Thursday, September 27, 2007

Red Hat Worth a New Look

I do not own Red Hat stock, but it is now on my list of stocks to consider when I can add a new position. After years in the wilderness, Red Hat has lately proven that it can make profits and grow them rapidly. Strangely, this once red-hot stock has been largely forgotten by investors, so it is reasonably, but cheaply priced.

You can get the latest details in my summary of the Tuesday, September 25, 2007 analyst conference with fiscal Q2 results. But the long-term history of Red Hat is more enlightening. Back around 1999 people were talking about the open source operating system known as Linux as being a Microsoft killer. I got started in technical research after pointing out that Linux was more likely to kill Sun Microsystems and other Unix players than to hurt Microsoft, at least in the short run. I was right: Linux then and now required a great deal of technical expertise to use.

Red Hat was the favorite stock of the Linux and anti-Microsoft crowd back then. It was always a good company with the goal of making Linux an operating system that enterprises could depend on. But you know about investor enthusiasm: Red Had stock was priced as if it was already on the inside track to defeating Microsoft before it had made any profits, even before it had substantial revenue. Recall that Linux is free. Red Hat had to find a way to profit from selling a product that is free, which is not so easy.

Take a look at Red Hat's stock price over the years (at You can see that its IPO price was above today's price. It peaked around December 1999. By July of 2001 it had slumped to $3 per share; I wish I had picked some up then! But in fact in 2001 Red Hat was not profitable and revenues were minimal, so $3 was pretty generous.

But while investors did what they do best, betting irrationally, the workers and management at Red Hat trudged on. Their Red Hat Linux gained traction year after year. It is worth it to corporations to buy a version of Linux that is proven to work at the enterprise level, and to be able to get support when they need it.

In Q2 Red Hat's revenues were $127 million. Microsoft's were $13.4 billion. Other major players are competing in the Linux space now, notably Novell and Oracle. But I think it is fair to say that Red Hat is the Linux brand leader. Red Hat is also a good virtualization play and now owns the JBoss brand; I think both of these will be valuable going forward.

Red Hat should now be able to grow revenues faster than costs, so profits should grow faster than revenues (on a percentage basis).

Another plus for Red Hat is its cash. With equivalents it has $1.3 billion. That is a hefty war chest.

Red Hat's main risks going forward are the usual macroeconomic and competitive risks. Microsoft is enormously profitable; it could lower its pricing on its server software if it ever thought Linux or Red Hat were a serious risk.

Thursday, September 20, 2007

Don't Count On Another Rate Cut

This week's 0.5% rate cut by the Federal Reserve was appropriate. But I would not count on any further cuts. If economic trends run as I expect, further cuts would send the economy fish-tailing.

Much of the economy is moderately strong, including exports. The fall in new housing construction combined with the uncertainty in the mortgage derivative markets has been slowing the overall growth rate. Everyone has reason to reassess our spending habits, from private equity buyout specialists to minimum wage workers.

Hopefully the Federal Reserve cut, combined with injections of credit in appropriate institutions, will mean that mortgage rates will go a bit lower. They never were high in this decade. The problem was stupid people thought lenders would be happy with eternally low returns on their loans. Once the Fed jacked up interest rates to normal levels the handwriting was on the wall. Yet the financially illiterate did not refinance their low-interest, variable rate loans to long-term fixed-rate loans. Some people who are in default were victims of scams, but most were just spendthrifts.

There is a lot of unsold housing, both new and used, on the market. But there is a great deal of evidence of pent up demand; fear is holding buyers back. Why buy a house or condo now if it will be 10% cheaper in six months? The U.S. population increases so rapidly now that all the housing stock is needed.

Housing prices lost touch with reality around 2004, earlier in some markets. But now that developers have cut back on building (permits issued were remarkably low in August), buyers will start digesting this inventory. Already housing in the Midwest is so cheap that I would not hesitate to move a business there to take advantage of the low costs. But every market is different. San Diego, with its near-perfect weather and ocean access, will probably snap back faster than real estate in the Central Valley of California, where most people live only because they can't afford a coastal home.

With the dollar low imports should continue to boom, meaning more hiring in manufacturing and agriculture. As soon as builders start seeing their inventories dwindle they will up their output, putting demand on lumber and other housing components. Selling furniture and appliances will swing back. Of course this process is one measured in months or quarters, not days.

Unemployment is at reasonable levels despite massive layoffs in the housing sector. So if the housing sector even stabilizes, labor availability will be tight.

Of course, there is always a spread of paths to the future, and you can guess at the probabilities to match to the paths. There is some real probability of a recession, perhaps brought on by more turmoil in financial institutions. But there is a real possibility that this summer was a panic for no good reason, and that the Federal Reserve will regret even the cut it made this week.

The most probable path, in my eye, is a return to moderate economic growth in Q4 followed by strong growth in 2008. Of course as more data comes in the Fed will evaluate it, as we all will. But given the most probable path, I think the Feds should hold interest rates steady for about 6 months. Then they will probably have to raise rates again to keep all the people jumping back into real estate and stock speculation from having too big of a party.

Work smart, spend cautiously, then save, and invest wisely.

Friday, September 14, 2007

Choosing a Biotech Stock 3: Biogen Idec

In the first installment of this series I explained the situation that led me to decide to add another biotechnology stock to my portfolio. In the second installment I reviewed Gilead since it is a stock that I think is worth buying. Today I am going to analyse Biogen Idec (BIIB). Much of the information for the analysis I have already accumulated in my analyst conference summaries (See my BIIB page). Both Gilead and Biogen are in the Nasdaq 100.

Biogen is now a well-established company with healthy revenues ($773 in Q2 2007, up 8% sequentially and up 17% from year-earlier) and net income (GAAP $186 million, up 41% sequentially and up from a loss of $171 million year-earlier). Avonex for multiple sclerosis revenues were $462 million. Another blockbuster drug is Rituxan, which is sold by Genentech. Its revenues from that venture were $230 million in the quarter. Tysabri is a newer drug with $48 million in revenues in the quarter. Fumaderm showed its first revenues at $5 million, and BIIB garnered another $23 million from royalties.

Research and development costs are significant at $218 million as numerous clinical studies are underway to increase the scope of the Tysabri label. A setback was Europe disallowing Tysabri for Crone's Disease, which Biogen plans to appeal.

So aside from possible future growth in Avonex, Rituxan, and Tysabri sales, and its pipeline of possible new drugs, how does today's price look? Biogen Idec stock ended today at $65.42; the company has a market capitalization of $18.75 billion. The 52 week low for the stock is $42.51, so anyone who bought at that price should be pretty happy. If I buy at today's price, how happy might I be 52 weeks from now?

Divide Q2 earnings times four into market capitalization and you get a current P/E ratio of 25, which is pretty cheap for a rapidly growing company. You can use non-GAAP earnings to make the ratio look better, but I don't like to do that unless there is a very compelling reason. The company's guidance is to non-GAAP EPS for all 2007 of $2.65 per share. Use that and P/E is 24.7

Which is not just reasonable. It is a steal, so long as you are thinking long term. So what is happening here? Earnings are growing faster than revenue, which is growing fast. This is often true once a biotech company has sales of a blockbuster well underway. Earlier in the curve research is the main expense. If a company is lucky enough to get a drug approved, at first marketing eats up most of the profits. Also usually companies try for a narrow scope for initial FDA approval. If that is accomplished they can often expand the scope of the label, but that takes more clinical trials and so more R&D dollars.

And what about the Biogen Idec pipeline? Wow, they have a very strong pipeline (See BIIB pipeline page). Lots of Phase I and II stuff. Cancer drugs, neurology drugs, immune system disorders, and an area where they have no present drugs, cardio. While a significant portion of drugs fail to get FDA approval, Biogen has a good track record. It looks likely that something or another will succeed from their present pipeline.

So in the 2008 to 2010 period the continued revenue growth from currently approved indications plus likely expansion of the Tysabri label should certainly justify investing in BIIB at today's price.

Downside risks are the usual for drug companies at this stage: macroeconomic; decisions by governments or insurers not to pay; and unexpected side effects that scare away patients or force the drug off the market. Plus competition from new or existing drugs made by other companies. Not to be discounted, but I see no clear danger on the horizon. That is why we diversify portfolios, right? No matter how good your analysis is, you can be wrong on a given stock because of unexpected future events.

So I like both Gilead and Biogen Idec. The rule for my portfolio is I can only buy one right now. Which do I buy (and this exercise is not yet over; I have more companies to look at)?

Using Q2 to run a P/E ratio, Gilead is the cheaper stock (P/E = 22) than Biogen's (P/E = 25), but not by much. Biogen has a more diverse pipeline, and its drugs are for more diverse indications. But Gilead's year-over-year revenue growth rate is much higher at 52% than BIIB's at 17%.

I think Gilead is a riskier bet than Biogen, but not a lot riskier, and it is a lot less risky than two stocks I own, ANSV and DNDN. But because it is both cheaper and growing at a faster rate, I am picking Gilead (GILD), from the two candidates.

Again, this is an exercise for a specific portfolio. It may not be right for your portfolio. Also, I have a lot more looking to do before I make my final decision. I have plenty of other work on my plate right now, so the process could take weeks.

And the decision is for specific stock prices. Even if GILD wins out, I'll be checking the its price, and BIIB's, before I buy. And BIIB will stay on my short list for when I have some more cash for investing.

Wednesday, September 12, 2007

AMD, Quad Core Opteron, and Korea

This has been an exciting week so far for those of us following the Processor Wars. Intel announced it is making more money than it thought it would. Korea announced (See Infoworld article) that it thinks Intel used illegal methods to make its dough, joining Japan and the European Union in that allegation. AMD released its genuine quad-core Opteron processors, to be distinguished from Intels dual-dual core Xeon processors. Preliminary reviews have already started emerging for the new AMD processors; they look amazing. Since this blog is primarily for investors, I'll be converting some tech-speak to a semblance of why this matters in reality.

First, as far as I know, all AMD executives and employees are alive and well, so the boys at Intel have been too busy trying to catch up with AMD advanced technology to watch the Sopranos. Their unethical business methods will doubtless be considered by Intel investors to be mere sharp business practices. Essentially what Intel is accused of by Japan, Europe, and Korea is limiting AMD to very small markets by illegally discouraging dual sourcing of processor chips. Intel says it never did this, and if it did it stopped doing it. And my understanding is that nothing Intel did, would, in itself, be illegal. You can price your products however you want. It is the context that matters: pricing schemes can become illegal when they are designed to create a monopoly. Intel's main defense is look, we lost market share lately, we can't be a monopoly. But they lost market share after two changes: AMD introduced 64 bit x86 processors when Intel tried to force its clients to switch to Itanium processors in order to get 64 bit, and Intel was informed by regulatory agencies that it was being investigated.

In 2006 Intel was on the ropes and responded by taking advantage of its capital position. It started a pricing war that benefited computer makers (Dell, HP, etc.) and consumers but that drove AMD to the wall. In the later half of 2006 Intel released a new processor design that showed some improvement on older designs. This happened while AMD was trying to absorb its acquisition of ATI, which simply put it in position to get its ass kicked by NVidia and Intel at the same time.

Today AMD's stock price is below its 2002 level, even though it is a much larger company now. 2007 revenues look to be roughly double those in 2002. Earnings are bad, in fact negative, because of the pricing war with Intel and the cost of the ATI acquisition.

But that is the past; the future depends on industry adoption of Barcelona technology, particularly the quad core Opteron processor for servers. Unlike when Opteron was introduced (no major players joined in the introduction), IBM, Dell, and HP all are ready with quad-core Opteron servers. These processor chips can also be plugged into AMD-based servers that have been selling in 2007 because they are pin-compatible with the dual-core Opterons. I doubt many companies will be pulling out dual-cores to put in quad-cores, but it means the motherboard designs were ready to go well in advance of chip availability. So it is off to the races.

Now we will enter the benchmark propaganda wars. Intel fan boys will claim that Barcelona sucks. AMD fan boys will say it is way superior. Both will show benchmarks to prove their point. How can that be? Well, there are two big issues (and a swarm of small ones) with benchmarks. One is optimization, the other is specialization, in this case floating point versus integer. For people who actually buy servers, who actually want the best bang for the buck, who are not locked into Intel, they are going to need to run tests on both platforms to see what works.

There is agreement that AMD has really good floating point capabilities. So that means scientific applications are going to lean to AMD. But there is a claim from the Intel camp that servers mostly just serve up data; Intel's floating point capacity will do just fine. Ten years ago I would have agreed with that, but things have changed. Visual is in. Visual requires floating point. Fewer and fewer servers are being devoted to just plain accounting or data serving.

To me the new AMD architecture looks superior for a couple of reasons, but I know that superior looking architecture does not always translate to real performance. First, the AMD memory controller is still on the server chip. Intel likes to run benchmarks that go to memory infrequently enough that its off-chip memory controllers don't appear to be a bottleneck (this is not new to Barcelona, but should become more of an issue with four cores needing to be fed memory). AMD's design will be a huge advantage in high end servers with as many as 8 chips, meaning 32 cores.

While both Intel and AMD have introduced technology to make virtualization easier, and both have some merit, I suspect AMD's architecture will work better in datacenters. If you are running a bunch of virtual machines on a multiprocessor, multicore server you also want to have multiple network connections (typically 10 Gigabit Ethernet connections), one for each virtual server. AMD's new design scales out nicely; Intel's current design, the Xeon 7300, does not.

Again, I have not personally tested the new AMD or latest Intel machines. I am analyzing what specialists are publishing.

I would say that AMD investors should take heart; Barcelona looks good. It will look even better as AMD ramps up processing speed (the first out the gate quad-cores have slower clock cycles than most of us expected). However, as long as Intel is willing to undercut AMD on pricing, you have to consider AMD a long-term investment, and a risky one at that. I own the stock; I want to see what its worth when AMD market share hits the 51% tipping point. That may never come; at best it is years away.

See also my AMD page

Monday, September 10, 2007

Choosing a Biotech Stock 2: Gilead

Analyzing Gilead Sciences, Inc. (GILD) will act as a template and standard of measure for my project of choosing a biotechnology stock to add to my portfolio. Gilead is on a short list of stocks I know I would like in my portfolio. I have cash to buy one biotech stock. I also want to look beyond the biotech stocks I have been following (See the list of stocks I follow). For more on my guidelines for this process see Choosing a Biotech Stock 1: Overview. For background information on Gilead see my Gilead (GILD) page. So the questions left for Gilead are, what is a good price to buy the stock at, and is there any better biotech stock for the money?

Gilead has several drugs on the market. Here are the ones producing substantial revenues in Q2 2007:

Truvada $385.4 million.
Atripla $212.4 million.
Viread $154.9 million.
Emtriva $9.6 million.
Hepsera $75.2 million.
AmBisome $64.8 million.

The first Atripla, Emtriva, Viread and Truvada are all for treating HIV infections. Hepsera is for treating Hepatitis B. AmBisome, is for fungal infections, which are often a secondary problem with HIV infections. Tamiflu sales are through Roche and were not broken out.

Sales totalled over $1 billion in the quarter. Net income was $408 million. Cash generated was $512 million, but $455 million was spent on stock repurchases. At today's closing price market capitalization of Gilead is almost $35 billion. So the price of the stock is steep: if revenues and earnings flatten out, you would be getting only $4 billion in revenues and $1.6 billion in net income if you bought the whole company. Still, that gives a price-to-earnings ratio of about 22. Pretty safe. But you should always ask about the upside and downside risks.

On the upside Gilead could sell more of the products it currently has on the market. With revenues up 52% from the year-earlier quarter, it would be a good bet that there will be more revenue growth in the short run. In addition, with development costs for these drugs now in the past, net income should continue to ramp faster than revenue.

The other upside for biotech companies is in the pipeline of potential future products. This is harder to judge because the risk of failure to prove both safety and effectiveness to the FDA's satisfaction is hight. Gilead's pipeline has three Phase III candidates, a Phase II candidate, a Phase I candidate, and a number of preclinical candidates. They have the cash to license more candidates if necessary. They have a good track record, so I would expect at least some candidates to make it to market as the years progress.

Downside risks for drug companies have three components: macroeconomic, safety, and competitive. Macroeconomic risks may come from the economy in general or from resistance of private or government insurers. Safety would not seem to be a big issue with antiviral drugs, given the alternatives, but some times issues reveal themselves years after a drug is introduced to market. The main danger for Gilead would be competition. Someone could actually come up with a cure for HIV infections. While the possibility cannot be discounted, I see nothing on the short term horizon that falls in this category.

So as far as I am concerned, Gilead is a buy at this price, but at this price appreciation will more likely be in the long run than in the short run. Two categories of companies could beat that. One would be an underappreciated company that has a likely but unproven drug candidate. That would be a far riskier investment, but could pay off big. The other type would be a biotech company that has a better price-to-earning ratio, is likely to grow earnings faster than Gilead, or that has a more promising pipeline.

Before buying Gilead, even if it wins this competition, I would look a bit more closely at its pipeline. But for now this overview will serve my purposes.

Monday, September 3, 2007

Choosing a Biotech Stock 1: Overview

September 3. Earnings reports for Q2 are mostly over except for the occasional firm with the odd fiscal year. Q3 does not end until September 30 for most companies. There will be some news, of course, and market fluctuations, of course, and maybe even some profit warnings. Basically this is a slow spell looming before me.

But I do have a project you might be interested in watching. I need to pick a new stock to invest in, and most likely it will be a biotechnology stock.

Note this is not "choose the best biotech stock for investors in general." There is no such thing as an investor in general. There are investors who have no biotech stocks and have decided to start accumulating some, including new investors who have no stocks at all. There are people whose main strategy is rotating sectors. There are people who like to spread out risk, and those who don't mind concentrating it. While my needs are very specific to my own portfolio and situation in life, I will try to illuminate factors that investors should research and consider when picking stocks, particularly biotechnology stocks, which have some peculiarities.

So first, how did I get here. Much as I would like to tell the story of how my grandpa lost his farm in a poker game and bring that on up to the present, let's just look at the current situation. I've been doing research for sophisticated investors for a few years now, and before that had a fair amount of experience in IT and other industries. I have a portfolio that currently contains only nine stocks: MCHP, RACK, MSFT, NAPS, AMD, and MRVL are in the IT camp. In the biotechnology camp I have only CELG, DNDN, and ANSV. I have some cash in my account I want to convert to stock, regardless of which direction the market takes short term. In the other hand I have some cash reserved for use only if a panick results in further bargain shopping opportunities. While I would never absolutely rule it out, I don't leverage investments with bets on stock options or even with buying on margin.

I think some biotechnology stocks are going to be worth a lot more money (better than market returns) in a few years than they are now, and may make me filthy rich if I live to see the long run. I could spread the risk out by buying a lot of different biotechs, or going to a fund. But, well, while I would recommend a fund to anyone too lazy to do their own research, the problem with spreading risk broadly is that you can't get any alpha (profits above typical market) that way.

Couple of other things. I aced Biology in high school. I worked for a biostatistics company in my youth. I spent a couple of decades writing novels and short stories, which is why I am not rich yet. Having fallen behind on biochemistry since high school, I am chewing my way through books with titles like Biochemistry, Cell Biology, and Molecular Biology of the Gene. You can pick these kinds of books up, only slightly out of date, used and cheap. Beware that there are management teams out there with listed biotech stocks that are not entirely honest with investors about matters of human chemistry and statistics. Also be aware that the FDA drug approval game is something like poker: a good hand is better than a bad hand, but it still may not be a winning hand. On the other hand a not-so-great hand can win if it is the best of the lot.

I have been following a number of biotech stocks at least to the extent of listening to their quarterly analyst conferences. I am familiar with their currently marketed drugs and their pipelines. These stocks are AMGN, BIIB, DNA (Genentech), GILD, and ONXX. All of these are good companies. I also follow some biotechs for a client that specializes in bottom fishing very high risk companies; these are not for me, or anyone that can't put together and follow a very diverse portfolio.

Among the stocks I follow the two I lean towards are BIIB and GILD. I'd be fine buying either, and that would save me a lot of time. But I like doing research; it is fun; I have the time. So what am I looking for? A stock that has good appreciation potential both over a short time frame (up to two years) and a long time frame (2 to 20 years). In the long time frame the most important factors are technology and management. I the shorter time frame the single most important factor is stock price. I want something that is clearly undervalued today. That provides the kind of safety net I like.

I try to think in terms of probability spreads. For example, stock B has a 10% chance of crashing (a better drug comes out, or a unexpected safety concern arises), a 20% chance of muddling along, a 50% chance of doing well enough to make me happy, and a 20% chance of major upside. Thinking there is only one path a stock can follow is a fools way of investing. Even if you are wrong with your probabilities in a single stock, you aren't very likely to be far wrong in your overall portfolio.

Keeping all this in mind, I am going to start researching stocks. The next installment of this series will probably be an analysis of BIIB or GILD. That will provide a baseline. I'll be looking for biotech companies that could beat the baseline. I want a company that has top-quality science, looks competent to convert that into a truly beneficial drug or therapy, and yet has a reasonable price. I will show you how I weigh the prospects of a small company with nothing approved by the FDA yet to a successful company like GILD. How much risk am I willing to swallow? I'll let you know as we go along.

In the meantime you can find some help at my Biotechnology Investor Aids Page.