If you have seen the biotech IPO market lately, then you're aware of the large valuations that are being awarded for essentially nothing. Epizyme (EPZM) and Bluebird Bio (BLUE) have $700 million plus market caps, but are yet to test any of their products on humans. Therefore, investors are willing to take big bets, have continued to take big bets on small groups of data, and continue to miss out on the best of opportunities.
There's a big problem forming in biotechnology -- if you're a retail investor -- and that's a massive disconnect in value and in the perception of a company. The industry has entered a phase where 10-15 times sales seems appropriate, but unfortunately, such valuations are the exception, not the rule, and usually lead to large losses. As a result, the presence of value and overvalued in biotechnology is wider than it has ever been, and in this article, I am giving three different levels of value in biotechnology.
Trading Above Potential
I already touched on the biotech IPO market, which includes preclinical companies with valuations that mimic that of companies with FDA approved or late-phase candidates. However, it's not just IPOs and preclinical companies that trade with exceedingly high market capitalizations. These exceedingly overvalued company's worth are also seen in companies with late-phase products, and even some that already have FDA approved and marketed products. One in particular that comes to mind -- a company whose value leaves virtually no room for error -- is Aegerion Pharmaceuticals (AEGR).
To prove my point, I am going to use the notes of a bullish analyst of Needham's Chad Messer. Messer likes the company's drug Juxtapid, which treats a rare cholesterol disease called Homozygous familial hypercholesterolemia (HoFH), and has led to Aegerion's 275% gains in 2013. Messer upgraded the stock, currently trading at $88, to $100 from $50. His logic is assuming that Juxtapid captures 17% of a targeted 14,000 patient population by 2018. If so, worldwide sales could reach $590 million, giving the stock an EPS of $7.28. Messer then puts a multiple of 30 on the EPS and applies a 25% discount to arrive at a $100 price target, which would represent a peak price/sales ratio of nearly 5.0.
Given the fact that Aegerion is trading at $88, I have no doubt that it will in fact reach $100. However, what's important to remember is that this valuation was supported with fundamentals that won't be created until 2018, which is five years away. In biotechnology, when a company is in clinical studies and doesn't expect data for 3-5 years, it is viewed as a negative, or a long waiting period on the investment. Yet, Aegerion is pricing all of its future fundamental gains five years early and, for some reason, analysts support the price.
So, at $88, Aegerion has nearly priced in all of its 2018 upside and its product just launched. Now, bulls will say that Juxtapid will capture more than 17% of the market. However, I don't think so. Juxtapid directly competes with Sanofi's (SNY) Kynamro, and Kynamro is priced significantly lower, while Juxtapid's clinical benefit was just slightly better. Moreover, it's not a far stretch to suggest that Sanofi has more resources than Aegerion, and can launch the drug easier and more effectively. Thus, a 17% market share is fair.
Next, the question of how large is this market. Messer assumes 14,000 patients worldwide. This is based on Aegerion's own estimates of 3,000 cases domestically. However, the FDA estimates the disease occurrence at one in one million people, or 315 annual claims. While I am sure the actual number is higher than 315 - Aegerion already has 215 patients on the drug -- I doubt it's 3,000. Most likely, the actual patient population is somewhere in the middle. Either way, this is a classic example of the market pricing in all of a stock's peak potential before fundamentals can support the price. This action usually leaves investors wounded badly when an unexpected event occurs that causes the company to miss a sales target, or faces some other headwind. At this point, there is very little upside, and significant risks, making Aegerion a bad investment moving forward.
Trading With Potential
The idea of a company that trades with its potential is for a company to have fair value based on the likelihood of its product approval; it has to respond accurately to key catalysts and reflect a fair amount of risk and reward. Essentially, these are 50/50 stock investments. Synta Pharmaceuticals (SNTA) fits into this conversation, and is a company that has Wall Street fairly excited as of the last month.
Synta rallied over 40% on Monday July 29, after its monotherapy ganetespib progressed into the second stage of a Phase 2 study. The company, which is supposed to enroll 70 patients, presented preliminary data on 15 patients, showing that four had significant tumor shrinkage in treating a rapidly progressing and very complicated type of breast cancer.
The company still has a lot to prove, as data in treating such an aggressive cancer can change quickly. However, the data does suggest that ganetespib works in treating this particular patient population, and therefore the stock adjusted to reflect the increased likelihood of a product approval.
Still, shares of Synta are trading lower by 35% in 2013, as ganetespib's results in treating lung cancer is less flattering. The company progressed into a Phase 3 trial in lung cancer without presenting final Phase 2 data. Although, Synta presented preliminary data from the lung cancer trial at ASCO, which was not statistically significant. With breast cancer, ganetespib looks more promising, and the stock's valuation has been adjusted with gains, after a year plagued with disappointment.
Now, with a market cap close to $500 million, Synta trades at one times peak sales potential of the drug on this one particular indication. This means that if ganetespib is proven to be effective in further studies, and on additional indications, the stock could return very large gains. Essentially, it means that Synta is valued correctly, and will trade with data. The expectations for the stock are in-line, and realistic. Therefore, Synta becomes a stock worthy of your due diligence if you believe in the legitimacy of the company's data and believe that ganetespib will prove effective in larger studies.
Trading Below Potential
Staying on the same subject, let's look at another breast cancer company, Galena Biopharma (GALE). This is a stock that I've covered for quite some time, and that I bought around $0.50. For the last six months I have not covered Galena quite as extensively, but still, it is a company that I believe is trading far below its worth, a stock that has upside that far exceeds its very limited downside. In this particular section, I am going to show you why I think it is undervalued, and why Galena is a good stock to explain this particular category.
The company has two key products: The soon to be launched Abstral for breakthrough cancer pain and NeuVax, a Phase 3 product that prevents breast cancer recurrence in patients with low and intermediate levels of HER2.
Galena trades with a market cap of $155 million. This means that if NeuVax is successful, and has peak sales in excess of $1 billion, Galena trades at just over 0.15 times peak sales - not including sales for Abstral.
First, let's look at Abstral, a fentanyl based product used for the management of breakthrough cancer pain. The upside in Abstral lies in its rapid absorption, delivering the medication in just 15 minutes. Already, Abstral has launched in Europe, creating sales of $54 million in the last year, and growing at 40% year-over-year. If Abstral achieves the same response in the U.S., and commands the same percentage of market share, Galena could earn over $100 million in sales. With that said, the potential of Abstral alone fully supports the valuation of Galena, which does not account for its most promising product, NeuVax.
Clearly, with every investment there are bulls and bears. Galena bears insist that NeuVax will fail in its Phase 3 trial because it was not statistically significant in its "Phase 2 study of 187 patients." The reason quotes are included is because this argument is flawed, and is based on 187 patients. Galena did what any normal biotechnology company does in clinical studies: It tested a product on a group of patients, and then from that study was able to identify a group where NeuVax worked best.
While bears will say that Galena's 187 patient Phase 2 trial was unsuccessful, I hardly call an overall 50% reduction in recurrence, and one recurrence shy of being statistically significant, "unsuccessful." However, it is important for investors to realize the structure of this study. First off, node-positive and node-negative patients were included. In the node-positive arm, NeuVax showed a 78.4% reduction in recurrence! Therefore, Galena built its Phase 3 trial around only node-positive patients, makes sense right? Moreover, according to NeuVax developer Dr. George Peoples, only one-third of the total patients were optimally dosed and only one-half received booster shots in the study. In the Phase 3 trial, all patients in the NeuVax arm will be optimally dosed and all will receive boosters. In the Phase 2 trial, those who were optimally dosed with boosters had the very best results.
The structure of a clinical study is very important to the outcome; just ask Acadia Pharmaceuticals' (ACAD) investors. In a 2009 study of pimavanserin, Acadia failed to achieve the primary endpoint of the trial. However, the failure was due to the combined results of a 10mg and 40mg dose. Thus, Acadia built a trial around the 40mg dose, which was successful, and has since produced stock gains of 1,100%. Essentially, Galena did the same thing. The company took all of NeuVax's strengths and created a study around those strengths. For Acadia, it failed its 2009 study when half of its patients were optimally dosed. Therefore, it seems logical to conclude that Galena could see much better results when its patients are optimally dosed, rather than just one-third of patients.
Nonetheless, when treating node-positive patients in its Phase 2 trial, NeuVax had a recurrence rate of just 5.6% at 60 months, compared to 25.9% in the control arm, representing a 78.4% reduction in recurrence. These numbers are staggering, yet because of that one recurrence short of being statistically significant in the "overall 187 patient study," Galena's valuation mirrors that of Acadia after its failed 2009 study. Other than this one flaw on behalf of assessing Galena, the only other complaint that bears present is the price paid to acquire NeuVax. This, combined with the Phase 2 study, is most likely why Galena falls in the category of trading "below its potential."
Galena acquired NeuVax for less than $10 million. Bears present logic that "if NeuVax really worked big pharma would have snatched it up" before Galena's acquisition. However, this argument is simply not true, but is one of the reasons that Galena trades far below its potential. Because after all, a product doesn't have to be purchased for billions in order for it to work. Questcor Pharmaceuticals (QCOR) paid $100,000 for Acthar Gel, and just recently produced quarterly sales of $196 million. Therefore, the price paid is irrelevant. Also, Big Pharma didn't see Acadia's pimavanserin, Sarepta Therapeutics' Eteplirsen, or Celldex Therapeutics' CDX-011 prior to data. Therefore, Big Pharma misses quite a lot.
Finally, what's important to remember is that a stock is only in this category if there is a legitimate reason to believe that the market has inaccurately valued its potential, and that the potential will be realized. These stocks are much harder to spot, as many in this category become duds. However, in the case of Galena, and other such stocks, there is a legitimate reason to believe that it will succeed in its Phase 3 study, because of study design. The company has removed all of the Phase 2 overhang and built its study around a subgroup that saw a near 80% reduction in recurrence. To me, this looks solid.
Over the last couple of years, I have provided countless charts, rules, and categories to group biotechnology stocks and gauge their risk vs. reward. In this particular case, you might be wondering how each category might perform in the years ahead. Therefore, I will conclude with this example.
An "above potential" stock might be compared to Dendreon (DNDN), which had a market cap over $6 billion before the company ever sold a drug. As a result, the stock traded at 6 times peak sales (at the time) before investors knew of the manufacturing woes and the increased competition that would follow its launch of Provenge. Therefore, with the company not clicking on every cylinder, the stock has collapsed 90% in the last three years, trading at 1.7 times sales.
A "with potential" stock could be compared to Santarus (SNTS), which is a volatile stock that trades with the ups and downs of its history. Santarus has exploded over the last two years with the success of Glumetza, the relaunch of Zegerid, and the successful product launch of Ulceris. However, when Zegerid faced patent concerns and the company's growth hit a rough patch in 2010/2011, the stock responded with loss. These stocks are great investments if you are bullish on the long-term direction of a company.
Lastly, a "below potential" could be a Questcor Pharmaceuticals, a company with dirt low expectations that knew how to manage and market its product. The problem with this space is that there are a lot more Celsion Corporations than Questcors. However, when a Questcor is found, great upside can be created for the long-term investor. As a result, this fact makes investing in "below potential" biotechs rewarding, so long as small investments are made and there is concrete reason, not emotion, that leads you to think that a product will prove successful. Then, seven-year Questcor-like gains of 11,000% can often be produced.