Biotechnology: Finding The Best And Worst Value In The Industry

by: Brian Nichols

Irrational exuberance and illogical downward trends are two extremes in biotechnology that are nothing new, and the savviest of investors can realize these trends to navigate the market and capitalize on the value it presents. In recent days, we have witnessed these factors at its very best, especially as it relates to cancer-fighting therapeutics.

Irrational Exuberance

Perhaps one of the greatest examples of investors reacting to news without really processing the news is with Dendreon (NASDAQ:DNDN) on Monday. Shares of the stock rallied as much as 17% in premarket hours, and then settled with gains of about 8% after news that the company is seeking a buyer.

In light of large pharmaceutical buyouts such as Onyx Pharmaceuticals, it makes sense that the market would view a buyout as positive. However, it doesn't appear that investors are processing why the company is seeking a buyer.

Since February of 2012, shares have fallen more than 80%, and in both of its last two quarters sales have actually declined year-over-year. The company now faces new competition from the likes of Johnson & Johnson (NYSE:JNJ) and Medivation (NASDAQ:MDVN). Also, the company now has a debt-to-assets ratio of over 100%, dwindling cash, and total liabilities of more than $675 million.

With all things considered, Dendreon might actually be a takeunder rather than a takeover, being purchased for less than its market capitalization. Earlier this year, Red Acre Investments wrote a great article explaining the difference. While this scenario might be possible, investors don't appear to be considering this outcome.

Illogical Valuation

While there are extreme cases of irrational exuberance, both long-term and intraday, there are also cases where valuation does not reflect data, near-term catalysts, and overall potential. To me, there is no greater example of this than with Galena Biopharma (NASDAQ:GALE).

On Monday, Galena fell 3%, giving it a three-day loss of nearly 5%, and giving Galena a market capitalization of $180 million. To me, this is baffling for two reasons: Abstral's launch and near-term data for NeuVax.

First, Galena has a marketed product called Abstral for the treatment of breakthrough pain in patients with ongoing treatment and cancer-related pain. In many ways, there is every indication in the world that this launch will exceed all expectations; yet the market is apparently valuing absolutely nothing for Abstral.

For example, Galena acquired Abstral in March of 2013, and since then shares are higher by about 5%. This is a product that had 42% growth in Europe and annual sales of $54 million in 2012. In Europe, it now commands a 30% market share of the fentanyl market, yet Galena is guiding for peak penetration of just 10%-15% of the U.S. market and Q4 sales of about $2 million.

Also, Abstral will directly compete with the Insys (NASDAQ:INSY) product Subsys, which saw 90% growth and sales of $18.5 million in its last quarter. This performance has given Insys a one-year 400% return and a market cap of nearly $900 million. Yet Galena, with a proven product in the same market, has expectations of just $2 million and a market cap of $180 million. In my opinion, this is a classic example of underestimating and eventually over-delivering. Given these facts alone, Galena becomes a great short-term opportunity.

Finally, Galena has interim data for NeuVax that will be released in the coming months. This is a product that reduced the recurrence of breast cancer by 80% in breast cancer patients with low to intermediate levels of HER2 who are node positive and optimally dosed. Such data is solid to say the least; and if results remain positive, NeuVax would target a market that's even larger than the $7 billion drug Herceptin. Yet despite this, Galena is only a $180 million company.

Combined, Galena has two near-term catalysts and is not being priced to reflect the likelihood of a positive outcome. Given the fact that essentially no value has been added to Galena since acquiring Abstral, there will likely be no effect on the stock if sales are bad, or at a worst 5%-10% loss. However, if sales are good, the company could possibly see Insys-like gains. Then, if interim data supports Phase 2 data for NeuVax, the stock might trade to reflect the potential of a blockbuster breast cancer drug.

Illogical Valuation Meets Irrational Exuberance

In biotechnology, rational investing often takes a back seat to momentum, with examples of irrational exuberance being found throughout the market.

Strangely, sometimes illogical value meets irrational exuberance, and perhaps there is no greater example than with Celldex Therapeutics (NASDAQ:CLDX).

Celldex used to be like Galena, but then reached a point where its valuation could not be explained. If we rewind to January 2012, Celldex has since gained nearly 900%. These large gains were created once data for its breast cancer drug, CDX-011, extended life and slowed the progression of breast cancer patients with the most advanced stages of the disease, those who don't respond to other treatments.

The success of this trial forced investors to look at the data from its Phase 3 glioblastoma drug, rindopepimut. While investors still await final data, we already know that the study was expanded due to early proof of anti-tumor activity. Therefore, investors are optimistic that this product will also become a success.

Finally, strong data from both of the company's key late-stage cancer trials forced investors to look further down the pipeline at products such as CDX-1135. This is an orphan product, similar to Alexion Pharmaceutical's (NASDAQ:ALXN) Solris, with strong preclinical data and human data expected this year. Combined, Celldex saw its market cap rise from $250 million in January 2012 to a 52-week high over $3.1 billion earlier this year.

So, the key point to note with Celldex is that with a market cap of $250 million it was clearly too cheap relative to the size of its pipeline, early data, and peak sales potential for its late stage products. But, at $3 billion Celldex was too expensive -- it got ahead of itself-- especially considering that no revenue had actually been produced, and we're still over a year from seeing sales. Therefore, shares of Celldex have declined 35% in the last month, and 4% on Monday, as irrational exuberance fades and the market finds a valuation that better reflects the company's current state.

With that said, it is very possible that irrational exuberance and upside value might once more meet, but this time as the stock falls from irrational exuberance. Fortunately, the process always repeats itself and can be very lucrative for those investors who understand the process.

Finding Value in the Middle

In the end, valuation must be accounted for. Investors must be savvy enough to realize that a stock's performance is actually connected to a company's fundamentals or outlook.

With Dendreon, the market has simply reacted to a headline, but apparently has not processed the reason for the sale or if Dendreon will ever really be purchased. Honestly, when we consider the rate at which Dendreon is losing money, large pharma may show no interest at all; and if anyone wants Provenge, it might be much cheaper to acquire the product in bankruptcy.

But to me, the most intriguing market performance is not what occurs on a day-to-day basis, or a response to a headline, but rather the wild swings in sentiment that creates clear value and overvalued companies. Celldex is a perfect example of this process at its very best.

For investors, the best way to capitalize is clearly to buy before the irrational exuberance begins. In order to do so you need some proof that data or product sales will be strong along with both common sense and basic valuation knowledge. If Celldex's two late-stage products have combined peak sales potential of $2 billion (theoretically), then 1.5 times peak sales might be pricey ahead of a marketing approval, thus explaining why the stock crashed after surpassing a $3 billion valuation. However, when it was a $250 million company, a 0.12 times peak sales ratio was a terrific opportunity and presented a favorable risk to reward ratio. Now, since the trend has turned, investors might once more find a good opportunity once the free-fall finds support, as the market tends to oversell and overbuy such stocks.

In the case of Galena, the same applies. When we look strictly at the facts we have a marketed product with proven success, and a similar product in Subsys that has also seen great U.S. sales. This suggests that low expectations can be met and that a 10%-15% peak U.S. market share might be conservative. Also, Galena's Phase 3 NeuVax study mirrors the subset of Phase 2 patients who saw a near 80% reduction in breast cancer recurrence. This gives us a good idea that its Phase 3 trial will be a success. When you factor in its $180 million market cap, and consider the blockbuster sales of Herceptin, then Galena's price to peak sales ratio is unprecedented, which also presents a favorable risk to reward ratio.

With all things considered, if it were easy to bet against the trend then everyone would do it. In retrospect, it is easy to follow the trend and allow your opinion to change with the performance of a stock. However, the only thing that's changed with Celldex in the last month is its price; the company is still the same. Dendreon has the same problems today as it had last week, and Galena remains cheap. Therefore, invest in companies, not stocks, and don't be a victim of irrational exuberance, but rather profit from it.

Disclosure: I am long GALE, JNJ. 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.