Separating the Biotech Wheat From the Chaff

Editor's Note: With this column, we introduce Gabe Hoffman, the biotech and pharmaceutical analyst for Welch Capital Partners LLC, a New York City-based institutional money manager with $250 million under management. Prior to that, Hoffman followed the biotech and pharmaceutical sectors at Paramount Capital, a biotechnology merchant banking firm and hedge fund manager. As always, we welcome your thoughts.

Ugh! What an ugly, miserable day yesterday was for anyone in the biotech sector! As most of you know by now, Bill Clinton and Tony Blair issued a joint press release at 7 a.m. yesterday concerning the sequencing of the human genome. Basically, they repeated what we all already knew: that the data from the Human Genome Project should be made publicly available immediately after the project is completed.

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That's nothing new. Genomics companies don't add value simply by mapping the human genome; they add value by decoding genes in order to determine which are relevant to therapeutic applications -- i.e., the treatment and prevention of disease. They then patent the relevant genes for those applications, and hope to generate royalty streams from any drugs developed from those genetic targets.

In my opinion, the severe selloff in the genomics companies after the Clinton/Blair announcement is evidence of two things:

1. Many investors obviously have no idea how genomics companies are supposed to generate future revenues and income. If they did, there wouldn't have been such a knee-jerk reaction to the announcement.
2. Many investors, whether uninformed or well-informed, are obviously uncomfortable with the valuations of many of the genomics companies. They were willing to jump ship the second they perceived "the end was near;" it was like 10 elephants trying to squeeze through a narrow doorway.

The second point is perhaps the most important one, and deserves an entire column at some future point. But the short story is that sell-side analysts on Wall Street can't perform a traditional valuation analysis on any of the genomics companies. Pure genomics companies like PE Corp.-Celera Genomics (CRA Quote) and Incyte Pharmaceuticals (INCY Quote) can be valued only on expectations for their future royalties, assuming the genes they patent turn out to be useful in designing successful pharmaceutical products, which is far from certain. The first drugs from such efforts, even if successful, are at least 10 to 12 years away.

As a result, most analysts don't even have a price target for these companies, often just a buy or a strong buy. The recommendations they make aren't based on anything concrete, just a perceived "technology" value or "intellectual property" value based on the market capitalization of some other genomics company, whose valuation is also somewhat arbitrary. Basically, they justify the valuation of, say, Incyte, on the valuation of Celera, and so on. Literally dozens of companies in life sciences are valued in this way.

A few of the genomics companies can be valued using more traditional approaches: Companies like Human Genome Sciences (HGSI Quote) and Millennium Pharmaceuticals (MLNM Quote) are also developing their own proprietary drugs, and therefore can be valued using more concrete, traditional measures, assuming the drugs are approved and successfully commercialized.

Investing vs. Trading

What was my reaction to the huge selloff in genomics stocks yesterday? I didn't care -- we don't own a single genomics company. But the entire biotech sector taking a dive in sympathy was completely unwarranted. Take one case, which I know well: Inhale Therapeutic Systems (INHL Quote). There's no reason such a company should have been down 28 points at 1 p.m. Like most developmental stage biotechnology companies, Inhale's value is based on expectations for its lead project, which is inhaled insulin.

Wall Street's price targets for Inhale are based on earnings projections, which assume low single-digit penetration rates for inhaled insulin. But common sense alone tells me that more than 1%-5% of diabetics will throw away their needles within the first two years of the launch of that therapy. Inhale's prospects have nothing to do with genomics, and they could make a ton of money even if the market suddenly decides (correctly or not) that all genomics companies will never make any money.

In the case of a biotech company like Inhale, it doesn't matter whether we're in a boom or a recession, a bull market or a bear market, for biotech or the entire market. If you've done your homework on a biotech company, and have the highest confidence possible that its lead product or products will be approved and successfully commercialized, then you were buying such companies at 85 yesterday. Because the only difference for a company like Inhale in a bull market or bear market for biotech or the entire market, is whether the correct multiple on earnings should be one, two, or three times the company's growth rate of 40%-50% (or higher) in 2002-05. And any one of those multiples on the kind of earnings I expect -- assuming market penetration of more than 5% -- gives me a stock price I'd be really happy with in two to five years.

So we sat tight and bought a bunch of our names, like Inhale, that were down huge in sympathy for no reason. By the close most of them had rebounded, some more than others. You've got to have really done your homework to have the confidence to buy more of a stock in a really ugly situation like yesterday afternoon. But if you did, you made money.