Stem Cells: Invest At Your Own Peril

by: EnhydrisPECorp

I wrote this series on stem cells at the behest of a handful of readers and friends, who have often demanded I pay more attention to stem cells. As our new intern aptly said, "more stem cells!" And given that I find the science behind regenerative medicine fascinating, I figured this would be an excellent opportunity to learn more about a sector that has long piqued my interest. So I figured why not? I would heed the demands of the masses and write about stem cells.

Before I began researching these pieces, I was generally bullish on the sector. The news coming out of the sector was certainly attention grabbing, with some clinical trials producing eye-popping results (e.g., Advanced Cell Technology's (ACTC.OB) RPE program), and a number of others were making steady progress (e.g., Neuralstem's (NYSEMKT:CUR) ALS program moving into Phase II trials later this year). The more research I did, however, the more pessimistic I became. In fact, this series has made me an unabashed pessimist on stem cells as viable investments.

My pessimism stems from the fact that the sector is plagued by poor financing deals that have literally run roughshod over retail investors, and worse still, there are too many bad actors within the sector that hype results and subsequently dump shares on unsuspecting retail investors (e.g., ACTC.OB, GERN, PSTI, just to name a few that have pulled this shenanigan in the past at some point). Moreover, fund managers conveyed to me during the research phase of this series that they have little to no interest in these stocks for the very reasons outlined in my last article. Not exactly confidence inspiring to say the least.

Topping it all off, one of my favorite companies in the sector, NeoStem (NBS), surprised the markets yesterday with a new round of financing that dropped the stock an unholy 21% in after-hours trading. A quick look at the offering shows it was priced well below market value prior to this drop, which is certainly a nice way to reward long-term shareholders. With a shrug of the shoulders, all I can say to beleaguered investors is that this is par for the course in this sector, and is the primary reason why I cannot offer a bullish outlook, despite the massive "potential" valuation gap stem cells offer (see last article and a number of recent Seeking Alpha articles). Echoing Adam Feuerstein, stem cell stocks, for the most part, do appear to be for "dreamers and fools."

Upon setting out to cover stem cells, I originally planned to conclude the series by offering investors a basket of promising stem cell companies as vehicles to gain exposure to this coming medical revolution. As I look at the Mad Max-like Wasteland that is the stem cell sector now, however, I honestly want to tell investors to run for the hills. There is way easier money to be made in biotech, and stem cell stocks have historically been absolute dogs. Driving this point home, the 5-year average performance for some of the scientific leaders in the sector (ACTC.OB, CUR, NBS, PSTI) comes in at an unholy -34%. Such performance clearly violates Mr. Buffet's first rule of investing.

Still, if you are like me and stubbornly believe there is value somewhere in this sector, I offer a single stem cell pick here. Even so, I offer this pick under the condition that readers understand the significant risks associated with these stocks (see last article), and understand that stem cell stocks are a magnet for dilution. In other words, invest at your own peril.

To be upfront, I am recommending this single company based on the assumption that it won't end up causing my readers to revolt and write me hate mails on a daily basis. That's not to say stem cell science won't work or the therapies are destined to fail - quite the opposite. I still believe stem cells will change the face of medicine as we know it, but I can't, in good conscience, recommend investing in companies that will be dilution machines for the foreseeable future. No one likes seeing a 20% drop in their investment in a single day after all, or 30% losses in their portfolio, despite employing the time-tested buy and hold strategy.

With the preamble out of the way, let's get to the pick. I based this pick on two rather straightforward criteria: ability to raise non-dilutive capital, and the likelihood of a success in their pipeline in the not so distant future. The first criteria literally ruled out 99% of the sector. I was thus left with two candidates, Osiris Therapeutics, Inc. (NASDAQ:OSIR) and Mesoblast LTD (MBLTY.PK). While MBLTY.PK certainly fits the bill so to speak, I believe the company's sector leading market cap (1.75B) combined with its 200+% historical performance in PPS puts it on shaky ground going forward. Specifically, Mesoblast is still at least three years away from producing a commercial product, making it hard to support such an outlier of a valuation. As such, I trimmed the roster down to only one company, Osiris Therapeutics, Inc. That said, I believe OSIR is simply the "best of the worst", and is still hampered by the many problems inherent in the sector.

Osiris Therapeutics, Inc. is a Maryland-based stem cell company that develops and markets therapeutic products for the treatment of medical conditions such as inflammation, cardiovascular disease, orthopedic disorders, and wound healing. The company's stem cell platform is based on a non-controversial source, namely adult bone marrow. According to the company's website, these cells differentiate, based on the tissue environment, to such lineages as muscle, bone, cartilage, marrow stroma, tendon and fat. Moreover, these cells do not provoke an immune response, allowing for the development of products derived from unrelated human donors.

Osiris presently has two candidates undergoing clinical trials for a number of indications including acute graft versus host disease (GvHD), Crohn's disease, heart failure, diabetes, COPD, amongst others. The company's lead stem cell platform is called "Prochymal", which is an intravenously administered formulation of mesenchymal stem cells. Prochymal is being evaluated in Phase III clinical trials for GvHD and Crohn's disease, and Phase II trials for cardiovascular disease, COPD, and diabetes. It is also the only stem cell therapy designated by the FDA as both an Orphan Drug and a Fast Track product. Most impressively, Prochymal was approved for the management of acute GvHD in children who are unresponsive to steroids in Canada in May 2012, making it the first stem cell therapy to be approved by Canada Health. Based on the status of OSIR's current Phase III trials, it is entirely possible the company will have Prochymal approved for a number of indications in the U.S. within a few years' time.

The trick to the company's ability to develop Prochymal and not totally wipe out shareholders in the process was its 2008 licensing agreement with Genzyme, which paid the company $130M in revenues. These monies, together with about $10M from DoD and Juvenile Diabetes Research Foundation, have allowed OSIR to pay for a number of clinical trials for a diverse array of medical conditions--a feat that is often sought after but rarely achieved in the stem cell field (e.g., Aastrom Biosciences (ASTM) terminating its critical limb ischemia study for financial reasons). These deals have given OSIR a 7.8% growth in PPS since its IPO, but the company still has a negative performance on a 5-year timescale (-2.98%).

Osiris concluded the agreement in September 2012, and now retains worldwide rights to Prochymal. In effect, OSIR got the money to develop Prochymal and gave away little in return. That said, the reason the agreement ended is because Prochymal failed to meet its primary endpoints in its Phase III GvHD studies. As such, there seems to be little hope that Prochymal will ever be approved in the U.S. as a treatment for GvHD, despite the company's statements to the contrary (see recent 10-K hyperlinked above).

With the GvHD indication shelved in the U.S., the primary value driver on the therapeutic side of the company is going to be the ongoing Phase III trial for Crohn's disease. The study is set to complete data collection in December of this year for the primary outcome (disease remission), but will be extended an additional three years to assess secondary outcomes. I presume a data release for the primary outcome will occur in the first quarter of 2014. If positive, it should act as a significant catalyst for a company with a market cap under $400M.

Even so, OSIR is far from immune from the problems inherent in this sector, and has repeatedly been accused of "data mining" to put a positive outlook on terrible clinical outcomes. Backing up these assertions by other authors, I did find OSIR's website devoid of any clinical setbacks and the 10-K seemed to be glaringly unrealistic about the future commercialization prospects of Prochymal for GvHD. To understand why stem cell companies are so fearful of taking negative events head on, one needs to understand the consequences of negative clinical outcomes for stem cells.

Namely, this is a sector where funding is tremendously difficult to procure, and negative results have absolutely been brutalized by the market (e.g., OSIR dropped over 50% upon releasing negative results for Prochymal). These issues thus place monumental pressure on management to soften the blow of negative clinical events. Essentially, negative clinical outcomes threaten to sink entire pipelines of promising therapies by making capital nearly impossible to raise, at least on terms that do not lead to the imminent demise of the company. Nevertheless, I believe it is paramount that stem cell companies start owning up to negative clinical outcomes, and give investors a balanced picture of what they are investing in. Without being upfront about failures, I find it difficult to imagine that the sector can win back the trust of retail investors that have so often been pummeled by these stocks. In sum, OSIR is the best bet in a sector mired in financial, governmental, scientific, and, to be frank, honesty problems. Invest at your own peril.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.