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Subject:  Bio Basket 5% Date:  7/20/2008  6:11 PM
Author:  TMFBreakerWade Number:  31 of 90

Hello All,

In the spirit of Ralph Wanger,

"I always thought that to be a good investor you needed to hit a lot of singles and not strike out as often. I was wrong. Investing, especially in small companies, is a home run hitter's game."


Warren Buffett,

"You could have a situation where we'd buy a basket of pharma stocks."

I've decided to allocate 5% of my portfolio to a collection of assorted drug companies. My basket will be made up of 7 different businesses all of which have the potential for massive amounts of growth. I'm very confident that one of these businesses will change the way we live. However,I don't know which it will be. Therefore, it makes sense to diversify among some of the best in class. IMO, these companies have the best opportunity to double, triple, or quadruple in value over a period of years.

Investing in biotech's, especially the smaller ones, must come with the understanding that it takes a long time for potential drugs to hit the market. These are essentially (long term) buy and hold positions. When they hit, they hit big. Unfortunately, trying for this type of hyper growth requires a great deal of patience.

Some considerations I took into account when constructing my "basket".

1. I was focusing on companies that have a deep pipeline. I understand that most drugs won't make it to the market. A bunch of different compounds in development will help hedge the inevitable failures. The fact is, it only takes one drug to create extreme shareholder value.

2. I spent significant time checking R&D and partnerships. Research partnerships are critical for small biotechs. These relationships bring liquidity in the form of upfront funding, which will help with quarterly cash bleeds.

3. I made sure that I knew the companies core strength. Is it the selling and marketing of an existing profitable drug, or is it predicated on R&D and discovery of new potentials? It's important to know and monitor what a particular company does well. If this changes it may be time to look for greener pastures.

The number 1 risk to in the drug business is that products will fail during trials.
When it happens, it is usually for 1 of 3 reasons.
A. The drug isn't effective. (Most common)
B. The drugs active ingredient can't be packaged into an easy to use form
C. The drugs projected sales don't justify the huge expense of development.

Also, it must be understood that traditional valuation measures can't be used for most biotechs. Typically, these businesses are running earnings and cash flow negative and will continue to do so until they create something innovative. Throw out your DCF's and Pe ratio's for these bad boys.

So by now you must be asking why would I bother? The answer is simple. Development costs and intellectual property protection make solid barriers to entry. When a drug does make it, it will be a cash cow for a very long time. Historically, the best biotechs have generated returns of 20% per year over a decade or more. To me that is motivation enough to do some serious DD and take a swing.

So without further ado, the basket will be broken up as the following:

Exelixis 1%
Array BioPharmaceuticals 1%
Vertex Pharmaceuticals 1%
Omrix .5%
Momenta Pharmaceuticals .5%
Myriad Genetics .5%
Biomarin Pharmaceuticals .5%

A bit about each -

Exelixis (EXEL) is my number 1 candidate to crush the market over time. This small cap creates more new drugs each year than many other large companies. Currently, there are 11 drugs in the pipeline, all of which are focused on cancer. To say the market for this type of drug is huge is an understatement. 4 are in phase 2, 1 is in phase 3, and the balance are in phase 1. I don't need all of these drugs to hit, just one or two could drive a portfolio.

Exelixis core strength is discovery.
It has R&D partnerships with some of the biggest pharmaceutical companies in the land, namely: Genentech, Bristol Myers Squibb,and Wyeth.

As with most small cap biotechs, Exelixis lost about 100M over a trailing twelve month period. While all the losses show up on the income statement, any potential pipeline winners cannot be found on any financial statement. I believe that this causes a disconnect between what investors think the company is worth and it's actual value. I consider this to be a competitive advantage for those that are willing to put in the time and see what is going on.

Array BioPharma (ARRY) Discovers and develops small molecule drugs and like (EXEL) has a deep pipeline of cancer and inflammation compounds. Several of which are already in trials.

The core strength of this company is also discovery. ARRY has produced 4 drugs ready for trials in 1 year (that's unheard of), with 7 cancer and 3 inflammation drugs in development.

Their Partners include: Amgen, Genentech, Calgene, Eli Liily, Japanese Giant Takeda, and Intermune. That is a truly an impressive list.

Array is burning through more than $80M a year in cash. Fortunately, it owns most of it drugs and that gives it a wide range of cooperative possibilities.

Vertex (VRTX)

When you think Vertex, think Teleprevir, a breakthrough Hepatitis C drug. We should expect to see a commercial launch sometime in 2010. If so, this would give Vertex first mover status in a large market. There are 4M Americans affected with HEP C. Competitor drugs are about a year behind. Clinical data on Teleprevir has been good, as it appears to kill the virus and will also reducing treatment time.

Another notable pipeline drug, is currently in phase 2. Vx770 is a cystic fibrosis treatment that is showing some promise.

VRTX is putting a ton of money into R&D and it is not currently marketing any drugs. That, along with the reliance on the success of Teleprevir, makes VRTX very risky. Currently, VRTX is losing 400M a year. Fortunately, they have a cash rich balance sheet and a partnership with JNJ to help control costs.

Omrix (OMRI)

Develops and sells human blood products. For Biosurgery, the company makes Crosseal, a surgical sealant, and it is developing a pure thrombin product for neurosurgery. Different surgeries require different sealants.

This is one of the few profitable small cap Biotechs in my basket.

Mgmt believes, that biosurgery is where the growth is. However, revenue from this segment only makes up 25% of its sales. It’s important to note that Crosseal is marketed by partner JNJ and OMRI get’s 39% of the revenue. There is also a second generation of Crosseal, which is easier to use than comps (as it only takes 2 mins of prep time as opposed to 20 mins), on its way.

Momenta (MNTA)

Has a partnership with Sandox the generic arm of Novartis. They specialize in the analysis and engineering of complex sugars also known as polysaccharides.

The Founders claim to have developed a way to sequence mixtures of these complex sugars. Their claims are now patented and no one else may copy it.

This technology is targeting a generic form of Lovenox, which is a particularly tough drug to copy and thus the reason for no equivalent. If mgmt can create an effective comparable they will be able to tap in to the market of a $3B a year drug.

Recently, Momenta has added 4 complex generic drugs to it’s pipeline some of which are from the partnership with Sandoz. Still, all profits will be shared between the two companies.

Myriad Genetics (MYGN)

Myriad recently had Flurizan show down in FDA trials. Why? Because it didn’t meaningfully do what it was supposed to do. While it's never good to lose a drug that far along in the process, due to the lack of development costs, MYGN will now be profitable this year.

Some of the more Foolish considered Flurizan to be a bonus drug, one in which the companies future did not hinge upon.

Myriad makes money by marketing predictive medicine tests that can assess a person’s risk to genetic types of cancers.

It also has a deep pipeline of preclinical drugs in the areas of cancer, hiv, and chemo induced nausea. Once these compounds are in trials, the company will be able to create immediate shareholder value by partnering these drugs.

Biomarin Pharmaceutical (BMRN)

Develops drugs to treat rare genetic diseases. Under orphan drug protection, it’s marketed products receive exclusive rights. This orphan drug approval expires after seven years in the U.S. and 10 yrs in the European Union. That is long enough for treatments to dominate a market. This protection is almost like a government sanctioned monopoly.

This business revolves around 2 drugs. The first came out in 03, is partnered with GENZ, and the profits are split evenly.

The second is called Naglazyme, out in 05, and BMRN controls all the rights to it. For perspective Naglazyme accounted for 80% of Biomarin's sales.

Both drugs are enzyme replacements, (which are very expensive), and must be taken for life.

Most biotechs are speculative because they depend on drug approvals to survive. BMRN already has 2 drugs (whose market is still growing), with a third (Kuvan) on the way. Kuvan could be the one that really drives this business.

If Kuvan is approved, (not a guarantee), Biomarin would have the orphan drug exclusivity and sole marketing rights. If it’s denied then the stock will obviously be crushed. Another risk is the govt could decide to give them some pricing pressure because their treatments are so darn expensive. Some of the treatments cost upwards of 100 thousand per year. In Q1 BMRN did 60M, almost half of what it did all of last year.

My portfolio was projected to have a speculative portion predicated on the potential for hyper growth. Quite frankly, it doesn't get any more speculative than small cap drug companies. That's why Im going to follow the advice of Buffet and Wanger, buy a collection and swing for fence.

Thanks for Reading -

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