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The biotech midcap market is unique on Wall Street. It is one of the most irrational, inherently unstable, and unpredictable markets out there. More so, I believe, than any other group of mainstream stocks you can trade today. Why is this? Though not so in every case, biotech midcaps are to a large extent made up of companies that only recently received a major FDA approval for a very promising drug, but have not successfully marketed the newly approved drug to the public yet. The FDA approval serves to dramatically increase the price of these stocks, bringing many of these companies from small cap to midcap in a very short time period. But clearly, as the marketing infrastructure for the new medicine has not been put in place, the positions of many of these companies are still tenuous and many continue to operate at a loss and even resort to dilutive financing as a company try to get its product to market.

I'd like to list four different midcap biotechs in this sort of situation, some more promising than others and some more clearly overpriced, and then share my advice on how to take advantage of some. Before I do that, though, I'd like to spend a few sentences explaining why this situation is inherently unstable and how it would look in a freer market setting.

Speaking strictly from a market perspective and leaving value judgments of the FDA and its efficacy aside, the heavily regulated nature of biotech through the FDA has the effect of shielding the true worth of many of these companies. The artificial barrier between product and its market that the FDA sets serves to severely suppress the net worth of small biotech companies during clinical trials because, simply, the companies are forbidden from selling unapproved drugs to the public. When the barrier is suddenly removed and a drug is approved, all the pent up suppression of the stock's price explodes in a volatile swing upward that brings with it overvaluation from speculators who are sure that the drug will succeed in the market. Add to that the fact that in many cases, especially for smaller companies the drug must succeed given the amount of capital put into its development to get through the FDA in the first place, so if it fails, the whole company can go down with it.

In a free market how would it work? Biotech companies would develop many drugs at once at much cheaper costs much more quickly without having to wait for bureaucratic approval. The drugs would be tested out on willing participants. Perhaps private, voluntary, and much cheaper and efficient third party certifying agencies would step in to fill the FDA gap. A drug or drugs from a small cap biotech company would slowly be introduced to the public and revenues would come in gradually from sale to the public. The price of its stock would gradually increase as sales increased, or it would go down if the drug was unsuccessful, but not catastrophically so, because a company can always try again at much cheaper costs to fix the drug or engineer a new one. There would be an ebb and flow in revenues for these companies which would reflect in the ebb and flow of its stock price. The situation we have today is one of artificially suppressed stocks and artificially overbought stocks based on expensive non-market barriers that can cost companies everything if a drug fails, and can mean extreme gains if a drug succeeds.

But this is what we have to work with. So what can investors do to make the most of the situation as it is?

Ariad Pharmaceuticals (ARIA)

The story with Ariad is basically what is outlined above. Though Ariad is not a new company by any means, it is in the tenuous position of one. The only thing stopping me from recommending a short on this one is that the stock looks so overbought considering the company's uphill battle and financial positions, that a short is almost too obvious. There must be something up Ariad's sleeve.

The story is that its blood cancer drug, Iclusig, received FDA approval in mid-December. Iclusig joins a long line of drugs into a $6B leukemia market, led by Novartis' (NVS) Gleevec with about a 66% market share. With Pfizer (PFE) also joining the fray (see previous link), it will be hard for Ariad to break through this wall of giants.

Its balance sheet shows an accumulated loss of over $700M and a cash burn rate of an average $55M per quarter over the last three quarters and just over $140M left. The company has enough equity to survive for a while, but Ariad needs Iclusig to succeed in the market. On the chance that it does, the best move in my opinion would be to straddle the January 2015 LEAP options on ARIA on either side of the current price. By 2015, we'll know if Iclusig succeeds or not.

Hospira (HSP), down but not out

Hospira (HSP), also a biotech focusing on oncology, mostly injectable cancer drugs, is an opposite story from the average biotech midcap that just got FDA approval. Hospira is a much more well-oiled machine than Ariad. Though its net cash flows have gyrated the last few years, its revenues have increased past $4B last year, and look set to meet or exceed that number this year. Its problem has been recent recalls of some of its popular drugs because of manufacturing problems. In FY 2011 alone, non-recurring expenses of this nature totaled over $444M, over 11% of its revenues.

HSP has suffered accordingly, its stock price cut in half from $60 to $30 in the space of a year. One can assume that the company has rooted out its manufacturing problems, and being that its revenues are still on the way up, this is a case of buy it while it's down.

Medivation (MDVN)

Prostate cancer is a $9B market. In October 2011, Medivation (MDVN), until then a struggling small cap, announced positive results on its prostate cancer drug which later became branded Xtandi, and MDVN promptly doubled. In August of last year, the drug was finally approved. Medivation is a picture perfect example of the inherent instability I described earlier. The stock was weighed down by the FDA for years. Finally, when it seemed the FDA would approve a drug with only the potential to make the company money, the stock doubles overnight and has climbed over 500% since pre October 2011 on hope and little more.

Xtandi is doing alright so far and is off to a strong start. $57M in sales in its first full quarter available to the public. I expect that number to rise. And revenues last quarter outstripped all of 2011. However, there is trouble on the horizon. As long as Xtandi continues to succeed, MDVN will at least stay stable. In my opinion, the current stock price assumes that Xtandi will be a smashing success. But if there are any bumps along the road, then MDVN is very overbought. The company over the last 3 quarters has suddenly taken on $193M in debt after being debt free for a long stretch. I wouldn't go long, but there are better stocks to short than this one.

Onyx Pharmaceuticals (ONXX)

Onyx is another one of those unpredictable companies that can lose or be net positive with wild swings every quarter. Just look at its quarterly cash flow. The good news is that revenues are up 78% from 2010 to 2011, but the bad news is that revenues will be down significantly this year, and losses will be large judging from the numbers so far. Onyx only pulled a positive Q3 because of a $96M tax credit loophole on its income statement. To make the skies even darker for Onyx, Celgene's (CELG) new drug Pomalyst for multiple myeloma is now approved by the FDA as of February 8, and it targets the same set of patients Onyx's new star drug Kyprolis targets.

Kyprolis was approved by the FDA back in July and the stock more than doubled from $44 to $91 in 3 months on nothing but the removal of an artificial barrier. ONXX has since settled back down now to $74. Considering its erratic earnings, the fact that Celgene has jumped into Kyprolis's exact market, the fact that Celgene is a $42B marketing behemoth, and the fact that the S&P is approaching all time highs, Onyx is in trouble. If you're into shorting, this one is a better bet than MDVN.

Conclusion

Ariad is at a critical juncture and could go either way in the next year or two. Straddling the 2015 LEAPS is a relatively safe bet. Medivation is not a good long idea, but in case Xtandi lives up to expectations, the stock won't go down either, so I say leave it alone. Hospira is clearly down, but this is due to mismanagement and human error in its drug manufacturing process. Revenues are steady and HSP is beaten down and has been consolidating for over a year, so it's a buy. Onyx has Celgene breathing down its neck with inconsistent earnings. Shorting may not make you much, but I think it's safe to say ONXX isn't going up any time soon.

Source: Biotech Mid Caps, Dangerous Slippery Slopes