Celgene: Still (Looks) Appealing

Celgene (CELG) has been on my watchlist for a while as its shares continue to lag despite the promise of a rich pipeline, high regard of the company among the scientific community, and the continued decline in the share price which has increased my interest in the name.

In January, I wondered if Juno Therapeutics could rejuvenate the pipeline of Celgene, yet this addition came at a sizeable cost of $9 billion, as I held a small long position at the time. I liked the strategy of smaller bolt-on deals in the past, but this large deal and recent operating struggles in the pipeline might suggest that management has become less disciplined in its dealmaking.

2018 – A Challenge So Far

As briefly discussed above, Celgene has acquired Juno Therapeutics earlier this year at a total value of nearly $10 billion. The company already took a 10% stake in Juno about three years ago, which is a comforting sign for investors as it is familiar with the business.

The deal is all about JCAR017, a promising cellular immunotherapy development, for which Celgene sees peak sales at $3 billion at some point beyond 2020. The technology behind this so-called CAR T and TCR therapeutics could be evaluated for treatment of other cancer indications as well.

After the announcement of this deal and the release of the full year results for 2017, Celgene’s shares continued to slip. Halfway February, Celgene announced a $5 billion share repurchase program to take advantage of the lower price. Even this news, as well as the first quarter results, could not comfort investors either, despite the fact that it appears that the company is off to a good start this year.

First Quarter Results And Valuation Discussion

Earlier in May, the company released the first quarter results as revenue growth accelerated to 20%, with revenues coming in at $3.54 billion. The reliance on Revlimid was stable as sales of the multiple myeloma blockbuster drug were up by 19% to $2.23 billion. The myeloma franchise is much bigger, however, as Celgene’s second best drug Pomalyst belongs to that franchise as well. Its sales rose by 24% to $453 million.

Fortunately, the company has some other indications as well as they are slowly reducing the reliance on multiple myeloma. Otezla is a treatment for patients with active psoriatic arthritis, and sales of this drug rose by 46% to $353 million. Abraxane, an injectable suspension for treatment of metastatic breast cancer, reported an 11% increase in sales to $262 million.

Other smaller drugs include a flattish $157 million revenue contribution by Vidaza. The remaining smaller drugs are all in decline, including Thalomid with $31 million in sales and Istodax with $19 million in sales. Of course, Celgene benefits from the FDA approval of Idhafa in the third quarter of last year. After sales came in at $7 million in their debuting quarter and rose to $13 million in the final quarter of 2017, the sequential pick-up to $14 million in quarterly sales in the first quarter of this year looks a bit soft.

All in all, the earnings number is quite a bit more complicated. The company reported net earnings (on a GAAP basis) of $846 million, vs. $932 million last year, as aggressive share repurchases limited the decline in reported earnings from $1.15 per share to $1.10 per share. The gap with adjusted earnings was very large by all means, with adjusted earnings coming in at $1.57 billion, or $2.05 per share.

The non-GAAP number excludes quite a few items which are really costly to investors and are structural in their nature as well. One key item is roughly $400 million in stock-based compensation expenses (pre-tax) which after taxes could easily work out to $300-350 million, being a real expense. Even if I kindly accept the adjustment made in relation to R&D and collaboration expenses being taken, adjusted earnings could fall from $1.57 billion to levels closer to $1.3 billion if I factor in the stock-based compensation expense. That results in earnings of $1.70 per share, as even this number excludes structural charges taken in relation to R&D charges.

Following the solid sales numbers, the company now sees full year sales around $14.8 billion, after it previously guided for $14.4-14.8 billion in sales, driven by relative strength across the board. The company hiked the full year adjusted earnings guidance from $8.70-8.90 per share to $8.95 per share ahead of the Juno deal. Factoring in that deal, adjusted earnings are seen around $8.45 per share after management already indicated before that this deal would dilute this year’s earnings by half a dollar.

With shares trading at $78, the multiples look very low at 9 times, but there are some caveats. As mentioned above, the gap with the GAAP numbers is likely to be substantial as GAAP earnings are seen at $6.31 per share, as potential further charges might lower that number. Yet even as there is a big gap between both earnings metrics, GAAP multiples remain very reasonable at 12-13 times earnings.

Another concern among investors is the rapid “deterioration” in the finances after the company traditionally operated with a strong net cash position, but this changed following recent share repurchases and deal-making efforts. Cash holdings stand at $4.7 billion, with debt amounting to $20.3 billion, for a $15.6 billion net debt load. Based on adjusted earnings of around $8.50 per share, adjusted earnings are seen at $6.5 billion this year. Adding back roughly half a billion in interest and applying back a near 20% tax rate, I come with adjusted EBITDA of around $8.5 billion, for a 1.8 times leverage ratio.

While leverage is still very manageable, and the valuation metrics look outright crazy, given the sales growth, it is understandable why investors act with caution as the company is largely an MM franchise, with great reliance on Revlimid. On the bright side, despite some failures in the much discussed pipeline, this pipeline is actually still relatively decent, certainly after the recent addition with the Juno deal. That being said, the process of a promising development in the pipeline to becoming a blockbuster drug is always a challenge.

The big elephant in the room is generic option for Revlimid, of course, as generic producers are pushing to start producing the generic version of the drug and have the public on their side with the drug costing close to a quarter of a million each year. If generic competition arises or prices have to be lowered following public outcry, that would have a big impact on earnings and leverage, given the reliance on the drug. The only good news is that it appears that the market has priced in these cuts to some extent already at these levels.

What Now?

I have been constructive on Celgene at the start of the year, but that was only after shares traded just below the $100 mark. That means that I am down a hefty 20% on my initial investment, as I like to average down. Having bought just a fifth of a desired “full” position, I am not too worried about this, yet wonder how aggressive I should be with averaging down.

The reliance on Revlimid and emerging discussion on effective patent protection is a concern simply for the sheer fact that the company relies so heavily on the drug. This does not have to be a problem, yet setbacks in the pipeline have created a gap in which no significant contribution is expected in the near term from other drugs. This could potentially create a similar situation as faced by Gilead with its declining HCV business, in a process which has been very painful for patient investors attracted to a very appealing cash flow yield, which unfortunately kept declining. Unlike Gilead, Celgene has now taken on quite a bit of debt (while Gilead operates with a relative strong balance sheet), and Celgene has seen real kickbacks in the pipeline, resulting in actual candidates being shut down for real.

For now, I am doubling my position to still just 40% of my target positioning, as I do feel that prospects have changed for the negative over the past twelve months following pipeline setbacks, expensive deals, buybacks at elevated levels, while Revlimid is coming closer to seeing real competition. If such event would arise, the $19-20 billion revenue target for 2020 and $12.50 earnings per share number projected for that year are way too optimistic, as a big reset in this guidance could furthermore shake out a few nerved long-term bulls.

The reliance on Revlimid, questionable M&A action, and debt being incurred create real risk despite the low expectations, as this prevents me from buying these dips in a more aggressive way.

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Disclosure: I am/we are long CELG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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