The other day I wrote about a hedge fund manager who was recommending Sunesis Pharmaceuticals (SNSS) to me. (Disclosure: I own the stock, and SNSS is a smallcap stock and will have the volatility and uncertainty inherent in all biotech stocks.) Biotech stocks are fairly simple to value, despite the uncertainty of whether or not their products will ever reach market because the FDA might simply say “no” to approval.
Sunesis makes a drug that will hopefully increases the survivability of people suffering from AML, a particularly vicious form of leukemia. Let’s break it down how I would value it and why it might be a $3 stock.
There’s 200 million shares outstanding, giving it a market cap of around $200 million. The AML market is $900 million a year. Conservatively, if their drug is approved, they could get a third of the market (at the moment, there are no FDA-approved drugs that are competing with SNSS).
Let’s say gross margins are 50%, a conservative estimate in a sector where margins can reach 80-90%. SNSS has other drugs and other uses of their primary drug. There is some evidence that their drugs might be good for ovarian cancer and lung cancer. But let’s not give these other possibilities any value at all.
Let’s say operating expenses are $50 million a year for (research and development, marketing, other drug trials, etc. This again is very conservative, given that operating cash flow was -$22 million last year.
That gives them an operating income of about $100 million. Slap a P/E ratio of 20 on that, which is conservative considering that biotechs like GENZ have a multiple of 34, and we have a potential market capital of $2 billion or a $10 stock.
Let’s assume just a 50-50 chance of FDA approval. The actual odds are probably better. The company has had nothing but good data and they’re already on the FDA fast track. So now we have an expected value of $5 by 2012-3, when we can expect trials to be over and sales to be in gear.
Let’s discount that back a few years with a 20% discount rate (in other words, anyone holding the stock now would want a 20%+ return, given the risk, per year). That leaves us with about a $3 stock right now. Which is why I consider where it currently is to be fairly cheap (albeit risky since we can never fully predict the primary risk - the FDA.