Forget High Tech, Biotechs Are Back: A Preview of 2002

by Brian Hicks

I just returned from a speaking engagement at an investment conference in Las Vegas. If there was ever a city that vacillates in tandem with the ups and downs of the stock market, it’s Vegas.

The effects of the bear market could be seen everywhere you looked.

Gone are the voluptuous women working the casino to land a millionaire boy-toy from Silicon Valley.

In their place are the countless "cousin Eddies" who’ve arrived by way of Winnebago. With discount coupons in hand for the all-you-can-eat buffet, they mill through the casinos to catch a glimpse of what was once the American dream.

To further drive the point home, the hotel I stayed in was in Chapter 11 bankruptcy. No taxi service whatsoever… no complimentary "wet bar" … and it took 2 hours just to get room service.

Not exactly my most pleasant business trip.

But you don’t have to visit Vegas to see the rubble of the once mighty high-tech bull market.

Check this out. As I write, shares of Sun Microsystems (SUNW:NASDAQ) have been down as much as 89% since its 2000 highs. The company has lost an estimated US$177 billion in market valuation.

But nothing compares to the devastation Cisco Systems (CSCO:NASDAQ) has experienced. Once the largest high-tech company in the world, with a market cap north of US$580 billion, Cisco has been down as much as 87%.

It lost a bowel-shaking US$500 billion in market valuation within 18 months.

And although high-tech shares have recently exhibited strength, investors are in no mood to buy stock in technology companies based on potential. They want profits… and they want them now. Which is why I’m really excited about small caps.

There is only a handful of small-cap stocks outside of biotech that I like. And the 3 I like best heading into 2002 are Titan (TTN:NYSE), JAKKS Pacific (JAKK:NASDAQ), and Optimal Robotics (OPMR:NASDAQ).

A stock among giants–Titan Corporation (TTN:NYSE)

Here’s another stock in the "who’d a-thunk it?" category. Taipan originally recommended Titan as a diversified conglomerate with a potential blockbuster product in its SureBeam (SURE:NASDAQ) division.

As you probably know, SureBeam makes a food irradiation product that can be used to kill harmful bacteria in meat. We recommended it as a way to take advantage of the big "mad cow disease" scare. Little did we know the U.S. was about to be attacked by terrorists mailing anthrax-laced letters. But, as it turns out, Taipan members were already well positioned.

SureBeam quickly announced that its product could kill anthrax bacteria, and the race was on. The stock rocketed upward and Titan, the parent company, soon followed. Taipan members are up 50%+ so far. And it looks as though there’s more to come.

The U.S. Post Office is buying some of these systems, and Taipan expects more sales will be announced over the next couple of months.

Trading at a market cap of US$1.7 billion on trailing twelve-month revenues of US$1.09 billion, Titan offers investors substantial growth at "value stock" prices.

Just check out the numbers:

Titan grew the top line 130% between 1998 and 1999. And then grew it 56% between 1999 and today. I love it.

As a safe, diversified play on the security and antiterrorist market, we continue to rate Titan a strong buy.

The real toy story–JAKKS Pacific (JAKK:NASDAQ)

JAKKS has been in full-on rally mode based on a strong third-quarter earnings report and anticipation of a good holiday season for its toys.

Christmas spending is expected to be very light this year, and that bodes well for JAKKS. Its toys are inexpensive, and that’s exactly what parents will be looking for.

Taipan expects to see JAKKS rally into the December shopping season on the strength of its Battle Bots toys.

Battle Bots could be this year’s Tickle Me Elmo or Cabbage Patch Kids. We’re looking at a price target in excess of US$30 and US$35 by the beginning of the year, with an outside chance of getting close to US$40.

US$25 a share would mean a P/E of 15.6, which is very reasonable for a company growing the bottom line at the rate of 19% a year.

Regardless of our price target, we’ll be looking to sell JAKKS Pacific sometime in the first quarter of 2002.

Toy companies generally run up in October and November in anticipation of good quarterly numbers. But they also tend to sell off after the holiday spending spree, because sales will take a nosedive after Christmas.

It’s typical buy the rumor, sell the news action.

Optimal Robotics (OPMR:NASDAQ) remains one of the most compelling small-cap stories in the market today

Optimal Robotics has been a core Taipan pick ever since we initially recommended it at US$11 a share back in 1998. At the time, Optimal was doing US$10 million a year in revenues, and no brokerage firms or analysts would touch it.

Except for Taipan.

We immediately saw the potential for this stock, and recommended it to our readers.

We knew the company’s U-Scan Express self-checkout systems were a potential boon to investors.

Well, 3 years and 155% profits later, our insight has proved correct. More than 5,000 U-Scan Express systems have been sold. And a total of 167 institutions now hold Optimal Robotics stock, with 7 brokerages covering it. And we’re still beating them at their own game.

I’d like to direct your attention to the events of October 2 and October 3, 2001. On October 2, Optimal announced a revenue shortfall and earnings warnings for its third and fourth quarters. The stock got killed the next day, losing 30% of its valuation. Brokerage firm Raymond James added insult to injury by downgrading the stock on October 3.

Things looked bad for Optimal Robotics. But I saw opportunity. We know this company inside and out, so we knew this was a one-time event–and the selloff made for a sweet re-entry point.

OPMR rallied as expected–going from about US$20 a share to more than US$30.

The stock has cooled off a bit. But we still love it.

WHY THERE ISN'T A BETTER TIME TO INVEST IN BIOTECH

There’s no easy way to say this, so I’ll just come out it say it–the terrorist attack on September 11 created probably the best buying opportunity in decades.

Don’t get me wrong–I wish things were different.

But they’re not.

And that’s the point I want to get across to you: Whatever you do in the next couple of months, do not–and I mean do not–let the terrorists scare you out of this market.

Please.

The current tragedy took stocks down to levels not seen in years.

The NASDAQ, for instance, was brutally hit by the attacks–making an already shaky index even more unstable.

As I write, the NASDAQ is trading just above 1,600. And this is still better than the 1,430 it slipped to in the first few trading days after it reopened.

If you’re keeping score at home, that means the NASDAQ has lost the last five years of gains.

Imagine!

Perhaps it’s justice for the mania we witnessed in 1999 and 2000, when any stock with a ".com" suffix ran up 1,000% after its IPO.

As Dr. Dennis Burger (CEO of AVI Biopharma) told me last August at a conference in Sun Valley, Idaho, "Sometimes you have to take your medicine and deal with it."

And, as it happens, medicine is a great place to start a new bull market.

Now, I’m sure you know about Pfizer and Merck. They’re the two largest, most successful pharmaceutical companies in the world.

But that’s not the point.

The point is that the combined market cap of Pfizer and Merck is greater than the entire biotechnology sector in the U.S.

That’s right, if you add up the market caps of all of the biotech stocks trading in the U.S.–that’s more than 400 biotech companies–they come to less than what Pfizer and Merck bring to the table.

What I’m getting at here is that even though biotechs will offer superior growth in the coming years, the sector continues to trade at a discount to just about every fundamental indicator.

The glory days of big pharma are numbered

There are two camps in the biotech world: 1) the pharmaceutical behemoths full of lab-coated technicians with their beakers and double-blind experiments; and 2) the cutting-edge technologists who accomplish more in a single "lights out" night of computer analysis than an army of lab-rat Ph.D.s might manage in two or three years.

Many of the established pharmaceuticals, mired in the traditional "Petri dish" approach to drug discovery, have failed to retool with the digital technology needed to mine the genomic data that’s now readily available.

By choosing to continue down the slow, tedious path of traditional trial-and-error experimentation, they have virtually eliminated themselves from the race.

Don’t get me wrong–we owe a lot to the likes of Pfizer and Merck.

Thanks to them, and others like them, life expectancy in the U.S. went from 46 years in 1900 to 77 in 2000. That’s a gain of over 100% in a century, mainly due to better drugs coming out of big pharma.

But biotech is about to take it up a notch. In the not-too-distant future, gene-based drugs developed by biotechs will extend life expectancy by another 20% to 25%.

It’s estimated that Americans will live to an average age of 93 by 2050.

How?

Consider this: in 1999, the cumulative total of potential drug candidates that had been laboratory screened was about 500,000. For the single year 2000, using new computer and biotech technologies, the number of compounds screened for drug use was 1.5 billion.

It’s simple math. More life- saving drugs will be developed in the next decade than in the whole of the last century.

For the investor who understands how to identify the biotechs that will dominate the US$400 billion pharmaceutical market, this means an astonishing opportunity for amassing real and lasting wealth.

And there aren’t any biotechs with more potential to produce lasting wealth than Millennium (MLNM:NASDAQ) and Human Genome Sciences (HGSI:NASDAQ).

If you haven’t already taken a position in these two stocks, I urge you to do so now. Because the golden era of genomics-based medicine is here. And it’s here to stay.

From golden helix to golden era

You can tell a lot about a company’s character by the friends it keeps.

And when it comes to research and development alliances, Millennium’s list of friends reads like a who’s who of big pharma and biotech.

Here’s just a small sample of Millennium’s partners: Parke-Davis, Proctor & Gamble, Pfizer, Abbott Labs, Hoffman-LaRoche, Boehringer Ingelheim, AstraZeneca, Schering AG, Harvard, Bayer, and LeukoSite.

Taipan believes Millennium, with its gene-to-patient drug capabilities, represents the new paradigm in the biotech sector. Millennium’s powerhouse gene and protein discovery platform has already delivered numerous targets to partners.

The company has also done an exemplary job of building its portfolio of proprietary genes, particularly in the areas of oncology, metabolic disorders, and inflammation.

And the market has rewarded Millennium for its success.

Millennium currently trades at a market cap of US$6 billion. With more than US$1.5 billion in the bank, it has one of the strongest cash positions in the sector. At its current burn rate, it would take Millennium 7 years to eat up its cash. And in biotech land, cash is king.

But that’s not all. Millennium’s technology platform is so robust that it gets more than US$1.5 billion in revenues just from licensing and R&D fees from its partnership deals.

Think about that for a second. Millennium doesn’t have to bring one product to market… and it’s already on the receiving end of US$1.5 billion in revenues!

But Millennium isn’t counting on R&D fees alone. By next year, the company is expected to have a total of 12 products in the clinic, addressing the lucrative markets for treatments of asthma, melanoma, multiple sclerosis, non-Hodgkin’s lymphoma, leukemia, and obesity.

Unlike high tech and other sectors, biotechnology isn’t valued on an earnings model. Instead, it’s valued mainly on a product pipeline and price-to-sales model.

Amgen, for instance, trades at a market cap of about US$60 billion. This is on US$3.8 billion in sales. That’s a price-to-sales ratio of about 15. Compare that with Microsoft’s P/S ratio of 13.

Currently, Millennium is trading for about US$25 a share. But based on a P/S ratio of 15, it could trade for as much as US$100.00 a share within a few years as its revenues shoot up to US$2 billion.

Human Genome Sciences (HGSI:NASDAQ) remains a buy

In the past decade, Human Genome Sciences has become an industry leader in gene discovery and therapeutic protein development.

The company has identified approximately 12,000 genes for secreted proteins that could be of medical/commercial use.

More importantly, HGSI has the most advanced clinical program derived from internal gene discovery efforts of any company in the biotech or pharmaceutical sector.

This pipeline will target medical problems like breast and ovarian cancer, stroke, venous ulcers, and wound healing.

Human Genome Sciences’ list of partners is as impressive as Millennium’s. They’ve already signed up the likes of SmithKline, Cambridge Antibody Technology, Hoffmann-LaRoche, Genentech, MedImmune, and Medarex.

Human Genome Sciences is well funded, with more than US$1.6 billion in cash in the bank.

At a market cap of US$5.4 billion, Human Genome Sciences is seen as a second-tier biotech stock. Remarkable–considering it’s years away from having a product on the market. But it’s a testament to the company’s advanced proprietary clinical pipeline, which is considered to be the best in the entire biotech sector.

In my opinion, every biotech portfolio should own shares of Human Genome Sciences.

If you haven’t bought MacroChem (MCHM:NASDAQ) yet, buy it now for under US$3.00 a share!

A recent study shows that the average American’s lifespan has reached an all-time high at nearly 77 years.

And, as I mentioned above, there’s only one reason for this–better drugs.

And MacroChem (MCHM:NASDAQ) remains one of my favorite drug stocks.

I should warn you that this stock is only for aggressive investors with a high level of speculative blood.

But those investors could be looking at a 5-to-1 return on their money by next year. That’s why I’m willing to buy it at current levels.

In case you don’t know by now, MacroChem is developing an alternative to Viagra.

But MacroChem’s drug–Topiglan–is administered differently than Viagra.

Here’s the skinny

You see, this drug uses a substance that is found in two impotence drugs already on the market, Caverject and MUSE.

The main ingredient in Caverject and MUSE is something called alprostadil.

Alprostadil is considered by many urologists to be the very best treatment for impotence, because it is safer than Viagra and even produces a better erection.

Up until now, however, the only way to deliver alprostadil used a very painful method indeed.

But that’s about to change.

Instead of using a pill that has to travel throughout your bloodstream before getting to the penis (like Viagra), this new drug, which also uses alprostadil, is applied directly to the penis.

This means a quicker response (15 minutes in the Phase II trial)… and more importantly, almost no side effects.

And that’s the biggest advantage this topical gel has over Viagra and all of the other oral impotence pills being developed.

The gel affects the penis… and only the penis.

As a result, the company–and its topical treatment–could quickly capture US$100 to US$250 million in its first year on the market.

I mean, MUSE captured US$137 million in sales in 1997, and that drug is administered using what is basically a suppository inserted into the urethra of the penis.

A topical gel could easily capture more.

Besides, there’s an estimated 6 to 10 million American men suffering from impotence who can’t take Viagra because of various heart conditions.

A topical gel that treats the condition locally, without affecting the heart or blood pressure, would be a godsend to these men.

That’s why I’m recommending MacroChem across the board.

It’s a tiny stock. So it meets my strict requirements for a microcap. At current levels of just US$2.50 a share, the company is valued at a paltry US$65 million.

At such distressed valuations, I’m willing to speculate aggressively.

I’m reiterating my recommendation of MacroChem (MCHM:NASDAQ). Buy it under US$3 a share.

I recently read a report by the U.S. Census Bureau claiming that the world’s population surpassed 6 billion in October 1999. That’s double the number of 1960.

Assuming this rate of growth remains stable, the world’s population will grow to 9.3 billion in 2050.

Apparently, this alarmed a bunch of empty-headed movie and rock stars, who promptly renewed efforts on behalf of the worst idea since Michael Jackson tried to open a daycare. I’m talking about population control.

Now, I’m no social scientist or anthropologist. And I’m far from being an expert on demographic trends or population issues. But I think weirdo Jeff Goldblum said it best in Jurassic Park: "Ummmm, life finds a way to… uhhhhhh… happen, yes." (Kudos to the acting coach who taught Jeff how to ad-lib from a script.)

Point is–how in the world are you going to control population growth when you first have to control sex?

You can’t.

First, population (nature) controls itself. So if the world’s population nears a dangerous level, other factors like disease, famine and war will take care of it for us.

Second, if you reduce the human species to its most basic form, it’s no different from any other organism. Our primary goal is survival. Survival of the species.

It’s already built into our genetic makeup, so why fight it?

Enjoy it!

Think about it. Nature tricked us. It doesn’t rely on man’s benevolence to propagate the species. Put another way, it doesn’t rely on man’s "altruistic" willingness to have offspring without a reward.

Nature made sex feel good. Real good. Good enough that we keep doing it again and again and again. (I mean, would the population grow if sex were extremely painful?)

Hit or miss

Think about how many times a healthy male ejaculates in his lifetime. It has to be a couple of thousand times by the time he’s 40 years old. At least!

The odds of having 2 or 3 kids from all of that ejaculation are pretty good.

So what do you get?

Well, just as the business cycle comes in waves, so does population growth.

And there’s no better example than when millions of U.S. servicemen came home from the war in 1945 and 1946. What happened? A national sex party that lasted several years! The result was the baby boom.

The baby boomer generation is an excellent example of the "pig in the python." Roughly 80 million strong (30% of the current U.S. population), baby boomers are the engine of the economy right now.

And in the next 12 years, the oldest segment of the boomer generation will begin retiring.

To make money on stocks… follow the herd

I know, I know. That’s blasphemy. But true nonetheless.

Let me explain.

A lot of things will happen when the boomers start retiring.

But the biggest trend will be in healthcare.

You name it, it will plague people 60 and older. Heart disease, cancer, arthritis. It’s just a fact of life. The older you are, the more ailments you get.

Two diseases that will–and already are–prevalent among our nation’s elderly population are Alzheimer’s and diabetes.

Alzheimer’s costs the U.S. economy roughly US$100 billion a year.

Diabetes is huge–costing about US$98 billion annually.

But there’s a big difference between the two diseases.

There’s no drug for Alzheimer’s. In fact, the best treatment for Alzheimer’s patients is playtime and reminiscing (or trying to). Not exactly modern science.

Diabetes, on the other hand, is a manageable disease. And the investment opportunities are enormous.

Right now there are 15.7 million people with diabetes in the U.S. It’s the seventh leading cause of death. In fact, 6.5 times more people die of diabetes than of AIDS.

And, unfortunately, this number is expected to increase drastically as the baby boomers get older.

Two for the road

My diabetes recommendations hit on two themes: a drug company that will treat diabetes and a company that supplies equipment to the diabetic population.

Supply side

First recommendation: PolyMedica (PLMD:NASDAQ).

PolyMedica’s story is a simple one–it provides the diabetic market with supplies and equipment. That’s a huge market–as evidenced by the company’s robust sales growth. In 1999, PLMD did US$104 million in sales. Last year the company grew the top line by 49.7% to US$156.9 million.

But get a load of this: in the next fiscal year, PolyMedica is expected to post revenues in excess of US$220 million. A 40.5% increase over the previous year.

If that isn’t enough, check out the EPS growth.

It is expected to come in at US$2.58 in fiscal year 2002–a gain of 16% over last year’s EPS of US$2.22. A gain of 16%… yet the stock currently trades at a P/E of 9. 9!

In fiscal year 2003, EPS is expected to come in at US$3.25, a growth of 26% over fiscal year 2002… and 46% over 2001.

Assuming the stock trades at a P/E equal to its EPS growth of 26%, it would have a fair value of US$67 a share. Yet it’s now trading for less than US$25!

Without a doubt, this is one of the better "growth at value prices" plays in the market.

At a current market cap of US$275 million, PLMD offers the potential for significant capital appreciation.

Buy PolyMedica at levels under US$25.

Inhale profits

Second recommendation: Inhale Therapeutics (INHL:NASDAQ).

Inhale Therapeutics (INHL:NASDAQ) has one simple claim to fame: it takes drugs administered by needle or IV, like insulin, and figures out how to deliver them by inhalation.

Just like Aviron, which is developing a quick, convenient, and painless therapy for a huge market (flu sufferers), Inhale is developing a quick, convenient, and painless therapy for another huge market–an insulin inhaler for diabetics.

So promising is Inhale’s technology, and the Phase II results so strong, that analysts estimate aerosolized insulin can capture at least 25% of the insulin market for diabetics within 24 months of launch. This would mean sales of roughly US$750 million.

Under the current agreement with Pfizer, which will market the inhaler insulin, Inhale Therapeutics could receive peak earnings of US$3 to US$4 a share once the product is successfully launched and commercialized.

No pain, no blood, no problem

The company is developing a pulmonary drug inhalation device capable of delivering a wide range of peptides, proteins and other macromolecules that are now delivered by injection or other means.

Delivering drugs to the lung sounds simple enough, right? I mean, I was using asthma inhalers back in the 1970s.

But developing more complex drugs has been difficult, because many drugs are macromolecules (molecules with a high molecular mass).

Because of their large size, most macromolecules are delivered by injection. And those that aren’t injected typically have a difficult time entering the bloodstream in safe and efficacious doses.

But that’s changing. Innovations in biotechnology and recombinant techniques have led to a large increase in the number of macromolecular drugs. Identical or similar to the body’s natural molecules, these drugs are enabling new therapies for many previously untreated or poorly treated diseases.

To give you an idea of the potential market for Inhale’s drug delivery system, there are now about 30 macromolecule drugs marketed in the United States, with another 120 in human clinical trials. These drugs have a market value–based on 1999 sales–of about US$8.7 billion.

Because of this, it is estimated that worldwide protein drug sales will surpass US$10 billion in 2003. Sales of US$18 billion are possible by 2005.

Drugs made for use with Inhale’s delivery device are developed into a fine powder. The patient inhales the powderized formulation of the drug as an aerosolized cloud.

After reaching the deep lung tissue, the drug passes into the bloodstream.

As an alternative to invasive delivery techniques like injections, a pulmonary delivery system could expand the sales of currently marketed drug therapies by increasing patient acceptance.

And that’s the other advantage to Inhale’s business:

It can take drugs that are already approved by the FDA, develop them into fine powders, and sell them as inhalation therapies.

Now, that doesn’t mean Inhale’s reformulated, fine-powder drugs will automatically receive FDA approval.

But as a biotech investor, you want to stack the cards in your favor.

Investing in a biotech that is refining drugs which already have a long, positive history with the FDA is one way to stack the deck.

The outlook–Inhale will have a US$5 billion dollar market cap in 5 years

Taipan estimates that shares of Inhale will double in 24 months. And the way I come up with that prognosis is very conservative: I only use a revenue and earnings model for inhaled insulin.

Based on this, I assume two things: 1) the biotech sector will maintain its higher-than-the-market P/E multiple; and 2) biotech companies with blockbuster drugs and technologies will be rewarded with premium valuations.

Because of the flood of product approvals in the next 12 to 24 months, and the hundreds of drugs currently in Phase II and Phase III trials, I fully expect the biotech sector to maintain its premium P/E multiples.

Just as with Aviron–and basically all biotech stocks–timing your entry point is everything. In 2000, Inhale rallied with the entire biotech sector, hitting a new 52-week high of US$70.

The stock is down 62% from its highs as a result of the crash in the NASDAQ last year. This is an excellent time to buy.

Buy Inhale (INHL:NASDAQ) under US$20 a share.

Busted–again

My old favorite biotech, Aviron (AVIR:NASDAQ), got some bad news this year. The company’s data failed to convince the FDA that FluMist was safe. Now, from what I’ve read, I believe the FDA is saying that Aviron didn’t prove FluMist was safe… although it may indeed be safe.

The stock, of course, sank to about US$20 a share. But as I write this, it’s trading for US$33.

Believe it or not, I’m pretty impressed with how this stock is holding up. I’ve been in some stocks that were absolutely crushed after a negative FDA meeting.

That Aviron is trading at such a high price after the negative FDA review leads me to believe there’s a window of opportunity to fix the problem and get FluMist approved and on the market.

I’m maintaining Aviron (AVIR:NASDAQ) as a hold.