Can You Trust Volatile Biotech Companies?

Biotech stocks are notorious for being extremely volatile. One day, a biotech stock could be up 30% on rumors that its drug will be successful. The next day, down 50% when the Food and Drug Administration shoots down the drug. For this reason, only extreme risk takers and biotech experts trade the stocks. It takes some effort, however, to find some reliable biotech stocks. Let us see if it is possible to find an undervalued small-cap biotech with promises to produce blockbuster drugs in the future.

Spectrum Pharmaceuticals SPPI operates with a market capitalization of $665.4 million. It is currently trading at about $15.60, and is up over 130% in the last year. Despite the significant appreciation, some investors may consider Spectrum to be a value investment with the characteristics of a growth stock.

The first thing that investors want to do is analyze the company itself; who is at the helm of the company and how the company actually garners revenue. The chairman, president, and Chief Executive Officer is Rajesh Shrotriya, a long-time scientist and businessman in the pharmaceutical industry. He has worked for SuperGen SUPG, MGI Pharma, and Bristol Myers Squibb BMY. Steven Fruchtman, the Chief Medical Officer, has a similar background, having worked at Johnson and Johnson JNJ, Novartis NVS, and various hospitals. Two executives have directed the company in terms of financial and strategic decisions. Brett Scott, the acting Chief Financial Officer, has had business development and strategic positions at various medical technology and pharmaceutical firms; Shyam Kumaria, the Senior Vice President of Finance, has had decades of experience with Deloitte & Touche, overseeing multiple initial public offerings as well as mergers and acquisitions.

Interestingly, insiders have been holding onto their stock since May 2011. In the year before May 2011, only four out of twenty transactions were sales or option exercising transactions.

Spectrum also offers a wide variety of products; reliable patent portfolios are absolutely necessary for biotech stocks to remain stable. As mentioned earlier, volatile biotech stocks experience such large swings because many of them are waiting on their first big drug to be approved. Pharmaceutical firms that have existing portfolios with steady revenues along with the prospect of blockbuster drugs offer investors stable stocks with the potential to break out to the upside significantly. Along similar lines, these stocks could break to the downside, but their existing product offerings buffers the carnage in stock price.

Spectrum Pharmaceuticals offers what they call a diversified base of products. The company offers drugs for a variety of cancers, including colorectal cancer, non-Hodgkin's lymphoma, and bladder cancer. Spectrum also appears to have multiple cancer-related drugs in the pipeline; they appear to be in the late stages of trials and studies as well. This may warrant concern for some investors. Investors prefer to see companies with diversified product offerings. Pfizer PFE and Merck MRK are perfect examples of this: they offer drugs for cosmetic and clinical purposes, and as far as clinical drugs go, they cover a wide variety of disease classes. Spectrum appears to be heavily invested in cancer drugs, and while cancer is a preeminent disease across the world, it may be better for some investors to see other types of drugs.

Investors are also concerned with the company's historical performance. Over the last five quarters, Spectrum has managed to increased its revenues significantly. Over time, the top-line has expanded from $17 million to $51 million. It has also managed to keep cost of goods sold down, during the rapid revenue growth. As such, gross margins have increased significantly over the last several quarters. Surprisingly, research and development costs have stayed fairly stagnant. This is an interesting observation, as the company has been able to pump out drugs for further studies and clinical trials. What may have happened is a gradual slowdown in research productivity, prompting management to stifle growth in R&D. Interestingly, sales, general, and administrative expenses have been stagnant as well. This could be a result of decreased salaries or marketing expenses. Regardless, the company has managed to grow revenues while keeping expenses down. From non-operating income and expenses, various charges and additions have resulted in volatile net income figures. While always positive, net income has fluctuated from $13 million to $7 million to $20 million in the last few quarters. As expected, EPS has been volatile along with net income.

The old adage, "cash is king," is extremely true for investors. A company can report the most impressive revenues, but if it is bleeding cash, management is doing something very wrong. In 2011, the company has been able to positively turn around its operational cash flow. Apart from positive net income figures, stock based compensation and other changes in working capital have helped increased cash flows. Accounts receivables decreased cash flow as well. Cash flow from investing activities have been fairly consistent due to a homeostasis in purchases and sales of investments. This may be a sign of proper hedging against economic volatility. The company has consistently had positive cash from investing activities, primarily due to continuous common stock issuances. This is not necessarily a good thing for shareholders, as equity issuances ultimately dilute returns back to equity holders. This may be a red flag for some investors.

As expected, cash has been growing rapidly for the company. There are two factors contributing to the rapid growth: operational success and equity issuances. Based on the statement of cash flows, revenues seem to be the main driver for cash growth rather than equity offerings. Current assets have grown very slightly as well. Property, plant, and equipment have been static as well; other non-current assets like intangible assets, however, have been more volatile. This may mean that Spectrum is trying to identify strategic asset purchases, including intellectual property and the like. Overall, assets have been able to increase significantly over the last five quarters.

Liabilities including accounts and taxes payables are extremely minimal this last quarter, lower from $11 million and $2 million, respectively, in Q1 2011. It has also been able to reduce various short-term liabilities. The company has been able to do the same with non-current assets. Ultimately, shareholders' equity has increased over the last several quarters. Apart from equity raises increasing paid-in capital, net income results have been able to increase retained earnings, although the figure is still negative. While there is an uptrend, prospective investors need to be aware that retained earnings are significantly negative.

Another method of determining the relative value of companies is by looking at its trading metrics, relative to comparable companies. Value measures like price/earnings, price/book value, and price/sales can be used to compare companies to each other. While Spectrum is slightly cheaper than its competitors based on price/book value and price/sales, it is especially attractive in terms of price/earnings. It is trading at about 14.5 times earnings while its closest competitors are trading at about 44.8 times earnings. Likewise, Spectrum's return on equity is about 37.6%, while competitors return, on average, about 9.2%.

Its growth metrics also help investors make a decision. Its three-year revenue growth is 113%, while competitors claim 15%. Its EPS growth is negative for the last three years, considering that it was operating at a deficit in the years before 2011. As discussed earlier, Spectrum has fairly high operating and net margins, and they appear to be higher than their competitors' margins. Lastly, Spectrum Pharma has virtually no debt, while many of its competitors have a debt/equity ratio of about 2.9.

Investors who are looking for stable biotech stocks may want to consider Spectrum Pharmaceuticals. Despite being a small-cap stock, it appears to have the components necessary for a successful business. It has an experienced executive team who believe in the company's success, it has a history of operational success, and it appears to be undervalued compared to its direct competitors. Investors should take the extra step and learn more about the drugs and more about the company's capabilities. They should learn more about Spectrum's supply chain, distribution channels, marketing mechanisms, and future outlook. Depending on investors' macroeconomic outlook as well as the their outlook of the biotechnology and pharmaceutical industries, Spectrum Pharmaceuticals could be a worthwhile investment.

Spectrum Pharmaceuticals is currently trading at $15.60, up over 130% over the last year.