A Drug Stock With Potential For Solid Gain

Cubist Pharmaceuticals (CBST) is an oft overlooked mid-cap drug maker that is among the most undervalued stocks out of entire research coverage of more than 5000 stocks. The company reported earnings for their fiscal fourth quarter ended last December that showed the company had increased sales of its Cubicin by 23% in the quarter and 26% for the full year. Cubicin is responsible for about 93% of the firm’s revenue so that growth obviously caught our eye. Furthermore, the company expects sales of Cubicin to reach $600-$620 million next year which would imply a growth rate of better than 16%.

Sales growth has been impressive, but often investors are wary of a stock that is considered a “one-trick pony”, especially in the pharmaceuticals business where one bad trial could derail a drug. Also, Cubist Pharmaceuticals is dealing with a patent-infringement suit with generic drug maker Teva Pharmaceuticals (TEVA) related to Cubicin. In December, these concerns intensified as a drug called ecallantide in Cubist’s pipeline was dealt a blow as safety concerns halted enrollment in Phase II trials. The trials continued with the 450 patients already enrolled in the trial, and the firm is confident that this sampling will be large enough to continue a sufficient study. If this drug is found to be dangerous or ineffective, Cubist may have to cut their losses and scrap the trials. However, the stock has climbed nearly 20% since that news, so apparently the market does not think that is likely.

Cubist has also taken a step towards fortifying their pipeline through its acquisition of Calixa Therapeutics which was completed in mid December 2009. Calixa, who focuses on the development of antibiotics addressing problems related to multi-drug resistant Gram-negative pathogens, has a drug in clinical trials that is showing promise. The way that the deal was structured, Cubist only paid $92.5 million in cash up front and the rest of the compensation of up to $310 million for Calixa will only be paid upon achieving certain development, regulatory, and commercial milestones. Calixa’s most highly anticipated drug, known as CXA-201, is currently in Phase II trials and is expected to file a new drug application in 2013.

From a valuation standpoint, Cubist’s stock has been range bound around $20 dating all the way back to late 2005. Since that time sales have increased by 468%, or an average of about 36% per year over those 5 years. Furthermore, over that same time frame earnings have swung from negative $.60 per share to a solid EPS of $1.43 last year and an expected $1.64 this year. If you look at the current valuation of CBST versus its historical valuation it is obviously attractive. For example, price-to-cash earnings have historically ranged from about 13.7x to 22x, but at current levels it is only 5.9x. Price-to-sales is currently only 2.13x versus the historically normal range of 9.2x to 25.1x.

We are not saying that CBST will achieve these prior valuation ranges, but the current level is so far below these that we think it warrants a further look. It is clear that investors are getting much more solid fundamentals for their $20 per share investment than they were in 2005. We think the long term prospects for Cubist appear bright overall, even with consideration for the potential headwinds of the ecallantide trial and patent disputes. There has been a flurry of very bullish options activity over the past few months for CBST, as traders may be betting it could get snatched up in by a larger drug maker. Of course, at this point that is just speculation, and we think the valuation is attractive enough to stand on its own.

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

We utilize this straightforward approach to value over 5500 securities, with key emphasis given to the study of individual securities' price-to-sales, price-to-cash earnings and other historical valuation ranges. Our long term value investing methodology is powered by the teachings of Ben Graham and it has proven to be very adept at identifying stock prices that are out of line with fundamental factors.

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