A Pharmaceutical Toll Bridge

• BySham Gad, RealMoney Contributor
• On 2:30 pm EDT, Tuesday August 4, 2009

As a value investor, I see how this rally continues to suck out any value that remains. The S&P 500 now trades at nearly 25 times 2009 earnings. Even worse, the Russell 2000, the benchmark index for small-capitalization stocks (in this case defined as a market cap below $2 billion), is now trading at over 50 times 2009 earnings. To be sure, profits under recessionary periods are obviously depressed, and Mr. Market is surely banking on the fact that 2010 and 2011 will be different.

Still, stock prices of good businesses are moving rapidly. Two weeks ago, I wrote about the commodity play Teck Resources -- it's up over 30% since, and I don't like it because it has gotten closer to fair value, thus eliminating my investment opportunity. In fact, just about any bullish piece written over the last month looks like gospel today. Unfortunately, when a market is up over 10% in little over a month, it's easy to preach the good word.

Still, amid the optimism, there remain some wonderful nuggets of value. One such opportunity lies within PDL Biopharma, a pharmaceutical company that now looks more like a toll bridge than a pharmaceutical outfit. PDL Biopharma, after recently spinning off its biotechnology business into a separately publicly traded entity, Facet Biotech, has turned itself into a royalty-collecting machine. When all is said and done, the total value of those royalties when received should handily exceed today's stock price.

PDLI derives its royalties from seven patents that expire in 2013 and 2014. These patents are for the "humanization" of antibodies, which are developed in mice and made suitable for humans. Antibodies are the proteins found in human blood and other bodily fluids which protect the body from harmful bacteria and viruses. Antibodies simply kill harmful bacteria and viruses that enter our body.

PDLI licenses these patents to some of the largest biotechnology firms, including Genentech, Elan and Wyeth. PDLI has been growing its royalty revenue at a phenomenal clip, from less than $150 million in 2005 to over $250 million in 2008. Assuming that royalty revenue shows no growth for the next five years -- which won't happen (see below) -- the company will pocket over $1.3 billion in royalties against today's market cap of $1 billion

You may be familiar with the name of one of the company's antibody products, Avastin, which treats cancer in the colon, lung, rectum and breast. The antibody is sold by Genentech and accounted for over 20% of PDLI's first-quarter revenue. Sales of Avastin are expected to increase by nearly 30% in 2009.

The company is guiding 2009 revenue to a range of $310 million to $325 million, up over 20% from 2008. After-tax cash from operations will be around $260 million to $280 million. At the end of 2008, PDLI had nearly $220 million in net operating losses, of which the company expects to use $170 million in 2009 to offset taxes.

If you take management at its word, it is clearly focused on one thing only: maximizing shareholder value. Last December, the company relocated its corporate headquarters to Nevada in order to reduce its corporate tax rate. The company now distributes a semiannual dividend of 50 cents a share, which represents an annual yield of over 12% at today's share price of $8.42.

A looming risk on the horizon is a lawsuit brought on by MedImmune, a maker of Synagis, a big moneymaker for PDLI. MedImmune has been paying royalties for over a decade and has now decided to sue.

PDLI has dealt with these issues before, and management doesn't feel that the lawsuit will carry any meaningful weight. Genentech sued years ago, and a settlement was reached in 2003 that upheld the "validity and enforceability" of patents. Alexion sued, and a similar settlement was handed down in December 2008. In both instances, the monetary consequence to PDLI was insignificant.

One additional item of note concerns a pair of $250 million convertible notes, one due in 2012 and the other due in 2023. The 2023 note holders have a put option to exercise them at par in 2010 at $8.08. Any conservative analysis should assume conversion, in which case the share count will go up by 25% and the distribution yield will likely be less than current levels.

Potential investors in PDLI should remember that PDLI is a fixed-term investment. The life of the company is only as long as the life of the patents. However, the risk/reward scenario is one of the most attractive I see today, regardless of what the market does. The downside, which includes a successful lawsuit from MedImmune, is likely an attractive, bond-like high-single-digit return. The other extreme, in which PDLI's growth continues to fire on all cylinders, could easily be an annual return of over 25% over the next five years.

You won't find many risk/reward scenarios that are this skewed today. In this case, we a have case of "heads I win, tails I win even more."

Buzz up!