I've always been amazed at the longevity of failing companies. Businesses clearly on their way to bankruptcy often defy the laws of financial gravity for years before they go all the way under. I first noticed this phenomenon early in my money management career. I was running a small cap-focused mutual fund at the time and, over and over again, I would find companies with no business being anything but penny stocks trading for $3, $6, or even $10 a share. That experience was very formative for me. It got me interested in shorting stocks, especially those of what I call "dead-companies-walking." Since then, as the manager of my hedge fund, I have shorted the stocks of over 230 businesses that have eventually declared bankruptcy. (I'm finishing up a book recounting my career and the methods I use for scouting out these doomed companies.)
Right now, there is no better example of a dead-company-walking than the biotech firm Dendreon (DNDN). I shorted DNDN at $8 and even though it has lost more than half its value since then, I'm not going to cover my position. That's because I am confident Dendreon is destined for one fatal outcome: bankruptcy.
An old Wall Street saying holds that stocks, especially biotech stocks like DNDN, are like love affairs: they go up on emotion and down on facts. Dendreon has certainly followed this pattern. When its one and only viable product--a treatment for late-stage prostate cancer called Provenge--was approved by the FDA in 2010, Wall Street breathlessly predicted billions in revenues and its stock price soared past $50. Then grim reality set in. The drug turned out to be expensive to make and, worst of all, didn't sell as well as two competitors manufactured by Johnson & Johnson (JNJ) and Medivation (MDVN).
As with many love affairs, the honeymoon ended swiftly for DNDN. In a single day in August of 2011, it cratered 67 percent--from almost $40 to just over $11--after the company withdrew its revenue estimate for the year. Since then, things have only gotten worse. When Provenge was approved by the FDA, analysts claimed that it would bring in $1.3 billion in 2013 revenues and $1.8 billion in 2014. Now, analysts expect that it will earn only a fraction of those amounts, $303 million in 2013 and $367 million in 2014, and that Dendreon will suffer significant losses each year. As of the end of June 2013, the all-important "accumulated deficit" on Dendreon's balance sheet was a staggering $2.095 billion. That's right, the company has burned through more than two billion dollars developing, manufacturing and marketing an unpopular drug.
And yet, despite all of these troubles, many investors refuse to let go of their romantic attachment to DNDN. Dendreon's stock has staged numerous short term rallies in recent months, and will almost certainly do so again before its inevitable demise. This is typical of a dead-company-walking.
In my opinion, the main reason troubled businesses like Dendreon retain relatively high stock valuations, which even surge upwards for short periods, is excessive optimism. Longs cling to every scrap of good news while ignoring overwhelmingly large amounts of contrary information. At the same time, bottom-feeders buy stocks based on those same implausibly optimistic scenarios in the hopes that they will turn around. Of course, the managements of failing companies--and large investors in them--encourage these behaviors by churning out a steady supply of rosy reports.
In the case of Dendreon, two recent narratives have lured in new buyers and kept stubborn bulls from selling off their stakes. As is so often the case with dead-companies-walking, each of these stories is easily refuted.
#1: Europa, Europa!
Members of Alcoholics Anonymous warn newly sober alcoholics against what they call "pulling a relocation"--moving to a new city or region in the hopes of escaping their problems. No matter where you are, they caution, your struggles will follow you. Dead-companies-walking often try to deflect attention from their fundamental flaws by touting opportunities overseas. In the late-1990s, for example, numerous executives in the paging industry tried to convince me not to short their companies' stocks by claiming that they would compete with cell phones by moving into third world markets. Dendreon, again, fits the pattern.
In June of this year, DNDN rose briefly on news that it had received preliminary approval to market Provenge in the European Union. Moreover, there have been some hopeful signs that Provenge's "label" could eventually be expanded to allow doctors to prescribe it to men suffering from earlier stages of prostate cancer. Both of these opportunities could be huge boons for Dendreon, opening up large new revenue streams, if not for one inconvenient fact: Johnson and Johnson and Medivation aren't standing still.
J&J's blockbuster Zytiga gained European approval two years ago and Medivation's Xtandi is moving speedily through the same regulatory process. Zytiga has already been approved for earlier-stage patients and Xtandi is seeking the same label expansion. Given these facts, why would anyone believe that Provenge would perform any better against these competitors in Europe than it has domestically--that is, third place in a three horse race?
At the same time, some DNDN bulls have been touting the company's cost-cutting, layoffs and improved margins. I visited Dendreon's corporate offices in Seattle last December and the effects of these actions were clear; it was a virtual ghost town of empty cubicles. While reducing staff and selling off assets like factories might appear beneficial on paper in the short term, they aren't going to achieve the one thing that can save Dendreon--vastly increased revenues. If anything, belt-tightening is going to hinder new sales.
#2: A Potential Buyout
In the decades I have been shorting stocks, I've found that one of the surest signs that the end is near for a dead-company-walking is when stories begin circulating about a potential buyout. Right on schedule, I have been hearing these rumors about Dendreon in recent months. Again, a buyout by a larger competitor would be a huge boon for Dendreon and its shareholders. Too bad no company in its right mind would ever do such a thing.
First, a potential buyer would have to retire the common stock. There are roughly 153 million shares of DNDN on the market. Even at the current 52-week low price of $3.10, that's a market cap of almost $500 million. While it's true that cancer treatments are rare and unusually valuable compared to other products, that's a massive expenditure for what amounts to the rights to one sluggishly-selling drug--and it's not even half of the actual price a buyer would have to pay for Dendreon.
To continue to fund the marketing and development of Provenge, Dendreon issued more than $600 million in convertible notes in 2011. Those notes come due in January of 2016. Counting embedded interest, they represent close to $700 million in liabilities now. That's a back-breaking amount of debt and it means that any potential buyer would have to fork over more than a billion dollars for Dendreon. At this point, only the most obstinate bulls and deluded day traders could convince themselves that DNDN is a billion dollar company.
Often, the best way to value dead-companies-walking as they move closer to bankruptcy is to track the prices of their corporate paper. The reason for this is simple: there are always optimistic stock traders out there willing to risk a couple thousand dollars on low-price stocks, even in the most severely troubled businesses. But corporate bond buyers are a different ilk. They are usually highly astute institutional professionals buying and selling multimillion dollar tranches. They can't afford to make loose bets. They have to be right. With this in mind, let's take a look at the current market value of Dendreon's 2016 convertibles.
The initial yield to maturity on these notes was a highly conservative 2.875 percent. It is now north of 22 percent (source: Morningstar):
(click to enlarge)
The current price on the notes is down to $65, just above its 52-week low of $62.75. You might wonder why bond traders would be willing to buy these notes so deep "in the hole," or below par value. The answer, again, is not good news for DNDN shareholders hoping for a miracle buyout: when Dendreon goes bankrupt--which will probably happen a year or so before the 2016 convertibles come due--its bondholders are going to own its assets, including its intellectual property and the rights to Provenge. They will sell those assets off to the highest bidders. Even at the fire sale prices they will likely get for them in the midst of bankruptcy, they believe that the current price of the bonds is low enough that they will make a profit. Meanwhile, the current owners of DNDN stock will earn exactly nothing, as their equity stakes will officially be wiped out in the bankruptcy proceedings. It's a brutal process, but then again, most deaths are.