Forbes Investor Team Recommends Genentech Stock, Even Though It Stopped Trading 16 Months Ago

File this away as the most amusing item of the day. I always get a kick out of some of the investment articles I see on various finance-related web sites. Now, I am sure I have made a few mistakes over the years on this blog, but never anything like what the Forbes Investor Team posted on their site today. In a piece written by John Reese of Validea Capital Management, there are four stock recommendations, including Genentech. Here is what John says about the company:

The South San Francisco-based biotech firm ($100 billion market cap) has averaged a 22.1% ROE over the past three years, has increased EPS in six straight years, and has almost three times as much net current assets as long-term debt. It isn’t cheap, selling for almost 30 times trailing 12-month earnings, but my Lynch-based model thinks it’s worth it, given its 41.6% long-term growth rate. (I use an average of the three-, four-, and five-year EPS growth rates to determine a long-term rate.) Another reason the strategy is high on Genentech: the firm’s conservative financing. It has a debt/equity ratio of less than 20%.

Of course, this is amusing because Genentech was acquired by Roche more than a year ago, in March 2009, and the stock has not traded since. I have to question this manager’s “Peter Lynch-based model” given that it flashes buy signals on stocks that do not even exist anymore. Hilarious.

Despite Better Growth Prospects, Investors Are Shunning Biotechnology and Big Pharma Firms Alike

It was not too long ago that leading biotechnology companies fetched premium multiples to their large-cap pharmaceutical competitors. As the large well known pharma companies face many patent expirations in coming years, smaller and more growth-oriented biotech firms commanded both higher valuations and more favorable outlooks among investors. However, for some reason in recent months we have seen biotech stocks give up much of that premium. For the first time I can recall, many biotechs trade for below-market prices, in-line with slower growth pharmaceutical counterparts.

Here is a summary of some leading large cap stocks in both the biotechnology and pharmaceutical areas. You can see that the P/E ratios are very similar but the projected growth rates are meaningfully higher for the biotech sector, by a factor of nearly 5x. The only conclusion I can make from this is that biotech stocks continue to deserve higher relative valuations, but for some reason Wall Street has lost sight of this recently.

Trading in Dendreon Stock Shows Why Short Term Trading Is Such A Gamble

You may have heard about Dendreon (DNDN), a small money losing biotechnology company that is in the process of getting its cancer vaccine, Provenge, approved by the FDA. Full results from a crucial phase three study were released yesterday afternoon in Chicago, but about half an hour prior to their release, shares of Dendreon fell off a cliff for a couple of minutes and trading was halted for “news pending.” Between 1:25pm and 1:27pm ET Dendreon stock fell from above $24 to as low as $7.50, and were halted at $11.81 per share.

Immediately investors were baffled. The most plausible explanation was that the full study results somehow were leaked early, someone learned they were bad and sold their stock, which in turn caused others to panic and sell too. That would have been an odd turn of events, however, because the company had indicated recently that the study results were clearly favorable.

When the news was finally released to the public there were no surprises, which makes those trades just before 1:30pm very strange. The NASDAQ exchange quickly investigated the trades to see if any were made erroneously, but they found nothing wrong and the trades will stand. Today the stock reopened and is currently fetching about $24 per share.

This story only serves to further my personal belief that short term trading in the stock market is so speculative that it is really nothing more than gambling. Evidently somebody somewhere thought they saw or heard something that was negative for Dendreon, others followed suit and sold their shares like lemmings jumping off a cliff, but in reality there was no news at all.

Undoubtedly some investors quickly hit the sell button during those few short minutes yesterday afternoon, fearing that if they didn’t their stock would fall even further (Dendreon stock sold for $2 in March, so many people had huge gains). They lost between 50% and 75% of their money for no reason. Other investors surely had large paper gains in Dendreon and had stop loss orders in place to limit any future losses. Many of those stops were triggered as the stock collapsed from $24 to $7 and rebounded to $12 and those investors also lost big time.

As you can see the market is very complex and sometimes things happen that are not rational and should never have happened. Speculating on near term movements of stocks (especially small biotech companies) is a very risky endeavor. All the market needs is a willing buyer and a willing seller to agree on a price in one split second. Reality need not apply in such a case, but millions of dollars can be lost in a matter of minutes, as was the case with Dendreon yesterday.

Traders beware. In some cases Wall Street can look very much like a casino.

Full Disclosure: No position in Dendreon at the time of writing, but positions may change at any time

After a Brief Break, Here’s A Merger Arb Trade For You

Regrettably I was out of town for several days and as a result it has been awhile since I’ve posted anything. So, I decided to give you all a conservative trade idea now that the market has had a huge run over the last four weeks. We are definitely getting overbought here, so tread carefully.

Anyway, I am a big fan of arbitrage opportunities and I think there is a merger arb play right now with the pending merger between Merck (MRK) and Schering Plough (SGP). The deal should close by year-end and the agreed upon cash and stock ratio (SGP shareholders get $10.50 cash and 0.5767 shares of Merck for each SGP share they own) implies a total deal value of $25.76 for each SGP share. That represents a premium of 9.4% based on Friday’s closing prices for both stocks.

Normally, someone wanting to make this trade would simply short ~58 shares of MRK for each 100 shares of SGP they were long, wait for the deal to close, use the new Merck stock they receive to cover the short position, and pocket the 9.4% financial spread as profit. In this case, the actual return would be slightly less because Merck’s dividend yield is above that of Schering.

However, there is another way to play this (and a more profitable one) because Schering Plough has a convertible preferred issue (SGP-PB). This security pays a higher dividend than the common (7.1% versus just 1.1%) and converts into SGP common in August of 2010. By that time, it will actually convert into Merck stock, since Schering will no longer be an independent company.

The attractive thing about the convertible preferred is that it too trades at a discount to implied value upon conversion. The convertible currently trades at $210 but would convert into $214 of SGP stock if converted today. Add in the $15 annual dividend and the spread is even higher.

How would an investor play this? Simply by buying the SGP preferred instead of the common when simultaneously shorting MRK common. Rather than using common stock from the merger to cover the short, you can simply wait until the preferred converts into common in August 2010 to cover the short. In the meantime you can collect the 9.4% deal spread, a 7.1% annual dividend as well as the 4% spread on the convertible security.

Full Disclosure: Peridot Capital has positions in both SGP and MRK at the time of writing. Positions may change at any time.

Intuitive Surgical Buyout Talk Likely Overblown, But Stock Could Approach Attractive Levels When Rumors Subside

If you follow the market closely you may know the name Intuitive Surgical (ISRG). The maker of the expensive da Vinci robotic surgical system had been one of the hottest stocks in recent years before the market took a tumble. At its high of more than $350 per share, the stock commanded a startling P/E of more than 70 but the recent market correction brought the shares back down to earth, to less than $100 earlier this year.

ISRG stock has soared well above $100 (it is $107 as I write this) in part due to rumors that Johnson and Johnson (JNJ) was considering making a bid for the company. JNJ has been active in acquiring medical companies lately, but this rumor is one that seems to be started by the hedge fund community more than by industry insiders.

If the same rumor keeps coming up over and over again (like this one) but a deal never materializes, it is usually a sign that it really is just a rumor. In the fast moving trading world, especially with a high flier like ISRG, starting a quick rumor can cause an immediate reaction in the market, and profits for those who start spreading it.

Since ISRG shares have come down so much from their obscene highs, I took a quick look to see if JNJ was even mildly interested, whether the price would be right or not. To my surprise, ISRG stock is not that expensive, thanks to the recent plunge. I am not in the camp that thinks JNJ will make a run at the company right now, but even on a standalone basis ISRG has an impressive cash hoard of $900 million, or about $22 per share, and no debt. I quickly calculated core operating earnings last year to be around $4.75 per share, so applying a very conservative multiple of 15x and adding back the company’s cash gets you to a price per share in the mid 90’s ($93 to be exact).

Considering ISRG was trading below $100 before these rumors resurfaced, any drop back to that level appears to be a very reasonable price for investors who like the company’s prospects. And if a deal does come to fruition (I can’t believe ISRG management would be inclined to do a deal at these prices), that would just be an added bonus.

Full Disclosure: No position in ISRG at the time of writing, but positions may change at any time

Pfizer Might Finally Move to Help Cushion Lipitor Blow

The relatively new CEO at drug giant Pfizer (PFE) has been focusing on cost cutting, not major acquisitions, since he arrived but investors have wanted more. The company’s blockbuster cholesterol treatment, Lipitor, represents 25% of Pfizer’s $48 billion in annual sales, but the drug faces patent expiration in 2011. Fears over how the company would replace such a loss has been hampering its share price for a long time. Despite a dividend yield north of 7%, investors have been uninspired, as the stock only fetches 7 times 2008 expected earnings.

We now hear that Pfizer is in talks to acquire Wyeth (WYE) for about $60 billion. While most large deals are met with initial skepticism (Pfizer shares are down in pre-market trading to $16 and change) a large deal is very important for an industry facing large scale patent losses and limited R&D pipelines. If this deal does come to fruition, it shows that Pfizer management actually did have a plan, they just weren’t going to be rushed into it by Wall Street. With a P/E of 7 and a dividend yield of 7.5%, Pfizer shares are very cheap and at the very least have limited downside. If the Wyeth deal happens and works well, the announcement of the deal could easily mark the bottom in the stock.

Full Disclosure: Peridot Capital had a long position in Pfizer at the time of writing, but positions may change at any time

Election Worries Have Put HMO Stocks Like United On Sale

Owning healthcare stocks in an election year, especially one in which universal healthcare has taken center stage on the Democratic agenda, is not surprisingly a wild ride. With less than six months to go until our country chooses its next president, near-term headline risk for healthcare stocks should stay elevated for a while. That said, some healthcare names, most notably the health insurance providers, have seen their share prices get beaten down to levels that can’t help but get value investors’ attention.

A perfect example is United Healthcare (UNH), one of the largest health insurance providers in the country. The combination of political risk and a recent acceleration in healthcare cost inflation have investors nervous. The stock has fallen from a high of more than $59 in December and hit a new 52 week low on Thursday, trading below $32 per share. This dramatic 45 percent decline leaves UNH trading at merely 9 times trailing earnings. Such a meager valuation indicates that Wall Street is genuinely concerned that a Democrat in the White House could cripple the fortunes of the HMO industry.

History has shown, however, that wide sweeping changes are rarely accomplished in Washington DC, especially when the issue is as complicated as the broken U.S. healthcare system. Even small, productive changes are difficult to attain when politicians and lobbyists are involved in decision making that is trying to make life better for the American electorate. In other words, using history as a guide seems to indicate the current pessimism on Wall Street regarding the HMO industry may prove to be overdone. The near term headlines could very well spook investors further as the election approaches, but getting arguably the best managed HMO company in the country for 9 times trailing earnings looks like it could turn out to be quite a bargain.

Don’t get me wrong, I would like to see transformative healthcare reform in this country as much as anyone. I simply don’t think the political environment as it stands currently has a very high probably of accomplishing such a magnificent feat.

Full Disclosure: Long shares of United Healthcare at the time of writing


Merck’s First Quarter Report Substantiates View of Vytorin Overreaction

Back in February I wrote that Vytorin worries looked overdone and concluded that Merck (MRK) shares especially looked attractive. Since then the stock has dropped further (MRK is down 32% year-to-date as shown by the chart below), but yesterday’s earnings report from the company leaves my prior view unchanged.

Merck reported first quarter earnings of $0.89 per share, three cents above estimates. They also reiterated their 2008 profit view of $3.33 per share. So, MRK shares have lost a third of their value this year but Vytorin losses are not expected to meaningfully impact their earnings. Such a dichotomy makes me even more confident of my previous assertions.

Merck has lowered its 2008 projections for its share of income from the cholesterol joint venture which sells both Vytorin and Zetia by $700 million to account for the negative ENHANCE study results. While it may be too early in the year to know exactly if such a cut is enough, the fact that a $700 million hit leaves earnings guidance unchanged shows that Merck is not overly dependent on these two products.

In fact, being conservative and using the company’s low end of guidance for the joint venture, these two drugs will only represent 9% of Merck’s 2008 sales. Given they can adjust their cost structure (staff, marketing, manufacturing capacity, etc) quickly to reflect lower revenue expectations, it is not difficult to see how $700 million can have only a modest impact on overall profitability.

Merck shares today fetch $39 each, down from $57 at the outset of the year. The stock trades at less than 12 times this year’s expected earnings and yields about 4%. Yesterday’s report did nothing to sway my view from back in February. The MRK sell off still appears overdone.

Full Disclosure: Long shares of Merck at the time of writing

Vytorin Worries Look Overdone in Shares of Merck, Schering

The drug sector has been a tough place to invest in recent years as the FDA has become more and more strict, not only in approving new drugs but also with respect to labeling requirements for existing ones.

Last year, new warning labels essentially crippled the anemia drug franchise at Amgen (AMGN), and a recently released study for Vytorin, a cholesterol drug from Merck (MRK) and Schering Plough (SGP), has investors worried. The market has slammed the two stocks, after study results showed that Vytorin (a combination drug composed of Zocor and Zetia) was no more effective than Merck’s Zocor in reducing the risk of heart disease. This is important because Zocor is available in generic form, while Vytorin is a new, more expensive medication.

Zetia and Vytorin, both products of a cholesterol joint venture between Merck and Schering, netted the two companies about $5 billion of revenue in 2007, but that business is coming to question. If Vytorin is not as helpful as the companies have been claiming, scripts could move heavily toward generic Zocor and significantly impact the profits derived from the joint venture.

One of the more interesting things about this story is that the drug trial in question (called “Enhance”) actually did show that Vytorin was better than generic Zocor at reducing levels of so-called “bad” cholesterol. That important point has been widely ignored, however, because of worries that Merck and Schering have been touting Vytorin’s ability to perhaps slow progression of disease. If marketing materials have to tone down their claims, Vytorin sales would be hurt.

All of this said, there are always drug studies that show less positive effects than others. Not every patient sees benefit from a drug, but just because some people do and others don’t does not mean these drugs should be pulled from the market. Often times drug companies don’t even know exactly why drugs work, let alone why they do for some people and don’t for others. As long as some patients see benefits, their doctors will likely still prescribe them.

The FDA has gotten very strict about studies that show possible harm to patients, even if it is in very small numbers. The important thing about the Vytorin study is that not only is the drug not harmful, but it still is better than the generic at reducing cholesterol. As a result, this trial is not going to result in Vytorin being pulled from the market. Rather, it will likely lead to some people who found success on generic Zocor going back to it, with the belief that paying the extra money for Vytorin might not be worth it. For those who see lower cholesterol levels with Vytorin, there is no reason to think they will stop taking the medication.

The stock prices of Merck and Schering, meanwhile, have gotten absolutely crushed as this news has come out. The cholesterol joint venture accounts for 20% of sales for Schering Plough and 10% for Merck. With Schering’s recent acquisition of Organon Biosciences, that number should drop to 15% in 2008. Meanwhile, SGP shares are down 25% since the news hit, with MRK dropping 20%. In total, the two companies have lost $35 billion in market value despite the drugs generating only $5 billion in annual sales. Even if both are pulled from the market (unlikely given what we know so far), the reaction would be overly harsh.

As a result, both of these stocks look like steals for long term investors. A pretty dramatic drop in scripts would still likely result in maybe a 50% decrease in Vytorin and Zetia sales, which amounts to $1.25 billion for each company. It appears that the dog’s bark in this case is likely to prove much louder than its bite. I’m not saying this study is a non-issue, I merely think the market value loss we have seen is assuming much more of a profit deterioration for these two companies than is likely to occur.

In my view, based on current prices, Merck gets the slight nod over Schering for the following reasons:

1) Strong developmental product pipeline relative to the industry

2) Less of its core business relies on the cholesterol joint venture

3) Higher dividend yield (3.3% for MRK vs 1.3% for SGP)

4) Potential for incremental generic sales gains when some patients inevitably switch from Vytorin to Zocor (a Merck product)

Full Disclosure: Long shares of all the companies mentioned in this piece at the time of writing

With Growth Stocks Seeing Multiples Compress, Investors Should Make a Shopping List

Even though the market has done well this year, It has been interesting to see so many former high flying growth stocks come back down to earth. Over the last few years there was always a group of great companies that were growing like weeds and their share prices reflected those prospects. If I think about the premier growth companies of the last five years, names such as Starbucks (SBUX), Whole Foods Markets (WFMI), Genentech (DNA), and eBay (EBAY) come to mind but there are dozens of others as well. These stocks had traded at 40 times earnings for a long time. Momentum growth managers scooped them up, but others were wary of the high P/E multiples, and that caution proved to be correct.

Not surprisingly, these stocks have underperformed as multiple compression has taken place. I even wrote about Starbucks back in late 2004, in a post entitled Sleepless in Seattle, warning investors that even if the company continued to grow, the stock might not. The coffee giant, along with the other companies mentioned above have in fact treaded water or are hitting new lows lately. At some point, though, the stocks will look attractive. Starbucks isn’t worth 40 times earnings, but maybe it is worth 20 times. Same with the other names. As former growth stars come down, investors should decide if they would like to own any of these companies, and if so, at what price. If things keep going in this direction, there might be entry points over the next year or so.

Do any of the four aforementioned companies grab my attention at current prices? After all, they now trade at between 20 and 24 times 2008 earnings projections. One jumps out at me in particular, Genentech. A 21 forward P/E seems very reasonable for a leading biotech company that can likely grow earnings 15 to 20 percent annually for the next five years. As you can see from the chart below, the stock has treaded water for two years now as the multiple compressed by more than 50%. Growth investors might want to take a look.

In general, it appears many growth stocks that were once wildly overpriced are getting more reasonable. I would suggest investors who once passed on a name or two due to valuation reexamine those companies again. Decide whether you still would like to own them or not. If so, make a shopping list complete with purchase targets and monitor them. You might find some bargains.

Full Disclosure: No positions in the companies mentioned