INVA - Innoviva's Reward Isn't Worth The Risk

2023-06-21 15:17:56 ET

Summary

• Innoviva Inc. shares have slightly outperformed the S&P 500, returning about 12% against a gain of about 10.8% for the S&P 500.
• The company has promising developments and the financials are "fine," but the shares are not cheap, making the risk-reward uncompelling.
• Innoviva's future prospects are positive, but the more an investor pays for future cash flows, the lower their subsequent returns will be.

It's been a little over three months since I announced to a waiting world that I was avoiding Innoviva Inc. ( INVA ), and in that time, the shares have slightly outperformed the S&P 500, having returned about 12% against a gain of about 10.8% for the S&P 500. I wouldn't be me if I didn't also point out that the shares have underperformed the S&P 500 by about 13% from the time that I wrote my previous " avoid " piece. The company has reported earnings again since, so I thought I'd see if it makes sense to plug my nose and buy or continue to avoid it. I'm going to make that determination by looking at the latest financials, and comparing those to the stock valuation. After all, if you can buy this stream of future cash flows at the right price, the investment will be a good one. Before getting into that, though, I thought I'd offer a synopsis of the latest from the company.

One of my many obsessions is that I want to know what's going to make my readers as happy as possible. Making your reading experience as pleasant as possible occupies at least 50% of my waking hours. One of the ways I've come up with to make life as pleasant for you as possible is the "thesis statement" paragraph. This allows you to get the gist of my thinking in a single paragraph placed near the beginning of each of my articles. The knowledge that I'm making your life as pleasant as possible is all the thanks I need. Anyway, I like many of the developments the company outlined in the latest Goldman Sachs Annual Global Healthcare Conference, and I think the financials are "fine", but I'm not going to be investing today. The reason for this is that the shares are not cheap, and in a world where an investor can earn decent risk free returns, the risk-reward just isn't compelling enough here in my view.

I Listen To This So You Won't Have To

On June 12, Innoviva participated in the Goldman Sachs Annual Global Healthcare Conference, and I thought I'd write about some of the highlights here for a few reasons. The conference sounded as though cotton wadding was stuffed into the mouths of all participants before they were lowered down a well, and then forced to talk into tin cans. Maybe not everyone would enjoy that listening experience, so I thought I'd write out the highlights here. In case one of your hobbies is listening to bad recordings, and you'd prefer the tedium of listening to such a thing over the much greater tedium of my writing, feel free to check it out at the recording at your leisure here .

The Broad Topics Covered Were These:

1. Viruses are increasingly becoming antibiotic resistant, but there are few ways to overcome this problem in a commercially viable manner. The company is of the view that it can "do well by doing good." Innoviva believes it has threaded this needle in some instances. The reason companies in the past couldn't solve this problem related to the fact that they lacked differentiation from many viable generics and lacked scale. According to the company, Innoviva doesn't suffer from these problems.

2. The XacDuro product is the first pathogen specific antibiotic approved by the FDA. Physicians will find this product much easier to prescribe because it can help deal with resistance concerns. There's little risk from generics with this product. Additionally, there's no background therapy that's been mandated, so the prescription process should be relatively smooth.

3. Zoliflodacin has just entered phase 3, and it's expected that the trials will be done by the end of this year. This product is for the treatment of uncomplicated gonorrhea, which is one of the more prominent STDs. Typically there's a good treatment against gonorrhea, but the injection is painful, and there's growing concerns about drug resistance. Innoviva's product is an oral, and it addresses resistance concerns.

4. The company is of the view that the staff of 30-40 salespeople will be sufficient to handle these and other new products.

Overall, I was struck by the hopeful tone here, and I'm curious to see how these two products impact the bottom line from the second half of this year, and into next.

Financial Snapshot

I've written it before, and I'm sure I'll write it again. The financial performance of this company is volatile. Revenue for the first quarter of this year was down by about 15% relative to the same period a year ago, yet net income was higher by about 121% or $19 million. Before getting too excited by that uptick in net income, we should remember that $22 million went to noncontrolling interests last year. Stipping out the impact of that would mean that net income this year was down by about $3 million, or 7.9%. I like the fact that operating expenses dropped along with revenue, suggesting that the company has the capacity to react relatively dynamically to changing market conditions, but the $10.1 million drop in operating expenses wasn't enough to compensate for the $13.7 million drop in revenue.

Comparing the most recent quarter to the same period in 2019 paints a different picture. Though the revenue this year was up by about 38%, net income is only up by about 3.2%. I'm hoping that in the future the company has the capacity to scale effectively.

Finally turning to the capital structure, the company has previously made a point of suggesting to investors that it wanted to clean up the balance sheet. As of the most recent filings, cash and equivalents are $79 million higher than they were in 2019. Total liabilities are up by about $178 million over the same time period. Additionally, this most recent quarter saw interest expenses of about $4.4 million, which was $785 thousand higher than the same period in 2019. I think it's fair to say that further work needs to be done on this front.

In spite of the above, I'd be happy to invest in this company at the right price. I think it's growing, and I would like to capture some of that growth.

The Stock

I treat the business and the stock that supposedly represents the business to be two distinctly different things. The business makes money by offering pharmaceutical products. The stock, on the other hand, is a scrap of virtual paper that gets traded around in a public marketplace, and its movements are driven by the crowd's ever-changing moods. The crowd may become enamoured of a given stock because of an optimistic forecast put out by a popular analyst. The stock may move higher or lower because of expected changes in interest rate policies. The crowd is capricious sometimes, and can drive the stock up and down much more aggressively than should be the case given the changing fortunes of the business. For instance, a person who bought the day after the latest 10-Q was released is up about 5% on their investment as of this morning. A person who waited 12 days is down about 5%. Not much happened in that period of time to justify such an extreme change in returns. If you doubted that we're buying and selling stocks, I think this offers an example for you to consider.

In my experience, the only way to profitably trade stocks is by buying when crowd expectations become too pessimistic, and selling when the crowd becomes too optimistic. Another way to say "too pessimistic" is "cheap" which is why I like to buy shares that are cheaply priced. I should also point out that no one's going to give you the shares of a wonderful company for a cheap price. In order to acquire shares cheaply, the company in question has to have some "hair" on it. Anyway, I measure "cheap" in a few ways, ranging from the simple to the more complex. On the simple side, I like to look at the ratio of price to some measure of economic value, like earnings, sales, book value, and the like. I want to see a company trading at a discount to both its own history and the overall market. When I last reviewed Innoviva, the PE was about 5.5, and the price to free cash was 5.35. The shares are now between about 6% and 75% more expensive per the chart below.

I previously suggested stock investing is about playing expectations, by buying when the crowd's expectations are too dour, and selling when the crowd becomes too rosy. I want to try to quantify expectations as much as possible, and to do that I turn to the works of Stephen Penman and/or Mauboussin and Rappaport. The former wrote a great book called "Accounting for Value" and the latter pair recently updated their classic "Expectations Investing." These both consider the stock price itself to be a great source of information, and the former in particular helps investors with some of the arithmetic necessary to work out what the market is currently "thinking" about the future of a given business. This involves a bit of high school algebra, where the "g" (growth) variable is isolated in a standard finance formula. Applying this approach to Innoviva at the moment suggests the market is assuming that earnings will grow at a rate of about 6% in perpetuity. This is fairly optimistic in my view.

In my view, the shares now range somewhere between "relatively expensive" and "expensive." I like the future prospects, but I'm firmly of the view that the more you pay for a stream of future cash flows, the lower will be your subsequent returns. I may miss out on some upside here, but in a world where an investor can receive a risk free return of about 5.2 %, I don't see a compelling reason to buy. The shares may rise in price from here, and if that happens, I'll console myself with the knowledge that we're not seeking "returns." We're seeking "risk adjusted returns", and the risk reward potential doesn't make sense at the moment in my view.

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