Small Caps For Big Cures (VRTX, VRX, MLNM)

By Dean Lundell | July 27, 2007 AAA

Cancer, HIV, hepatitis, inflammatory and infectious diseases are heavy duty illnesses. Three of the companies that develop drug therapies for these illnesses all have one thing in common - they have yet to make a penny of net income. Fortunately, as investors, we are rewarded not for what has been, but for what is yet to come. Quite often, fortune is a matter of keeping the faith. Read on to learn about three small cap drug companies that could boast big returns down the road. (To learn more, read Measuring The Medicine Makers.)

Understanding Gene Families
Vertex Pharmaceuticals (Nasdaq: VRTX) develops drug therapies for conditions such as HIV, cancer, immune and inflammatory diseases, hepatitis and cystic fibrosis. Vertex already has a proven track record for developing marketable drugs, but the company's latest effort is telaprevir, a drug for the treatment of hepatitis C, which has a potential billion dollar worldwide market. VRTX has enlisted Johnson & Johnson (NYSE: JNJ) as a partner in this venture. JNJ will cover half the costs of development and then market telaprevir internationally.

Despite VRTX's technical ability and marketing savvy, this company is not without formidable competition. For example, Amgen (Nasdaq: AMGN) and Wyeth (NYSE: WYE) are also developing alpha-inhibitors for rheumatoid arthritis and Schering-Plough (NYSE: SGP) is working on its own hepatitis C drug.

Despite these obstacles, Vertex is committed to being on the cutting edge; 174% of revenue went toward research and development in 2006. Competition is fierce in this business, but VRTX is making progress; its revenue has seen average growth of more than 45% over the last three years. Despite this positive growth, it will probably be several years before Vertex actually sees a net profit.

Focused on Infections
Valeant Pharmaceuticals (NYSE: VRX) markets products for the neurology, dermatology and infectious diseases markets. Interestingly enough, it appears that no single drug accounts for more than 10% of the company's revenue. This is a double-edged sword; while it's good that the firm is well diversified, many say it is too diversified.

To address that over-diversification, VRX is increasingly focusing on the infectious disease portion of its product suite and development pipeline. This is a positive development because the firm will lose many of its protective patents over the next few years. (For more on patents, see The Hidden Value Of Intangibles.)

While VRX has a strong international presence in Europe, Latin America, Asia and Australia, it is also saddled with roughly $750 million in debt plus a large amount of fixed overhead. That kind of leverage can be particularly bothersome in any kind of rough economic waters. The firm may need to raise additional capital before its first debt repayment in 2011.

All Its Eggs in One Basket
Millennium Pharmaceuticals (Nasdaq: MLNM) is best known for selling one drug, Velcade, which is one of the leading treatments for two forms of cancer: multiple myeloma and specific types of lymphoma. MLNM also benefit from the revenue stream it receives from its agreement with Schering-Plough in which the company is given exclusive U.S. development and commercialization rights to MLNM's cardiovascular drug, Integrilin.

That said, MLNM also faces stiff competition: Celgene Corp. (Nasdaq: CELG) is developing what may be a better competing product.

MLNM's goal is to focus on oncology, and cardiovascular and inflammatory diseases. However, all but one of its drugs is still in clinical trials, so it will be a while before this company sees a net profit.

While Millennium dedicates a healthy 65% of its $475 million in revenue to research and development and generates a 90% gross margin, the company has limited means to finance acquisitions or fend off competition.

Expectations
Price/earnings multiples are a good indication of the market's expectations of a company besides its volatility. Because these firms have no earnings, we have to resort to our "leap-of-faith" index - market capitalization as a multiple of revenue. Valeant is the most sedate of this group, with sales of $920 million and a market cap of $1.6 billion, or 1.7 times. Millennium has sales of $475 million and a market cap of $3.2 billion, or 7 times. Vertex is far ahead of the pack in terms of expectations, showing sales of $246 million and a market capitalization of $3.7 billion.

While all of these companies have definite potential, there is just one caveat: The market is fickle and is quick to become disappointed with a company that doesn't live up to expectations.

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