The market is buzzing about Biogen Idec ph1b BIIB-037 data for Alzheimer's disease tomorrow. The press release is coming out at 5:35 am EDT. BIIB represents a 9.72% holding for most common benchmark in biotech, the Nasdaq Biotechnology index, the ETF that tracks this index is IBB. Other ETF's with large exposure include BBH, and PBE.
The data are widely expected to be positive. Either way, it will move the sector. Best of luck.
Data above is from morningstar and etfdb.com
A must read book for any value investor is The Warren Buffett Way by Robert Hagstrom. Now in it's 3rd edition, the book profiles Buffett, his process, and deconstructs his most well known investments. It provides a valuation framework and quantifies Buffett's famous Margin of Safety.
Unlike many of Buffett the books out there, this one is by and for investment practitioners. Robert Hagstrom is Chief Investment Strategist and Managing Director of Legg Mason Investment Counsel. The forward to the first, second, third editions are by Peter Lynch, Bill Miller, and Howard Marks, respectively. While it is not endorsed by Buffett himself , Hagstrom reports he was granted permission to quote extensively from Buffet's letters, after he had reviewed the book.
American Express is one of Buffett's best known investments, and it is well examined in the book. This is the first in a series wherein I'll review a valuation from the book, and then perform an updated valuation of the company with the same approach as the author.
AXP has under performed the market over the past year, among the reasons are the Costco deal, and the anti-trust case.
EDIT 3/16/15: Talking with some investors brought up other risks:
Are these problems actually a buying opportunity? Buffett recently opined on these issues on CNBC.
Buffett has actually gone several rounds with American Express, first with The Buffett partnership during the Salad Oil Scandal in the 1960's and then again with Berkshire in the 1990's when he infused AXP with capital via preferred shares during a cash crunch (sound familiar?).
Buffett converted his preferred to common in 1994, after AXP management sold off under performing divisions and began buying back shares. He bought more in 1995, owning almost 10% of AXP.
In The Warren Buffett Way, the Hagstrom uses a two-stage "dividend" discount model, however in lieu of dividends he substitutes "owners earnings" defined as:
In the 1990's American Express situation , it was approapriate to use net income, as non-cash charges roughly equal capex.
The author uses the following conservative assumptions:
Based on these assumptions, he concludes that Buffett determined AXP had an intrinsic value of $43.4B while its market cap was only $13B. A whopping 70% margin of safety!
There are a host of qualitative factors to consider. The author goes into AXP's consistent operating history, and management rationality. You'll have to read the book if you want a discussion of those.
Of course, since 1994 AXP has performed very well.
To assess the current valuation we are going to carry forward the authors assumptions about owners earning's being equal to net income. Over the past few years, depreciation, depletion, and amortization has roughly equaled capital expenditures at AXP, so we are going to keep that simplifying assumption.
As for owners earning growth rate, AXP management is still targeting 12% to 15% long term growth, same as 1994. Now that is consistency!
We have been able to drive strong EPS growth within our 12% to 15% long-term target range. - Jeffrey Campbell, Chief Financial Officer- Q3 2014 earnings call, Oct. 16, 2014
To be conservative we are going to keep our model's growth of 10% for 10 years, and a terminal growth rate of 5% after 10 years.
As for discount rates, long term treasury rates are much lower today than 1994. However, I love building conservative assumptions into my models. This way, if your valuation work points to a screaming buy, you know its not because of your optimistic assumptions. For these reasons we are going to stick with a 10% discount rate.
One interesting take-away from the book is Buffett doesn't adjust his discount rate up or down to account for perceived risk. Rather, he demands a larger margin of safety. This is just another example of value iinvesting contradicting the approach taught in business school.
After re-running the two-stage "dividend" discount valuation model with 2014 earnings and the assumptions outlined above, the model concludes AXP is worth $179 a share. This figure is much higher than any sell side analyst price targets. This is an intrinsic value estimate, not a price target. It also implies a 56% margin of safety at the current market price of $79. Please note, this is the book's sheet, not mine. You can get a copy of the model from the books companion website.
It's worth noting a few take away's from this intrinsic value estimate:
The biotech space is hot with merger activity right now. Last night, Pharmacyclics (PCYC) agreed to be acquired by Abbvie (ABBV), and a few days ago the Salix / Valeant (VRX) deal was announced. Merger arbitrage, or speculating on mergers & acquisition activity, can be a high risk game. However a lower risk variation of merger arbitrage has been practiced by Warren Buffett, and of course it fits nicely in the value investor's framework.
Note: if you just want the merger arb tracking sheet, scroll to the bottom. If you want to learn about how Buffett does it, read on.
Not much has been written about Buffett's approach to merger arbitrage. However, I have found two books:
Warren Buffett and the Art of Stock Arbitrage cites this study and a Forbes article that state Buffett has produced annualized returns of 80% to 90% on his merger arb investments, or "work outs" as he likes to call them.
Buffett practices long-only merger arbitrage, taking long positions in the company to be acquired. This contrasts with traditional merger arbitrage, in which one goes long the acquired and shorts the buyer. This approach hedges out market risk and some other factors. However some criticize it as twice the risk for half the return.
Here is Warren Buffett in his 1988 letter writing about arbitrage:
Below is a summary of the investment criteria in Warren Buffett and the Art of Stock Arbitrage and Trade Like Warren Buffett.
With these factors in mind, Warren Buffett and the Art of Stock Arbitrage describes a model that incorporates these factors. One of my pet peeves is investment calculations in paragraph form. So I built the model below for you, and loaded it with my best estimates for PCYC and SLXP.
The entire sheet doesn't fit into this web page well, so you may just want to look at it here. I should mention this model is only good for all cash deals. If there is interest, I may build one for a mix of cash and stocks. My take away at time of publication: there is some opportunity in PCYC, but not much in SLXP.
While this blog has been focused on biotechnology as of late, I do have interests in a few other sectors. Inspired by Bershire Hathaway and the mini-Berkshires, I have compiled a few resources on insurance company investing.
Have something to add to this list? Put in the comments below:
EDIT 2/27/15: I should have included Shreyas Patel's Insurance Investor blog. This value oriented blog, which appears to have been unfortunately short-lived, has a several great posts:
Have a recommendation? Put it in the comments section or contact me. I am particularly interested in a book recommendation.
Occasionally people ask me for book recommendations regarding biotechnology investing. I always recommend the following two books:
The first book I always recommend:
I used to give this book to interns on their first day. It has two parts, the first is a concise and non-technical introduction to the space. My interns could typically read that in an hour or two. The second part is an introduction to option trading in biotechs, and is appropriate for those who want to step their trading up beyond straight equity.
The second book:
Have you ever been invested in a biotech company and seen it go down after it's drug was approved by the FDA? If you go to Yahoo message boards afterword, you will see investors saying "I just don't get it" and blaming short sellers. In reality, unsophisticated investors don't get valuation. Most likely, the stock was overvalued going into the FDA approval, and now its getting back to reality. This book with teach you rNPV modeling of pipelines, so you are not surprised again.
Full disclosure: I recently became a contributor at Chimera Research Group. The author of Biotech Traders Handbook, Tony Pelz, is a founder of Chimera. However, I have been recommending the book for years.
One my favorite things in the market is finding obscure situations that elude conventional analysis. My latest interest is the pricing of Priority Review Vouchers.
A little background: The 2007 Food and Drug Administration Amendments Act (FDAAA) created Priority Review Vouchers (PRV). The purpose of the vouchers are to incentivize drug development for neglected tropical diseases which can represent a limited commercial opportunity.
These vouchers reduce the FDA review time for drug approvals from 10 months to 6 months, and are awarded by the FDA to a company that obtains approval for a treatment for a neglected tropical disease.
Things got interesting in November when Gilead Sciences (GILD) paid $125,000,000 to purchase one of these vouchers from Knight Therapeutics (GUD/CN).
How many of these vouchers exist? According to Evaluate Pharma, only four have been issued, with three being of the Neglected Tropical Disease type, and one being for Rare Pediatric Disease. The two programs currently have some important differences, so for the purposes of this article we are focusing on Neglected Tropical Diseases. Below are the status of all four:
Things got even more interesting when the Senate voted for the Adding Ebola to the FDA Priority Review Voucher Program Act, which would change three elements of the Neglected Tropical Disease Priority Review Voucher program:
The bill has broad bipartisan support, and is expected to be passed by the House and signed into law by President Obama. While the headline is about Ebola, we are interested in points two and three, which would bring the neglected tropical disease program more in line with the rare pediatric disease program.
The reason we are interest in the time frame shift ( from 365 days to 90 days) is because it impact the value of the PRVs. Simply put, the sooner a firm can see revenue from a drug, the more its worth today. This is especially true if one were to factor in a the competitive landscape, where the first mover advantage can be critical.
To estimate the impact of this shortened time frame I ran the back-of-the-envelope calculations below:
The take away here is once the Adding Ebola to the FDA Priority Review Voucher Program Act becomes law, the Neglected Tropical Disease PRVs will be come more valuable based on the reduced time frame alone. As for the discount rate, I came to 15% via a sophisticated method known as "from thin air". Yes, I can already hear you CFAs saying "you should use the WACC". To that I say drug development is a risky business and you should be more conservative in your modeling assumptions.
An additional factor that will drive up the value of PRVs is the lifted re-sale restrictions. Previously, if you bought the PRV you had to use it, as only one re-sale was allowed. However, with no re-sale restrictions, the pool of capital that could potentially purchase a voucher is much larger. One could see a healthcare firm with a large amount of capital scoop one of these up with the intent of selling it later. The liquidity premium is a real thing, and in this case I'm going to give it a conservative 2.5% liquidity premium, bringing the value to $142.3M.
This brings the total gain from the legislation to +$17.3M per PVR. While this amount isn't going to move the needle for giants like J&J or Gilead, it certainly is material for a firm like Knight Therapeutics, which has a market cap of just $540M (Canadian). Ask them if they would like another $17 million for the PRV they sold to Gilead.
It is no surprise the Biotechnology Industry Organization (BIO) has come out in support of the bill.
Of course there are additional factors at play here, as I said this a back of the envelope exercise. For example, from a drug developers perspective, much of the value is derived from the drug and indication for which the priority review will be used. Furthermore, as the FDA issues more PRVs over time, the increased supply may drive down prices. One could also Again there are many factors that firms buying and selling will consider next time these trade hands, but I digress.
Those who want to learn more about Ebola can check out the classic The Hot Zone: The Terrifying True Story of the Origins of the Ebola Virus.
One last thing, once Filoviruses (Ebola et al) gets added to the list of indications PRVs can be used on, what does that list look like? See below:
My favorite way to generate investment ideas is reviewing Form 13F filings from great healthcare investors. I first read of this approach years ago in Mebane Faber's book.
If searching for investment ideas is like looking for a needle in a haystack, then 13F filings are a stack of needles.
I later found out the great Mohnish Pabrai also uses filings for idea generation.
I've backtested the filings of 60+ healthcare focused investors, and I have ten that are worth following. These include the well known Perceptive Advisors, and Baker Bros Advisors, but also more under- the-radar firms such as Broadfin Capital. It is important that 13Fs are the beginning of an investment research process. Due diligence is still critical.
Some of my most successful biotechnology stock picks generated by 13Fs have been in the oncology space. An example would be when I bought Pharmacyclics (PCYC) at $19 in February 2012, and held it for a multibagger.
The most recent set of 13Fs were as of September 30, 2014. Here are the two most popular oncology stocks held by my group of hedge funds.
Pharmacyclics (PCYC): A long time favorite of Baker Bros., also owned by Perceptive and BB Biotech, as of September 30, 2014. Ibruvica is currently approved for Mantle cell lymphoma (MCL) and Chronic lymphocytic leukemia (CLL) patients who have received at least one prior treatment.
PCYC is in growth mode, after having Ibruvica approved, the company swung into profitability during the 3rd Quarter of 2014. Analysts expect 37% year over year revenue growth in 2015.
At the upcoming ASH conference the company will be presenting data in the effort to get indication expansion into B-Cell Lymphoma.
Investors are clearly very excited about the growth story here, as the stock currently trades at 11x next years estimated revenue. The bear case revolves around next generation competitors to Ibruvica.
The stock does appears to be near full value, as analyst average price target is $161, which is only 16% higher than current prices.
Celgene (CELG): Owned by RA Capital, Orbimed, BB Biotech, and Perceptive as of September 30, 2013. Celgene is a major player in the oncology space and has products approved for many indications. Revlimid represents 66% of Celgene's revenue. It is approved for Multiple myeloma (MM), myelodysplastic syndromes (MDS), and Mantle cell lymphoma (MCL). Furthermore, there will be many presentations at ASH 2014.
It is worth noting this company has a less concentrated product portfolio than PCYC, with a single product on the market.
Analyst are expecting very strong growth from CELG specifically from their Revlimid, and Abraxane franchises. Celgene's IR site tracks analyst estimates, and it states that EPS growth of 32% is expected in 2015.
CELG investors have been impressed with the growth story. The company trades as 9.7x forward sales estimates, and 25x forward EPS estimates. These valuations could be justified if the firm can pull off its growth plans without any miss-steps.
No value investor would call this either PCYC or CELG "cheap".
Most analyst would not call CELG cheap either. The current analyst price target is $116, which is about where the stock trades now. Investors would be wise to wait for a pull back, or wait for analyst upgrades.
Disclosure: I own none of the stocks mentioned in these articles and have no plans on buying them in the next 48 hour
Data: Ycharts.com/Morningstar and 4-Traders.com/Thompson Reuters.
Investors in Salix Pharmaceuticals were treated to some unpleasant news on November 6th. The company announced they had misrepresented key drug inventories, and the CFO resigned. SLXP traded down -34% the next day and -46% from its September highs. I believe more accounting issues will be uncovered by the audit committee.
The company has all but admitted that it was channel stuffing, a practice used to inflate earnings, as discussed in my last post Was the Salix Blowup Predictable? This earnings inflating trick increased wholesaler inventories to levels way beyond their stated target, and much higher than industry norms.
Since the sell off, shares have rebounded. Investors are speculating either there is only one cockroach in Salix's kitchen, or it is still a takeover candidate despite the accounting issues. Indeed this company has a valuable GI drug franchise, and management with a credibility issue.
The setup seems ripe for M&A activity. Further bolstering this line of thinking is Salix was previously a target of both Actavis (ACT) and Allergan (AGN), but talks fell apart during due diligence around inventories. However, an audit committee composed of independent directors have been convened, and I believe that the audit committee will uncover more accounting problems. For those who still wish to wager on a Salix acquisition, I have outlined a strategy at the end of this article.
One of the most useful tools for detecting earning manipulation is the Beneish M-Score. Developed by Dr. Messod Beneish of the Kelly School of Business, and detailed in The Detection of Earnings Manipulation. The M-Score uses forensic accounting principles to produce a "Probability of Manipulation" or PMAN for any given company by comparing two 12 month periods.
I was first introduced to the Beneish M-Score in Quantitative Value: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors. This book is excellent and I wholeheartedly recommend it.
In the book, the authors relate a story about an MBA team from Cornell which used the M-Score to give a "sell" recommend on Enron, a full year before it's collapse.
So what does the M-Score and its Probability of Manipulation say about Salix Pharmaceuticals?
"Never is there just one cockroach in the kitchen" - Warren Buffett
In Quantitative Value, they noted the M-Score gave Enron a 30.5% PMAN. For 1Q14 Salix has a 50.8% PMAN. That is what I call a red flag. Even it's 2Q14 score of 5.8% is high enough to be considered a weak signal.
Let's do some more digging; what is the M-Score recognizing in Salix to give it such a high PMAN?
The Beneish M-Score is a multifactor model with eight variables, each being a hot spot of earning manipulating activity. The eight variables are below:
Lets look at the table below to see how Salix scored on these variables compared to peers:
Based on the table above, and information the company has shared, I expect the following outcomes from the audit committee:
In short, I believe investors should be very cautious on owning Salix shares until the audit committee releases their findings. An approach for those determined to make a bet on a Salix acquisition should consider a small starter position, with the intention to use the negative headlines from the audit committee as an opportunity to buy on weakness.
I have no position in Salix Pharmaceutics as of this writing, but may establish one in the future.
Could the blowup at Salix Pharmaceuticals been seen in advance? This is a Monday morning quarterback look at the financials in search for a tell.
Investors in the pharma and biotech space are accustomed to certain risks; Clinical, regulatory, and commercialization risk are at the top of healthcare investors mind.
Accounting shenanigans are not the sort of thing that keeps healthcare investors up at night. This is why the channel stuffing scandal at Salix Pharmaceutical has been so shocking, despite Bristol-Myers and Medicis having paid to settle channel stuffing allegations in the past.
With Q3 2014 earnings, Salix Pharmaceuticals announced that key product inventory levels at distributors are elevated to nine months, well beyond the levels previously disclosed. Adam C. Derbyshire, former Chief Financial Officer, has stepped down, and an independent audit committee has been convened to figure out what exactly went wrong.
The problem with channel stuffing (besides being misleading) is it steals sales from future periods. This approach could be used by management in a one-off scenario, with a low risk of being found out. However human nature leads them back to the same well until it is dry.
There are legitimate reasons for distributors to allow inventories to build. For example, expected price increases, supply issues, and rising demand. While these all could play a part, management has all but admitted to channel stuffing. Below is a great graphic on the pharma supply chain from ContracIQ.
Why would distributors accept more inventory than needed? Because the company incentivizes them to stock up, so that the company may meet their sales targets. This is typically done through special financing arrangements. Extended payment terms, and product discounts are typical.
A channel stuffing company would show an unusual rises in accounts receivable due to the extended payment terms, and timing. These deals typically occur near the end of the quarter, when management knows it won't hit sales targets on their own. Also look for some impact on gross margins, due to discounts offered to incentivize distributors.
I recommend What's Behind the Numbers?: A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio. Authored by a short bias fund manager, it exposes many of the accounting tricks companies pull, such as channel stuffing.
When evaluating receivables, you have to look at it relative to revenues, as a quickly growing firm would naturally have rising receivables. Furthermore, you have to look at the trend in receivables. Quarterly Year over Year comparisons smooth out seasonality, and is the preferred metric.
There few reasons AR can grow faster than sales:
The huge spike in Q1 2014 is suspect. Salix closed the Santarus deal on January 2, 2014. Could it be related the the Santarus acquisition?
Santarus had $43.5M in receivables in Q3 2013. Salix receivables rose from $146.9M in Q4 2013 to whopping $438.5M one quarter later Q1 2014. So that doesn't explain it. If there is a smoking gun, I would say Quarter Y/Y receivables growth is it.
These types of issues apparently scared off Allergan.
Furthermore, I haven't seen anything in the earnings calls or filings that explain the dramatic rise. Not that I would believe it now, coming from a disgraced CFO.
The overall level of receivables were also very high. Among a peer group of companies I created for this research, Days Sales Outstanding for Salix was the 3rd highest.
What about that other factor I mentioned, gross margins?
Margins have been impacted too. On this item, management had an explanation, however I would not be surprised if the audit committee ends up questioning this statement:
“The lower gross margin in the second quarter of 2014 was due primarily to the inclusion of sales of GLUMETZA, which carried lower gross margins than our other products.”
I find it particularly telling that in the Q1 2014 and Q2 2014 earnings call transcript, the word "discount" never appears. However, on the Q4 2014 call , the interim CFO had this to say:
"As we said, the shortfall is because of our prescription growth on our key products is less than we had expected and then because of the turnover in the Santarus sales force, wholesaler discounts higher than budgeted and higher-than-expected rebates on the Santarus products."
Going forward, what should investors focus on? We have the pending audit committee review, and this statement:
"...management believes that the company's accounting in relation to sales to wholesalers has been appropriate, and that any questions related to that have all been vetted. Our auditor, Ernst & Young, has conducted its quarterly reviews for each of the 3 quarters. They've also informed us that they stand by their unqualified opinion in respect to their 2013 audited financial statements."
This does not mean there will be no revisions to prior period financials, it does mean E&Y does not expect the revisions to be material in nature. While management has tried its best to assure there are no other issues, investors are applying the "one cockroach in the kitchen rule" and staying away. I missed the drop in Salix due to my focus on smaller firms. I currently have no position, but that may change, pending my research below.
In the next post, I will be exploring metrics that may be used to identify earnings manipulators, in the attempt to determine what other revelations Salix investors should expect from the audit committee, if any.