen IDEC sees only about a third of the drug's sales.

•  Because future cash flows are so difficult to predict, does the stock price
trade at a big enough discount to fair value to provide a margin of safety?
A 50 percent margin of safety is reasonable given the risks of biotech.

Speculative: Newer biotech companies, which make up the majority of all companies in this industry, are too risky for the vast majority of investors. Although firms in this category undoubtedly have interesting technology and could be extremely successful some day, real revenues from real drug products are many years away, and positive cash flow from operations is even further out. Compound that risk with the slim odds that most early-stage drugs will ever reach the market, and we'd classify them as high-risk, no- moat stocks—which means we'd need a gargantuan margin of safety before we'd be willing to own them. These stocks are more like lottery tickets than anything else.

If you're doing research on a biotech company, the company's IO-K is the best place to start. Here, the company typically explains in layman's terms the technology and drugs in development and explains how the company is funding its research and partnerships. Disease Web sites cancer.gov and MedicineNet.com and science journals often have information about drug classifications, market sizes, and competing and substitute products. In addition, industry resources such as the Biotech Industry Organization and Bio- Space each have drug, company, and industry information.

Medical Device Companies

Medical device companies are probably the most straightforward of the health care industries. These are the companies that make the hardware, such as pacemakers and artificial hips, for medical procedures. There are two main types of device firms—cardiovascular and orthopedic—and they're well worth getting to know, given how many firms in this industry have wide economic moats.

As with the other health care sectors, the aging population and increase in life expectancy will drive sales growth in medical devices. Both the incidence of heart disease and the need for joint replacement rise substantially among older people. Also, now that physically active Baby Boomers are suffering from a few aches and pains of aging, physicians are starting to perform more joint replacement procedures in younger patients. Because a new hip has an average life of about 10 years, this should eventually expand the market for revision surgeries when the first hip wears out.

The ongoing pressure on medical costs also helps spur demand for some medical device companies, as new surgical techniques dramatically reduce the cost of some procedures by reducing the length of the associated hospital stay.

For example, traditional cardiac bypass surgery, aimed at Increasing blood flow to the heart, involves a 10- to 12-inch incision down the chest, cracking open the rib cage, and approximately eight days in the hospital, followed by two months of recuperation. Less invasive cardiac bypass surgery is performed with a three- to five-inch incision between the ribs (or several one-inch inci­sions) and requires a three-day hospital stay and about two weeks of recovery time. What's more, minimally invasive procedures typically cost 25 percent less than the traditional open-heart bypass.

In addition to their attractive growth characteristics, device companies also typically boast wide economic moats. Economies of scale, high switching costs, and long-term clinical histories (in excess of 30 years for some orthopedic devices) all serve as high barriers to new entrants. As a result, a few major players dominate both the cardiac and orthopedic device markets. Patent protection on devices and instrumentation used for installation also provides a measure of protection from competitors for each company.

Switching costs tend to be high for orthopedic devices because physicians are often reluctant to drop one firm's devices in favor of another's. Installing an artificial hip or knee is complicated, and the procedures require specialized tools and training. Because each company makes its own proprietary set of tools that work exclusively with its own joint replacements, a surgeon who de­cides to use a different company's artificial hip must squeeze in time to receive training on how to use the new instrumentation system. Given how busy surgeons generally are, that's unlikely to happen unless the new joint is significantly better than the one the surgeon is currently using. It also takes time to complete enough procedures to become comfortable with the new system.

Medical device companies hold a great deal of pricing power as well. Medicare and insurance companies have so far been reluctant to limit brand choices when it comes to joint replacements and pacemakers, which has allowed orthopedic device makers (for example) to consistently raise prices by 3 percent to '% percent each year.

Finally, some device firms face less risk than pharmaceutical firms because product improvements tend to be evolutionary rather than revolutionary. This benefits industry players in two ways. First, it decreases regulatory risk because incremental improvements to existing devices can go through a streamlined review process at the FDA. Second, it reduces the odds that one company will leapfrog the rest by rolling out a truly revolutionary product. Although major advances in medical devices do occur, they're less common than in some other areas of health care, so industry players tend to compete by making each successive generation of any particular device just a little bit better than the previous one. (Contrast this type of competition with the winner-take-all structure of the drug industry, in "which anew drug can literally wipe out the market for competing drugs in very short order.)

However, device firms are not without risk. Product cycles can be very short, so companies must spend heavily on research and development to keep up with their competitors. Especially in cardiac devices, where switching costs for surgeons are lower, market share among the major competitors can change dramatically within the space of 12 or 18 months as new products arrive on the stock market. The implantation procedure for a cardiac device is largely the same "whether you're using this year's model or last year's, "which makes it easy for physicians to switch over to the latest product very quickly.

Legal risks are also an issue. In recent years, cardiac device companies have used litigation as a defensive (and sometimes offensive) tactic against competitors. All the suits and countersuits eat up a great deal of time and money and increase risk as well because the outcomes are usually difficult to predict.

Hallmarks of Success for Medical Device Companies

Medical device firms often enjoy high margins and strong earnings. Here are

the key factors "we look for in a device firm:

•  Sales force penetration: Many firms train their sales reps to serve as consul­
tants, "with some even assisting in surgeries. For example, Biomet sales
representatives attend the majority of joint replacement surgeries where
the company's products are being used and often contribute their expert­
ise on the devices and instruments to the surgeon during the procedure.
This deep relationship with physicians can increase the cost to switch to a
competing product.

•  Product diversification: Firms can reduce their risk by offering a strong
mix of high-margin products (such as replacement hips or pacemakers)
and commodity or recurring products that often have lower margins. For
example, Medtronic has been working on adapting its core electronic
stimulation technology (used In pacemakers) for use in controlling
tremors from Parkinson's disease. Developing this higher margin product
should help offset anticipated declines in its lower margin stent business.

•  Product innovation: Looking at new product introductions relative to re­
search and development costs is a good way to measure a firm's ability to
pump out new products. A firm's annual report will mention new prod­
ucts being released in a given year as well as R&D expenditures. Going
back several years may take some digging into past reports.

Smarter trading The art of day trading Trading Chaos Sane Investing In An Insane World
Beat The Odds In Forex Trading