Are You Valuing This Biotechnology Company Correctly?

Sherrie is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

At some point, a company’s valuation must be considered when you’re deciding on an investment. This may sound like a fairly obvious statement, but in biotechnology this often gets forgotten.

Take Theravance (NASDAQ: THRX) for example: The company has an extensive partnership with GlaxoSmithKline (NYSE: GSK), a blockbuster product in its pipeline, and trades with a market cap of $3.7 billion. In 2013, Theravance has traded higher by 67%, and has been an investment favorite among retail and institutional investors.

However, at what point does a company become too expensive, and have all upside already priced into its stock? In the case of Theravance, that point might be right now.

Assessing valuation to “benefit” on sales

Theravance and its partner GlaxoSmithKline are developing four products, one recently approved and one soon-to-be-approved drug. These drugs are ELLIPTA (FDA approved) and ANORO (2014 expected approval.

These two drugs treat chronic obstructive pulmonary disease (COPD), a massive market that is estimated at over $15 billion annually. ELLIPTA is taken twice daily with peak sales potential of $4 billion, and ANORO is taken once daily with peak sales potential of $2 billion.

Unfortunately for Theravance, GlaxoSmithKline has the most to gain from the success of ELLIPTA and ANORO. GlaxoSmithKline paid for most of the clinical studies and will receive most of the profits from these two potential blockbusters. In fact, Theravance will earn just 15% of the total sales on these products. However, once $3 billion in total sales is reached, Theravance will only receive 5% of total sales.

It won't take long for $3 billion in total sales to be reached with these two products. Hence, if we fast-forward several years and assume that Theravance/GlaxoSmithKline are successful at squeezing $6 billion in total annual sales from these products -- the company's 15% royalty rate would've already been surpassed within three years of launch -- and a 5% royalty would earn Theravance just $300 million annually once peak sales are reached (if peak sales are reached).

This means that Theravance is trading at more than 12 times its peak benefit on sales right now. For a clinical company, this is extremely expensive.

A far better choice with more value/sales

Instead of investing in a company such as Theravance, I prefer a company such as ACADIA Pharmaceuticals (NASDAQ: ACAD). It currently trades with a market cap of $1.3 billion, has no partner, and is expected to see its Parkinson's disease drug approved early next year.

Neither company is currently producing sales; however the upside lies in the valuation compared to “benefit” on sales. A biotechnology company’s price/sales ratio is meaningless as is trying to predict margins on unknown products. However, by assessing the amount that a company could earn on a product after partnerships or licensing agreements, we can better illustrate its level of value.

As I explained, Theravance is trading at a very lofty premium. ACADIA’s drug pimavanserin will never return $4 billion in annual sales, but is expected to peak at $1 billion annually. Most importantly, all of that potential revenue will belong to ACADIA if it reaches the market successfully.

Last month, the FDA decided that ACADIA does not need to complete a Phase 3 study based on its prior data. Therefore, ACADIA is submitting a new drug application to the FDA and Pimavanserin should be approved by early 2014; judging by the FDA's decision to bypass Phase 3 studies.

The indication that ACADIA is seeking approval, Parkinson's disease psychosis, currently has no approved treatments -- but is treated with the off-label use of other antipsychotics. Pimavanserin is also expected to treat Alzheimer's disease psychosis and schizophrenia, off-label, two indications that are being explored in clinical studies. As a result, with the antipsychotic market being large and Pimavanserin being the best new treatment, most analysts believe that $1 billion in sales is very likely. 

With a $1.3 billion market cap and a $1 billion product, ACADIA is actually much more attractive, trading at 1.3 times peak sales. After a one-year 1,000% gain, there is a possibility that the short-term direction of the stock could produce loss, as the company is now simply waiting for FDA approval with no other catalyst. However, long-term, I think it is a great investment, and is obviously more attractive than Theravance.

Conclusion

Seeing as how both Theravance’s product is already approved, and ACADIA’s expected to have no problems with FDA approval, this is a fair comparison, and one that shows you how to assess and value biotechnology investments in the clinical setting.


Sherrie Stone owns ACADIA Pharmaceuticals. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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