A Value Investor In Biotech
As a value investor, and contrarian, I am attracted to companies, sectors, and industries, that other investors are currently afraid of. This lead me to the Health Care sector and United Therapeutics Corporation (UTHR). At today's price in the current market conditions, is United Therapeutics going to outperform the market over the next 7-10 years?
“Value investing is at its core the marriage of a contrarian streak and a calculator," Seth Klarman
Source: Google
United Therapeutics is a mid-cap biotech company with a market cap of about $4.86 billion that develops and sells drugs treating chronic and life-threatening diseases. The stock is currently trading just above its 52-week low of $107, and well below its all-time high of $188, at about $111. Over the past five years the stock is up about 82%.
Source: Google
Competitive Advantage(s) and Catalysts
The company owns a patent portfolio protecting its most valuable products, they dominate a niche market, they operate in an industry with high barriers to entry, and they have an intriguing growth opportunity lurking.
Their patent portfolio is currently a competitive advantage as it stands, but investors must be aware that this competitive advantage is not durable, and will be removed at the expiration of their patents if they are not replaced with equal (or better) quality patents.
They operate mainly in a niche market focusing on the treatment of Pulmonary Arterial Hypertension. According to Million Insights, the Pulmonary Arterial Hypertension market is expected to grow annually by about 5.7%, from $5 billion in 2015 to $8.7 billion in 2025. Their niche focus has allowed them to become a dominant player in this market, and their continued focus will allow them to benefit from the growing market. This focus has also allowed United Therapeutics to efficiently control its R&D costs and significantly outperform the industry in multiple key operating metrics.
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Source: Graph, self-created. Data, TDAmeritrade/FactSet
On the surface, it may not seem that there are high barriers to entry when it comes to biotech, as there are new companies popping up frequently. However, when you think of it from a regulatory perspective, there is quite high barriers to entry. Not only is it difficult to obtain regulatory approval for new drugs, but it would be very difficult to challenge United Therapeutic's dominate market share position. It would take significant capital and resources to challenge United Therapeutic's current market share, limiting the number of potential competitors.
United Therapeutics also has an intriguing growth opportunity underlying their normal business model. They acquired a company that once cloned a sheep (it sounds kind of crazy, I know), and is now focusing on creating an unlimited number of organs that can be transplanted. Their subsidiary is currently the early leader in an estimated $100 billion industry. It is very early on for this industry and company, but is certainly an intriguing area to look towards for growth. It is speculative and a long-term play, but this could prove to be a large catalyst for the company.
The largest catalyst on the horizon for United Therapeutics (and most biotech companies) are the drugs they have in their pipeline. Their Near-Term Pipeline Program (2018-2021) includes Implantable System for Remodulin (pending regulatory approval), RemUnity (Pre-NDA), OreniPlus (Phase IV), Tysuberprost (Phase III), RemoPro (Pre-Clinical), Dinutuximab (Phase II/III), and Tyvaso-ILD (Phase III).
Source: United Therapeutics website
Their Medium-Term Pipeline Program (2022-2025) includes Tyvaso (Phase III), Auror-GT (Phase II/III), and OreniLeft (Phase III).
Source: United Therapeutics website
Source: Pharmacology 2
Risk(s)
{C}Those patents I mentioned, some of their most important products have patents that are expiring - Orenitram, Remodulin, and Tyvaso. Once these patents expire, United Therapeutics will likely lose a significant portion of their revenue from these drugs to generics. This is much of the reason why the stock has been on a decline over the past 52-weeks. Investors are uneasy with the future of United Therapeutics once their most important patents expire/as they near expiration. However, this risk can be reduced/removed through FDA approval of drugs described above in their pipeline.
The high barriers to entry help protect United Therapeutics against their competition, but the regulatory requirements (FDA approval) that create this barrier to entry cause issues and provide great risks for the future of United Therapeutics. The risk of their future drugs not being approved by the FDA is certainly prominent. If their new drugs are not granted FDA approval, they will see their operating results decline rapidly. This has also cast a dark shadow over the future of United Therapeutics as investors are pessimistic about the approval probability of some of their drugs, and to what degree of impact they will have, if approved.
Management receives overwhelmingly high compensation that I do not particularly agree with; this could be an early characteristic of poor culture within the organization.
Valuation
With the significant risks discussed above, I attempted to be conservative with my growth estimates in my models discussed below.
Starting with a sales multiple, it seems the company is significantly undervalued. Al Meyer's Price to Sales Ratio Rule of Thumb says the following:
Source: Graph, self-created. Data, ValueWalk
Based on United Therapeutics current net margin, they should receive a 5-6x multiple on their sales. Leaning on the more cautious side, I used a 5x multiple, which values the stock at $192 - quite a bit higher than today's price of $110. With the patents set to expire, it is possible sales will fall in the short-term before rising over the long-term. Based on today's price and the previously used 5x sales multiple, sales would need to fall to $997 million for the stock to be fairly valued.
Taking a look at their free cash flow, it has been in a strong uptrend, with about 13% annual growth over the past five years. With the company facing multiple challenges in the near future, it is unlikely their free cash flow will continue to grow at this rate.
Source: Graph, self-created. Data, United Therapeutics 10-K
In my conservative estimation, I expect them to continue to grow their free cash flow at an annual growth rate of about 6% over the next five years (half of the growth rate of the past five years), and 3% over the following five years. Using those growth assumptions, the company's stock has an intrinsic value of about $127-128 - again, quite a bit above today's price.
Source: Graph, self-created. Data, United Therapeutics 10-K
At its current stock price, I expect the stock to return about 10% annually. On a relative basis, they are undervalued compared to their peers, commanding a 15x P/FCF multiple, as compared to their 10-year average of 17.5x and an industry average of about 33x.
On a relative basis, the company is trading at an Acquirer's Multiple of just 5.23.
According to Tobias Carlisle, The Acquirer's Multiple is the value metric financial acquirer's use to find takeover targets. It is calculated by taking the market cap of a business, adding in their debt, minority interest and preferred shares, then removing cash and cash equivalents to get the business's enterprise value. The enterprise value is then divided by operating earnings (similar to EBIT, but without special revenue sources). I prefer to use operating earnings instead of EBIT due to the reasons Mr. Carlisle explains in his book The Acquirer's Multiple, "Operating earnings differ from EBIT because the operating earnings figure is worked out from the top of the income statement down, and EBIT is worked out from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries, and sectors possible. By excluding special items - income that a company does not expect to recur in future years - ensures that these earnings are related only to operations … Operating earnings allows an apples-to-apples comparison between stocks with different mixes of debt and equity." (Carlisle 75).
The lower the Acquirer's Multiple, the more undervalued a business is. "Think of the enterprise value as the price you pay and operating earnings as the value you get. The lower the Acquirer's Multiple, the more value you get for the price you pay and the better the stock." (Carlisle 67). An Acquirer's Multiple of 5.23 is quite low, especially in this market environment.
Opportunity Cost and Macro Factors
{C}Before making any investment decision, an investor must weigh that opportunity against other available opportunities; one investment may be expected to return satisfactory results in isolation, but could be subpar when compared with other opportunities. With the S&P 500 at a Shiller P/E ratio of about 32, the US market is priced for a 3% annual return. 10-year US Treasuries are yielding a nominal 2.8%, and a real return of less than 1%. The opportunity to invest in United Therapeutics discussed above are all priced at an expected return significantly above that of the S&P 500 currently.
Not only are opportunity costs important to consider, but there are multiple concerning macro factors that could impact the short-term success of this investment:{C}
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- US private debt to GDP is at 200% - highest since the last financial crisis.
- Business cycle may be near its peaks with US unemployment rates at 30-year lows.
- S&P 500 is priced over 90% higher than its historical average of 16.8, on a Shiller P/E basis.
- One of Buffett's favorite metrics for valuation, the Wilshire 500 Total Market Index/GDP, is at 162.52% - far higher than we have ever seen before.
(Click on image to enlarge)
Source: St. Louis Fed
Summary
As a value investor, I am far from a market timer; I look for opportunities to buy great businesses at a reasonable price with a margin of safety. However, I cannot help but think that there may be much better opportunities on the horizon. Are investors better off accumulating a large cash position so they have a large sum of capital to deploy when better opportunities present themselves? Before every investment decision I make, and even more frequently these days, I remind myself of one of my favorite Warren Buffett quotes, "Charlie and I have no magic plan to add earnings except to dream big and to be prepared mentally and financially to act fast when opportunities present themselves. Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do."
United Therapeutics has recently settled claims about their participation in illegal Medicare activity, and have many new drugs in the pipeline, a few of which FDA approval is expected with relative certainty. They have done well in the past keeping costs low, but have struggled as of late with R&D costs and costs of product sales doubling, and significant increase in royalty fees for Adcirca. They are also facing increasing competitive pressures and management has guided for lower revenue and profits in 2018. There is also great risk in biotech companies not having their drugs approved by the FDA. There are possibly bright spots for United Therapeutics, but their future is uncertain. Their stock is priced to outperform the S&P 500 over the next ten years, but may not be worth the opportunity costs for an investor.
Based on the current risks facing United Therapeutics, the risk-return profile, and the macro factors discussed above, I am not interested in initiating a position at today's prices. It is certainly an interesting company I will continue to watch; should the price of their stock continue to drop, I may reevaluate the investment thesis.
As an investor, you must decide if you'd rather make an investment now, or prepare your washtub for the impending dark clouds. I will be passing on United Therapeutics and preparing my washtub.
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