Outside the biotech bubble

December 22, 2015 01:00 PM

According to AARP, there are more than 7,000 baby boomers that turn 65 every day and well more than 40 million individuals older than 65. Since aging typically leads to increased need for healthcare, it is no surprise that many investors view healthcare as a growth industry. Investors and capital allocators, well aware of these demographics, have been investing heavily in the sector. Healthcare stocks, particularly biotechnology stocks, have been one of the strongest sectors during the past five years (see “Growth sector”). In fact, the biotechnology weight within the Russell Microcap Index has nearly doubled. Before you get too excited about the space, consider the valuations of biotech stocks.

Of the few companies in the Russell Microcap Index with revenue, biotech companies are trading at a median price to revenue multiple in excess of 30X. Current revenue multiples only tell a small part of the valuation story, however. Market expectations are based on the longtme prospects of these companies. Nearly 80% of biotech companies in the Russell Microcap Index have a published analyst revenue forecast for 2018. That so many analysts are providing 2018 forecasts is astounding. Tellingly, the 2018 analysts’ estimates typically were provided by the same firm that had bankers who helped to leverage a company to the detriment of its balance sheet.

It is difficult to forecast results for the next year, or even next quarter, so revenue predictions four years out should be taken with a grain of salt. There are so many if/then hurdles that need to be passed for these 2018 forecasts to come to fruition. Will the Federal Drug Administration (FDA) approve a drug? Is the company able to market it? Will consumers buy it? Finally, will company management prove to act in shareholders’ interest? Perhaps a select few companies will manage to accomplish all of these milestones; however, given the rich valuations of the sector, the biotech companies that may succeed are priced for perfection. The rest of the companies are priced for disaster. Even if a select few biotech companies survive and thrive, the lofty valuations of the group and “bubble-like” appearance of the space tells us that this story will not have a happy ending. The service sector of healthcare has more attractively priced stocks and has revenue and profits.

One of our newest healthcare services investments is DLH Holdings (DLHC). DLHC provides healthcare delivery solutions, logistics and technical services in the United States. The company offers services to government agencies, including the Department of Veteran Affairs and Defense. DLHC hired new management highly incentivized through stock options. It has been successful in retaining key business, winning new business and reducing overall costs.

Revenue has grown by more than 20% in the past two years, and could grow another 10% in 2015. Profitability has also improved. After losing money in 2012, DLH has been profitable the past two years. Profits also should show improvement in 2015. Management is now turning its efforts toward revenue growth through acquisitions.

With no debt and $10 million worth of both cash and a line of credit, DLHC has the resources to make a few small acquisitions. Revenue in the past 12 months was nearly $65 million. We believe management will be successful in its first revenue goal of revenue in excess of $100 million within the next few years. Once revenue tops $100 million, EBIDTA margins should reach 7%. On a longer-term basis, management’s goal is to grow revenue north of $200 million and EBITDA margins near 10%. DLHC currently has a market capitalization of less than $27 million and an enterprise value of nearly $22 million. With shares trading at 25% of 2016 revenue, and a little less than 4X 2016 EBITDA, we believe shares are undervalued.

About the Author

Michael J Corbett is CEO, CIO and Portfolio Manager for all equity portfolios with Perritt Capital Management, Inc. Perritt first employed Mr. Corbett in 1990 as a research analyst, and became lead portfolio manager of all micro-cap portfolios in 1999.