Tooling up for stem cell stocks

In the stem cell gold rush, it might pay to avoid the diggers and invest in the companies that sell the shovels.

By Katie Benner, writer-reporter

NEW YORK (Fortune) -- Biotechs working on cell treatments seem poised to profit from President Obama's decision to lift the ban on federal funding for embryonic stem cell research and the $15 billion in stimulus money marked for scientific research. But for investors, the best way to play the sector might be the companies that make the tools used by biotechs.

A lot of biotech companies are developing stem cell-related treatments, but only a few of them have been tested on humans. It could be at least a year before one of these therapies is ready for the market. Meanwhile, biotechs will burn through cash on research and development that may not lead to viable products.

The stimulus money is unlikely to flow directly to biotechs anyway. The bulk of the funds will go to the National Institutes of Health, which will receive about $10 billion. The NIH traditionally distributes grant money to universities, government labs, and non-profits.

No matter who gets the money, there will be a lot of activity in the space. A study from Thomas Weisel Partners says that the stem cell market will be a growth driver for medicine over the next 10 years, and scientists - no matter where they work or whether they are successful - will have a growing need for the tools they use to develop stem cell-derived treatments.

Two of the tool makers are Life Technologies (LIFE) and Sigma-Aldrich (SIAL). Life Technologies has market cap of $5 billion and is trading at 10 times next year's estimated earnings. Sigma-Aldrich has a market cap of $4.2 billion and is trading at 12 times earnings. By comparison, biotechs are often small-cap or over-the-counter stocks that don't have products to sell - and they don't have P/Es because they don't have earnings.

Life Technologies was created in November 2008 when Invitrogen and Applied Biosystems merged, creating a company with a major presence in biodiscovery (cell biology, molecular biology and drug discovery), applied biosystems (DNA sequencing), and cell systems (cell and tissue culture media, reagents, and sera).

Cell systems is directly related to stem cell research and is Life Technologies' fastest growing division, with revenue up 17% in 2008. The company and analysts forecast high single-digit growth in 2009 in this area as well.

Cell systems provides 1,200 products that are used across the spectrum of stem cell research - from substances that allow the cells to grow in culture, to formulas that characterize and differentiate stem cells once they begin to grow. Lots of companies sell similar offerings, and the market is extremely fractured. But in a survey of stem cell researchers by Thomas Weisel, Life Technologies ranked No. 1 for the quality of its products, including media (the stuff that stem cells grow in), instruments, antibodies, and stem culture stem cells; and it seemed to have the best brand recognition. Life Technologies is committing about $300 million to R&D, more than any other company in its space.

When the NIH gets its $10 billion, Life Technologies could be a big winner because about 20% of its revenue comes from NIH spending and clients who get NIH funding.

"Our focus is on helping our customers get these funds for breakthrough research," says Amanda Clardy, a Life Technologies spokeswoman. But the company also maintains a diversified customer base, with no one customer making up more than 5% of revenue.

Life Technologies' balance sheet also looks healthy. The company has about $3.5 billion in long-term debt, with $80 million due this year and another $185.7 due in 2010. It expects to generate about $400 million to $450 million in free cash flow, a number that analysts at Deutsche Bank and Barclays feel can be achieved; and the cash will be used to pay down 2009 debt.

As long as no other needs arise, the company will also pay off other debt obligations as well. "Debt repayment is our number one priority and will be the primary use of excess cash," according to Clardy.

Sigma-Aldrich sells 100,000 different chemical products to life science and high-tech researchers. Last year, about 70% of its $2.2 billion in sales came from supplying products to research labs, pharmaceutical companies and biotechs for life science applications.

Any increase in research funding should benefit this chemical company, says Dan Leonard, who covers the stock for First Analysis. "Government funding should help offset the fact that small biotechs are having difficulty getting financing and the reduction in headcount at large pharma R&D labs," he says.

Sigma-Aldrich makes a large variety of media, cell cultures, and growth factors (the stuff that influences how the cells grow). No one product will move the needle for the company. Like Life Technologies, it has a broad reach in a fragmented market. Sigma-Aldrich treasurer Kirk Richter says Sigma-Aldrich has about a 15% market share across the research chemical market.

The company is in good financial shape as well. It expects to generate about $300 million in free cash flow in 2009 and had about $250 million in cash on hand at the end of 2008. That should be enough to support its $529 million in short-term debt, most of which is commercial paper. Sigma-Aldrich hasn't had problems rolling over its paper in part because it has support from the government's Commercial Paper Funding Facility.

Sigma-Aldrich has a diverse customer base, with no one account making up more than 2% of revenue. Both Life Technologies and Sigma-Aldrich have large patent moats and they do business all over the world.

Both companies lowered their full-year 2009 guidance, and neither of them factored into their earnings estimates the potential benefit they'll get from the stimulus or funding for embryonic stem cell research.

But analysts think this was a smart move because it increases the likelihood that the companies will not only meet their earnings expectations and post low-single digit earnings growth, but they could even beat them. To top of page

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