I’ve been thinking about biotech stocks a great deal lately. The sector seems to be trading much better in the early weeks of 2012, with a few spectacular gainers already in the bag and likely more to come.

Yet investors are also well aware many biotech stocks simply flame out as cash dwindles or as a drug fails to meet clinical testing hurdles. So how do you gain potentially big upside without suffering significant downside (which is my entire $100,000 Portfolio mission) in this speculative sector?

I think I’ve found the perfect vehicle.

It’s a company with ties to a range of promising drugs and only needs to see a few hits to give its shares a solid boost. I’m talking about Ligand Pharmaceuticals (Nasdaq: LGND), which has been around for more than 20 years. After a major revamp about five years ago, the company is just now hitting its stride.

Just-released fourth-quarter results underscore a long-awaited milestone. Ligand had been losing money because its portfolio of drugs had yet to mature, but now it’s finally profitable — and potentially hugely profitable within a few years.

Before I get into Ligand’s slate of investments, let me show you what this company has looked like by the numbers.

 

As you can see in the table above, Ligand’s heavy investments to acquire the rights to promising drugs have led to a string of money-losing years. EBITDA is the more salient metric than earnings per share (EPS), because it best highlights an ongoing cash burn. Not only did Ligand sharply reduce the EBITDA drain in 2011, it actually delivered positive EBITDA in the fourth quarter — for the first time in a number of years. And now that Ligand is in the black, it’s highly unlikely to slip back into the red.

Credit for this company’s coming turnaround goes to CEO John Higgins, who took the reins in January 2007. Since then, he has deployed the company’s cash into four key deals, which have provided a pipeline of drugs, and more important, some key biotechnology platforms that can boost the efficacy and safety of many other companies’ drugs.

 

Reaping what they sow
Through its investment in various small biotech firms, Ligand now has exposure to 60 different drugs that are either in clinical trials or are already on the market. Specifically, roughly 10% of its drug pipeline has already received Food and Drug Administration approval, another 10% is in Phase III testing, another 25% is in Phase II testing, with the remainder either in Phase I or pre-clinical testing.

Here’s a quick summary of a few key programs that are already generating income:

• Captisol. Captisol is a chemical solution that makes drugs more stable and can lead to more precise dosing. More than 20 drugs currently in development are being tested with Captisol. This platform is providing a boost to many of Ligand’s drugs in development, and is being licensed by major pharmaceutical firms to improve the performance of existing drugs. Partners include Baxter (NYSE: BAX), Merck (NYSE: MRK), Bristol-Myers Squibb (NYSE: BMS) and Medicines Co. (Nasdaq: MDCO).

• Promacta. GlaxoSmithKline (NYSE: GSK) currently sells this drug, which stimulates platelet formation and targets patients with bleeding disorders. Glaxo is also testing Promacta to gauge its efficacy in patients with hepatitis C. According to the World Health Organization, about 170 million people worldwide are infected with the hepatitis C virus, which can result in cirrhosis of the liver and liver cancer. If Promacta proves to be efficient in the treatment of the disease, then it could potentially become a blockbuster drug.

Ligand earns a sliding 5% to 10% royalty scale, depending on sales volume. It is likely to make around $10 million in Promacta royalties this year, but this figure could be 10 times higher by the middle of the decade. UBS projects sales of Promacta to rise 150% to $123 million this year, and sees 2013 sales exceeding $200 million, on the way to $500 million in sales by 2015.

Ligand’s sales are expected to remain stable or trend moderately higher over the course of 2012 as these two drug platforms gain greater traction. Management has formally issued guidance for 2012 sales of $30 million and positive cash flow, though this figure appears to be conservative in light of recent quarterly sales run rates.
 
Not only do the two platforms have significant growth opportunities in the years ahead, but Ligand’s pipeline of yet-to-be-approved drugs also looks quite promising.

For example, Ligand’s partner Onyx Pharmaceuticals (Nasdaq: ONXX) is testing a drug called carfilzomib, which is a Captisol-based protease inhibitor that has appeared quite effective in the treatment of multiple myelomas (blood cancers). Phase II testing is underway, and carfilzomib could be on the market a year from now. The company and the analysts who follow Ligand say this drug also has the potential to be a blockbuster.

Behind carfilzomib stands a fairly deep drug pipeline, though it’s too early to place a value on it. The company is spending about $16 million in general overhead each year and another $10 million on research and development (R&D) — with partners spending much more on their own R&D that could yield royalties to Ligand.

So combined, we’re talking about roughly $26 million in annual expenses. Notably, Ligand’s revenue stream has already surpassed this amount and is likely to march much higher in 2013 and beyond. That’s why I think this former money-loser should be a money-maker from here on out.
 
The Downside Protection –> Shares have traded as low as $9 when the market was in full sell-off mode last summer. If the market hits another deep rough patch in 2012, then that’s a floor that you need to think about. Insiders tend to step in and support the stock with open market purchases in the $11 range. Now that Ligand is profitable, shares may never touch those lows again.

Upside Triggers –> The two drug platforms noted above are just beginning to hit their stride. As a result, 2012 should see a steady stream of announcements from Ligand and its partners regarding clinical trial progress or new sales agreements. Analysts are still hard-pressed to specifically gauge forward quarterly revenue streams, but the projected income statements should get much more clarity over the course of 2012.

As a very rough gauge, assume 2012 sales of $30 million, 2013 sales of $40 million and sales approaching $100 million by 2015. Notably, these sales carry very high margins, which is why analysts say Ligand could earn $3 to $4 a share by 2016. If this scenario plays out, then shares could rise from a current $14 to $30 or $40 in the next few years.

Action to Take –> I will be buying 700 shares of Ligand (or roughly $10,000 worth) 48 hours after you read this.

I’m not expecting rapid appreciation for this stock. Indeed, it carries a fairly low beta and wouldn’t necessarily surge in value just because the market takes off. More cyclical holdings in my $100,000 portfolio, such as Ford (NYSE: F) and Alcoa (NYSE: AA), have much greater leverage to expectations of a rebounding U.S. economy. That said, Ligand’s shares are more likely to hold their own if the U.S. economic outlook becomes constrained. Frankly, this isn’t a stock to hold for the next six months, and instead should be seen as a solid long-term growth portfolio holding.

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