The Case For Highly Speculative Biotechs

by: Bill Maurer

For some investors, building a diversified portfolio means trying to balance a risk/reward profile that you can be comfortable with. Generally, a portfolio with 25 holdings should be less risky than a portfolio with just 5. However, if you have a very diversified portfolio and want to take a little risk with a small position, highly speculative biotechs might be right for you. Now, you could make the argument that investing in these companies is like buying a lottery ticket. A fair amount of times, that argument is proved right. When prospective drugs fail, these companies plummet. But when they are successful, the rewards can be tremendous. Let's look at 3 firms in particular, and then I'll throw in a more established firm just for comparison. I'll throw some charts up here first, and then the analysis part afterwards.

PharmAthene (NYSEMKT:PIP) KV (KV.A)
Dendreon (NASDAQ:DNDN) Celgene (NASDAQ:CELG)
Current Price $2.35 $1.44 $11.34 $65.00
52-week high $4.96 $13.55 $43.96 $65.06
52-week low $1.28 $1.13 $9.22 $48.92
Market Cap $113M $86M $1.69B



Revs (2010) $20.99M $152.22M $48.06M $3.62B
Revs (2011 est.) $29.40M N/A $212.75M $4.69B
Revs (2012 est.) $38.00M N/A $372.55M $5.27B
EPS (2010) ($1.08) ($5.80) ($3.18) $2.80
EPS (2011 est.) ($0.26) N/A ($2.71) $3.60
EPS (2012 est.) ($0.21) N/A ($1.26) $4.23
Gross Margin 100.00% N/A 40.64% 92.72%
Operating Margin -50.25% N/A -303.02% 33.07%
Net Margin -96.76% N/A -322.80% 23.91%
Current Ratio 3.87 N/A 1.35 3.99
Debt Ratio 46.52% N/A 58.89% 40.36%
Working Capital $17.01M N/A $196M $3.24B
Cash $14.26M N/A $490M $1.65B
Short Term Debt None N/A $500.79M None
Long Term Debt $5.855M N/A $39.54M $1.26B

Obviously, Celgene is the most established and the least risky of the four. I'm not going to analyze the firm here, I just wanted to show how a large biotech compares to the smaller ones.

So we'll start with PharmAthene, a Maryland based biodefense company that tries to develop medical defenses against biological and chemical weapons. Basically, it looks to produce vaccines and possibly drugs to either prevent or mitigate the effects of anthrax, smallpox, and the like. The company is not losing money, but revenues are growing and the company's financials are intact. The main argument for buying this company is a pending lawsuit that could make shares soar. Basically, PharmAthene and Siga Technologies (NASDAQ:SIGA) were partnering to develop a smallpox treatment. They had a license agreement on paper, and PIP gave a bridge loan to Siga to help fund it, but the agreement was never signed. Siga was eventually awarded a defense department contract worth $433 million that contained options for more product, bringing the possible total up to about $3 billion. Well, PIP sued Siga claiming that they should have either been merged into one, or that PIP deserves its fair share of that contract. After a couple of years in court, a decision may finally be coming (or may not). Initial reports on the lawsuit stated that if PIP were to win the case, the stock could be as valuable as $20 per share. Now that estimate was initially overblown, and my guess is that a win for PIP would get this to $5 to $7, maybe $10 at best. At $2.35 now, your potential reward/risk is about 1:1 at the bottom end of the range. Even the best case gives you a 3:1 ratio. If some sort of biological attack were to occur, this would be a good play. It may even be profitable in a couple of years. But for now, this company's sole hope is on winning a lawsuit.

The next fun one to deal with is KV Pharmaceutical. KV got approval for its pre-term labor drug Makena, which was supposed to be the blockbuster that brought this company into the competitive landscape. Well, as you can read here, sales did not go well early on this year, and the company's auditors issued a going concern notice. This company took a big hit in its public relations department after it initially priced the drug at $1,500. Apparently, it thought that since the drug was so special, it could just price it tremendously high because people would be forced to use it. Well, that didn't work out. So it lowered the price to $690 per dose. That didn't work either. The FDA did not grant exclusivity rights, so the company has to deal with other, lower cost options. Not good if this is your blockbuster drug. While patients have been getting enrolled for the program, prescriptions just aren't being filled as well as the company hoped. In just two months, the stock went from $1.50 to over $13.00. And two months after that, it was back below $4.00. It now trades at $1.41. If the company gets things turned around, this stock could be worth $4 to $6 in the next year or so, and maybe $10 in five years or so. That's a decent reward to risk tradeoff, better so than PIP, but KV has just as many challenges. The question is would you rather gamble on a blockbuster drug or a lawsuit, if you were comparing one to the other. KV is also a little harder to get financial data for, as you can see in the above tables. So you may not always know what you are getting into.

If you were to ask traders over the past few years what their favorite speculative biotech was, I would assume Dendreon would be high on their list. The company makes a prostate cancer treatment named Provenge, which like Kv's Makena, is supposed to be a blockbuster. But last quarter didn't go so well. Concerns over insurance reimbursements cause some doctors to avoid the treatment, so Provenge sales of less than $50 million missed the $58 million estimate. Furthermore, the company withdrew its full year guidance of $400 million in sales for the year (analysts currently project about $213 million), and said it would be slashing jobs, which it did recently. The company cut 500 jobs at a cost of $21 million, and stated revenues for August were $22 million. The stock lost 2/3 of its value overnight, falling from $36 to under $12. It has bounced back 20% from its low of $9.22 to settle in around $11.50. This stock really gained attention when it went from $4 to $25 in just a matter of two weeks in 2007, and then lost all of those gains in the next 5 weeks. All of this was due to Prevenge's trials. In 2009, it saw a similar rise into the $20s, but was able to maintain it this time. By May of last year, it was able to get into the mid $50s. It backed off of that for a while, settling in a range between $30 to $45 until the collapse a few months ago. People who trade and invest in Dendreon are like ultimate sports fans. They jump on and off the bandwagon often, quickly, and decisively. I doubt that this stock will get back to $35 or so in the next year, but a couple of good quarters from Provenge could lead to an easily double. Once the train gets some traction again, people will come and it will rise quickly. But at the same time, another bad quarter or two and this stock will be back to that famous $4 level again, or perhaps even lower. While many three months ago had expected this company to be profitable in 2012, they are no so rosy anymore. Over the past 60 days, EPS numbers for 2011 have dropped from a $2.36 loss to a $2.71 loss, and 2012 numbers have been revised from an $0.18 profit to a $1.26 loss. Maybe, just maybe, it can be profitable in 2013.

These are some good names for speculative positions. Obviously, if you want a solid company with good earnings, Celgene is your stock. But if you are willing to take a gamble with a small portion of your portfolio, these other three may be for you. If you were going to buy options for 5% of your portfolio, you probably could have just as much luck with KV or PIP. At their current prices, they basically are long term options. Dendreon has more price risk to the downside, but has a $1.7 billion market cap and is probably the least risky of the three in the long term (maybe riskiest in the short term, however). As always, do your own due diligence on these before you start building a position. These are very speculative and can give you tremendous returns, but can also lose most of their value overnight.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.