Swallowing biotechs in small doses

Biotechnology stocks can have negative side effects, but the good ones have high growth potential.

PORTFOLIO POINT: Investors adding biotechs to their portfolio should make sure they are profitable, proven and predictable.

As a specialist in ASX-listed small industrial stocks, I rarely get involved in biotechnology stocks.

So-called “biotechs” usually have several characteristics that do not sit well with my basic investment philosophy. They are typically unprofitable, unproven and unpredictable. Let’s look at each of these terms in turn to see what I mean.

Unprofitable – I want my stocks to have a history (preferably a long history) of making money. Biotechs typically have a long history of losing money. There can often be a period of five to 10 years before a biotech even generates any revenue at all. On occasion, a biotech may succumb to market forces or failed science or both before it turns even a single dollar in profit.

Unproven – I want my stocks to have a proven business model. And whilst you can argue about whether or not the biotech business model in itself is proven or not, it’s not difficult to argue that the technology behind a biotech is more often than not unproven. Biotechs start life as a novel idea or technology that will hopefully one day solve some sort of medical problem. The technology can be aimed at anything, from a cure for cancer to a solution for erectile dysfunction. To get to its end goal, biotechs will go through years of trials and regulatory approvals. Until the technology is seen to be effective, to my mind it’s unproven.

Unpredictable – I want my stocks to have predictable earnings, news flow and operations. The predictability of a biotech is usually limited to the fact that you know it will lose money for an extended period of time. Biotechs are otherwise inherently unpredictable. In running the twin gauntlets of technology and regulatory risk, the biotech graveyard is littered with stocks that are subject to unpredictable and unfavourable outcomes.

So, having said all that, why does my portfolio include a company that has developed an innovative liver cancer treatment? Why? Because Sirtex Medical Limited (SRX:ASX) is a member of that exclusive club of biotechs that has made the leap from research and development hopeful to a profitable, proven and predictable company.

In fact, SRX has advanced so far down the biotech evolutionary pathway that I now consider this company to be more akin to an industrial stock than a biotech. Whilst it still has plenty of upside to come through from ongoing R&D and product development, SRX is in the enviable position of being self funded from its existing product, SIR-Spheres Microspheres.

Before considering the SRX product, you can see that the financials speak for themselves:

  • 32 consecutive quarters of does sales growth (that’s eight years to you and me; including right through the GFC).
  • Profitable, cash flow positive with zero debt.
  • Annual dividends paid since 2009.

SIR-Spheres Microspheres are a proven and highly effective treatment for inoperable liver cancer. The Selective Internal Radiation Therapy (SIRT) targets tumours in the liver while maintaining a low radiation dose to normal tissue.

With its technology proven, SRX is now (like many industrial stocks) focussed on production, marketing/penetration and distribution. To this end, it recently announced the tripling of its production capacity in the US.

SRX is also actively moving up the treatment spectrum from its current position as a salvage treatment (less than 1% of the patient population) toward first and second line treatments where it would potentially be available alongside mainstream liver cancer measures such as chemotherapy. In terms of distribution, SRX is well established in Europe and North America but is just beginning to penetrate the potentially massive Asia-Pacific market (currently less than 10% of dose sales).

Add to all this SRX’s ability to further develop and leverage new products from its existing R&D and clinical trial pipeline and the company is well placed to continue on its spectacular growth trajectory over the next eight-plus years.

Another stock that I consider has recently crossed the threshold from biotech hopeful toward industrial stock status is Acrux (ACR:ASX). Like SRX, ACR has a market capitalisation of around $500 million and is right in my investment universe sweet spot of mid cap industrial stocks.

After spending almost a decade in the public arena developing its transdermal (or, “through the skin”) drug administration technology, ACR is on the cusp of turning a profit with royalty revenues expected to become consistent and financially material in the next quarter or so.

ACR is in the enviable position of having a partnership agreement with global pharma giant, Eli Lilly (market cap US$50 billion). Lilly is the licensee of ACR’s main product technology and recently launched it into the lucrative billion-dollar-plus US male testosterone therapy market.

The key to ACR’s success is in it combining proven existing drugs with its innovative, patented delivery technologies. Using proven drugs means that the product development timeframe is usually shorter and the risk and expenditure lower than is typical for new drug development.

Consensus estimates have the company making $0.06 cents per share in FY13, moving to $0.25cps in FY14. At current levels the stock is trading on around 13.3x FY14 earnings, which may sound a little expensive but the growth rate more than justifies the price. After quadrupling earnings in FY14, ACR is estimated by analysts to go on and double its earnings in FY15. This is a clear demonstration of the leverage of biotechs once their products are commercialised and rolled out into large markets.

Like SRX, ACR has a suite of products it can further leverage from its existing R&D and clinical trial pipeline (including animal applications). Additionally, for the tax minded among you, ACR operates through a pooled development fund (PDF) structure, so any capital gains and dividends are ordinarily tax free to shareholders (seek your own tax advice of course).

Rob Calnon is portfolio manager at OC Funds Management Limited.

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