A Chance to Buy a Cash-Generating Machine at a 25% Discount
Financial statements offer a great deal of insight into the complex process that is investment analysis. Successful analysis requires understanding what these statements say… but also what they don’t say.
For example, the income statement offers insight into how much a company is earning, but it doesn’t tell us whether earnings are likely to grow. To answer questions about the quality of earnings and whether earnings growth is sustainable, we need to look at the cash flow statement.
Personally, I believe cash flow is one of the most important fundamental indicators. To understand the importance of cash flow, think of your own financial situation. How much you earn is important, but it’s not the only factor in play. The key to success is managing your cash flow. If you spend less cash than you take home, you’re probably not going to be dealing with money problems. But consistently having bills that exceed the amount of cash coming in is simply an unsustainable model and a recipe for bankruptcy.
The same is true of businesses.
Whether you’re looking at the components of a personal or professional budget, it’s crucial to understand where the money is coming from, where it is going, and which funds can be allocated for the “extras.”
There are several ways a company can generate cash inflows, like selling products or services, selling stock and issuing bonds. A company will also have cash outflows from things like reinvesting in itself and paying expenses like wages, debts and dividends.
Regardless of where it comes from, all companies need to generate sufficient cash flow to continue operating. For a company to continue operating successfully, how much cash is spent is more important than how much is earned.
Earnings for a business are determined by a set of accounting rules. And when earnings “results” come from accounting principles rather than sales, it’s possible for a company to have high earnings but be unable to pay its bills.
Unlike earnings, cash flow is difficult to manipulate, which is why I believe it’s an important factor to consider when determining whether a company has healthy growth potential. It’s simply a way to measure how much cash comes into a company and how much cash the company uses, which can be a good indicator of how much earnings growth is due to real results and how much is due to clever accounting.
To find companies that have a healthy outlook, I look at both cash flow and earnings. The cash flow statement allows me to evaluate the quality of a company’s earnings and, if the earnings are high quality, the earnings themselves allow me to determine the fair value of the company.
Celgene (NASDAQ: CELG) is an undervalued biotech company with strong earnings growth and equally strong history of cash flow growth. Over the past five years, Celgene has been able to triple the free cash flow it’s left with at the end of the year, from $816 million in 2009 to $2.6 billion in 2014.
A lot of that free cash flow growth has stemmed from the success of its four major drugs — Revlimid, Pomalyst, Abraxane and Otezla — which are each on track to produce annual sales of $1 billion or more by 2017.
The company’s current top seller is Revlimid, a drug used to treat blood cancer. CELG reported revenue of almost $5 billion for the drug in 2014 and expects sales to reach $7 billion in 2017. The drug’s patent does not expire until 2027, according to the company’s SEC filings.
Pomalyst is used to treat multiple myeloma, another deadly form of blood cancer that primarily affects older adults. An aging population will most likely see more cases of multiple myeloma, and CELG expects sales of this drug to increase from $680 million last year to $1.5 billion in 2017. The patent on Pomalyst expires in 2024.
Abraxane is used to treat pancreatic cancer and was approved by both the FDA and European Union in 2013. In 2014, Abraxane recorded sales of $848 million. CELG expects average sales growth of 28% a year, reaching $1.5 billion to $2 billion in 2017, as the drug is approved in other countries and usage increases. Its patent expires in 2026.
Otezla could also reach $1.5 billion to $2 billion in sales by 2017. This drug was approved to treat psoriatic arthritis and plaque psoriasis in March 2014 and generated sales of $70 million last year. Reports indicate it is being prescribed by a number of physicians, and the drug is currently in Phase III trials for the treatment of other diseases, which could increase sales. Otezla is covered by several patents that begin to expire in 2019.
In 2015, CELG is expected to report earnings per share (EPS) of $4.74, and analysts expect earnings to grow at an average of 25% a year over the next five years.
The PEG ratio compares a stock’s price-to-earnings (P/E) ratio to the EPS growth rate. A stock is fairly valued when the PEG ratio is equal to 1, which is the point where the EPS growth rate is equal to the P/E ratio. For CELG, this points to a fair value of $118.50 ($4.74 projected EPS for 2015 with a P/E ratio of 25).
Based on current prices, CELG is fairly valued. But using a put selling strategy, we can get paid to wait for shares to trade at a more attractive price.
If CELG pulls back, this strategy will give us an opportunity to buy shares at $90 — a 25% discount to current prices. But if the pullback doesn’t happen, we’ll get to keep about $65 in income that we receive just for agreeing to make the trade.
Here’s how it works.
If you sell a CELG Oct 90 Put you will earn $0.65 per share ($65 per contract).
Buying 100 shares of CELG at $90 each would cost $9,000. To initiate this trade, your broker will likely require you to deposit a percentage of that obligation in your account, like a down payment on a house. This is called a “margin requirement.” It usually runs about 20% of the amount it would cost you to buy the shares. This CELG trade would require a margin deposit of $1,800 (20% of $9,000).
Assuming CELG closes at or above the $90 strike price at expiration on Oct. 16, we keep the premium and make a profit of $65 on $1,800, or 3.6%, in 103 days. If we can repeat a similar trade every 103 days, we’d earn a 12.8% return on our capital in 12 months.
Worst case, if CELG closes below $90 on Oct. 16, we’ll have to buy shares at that price — a price we believe offers a good value for the stock. Since we received $0.65 in options premium, our actual cost basis is $89.35 per share, a 25% discount to current prices.
At $89.35, we’d own CELG at 19 times 2015 estimated earnings — a bargain price for a company expected to grow earnings at an average rate of 25% a year.
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