For those who are into small cap speculative buys, it is common practice to bet on clinical milestones. But as it always is with markets, common practice is usually wrong. Much like sentiment is a contrary indicator - it is often the same with these milestones. At market tops, sentiment is wildly bullish, eyes are glazed, the VIX is suppressed, and people are counting their paper wealth while they're still strapped into the roller coaster. But everyone's already in so there are no more buyers. That's when the selling begins. At bottoms, everyone hates the market, everyone's a bear, and there are no more sellers. That's when the buying begins. To paraphrase Warren Buffett, when everyone's panicking, get greedy. When everyone's greedy, it's time to panic.
With clinical milestones in the healthcare sector, the story is similar, though slightly different. Phase I and phase II, and to a certain extent even phase III trial successes often lead to drops in price for development stage companies because the ugly truth is that even after these successes, these companies are still operating at a loss and have very little, if any, revenue. Dilution is a real possibility after a trial success because they need more money to fund the next expensive time-consuming trial which comes at them like a linebacker; there are many ways to explain it.
One concrete example is Trius (TSRX). Right after they reported positive results from phase III trials for tedizolid phosphate in December of last year, TSRX fell from $7.24 to $5.33 in less than a month - a drop of over 25%. This was because they announced an offering of 9.89M shares at $5.25 each right after that success, diluting the shares by over 33%. This is the danger. Small caps - even the best of them - dilute into successes to raise cash. You can't blame them, and if you're a buy and hold type it's not even relevant anyway, but this is why it is not wise to buy right into a clinical milestone.
And yet, dips on good news can only go so far before the spring is loaded. There is a gray area between speculation and investment somewhere after phase III that, once crossed, signals the trend change. It is important to keep in mind that a successful completion of a clinical trial is only one condition albeit a necessary one, for a development stage company like Trius to really shine, so here's a deeper look.
Trius is set to announce top line results on its second, and presumably final phase III trial of its tedizolid antibiotic in Q1 of next year. If results are positive, FDA approval is possible by 2014. Once approved, they'll need the capital and/or partnerships to market it. Under their agreement with Bayer (BAYRY.PK) signed in July 2011, Bayer will fund all clinical trials in countries outside the US, Canada, and the EU (with the exception of the Koreas, though I don't think the North Korean market is all that crucial) and Trius will receive an unspecified double digit royalty on all sales in those countries. Bayer will also fund 25% of clinical development costs in the US, Canada and EU. Trius will keep all sales revenues, but will have to develop its own marketing.
They have the funding, but they will also need a substantial market to offset costs and turn a profit. The chief competitor to Tedizolid, Pfizer's (PFE) Zyvox, sold $1.3B last year, so the market is there. Tedizolid does kill bacteria that is Zyvox resistant, but undercutting Zyvox is crucial, and the danger of a generic Zyvox being manufactured in the near future by generic leader Teva (TEVA) is a threat. Fortunately, Pfizer and Teva reached a settlement on the issue back in May, the details of which are mum, but could indicate that Teva's launch of a generic Zyvox is a few years off, giving Trius the needed time to solidify its market share. For an interesting possible timeline on this, see the Smith on Stocks analysis on the deal.
The only thing that makes me nervous is that Trius has $57M in US treasuries, which represents 42% of its accumulated deficit. US bonds are not safe and anything funny happening in the bond markets could mean trouble, especially for a company that needs all the cash it can get.
Aside from that, Trius is only 9% off its 52 week low, with final phase III results on the way next quarter, Bayer backing them, Teva probably held off for a while, and a $1.3B global market to explore. Let's see what happens.