Tuesday, May 24, 2011

Does Vertex Pharmaceuticals Belong in Your Portfolio?

When it comes to biotechnology, it is important to be losing huge amounts of money. Without those losses, how can the company make passionate claims about how much better it will do in the future? This is the basic philosophy behind selling shares of unprofitable research projects to the general public.

And it may help explain why Vertex Pharmaceuticals (NASDAQ: VRTX) -- in the news for getting its Hepatitis C drug approved and building a big new corporate headquarters on the Boston waterfront -- sports a market capitalization of $11.5 billion to go with its spectacularly bad -239% net profit margin. Is now the time to add Vertex to your portfolio?

Vertex is one of many biotechnology companies that have managed to sell shares to the public without generating a penny of profit. Drugs take a long time to go from a research lab into people's bloodstreams and getting them there involves big risks and big money. Vertex's corner of this world includes "phase-I clinical trials and/or nonclinical activities for treatments of hepatitis C virus infection, cystic fibrosis and influenza."

Reaching that potential spells ugly financial statements in the case of Vertex. Between 2007 and 2010, Vertex lost an impressive $2.2 billion on revenues of $620 million. Of its $2.8 billion in operating expenses, 79% went to research and development and most of the rest to selling, general and administrative expense.  To keep this research machine going, Vertex has persuaded equity and debt investors to part with about $2 billion worth of their hard-earned cash. 

Good news for long-suffering Vertex shareholders came on Monday when the Food and Drug Administration approved its hepatitis C drug, Incivik. 170 million people have hepatitis C -- 3.2 million of them in the United States. Incivik is expected to gain 70% of the market for hepatitis C treatments due to its superior cure rate of 79% compared to the 66% rate of Merck's (NYSE: MRK) Victrelis.

FDA approval of Vertex's Incivik is expected to change Vertex's financial profile for the better. How so? At $49,200 for a 12-week regimen, Incivik could generate $5 billion in sales -- $1 billion more than the $4 billion cost of developing it, according to Vertex CEO, Matthew Emmens, who expects Vertex to become profitable in 2012. If you take into account the cost of making and selling Incivik, it might break even on that investment.

In what can be seen as an amazing coincidence, this good news on the FDA front is accompanied by other news on Vertex's real estate front. On Monday, the company announced that it is constructing two buildings totaling 1.1 million square feet for $800 million on Boston's Fan Pier. Vertex plans to move its 1,500 employees there when the project is completed in 2013 or 2014, according to the Boston Globe.

Meanwhile, Vertex's stock market value has soared. Since its 1991 initial public offering, Vertex stock has risen 11 fold to its current $55.81. Its best year was 2000, during which the stock spiked from $18 in January to $94 in November. It then plummeted and spent the following decade below its peak. However it's enjoyed a revival in the last 12 months -- rising 64%.

What does the future hold for Vertex? If Goldman Sachs's (NYSE: GS) April 2011 call is to be believed, Vertex's stock price should hit $59 -- so all so all but 5.7% of the upside for the company is currently reflected in its stock price. Perhaps more interesting is that Goldman believes that Vertex will earn a profit between 2012 and 2015. In April, Goldman raised its EPS estimates for Vertex by 5% to $5.36 in 2012, $7.13 in 2013, $6.41 in 2014 and $6.25 in 2015.

That four year average growth rate in earnings of 3.9% is not all that exciting. Although investors will no doubt focus next on the prospects for Vertex's other research projects. One thing's for sure -- Vertex's decision to build an edifice on the Boston harbor after decades of losing money suggests that it has tremendous confidence in its ability to convince investors to part with their money.

But so far, it has not demonstrated that it can use that money to generate enough profit to offset that investment. What's broken in our financial markets is that the hope that Vertex might someday offer such a return is enough to drive up its stock price.

In my humble opinion, that is a pretty thin reed on which to bet a part of your portfolio.


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