2 Cheap Biotechs With up to 80% Upside

Tim Begany's picture

Monday, April 18, 2011 - 11:00am

by Tim Begany

If you're seeking worthy biotech stocks, don't let the industry's high price-to-earnings (P/E) ratio of 28 deter you. Though generally expensive, the biotech sector still has great values.

In fact, there are biotech stocks with P/E ratios less than half the industry average. I foresee some of these stocks delivering absolute returns of up to 80% in the next three to five years. That's roughly 12% to 22% annually through 2016.

Here are two stocks which currently fit that description.

Gilead Sciences (NDQ: GILD) is a large cap that develops drug treatments for HIV, the virus that causes AIDS. It's trading at only 12 times earnings -- just 43% of the industry average -- because key HIV drug patents will begin expiring. But that's not for five years, which gives the firm time to address the problem -- a process that's already underway. Meanwhile, earnings are expected to grow an average of 11% to 12% annually.

Future depends on HIV meds
Gilead's patent concerns are related to Truvada, an HIV drug that accounts for a large portion of revenue (33% in 2010). Truvada is actually a combination of two other HIV drugs made by Gilead -- Emtriva and Viread -- whose patents expire in 2016 and 2017, respectively. While years off, the expirations could severely hinder long-term profitability by allowing rivals to introduce competing products.

However, there's a new "quad" medication in the works that combines four of Gilead's HIV drugs. The quad drug's efficacy hasn't been conclusively proven yet, so the Phase III clinical trial results expected late this year will provide crucial data.

Favorable findings would likely push Gilead's stock up immediately even though the quad drug wouldn't be on the market before late 2012. Because the HIV epidemic keeps growing, strong demand is certain as soon as the drug is available -- provided it does well in the Phase III trial. If it does, then the stock could pop 5% to 10% right off the bat followed by additional gains of 50% to 70% in the next several years.

A lot rides on the new drug, but Gilead also has other meaningful revenue sources like royalties on the influenza drug Tamiflu, a line of hepatitis B therapies and new heart-disease drugs. The company is also looking for acquisitions to enhance the heart disease and hepatitis B franchises, and reduce reliance on HIV medications.

Amgen (NDQ: AMGN), also a large-cap biotech company, has three key drug types: anemia medications for patients with chronic kidney failure, infection fighters for chemotherapy recipients and autoimmune therapies for diseases like rheumatoid arthritis and psoriasis. This stock trades at only 11 times earnings, a mere 39% of the industry average.

Why so cheap?

Two of the firm's blockbuster anemia drugs, Epogen and Aranesp, were found to have safety issues. On Feb. 16, 2010, the Food and Drug Administration (FDA) confirmed reports beginning in 2007 that both drugs can increase tumor growth and shorten survival in cancer patients at higher doses. They can also raise the risk of heart attack, heart failure, stroke and blood clots in non-cancer patients.

As a result, shares have been trading in a fairly narrow range despite rising profits and measures to address the risks of the drugs. It's a value opportunity you don't see that often, especially three years into a bull market.

Controlling risk through REMS
To avoid further safety issues with Epogen and Aranesp, Amgen has developed an FDA-mandated Risk Evaluation and Mitigation Strategy (REMS). That simply means patients treated with Epogen or Aranesp have to get a printed guide detailing all drug risks and benefits. Amgen must also ensure the drugs are only prescribed by hospitals and health care providers who've completed an FDA-mandated training program.

Despite the Epogen and Aranesp headaches or perhaps because of them, Amgen's stock has 80% upside potential through 2016. It's very much a case of the stock price catching up with prior earnings, which grew an average of nearly 11% annually during the past four years even as the stock went virtually nowhere.

Importantly, earnings growth for Amgen is expected to remain solid, averaging an estimated 7% to 8% annually in the coming three to five years on existing product sales and new acquisitions. In January, for example, Amgen bought the Massachusetts-based biotech company BioVex for $1 billion, thus adding the promising cancer vaccine OncoVex to its product pipeline.

The list of current blockbusters includes five drugs, each with annual sales of more than $1 billion. Two examples are Neulasta and Neupogen, drugs used to prevent infection in chemotherapy patients. Prolia, an osteoporosis drug approved by the FDA on June 2, 2010, could easily join that list.

And while safety issues have hurt sales of Epogen and Aranesp, both are still bringing in big bucks -- about $2.5 billion each last year. Epogen faces growing competition from generic alternatives in Europe though, and its U.S. patent expires in 2013. Aranesp's U.S. patent expires in 2014.

Action to Take --> Of the two stocks I've described, Gilead is obviously more speculative because its future depends so much on the new quad drug it's developing. The drug has shown lots of promise and could be highly profitable if proven effective.

Previous study findings have been mixed, though. So it's up to the Phase III trial to provide the definitive results that either help propel the stock to large gains or prompt the market to mete out some more severe punishment.

I'd wait for those results and buy Gilead stock if the findings are positive. Since key patents begin expiring in five years, I'd also evaluate the stock regularly to see if it's worth holding beyond the intermediate term.

Amgen seems a surer bet because of its impressive list of blockbuster drugs and more varied product pipeline. I suggest buying it now before the market realizes it overreacted to the troubles with Epogen and Aranesp.

P.S. -- I don't know if you're aware of this or not, but a 20-year energy agreement between the United States and Russia is about to expire. The problem is, this deal supplies 10% of America's electricity. When the Russians refuse to renew the agreement, the U.S. will face an entirely new kind of energy crisis. This disruption could send a handful of energy stocks through the roof. Keep reading…

Tim Begany does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.