Who Says You Can’t Value Biotech?

First things first, a special thanks to my extremely intelligent and talented friend and colleague, Brad Hargreaves, who kindly contributes the following insights:

Who says you can’t value biotech?

Outside of supercat bonds and weather derivatives, very few things in the market are stochastic. Some things are harder to predict than others, but even the seemingly daunting waters of biotechnology can be analyzed and priced. Today, I will look at valuation of biotech companies with a very straightforward example—Curagen (CRGN), about as sure a bargain as one gets in emerging technology.

Curagen, a Connecticut-based biotech company, isn’t your typical drug-development firm launched straight out of the lab. Rather, it has a penchant for speculating in other nascent technologies unrelated to its drug pipeline. Most notably among these is a 66% stake in 454 Life Sciences, a small (~120 employee) company that develops technologies to sequence DNA for labs, hospitals, and eventually personalized medicine.

However, the details of the technology aren’t terribly important as long as similar companies exist. Cambridge-based Solexa (SLXA) started marketing a similar product last year, over a year after 454 entered the market. The take-home: Solexa, despite burning cash at the rate of $10 million per quarter, was recently acquired for $600 million by Illumina (ILMN), a biotech powerhouse. With net tangible assets of under $50 mm, Illumina paid a premium for Solexa’s technology and growth potential.

With that in mind, Curagen’s roughly $250 million market cap is surprising. Even making the very conservative estimate that 454’s weak intellectual property portfolio cuts its value to two-thirds that of Solexa’s, it’s hard to believe that Curagen’s drug pipeline is worth negative twenty million dollars. Rather, I believe that investors have simply overlooked the value of Curagen’s subsidiaries by relying on traditional pipeline-based biotech analysis.

Apple iPhone Hype – But how ’bout the long term?

Hype is by definition a short-term phenomenon. And Apple’s iPhone has epitomized it.

Of course hype, short-term results, and pumped up demand for product often blind market participants to long-term business ramifications and actual shareholder value creation. But on the other hand, world-changing innovations which started as hypes and were derided as fads have gone on to make fortunes for owners. So what’s the deal on the heels of the iPhone’s much-awaited debut — is AAPL overbought or underestimated?iphone hype

Well, first a few qualitative thoughts. As much as I may not be able to tell you with certainty where AAPL will be in ten years, I can say this: they are the reigning kings of what I’d call synergistic marketing and demand creation. In other words, whether or not they are actually innovative (that’s up for debate — iPod was not the first MP3 player, for instance), they are better than anyone at convincing customers that there product is the coolest, hippest, and best must-have invention on the face of the planet. And their success has bred only more success and greater cross-selling revenue (Paul Carton has a great discussion of Apple’s halo-effecthere).

Think of it this way — that Apple has been so successful and hip with the iPod has made computer buyers more interested in their other, largely unrelated product, the Mac. This should come as no big surprise — simple psychology informs us that, well, people love winners. This is at the heart of what I believe is Apple’s true competitive advantage. Apple has been and should continue for the foreseeable future to be a winner.

From a quantitative perspective, the added revenue if the company meets sales prediction for the next twelve months should be around $5-7 billion (or about 20% of TTM revenue). That’s assuming sales of 10 million iPhones. My quick and dirty estimate might put incremental net income from iPhone sales at around $0.60/share. So it’s not an insubstantial short-term factor. But in the long-term things become more interesting. Who’s to say the iPhone won’t flop in a couple of years and that the shares that have been so heavily bid up will topple?

Certainly not me, which is just part of the reason I won’t take a position in any shares (I generally don’t short, and almost universally avoid stocks with such rich multiples as AAPL unless exponential growth is a no-brainer). But I can at least speculate on what I think the future of the iPhone or iPhone-like products will be. For what it’s worth (and that’s probably not much coming from me), I’ll attempt to prophesy the future. I’ll keep it brief, but bold:

1) 1-4 years. The iPhone sees significant demand, but competing products (likely from shops like Research in Motion) begin to cut into market share and drive down prices as quality and functionality also increases.

2) 5-10 years. Hand-held, all-in-one personal devices will ultimately become nearly as good, affordable and universal as personal computers. They’ll steal share from the desktop and laptop markets, but those devices will never entirely disappear, though they may change forms. We enter new tech era.

3) 11-15 years. Owners of said devices begin to realize that it is too risky to carry their whole life in tablet form, so devices come equipped with a body-encapsulating bubble and a life-insurance policy.

4) 16-17 years. Given the slight inconvenience of personal bubbles, the iPhone as physical device is replaced by implanted brain chip with telepathic email functionality, trance-inducing sedatives that allow you to watch YouTube videos in your mind.

5) 18-20 years. YouTube, Apple, and Google merge to form You-Google-Appletube, with combined market cap (adjusted for inflation) of $17 trillion and a PE of 245.

6) 21-24 years. All human interaction is replaced by electronic communication.

7) 25-26 years. World peace.

Citigroup, Lampert et al.

I just scooped up some Citigroup shares. I’ll be honest: I didn’t dig ultra deep into any filings yet, as I figured the thesis may no longer be applicable by the time I finished reading the massive tome that is a Citigroup annual report. My reasoning was simple — the sprawling firm has some premier properties, trades at what I consider unjustifiably low valuations, sports a strong dividend yield to provide downside risk protection, and has garnered the sponsorship of a few well-respected value guys, namely someone I consider a Graham and Doddsville superinvestor, Eddie Lampert.

Given that I don’t have many extraordinarily knockout ideas right and had some cash that could have been put to work, I felt this was a safe place to park some dough with the added benefit that a catalyst (breakup, anyone?) could send the shares significantly higher. My back of the envelope calculations put a break-up value at somewhere between current prices and a whole lot more. This highly scientific reasoning is coupled with the fact that Citigroup sports solid returns on equity, respectable — albeit modest — growth for a behemoth its size.

Bottom line: potential for outsized upside, downside protection with dividend yield around 80% of Treasury yields, and lots of smart money showing interest in catalyzing an opportunity.

FreightCar America (RAIL) still temptingly cheap

I’m still doing some work trying to understand the railcar and coal industries, motivated largely by my feeling that RAIL represents a great opportunity. With 80% North American market share in the coal car manufacturing and with the substantial majority of the company’s business tied up in delivering to this market’s participants, it’s clearly an important item of research.

The industry is in a bit of a bubble, some say, that will burst within the next few months/years. Nonetheless, I think this may be a good time to by RAIL, since the bearishness on the industry going forward in the short-term has left the stock under-appreciated and poised to break out over the next few years, as coal has become a more long-term viable and growing business.

Things I like about the company:

– Great market share

– Working to diversify its revenue stream by offering cars catered to the needs of other buyers (not just coal transporters)

– Great returns on capital and respectable margins

– Growing institutional interest given Buffett’s recent railroad purchase and the cheapness of the stock

– Transparency of a good chunk of the next year to two year’s revenue given the nature of contracts with customers and order backlog records.

Things I don’t like:

– Cyclical business

– Product with long life-cycle, dependent upon spotty orders and infrequent repeat business for replacements

– My own uncertainty of the coal industry

Follow up with ETLT

I had some entirely unsuccessful and obfuscating conversations with Heron Public, Eternal Technology’s investor relations department. The failed to follow up on some simple questions (like “who are your major customers?”) and had trouble understanding what I was asking for others.

Language barriers are a problem, so I won’t fault the company for this (yet). I still think the opportunity, if nothing lurks beyond the surface, is interesting and enticing. I bought a small chunk of stock weeks ago and have seen a nice return following the 5% stock buyback announcement. I don’t think it’s all that great news, given that the company has been massively dilutive in its issuance of lots of shares, often at cheap prices (not a spectacular sign).

Yet the multiples are still dirt cheap (less than 65% of my estimated book value and at a PE multiple that will make you salivate) and I figure it’s worth the calculated risk given the small stake and possibly large upside. The verdict is still out on whether the business model is sustainable, but the downside risk exposure of massive failure in the operations of the business anytime soon is virtually nil.

The Month of June

Clearly I checked out from writing in June. But I’m back from that little hiatus, and I’ve decided to write more concise, to-the-point articles that will allow me to be more prolific in July. I’ve been thinking that I’m at the point where I have a bunch of ideas, but just don’t have time to share them in the the standard, longer article format.