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Summary

  • Positive results in one or more of the company’s five Phase III trials could send price soaring.
  • The company could be acquired, currently has working relationship with Roche Holding.
  • Treatments going to market could have better than expected returns.
  • The high amount of leverage provides more upside to the long position.

The current price provides a great entry point for investors in Exelixis, Inc. (NASDAQ:EXEL). Since the company is not profitable the stock price moves closely with news, and events that impact future business prospects. The most important events are those related to clinical trials. There are many possibilities with potential to unlock value for the shareholders.

Background:

Exelixis, Inc. is a biotechnology company that develops and markets treatments for cancer. The company is in its development stage with one approved treatment. It is hoping to build the infrastructure to sell further products by taking its niche thyroid cancer treatment to market now. Exelixis has two primary cancer treatments cabozantinib ((Cabo, Cometriq)) and cobimetinib ((Cobi)). Exelixis has a partnership with Roche Holding (OTCQX:RHHBY) to commercialize, market and distribute cobi. Under the terms of the agreement, (EXEL) receives 50% of the profit up to $200m, decreasing down to 30% after $400m. Cobi is expected to earn approval by late 2015, after receiving positive Phase III trial results in July 2014. Cabo is marketed and distributed in the U.S. by the company, and in Europe by Sobi. Sobi receives an undisclosed management fee for its services. European revenues are expected in Q2 after a March European approval.

The company has five Phase III trials for various cancer treatments using cabo and cobi. On top of those, the company has numerous partnerships with other drug companies, and multiple treatments in Phase II trials. Exelixis has a huge pipeline of potential uses for its treatments. The most important trials are COMET-1 and COMET-2, relating to prostate cancer treatment. Results should be in later this year. Prostate cancer has the largest addressable market of any potential cabo use. The results of those trials are the most important near-term catalyst to the stock. A negative outcome would not kill the investment, but would put more pressure on upcoming liver and renal cell carcinoma trials. The large pipeline of trials creates high R&D expenses, and the company will need to raise funds again in 2015. One risk is that the equity markets may not be the best place to turn for the company to raise money if Comet-1 and 2 fail. The stock price will be further depressed if that were to occur.

The company's stock price has been hammered by short sellers, and recent events. The stock price is down 64% from its 52-week high of $8.41 and now trades at $4.20. The short interest as a percentage of the float is 27%. People are very bearish on Exelixis. The price tanked after news in March from the mid-point of the company's prostate cancer Phase III trial. The news was that the company would need to finish the entire trial. The results were not good enough to end testing at that time. The update was very concise and did not report anything was wrong, but the street reacted very negatively to the news. Recently two competitors had results that were favorable enough that testing was concluded at the mid-point. Exelixis was not that lucky, and the stock price was hammered for it. The stock price stayed steady at a little over $3 after March until good news came in July 2014. The results from cobi Phase III melanoma testing were positive. With Roche as a Partner, Exelixis will be bringing the product to market.

Thesis:

I see the upside as being greater than the downside in this case. At $4.18 a share there is only so far that the price can fall. At a lower price there will be potential suitors. The company's larger competitors have scale and infrastructure in place to bring Exelixis' treatments to market at a lower cost. There have already been rumors of an acquisition by Roche. It and EXEL will make a lot of money together selling cobi. Roche makes a drug called Zelboraf that when combined with cobi increased survival rates in Phase-III trials by 13.7-months.

One American dies almost every hour from melanoma. Between 40-50% of those can be treated by the combination treatment. The addressable market could be as high as $1B a year. This is expected to grow as healthcare costs increase. Cobi will get to market in 2016. If the stock price fell to $2.50 it would be a smart to acquire EXEL. At $2.50 the company's market cap would be under $500m and the NPV of the cobi melanoma deal would be worth around $510m, and that is without factoring in everything else that offers. I assumed that the drug combination could take 40% of the $2B market, healthcare costs increase with GDP, and cash flows were discounted at 20%. I used Roche's current profit margins and added back 75% of R&D costs. I also assumed a $200m terminal value in year 5. This sets a floor for how low the stock can fall. Take in mind also that this does not factor in everything else that Exelixis offers.

If coba is found to be successful in treating prostate cancer then EXEL is easily worth bull's estimates of $11. Stifel Nicholas targets a price of $11 without giving the prostate cancer treatment a 100% chance of getting to market. It is hard to determine the value of the entire pipeline of trials, but I just look at them all as options to unlock further value. The market for prostate cancer treatment is large and growing. It appears that the stock price will fall at most $1 and could go up by $7 or more. Given all of the trials in the works, I expect that most potential outcomes end with investors making money.

Pipeline of Trials: The market for prostate cancer is large and growing as the population grows. Statistics show that 1-in-7 men will be diagnosed with prostate cancer in their lifetime. 233k new cases are diagnosed each year in the United States. Company management asserts that if it can penetrate just 15% of the market that it would earn $1B in sales. Positive results in these trials would be a game changer for the company. Results are expected in the fourth quarter of this year. If those trials were to fail there are still trials related to renal cell carcinoma, and liver cancer underway. The market for these forms of cancer is $2B, and EXEL would be targeting the second line, which is about $1B. With fewer players, and plenty of room for enhancements, EXEL could steal a lot of market share. The company also has a bevy of trials and collaborations with large companies in the pipeline.

After the first sign of positive news in any of these cases the stock price will rise. With the high amount of short interest, a short squeeze will occur. A sharp increase in prices would cause shorts to buy, covering their losses. When the shorts buy it will send the stock up even further, hence the short squeeze.

Acquisition: Rumors have been circling that RHHBY is giving EXEL too big of a cut of the cobi profits and a takeover may occur. The combination of these two partners drugs could represent $1B in annual revenue. Investors are so focused on cabo as a prostate cancer drug that cobi has been overlooked. If the cabo prostate trials have poor results then the timing would be good to purchase EXEL. At the very least this provides a solid floor to the investment. If does not buy then one of 's other partners may. The price will likely be higher than my $2.50 estimate, depending on how bullish suitors are on the company's pipeline of trials.

Approved indications going to market: As discussed above the combined revenues of cobi with RHHBY could be very high. Stifel Nicholas analysts factor in $150m in 2019 revenue to EXEL from the partnership, my calculations were slightly less at $147m. Also, if no other drugs are approved, cabo would likely make in the ballpark of $60-$70m treating thyroid cancer. That is based on 600 new cases per year and $10,400 per treatment per month. If Exelixis could scale down R&D expenses it could turn a profit with just the sales of these two products. The combination treatment with cobi could easily exceed expectations. Based on Phase III trials it is the best treatment in the market. Sales of cabo treatment could grow quickly abroad. Europe has a larger population than the U.S. The increase in sales will depend on how well Exelixis' European partner, Sobi, executes the marketing strategy. I could see a positive surprise since Sobi will be working hard to monetize its two year contract with EXEL. Exelixis could earn a profit with no suitors or FDA approvals.

Leverage and NOLs: The company has a debt to equity ratio of 5.24x and close to $1B in net operating losses (NOLs). I believe that this creates more upside. Total long-term debt is $342m as of Q1 2014 with total assets of $497m. Since the company is so leveraged when it does become profitable it will be at a faster rate than a company with less leverage. Joel Greenblatt, the Ivy League Professor and hedge fund manager, often looks for inexpensive stocks with leverage to invest in. He likes the upside potential that the situation creates, and the limited downside because the stock can only go to $0. The NOLs provide further advantage, sheltering the company from taxes well into the future. EXEL has $988m in federal NOLs and $918m at the state level.

Risks:

The biggest risk that the company faces is failing its prostate cancer trials. Most of this risk is baked in. Short sellers assumed that failure was eminent in March.

No one believes that EXEL will be profitable until 2018 at the earliest. This will certainly cause liquidity problems. Management has guided towards having $200m in cash at the end of 2014 after annual expenses of $250-$280m. The company will need to raise funds in 2015. Depending on how much it raises, it may need to raise funds again down the line. The company only raised $75.6m in its last equity offering in January. This means that at any point if the capital markets turned the spigot off, EXEL would go bankrupt. The company will continue to have high expenses related to its clinical trials. In addition, the company has $173m in contractual obligations over the next three years.

Dilution of shares will likely occur and will erode value to shareholders. Dilution would occur if the company pursued another equity offering, if options were exercised, or if convertible debt was converted to shares. Exelixis has the option of raising capital through debt or equity. Since convertible notes are the customary source of debt in this situation either scenario could lead to further dilution of share. If things go well and the stock price rises substantially there are ~24m options outstanding that will dilute share count, more than half of which have strike prices below $6. There is $261m in long-term convertible debt and a total of ~197m shares outstanding.

CONCLUSION:

Because of the high upside and limited downside, $4.18 is a solid entry point on this stock. The stock was hit very hard by recent events and has a lot of room to run up. News about Comet clinical trials was not as grim as the bears believe that it was. The bears are focused on cabo to treat prostate cancer and have missed value in the rest of the company. The upside could be unlocked by positive news on any of the company's Phase III trials. In addition, filing for final approval of cobi this year could further boost price. In the long-term good execution of the firms marketing strategy, and high leverage could rapidly increase the company's profits. The downside is buoyed by a possible take-out by RHHBY or other competitors. Going long EXEL is the smart play here.

Editor's Note: This article discusses one or more securities that do not trade on a major exchange. Please be aware of the risks associated with these stocks.

Source: Exelixis' Rumored Acquisition And Large Pipeline Offer Short-Term Gains, Long-Term Sustainability