- MannKind Corporation is an emerging biopharmaceutical company listed on the Nasdaq GM.
- With a short position of around 68 million and lopsided options activity, it appears that many professionals are positioning for a drop following the July 15 PDUFA binary event.
- The standard buy-and-hold strategy exposes investors to extensive risk, leading me to conclude that an options strategy that provides significant upside potential with downside protection is far superior.
MannKind Corporation (NASDAQ:MNKD) focuses on the discovery, development and commercialization of therapeutic products for patients with diseases such as diabetes.
MannKind is developing Afrezza, which is an ultra-rapid acting pulmonary insulin that closely approximates the normal early insulin release seen in healthy patients. In completed Phase III studies for the treatment of diabetes, Afrezza has shown similar efficacy to standard care, thereby demonstrating the great potential of the product to replace available therapeutics, should it receive a positive regulatory approval on the anticipated PDUFA date of July 15, 2014.
As I see it, the share price of MannKind will react strongly to the event anticipated to be on July 15, 2014, at which time the FDA decision on Afrezza is expected. If the FDA renders a negative decision, we suspect substantial downside. On the other hand, if the FDA renders a positive decision for Afrezza, we suspect moderate upside, because the predominant analyst view is that approval will be granted, which is corroborated by the AdCOM vote which precedes the company's PDUFA date. The following excerpt from MannKind's latest conference call details the vote:
A very significant event during this past three months was as Hakan mentioned the FDA Advisory Panel meeting on April 1. During that meeting there was an extensive open discussion after which the panel overwhelmingly voted to recommend approval of the AFREZZA 13-1 for type 1 diabetes and 14-0 for type 2.
Of course we were really very pleased with the proceedings of the AdCom and with the overwhelming positive vote. There was so much that was satisfying. Our MannKind team delivered effective presentations on the safety, efficacy and many valuable attributes to the AFREZZA.
As a result, we suspect that regulatory approval for Afrezza is likely not a surprise to the market; however, disapproval would be.
What if Afrezza receives approval?
If MannKind receives regulatory approval for Afrezza, I suspect that three outcomes are possible. First, the company could decide to pursue a "lone-wolf" approach to commercialization. Even with the approved drug, this path could lead to a major decline in share price given the enormous adversity that similar companies have faced. Look at Vivus (NASDAQ:VVUS), for instance, which markets the prescription obesity drug Qysmia without a partner. Vivus' share price has nearly lost all of its value within two years after Qysmia received regulatory approval in July, 2012. Thus, the probability that MannKind will pursue commercialization of Afrezza alone must be examined.
In order to put this in perspective, consider the fact that the company reported a cash position of $35.8 million at the end of Q1 2014, compared to $70.8 million in Q3 2013, with an average cash burn of approximately $35 million per quarter in 2013. I calculate that MannKind has enough capital to fund operations through Q3 2014. As a result, it is expected that the company would necessitate additional capital in order to continue R&D for other clinical programs and marketing efforts for Afrezza. This would likely be achieved through debt or equity raises, which would dilute current shareholders and likely have a negative impact on the share price. The capital required to provide an optimal commercial platform for Afrezza would be substantial, so it may not be cost-effective to pursue this lone-wolf strategy. Therefore, I suspect that this deterrent -- that is, insufficient funds -- could be significant enough to have a low probability of playing out.
On the flip side, there is the possibility of a partnership. I suspect that this outcome is the likeliest of the three, as well as the most strategic. With the PDUFA date only a month away, the fact that Alfred Mann has not entered into a licensing deal for Afrezza could be a leverage play. Specifically, a license deal at this stage (potential approval within one month, and a highly encouraging AdCOM vote for Afrezza for type 1 and type 2 diabetes) would garner a hefty royalty rate and considerable upfront fees and milestone payments.
The other consideration that, in my opinion, increases the likelihood of a partnership is the potentially large market share for Afrezza. The global insulin market is estimated to be $32 billion. Dr. Christopher James, managing director and senior equity research analyst of Brinson Patrick, projects that Afrezza will capture approximately $3.65 billion by 2025. Similar estimates have been disseminated by MLV & Co., whose senior analyst, Dr. Graig Suvannavejh, outlined a projection upwards of $3 billion. With potential approval only a month away and high sales projections constructed by respected healthcare analysts, it is conceivable that a license deal would be very favorable to MannKind. A partnership would also allow the company to continue developing additional clinical products and explore new indications without being financially restricted by the marketing and advertisement for Afrezza. Precisely, the non-dilutive cash coming into the company in the form of an upfront payment for any potential licensing deal for Afrezza would offset R&D expenses.
However, we must consider Arena Pharmaceuticals (NASDAQ:ARNA), which markets an obesity drug called Belviq with Eisai Corporation. Despite the partnership, Arena's share price has also plummeted, although Belviq continues to gain traction among patients, doctors and insurance companies. The cause of decline was slow uptake, which clearly did not satisfy the high expectations of the launch for Belviq. With respect to MannKind, investors should be aware of the danger of being overly ambitious when it comes to Afrezza's sales potential and immediate uptake following potential launch in Q1 2015.
The third outcome, of course, is an acquisition. Because it would be a direct competitor to Novo Nordisk's (NYSE:NVO) and Eli Lilly's (NYSE:LLY) injectable products, it is not ludicrous to speculate that regulatory approval of Afrezza, an inhalable product, could catalyze a bidding war. Other noteworthy potential acquirers are AstraZeneca (NYSE:AZN), which recently acquired a portion of Bristol Myers Squibb's (NYSE:BMY) diabetes franchise for $5 billion; Merck (NYSE:MRK), which markets Januvia and Janumet, a combined $6 billion franchise; and Johnson and Johnson (NYSE:JNJ), which markets Invokana. Clearly, the competition is intense within this space, and any new product like Afrezza that threatens to alter the market share for established products is worthy of buyout consideration.
The moral of the story is that regulatory approval does not necessarily lead to commercial success. Granted, if MannKind receives approval for Afrezza, the share price would likely rise. But the recent spike over the last several months prompts the question of whether regulatory approval is already priced into the stock. Having said that, if the company successfully acquires a partner to commercialize Afrezza, I strongly believe that shareholders will be rewarded handsomely. Then, there is the actual process of advertising to consumers, optimizing sales efforts and meeting analyst sales projections. Needless to say, achieving these endeavors is no walk in the park, as mishaps are ubiquitous in this line of work. Ultimately, investors should be aware that the obstacles to market are extensive, and a massive spike in share price following regulatory approval could distort that reality.
There is a short position in MannKind at around 68 million shares out of roughly 389 million outstanding, with about 11 days to cover as of May 15, 2014. This indicates that there are many who are betting on a decline, following the PDUFA decision. In conjunction, my analysis of the options sentiment for the August 14, 2014 expiration leads me to conclude that many professionals are positioning for a drop in MannKind shares.
Provided this understanding of the PDUFA binary event on July 15 and the overall market sentiment with respect to MannKind, I feel that the risk to the standard buy-and-hold strategy should even make those with the utmost confidence in Afrezza uncomfortable. Nevertheless, this risk is completely unnecessary, since it can be avoided through several options strategies.
I have constructed two options strategies, both of which offer downside protection, with distinct benefits that will be discussed in depth. While the more conservative of the two, referred to as Strategy A, costs very little to hedge your position at the expense of capped upside at $4.72/share (sale at $15/share), Strategy B is more costly, but offers uncapped upside with similar protection. The reason I advise a hedged position is due to the uncertainty surrounding the PDUFA decision, but more importantly, the possibility that approval is already priced into the stock. This is ultimately a volatile period for MannKind, and should any regulatory decision or company action disappoint shareholders before or after July 15, investors can have some peace of mind knowing that their position is significantly insured against catastrophic downside.
Options Strategy A
Strategy A seeks to enhance upside gain without incurring all of the risks of the standard buy-and-hold investment approach. In summary, this strategy creates income through the sale of Calls covered by your current share position, as well as the sale of Puts, and uses the income to purchase a protective Put position. Thus, we will accomplish valuable protection at very little cost. Implementing Strategy A requires three steps:
- Sell the August 14, 2014 $15 strike Call for around $0.52/contract. At this point, you would have then benefited from the option premium of $0.52/share (or $52). Tradeoff: Selling these Covered Calls imposes an upside cap at $4.72/share. However, I suspect that regulatory approval is already priced into the stock, and the $15 target is indicative of what I believe to be the maximum potential upside within this roughly three-month period.
Sell the August 14, 2014 $4 strike Put for around $0.33/contract. At this point, you would have then benefited from the option premium of $0.33/share (or $33). Tradeoff: If MannKind shares trade at or below $4 by August 14, given the worst-case scenario, you would be obligated to repurchase the shares under contract (at or below $4). However, should MNKD trade below $4, you may be happy to increase your exposure at this price.
Buy the August 14, 2014 $7 strike Put for around $1.01/contract. This transaction would cost you $1.01/share (or $101). However, using the $85 in proceeds from steps 1-2, the total transaction would only cost you $16, while providing you with 3 points of protection (from $7/share to $4/share). Maximum downside is $7.28/share as of the close on June 6. Keep in mind that this loss would only occur if MannKind plummeted to $0/share. Practically speaking, I suspect that a worst-case scenario would see $4.28/share, meaning the total loss you would incur is $428, if the share price traded at $3 by expiration. My rationale for the $3 bookend is that MannKind's other clinical developments (e.g. Sprout for acute pain settings and MKC253 for type 2 diabetes) could have considerable value if shown to have similar efficacy to standard care with respect to their distinct indications. Tradeoff: None.
(Note #1: Strategy A assumes that the investor already has a position greater than or equal to 100 shares of MannKind)
(Note #2: The transactions above may take place over several days, depending on options volume)
The outcome of Strategy A falls into one of four possible scenarios:
- Scenario 1) On or before the August 14, 2014 expiration, MannKind stock trades at or above $15. At that point, you would have to sell the shares under contract for a profit of $4.72/share. Tradeoff: Should the stock price skyrocket past $15, you would miss out on the value difference between the new stock price and the $15 strike price.
- Scenario 2) On or before the August 14, 2014 expiration, MannKind stock stagnates around $10.28. While unlikely, this scenario would cost you $16, factoring in the unchanged stock price, the $52 and $33 premiums from the Covered Calls and sold Puts, respectively, as well as the $101 Put cost. You would also retain the shares under contract, since the $15 strike Calls were not triggered. Tradeoff: You would lose $16 more than the standard buy-and-hold strategy that has no downward protection.
- Scenario 3) On or before the August 14, 2014 expiration, MannKind stock plummets to $4.01. This scenario would only cost you $3.28/share, as compared to $6.27/share without the $7 strike Put -- a savings of $2.99/share. Tradeoff: None.
- Scenario 4) On or before the August 14, 2014 expiration, MannKind stock plummets to $3, reflecting the price that I believe is the worst-case scenario within this roughly 3-month time frame. This scenario would cost you $4.28/share, compared to $7.28/share without the protective Put position -- a savings of $3/share. Tradeoff: The $4 strike Put would be triggered, thereby obligating you to repurchase the shares at $4. This transaction would cost you $400/contract, but of course, you can resell the shares at your own volition.
Strategy A offers the most protection at the lowest cost -- that is, $16/contract and a profit cap at $4.72/share. Being a conservative value investor, I advise Strategy A, since it is ultimately the safest among the two strategies proposed along with the standard buy-and-hold approach, and the upside cap is employed at a level which reflects what professionals believe is ascertainable, should the FDA approve of Afrezza. Nevertheless, for those interested in a more aggressive options strategy, see Strategy B.
Options Strategy B
A more aggressive strategy can be implemented, which gives investors unlimited upside and significant protection at a higher cost. In this proposed strategy, we advise the purchase and sale of Puts to establish a Put Spread that will provide the same level of protection as Strategy A. Additional cash is required, since we are not selling Covered Calls to offset the cost of buying Puts as Strategy A endorses. Thus, the investor's standing shares are left untouched, awaiting the PDUFA date on July 15, but downside protection is purchased in case this event turns ugly. Implementing Strategy B requires two steps:
Sell the August 14, 2014 $5.50 strike Put for around $0.45/contract. At this point, you would have then benefited from the option premium of $0.45/share. Tradeoff: If MannKind shares trade at or below $5.50 by August 14, you would be obligated to repurchase the shares under contract at whatever the price is (at or below $5.50).
- Buy the August 14, 2014 $7 strike Put for around $1.01/contract. This transaction would cost you $1.01/share (or $101). However, after combining the $0.45/share in proceeds from Step 1, the remaining cost would be $0.56/share. Tradeoff: Maximum downside is $8.78/share (or $878) as of the close on June 6. Keep in mind that this loss would only occur if MannKind plummeted to $0/share. Practically speaking, I suspect that a worst-case scenario in this case would be $5.78/share, meaning the total loss you would incur is $578/contract, if the share price traded at $3 by expiration.
(Note #1: Strategy B assumes that the investor already has a position greater than or equal to 100 shares of MannKind)
(Note #2: The transactions above may take place over several days, depending on options volume)
The outcome of Strategy B falls into one of four possible scenarios:
- Scenario 1) On or before the August 14, 2014 expiration, MannKind stock trades significantly above $15. Since no Covered Calls were sold, you reap the benefits of the margin between the new share price and the current share price of $10.28 as of the close on June 6, 2014. Tradeoff: For you to break-even in Strategy B with respect to Strategy A, the share price must reach around $16.46, because Strategy A employs Covered Calls for a 4.72 maximum increase ($15/share).
- Scenario 2) On or before the August 14, 2014 expiration, MannKind stock stagnates around $10.28. While unlikely, this scenario would cost you $56/contract, factoring in the unchanged stock price and the funds allocated for insurance. Tradeoff: You would lose $0.56/share more than the standard buy-and-hold strategy that has no downward protection.
- Scenario 3) On or before the August 14, 2014 expiration, MannKind stock plummets to $5.51. This scenario would only cost you $3.28/share, as compared to $4.77 without the $7 strike Put -- a savings of $1.49/share. Tradeoff: None.
- Scenario 4) On or before the August 14, 2014 expiration, MannKind stock plummets to $3, reflecting the price that I believe is the worst-case scenario within this roughly 3-month time frame. This scenario would cost you $5.78/share, compared to $7.28/share with the standard buy-and-hold strategy -- a savings of $1.78/share. Tradeoff: The $5.50 strike Put would be triggered, thereby obligating you to repurchase the shares under contract at $3. This transaction would cost you $300/contract, but of course, you can resell the shares at your own volition.
Just to reiterate, I only advise selecting Strategy B if an investor strongly believes the upside exceeds approximately $16.46/share. If not, it is more cost-effective to employ Strategy A.
Given our view of MannKind, we endorse both options strategies constructed above. For the most conservative of our investors, we recommend Strategy A, which includes insurance against a catastrophic loss at the expense of capped upside at $4.72/share (as of June 6, 2014). For more aggressive investors, we recommend Strategy B, since it provides unlimited upside with a higher cost of protection. Ultimately, both strategies are viable, since they provide various levels of protection around which each investor individually must assess his/her risk tolerance.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.