Is 'Worthless' Really A Fair Assessment Of Targacept?

| About: Catalyst Inc. (CBIO)

It's not often that you find companies trading at a negative enterprise value and/or less than cash on hand, so it caught my eye recently that Targacept (Nasdaq: TRGT) had fallen so far. Although investors have definitely had to weather some major disappointments here and the true value of the company's neuronal nicotinic receptor technology is very much in doubt, it's not often that the normally too-optimistic world of biotech says that a company would be better off shutting off the lights and passing out the cash.

The Bad News, In Brief

The failure of Targacept's TC-5214 got plenty of attention in late 2011; earlier studies had been quite encouraging and there was optimism that Targacept and partner AstraZeneca (NYSE: AZN) had a potential blockbuster on their hands with a very new approach to treating major depression. In marked contrast to earlier studies (including a Phase 2b study run in India), the pivotal REN 2 and REN 3 studies failed to show a clinical benefit.

There are still ongoing studies (notably the fixed-dose REN 4 and REN 5) with this drug in major depression, but nobody expects anything from them now. At best, any success in these remaining studies would confuse the heck out of scientists and biostatisticians and require at least another pivotal study.

This is not the only failure in Targacept's books, though. TC-5619 did show enough efficacy in ADHD for AstraZeneca to license the compound, though Targacept is giving it another shot in inattentive-predominant ADHD.

Still Addressing At Least Two Major Markets

The encouraging news for shareholders is that these weren't the only shots on goal the company had.

In addition to the inattentive ADHD indication, Targacept is investigating TC-5619 for use in treating what are called residual symptoms in schizophrenia. While plenty of people are aware of the “positive” symptoms of schizophrenia like hallucinations, delusions, and agitation, less attention is given to the “negative” symptoms like blunt affect, anhedonia, and emotional withdrawal.

Atypical antipsychotics are some of the best advances in the history of drug therapy, sparing many schizophrenia patients from being sedated into oblivion, and have produced blockbusters like Abilify (marketed in the U.S. by Bristol-Myers Squibb (NYSE: BMY), Lilly's (NYSE: LLY) Zyprexa, AstraZeneca's Seroquel and Johnson & Johnson's (NYSE: JNJ) Risperdal. That said, these drugs can have serious side-effects and they aren't often very effective in dealing with the “negative” symptoms of the disease, leaving a real unmet clinical need.

Targacept also has two drugs in trials for one of the holy grail's of biotechnology – Alzheimer's disease. AZD-3480 is already in a Phase 2 study comparing the drug with Aricept after an encouraging earlier Phase 2 study, and Targacept announced during the first week of January that AstraZeneca had elected to move AZD-1446 into a Phase 2 study in Alzheimer's as well, despite a prior unsuccessful trial in ADHD.

Although Alzheimer's has chewed up many biotechs and only a handful of drugs have made it to approval (Forest Labs' (NYSE: FRX) Namenda and Pfizer (NYSE:PFE)/Eisai's Aricept among them), it too is a multi-billion dollar opportunity for an effective drug.

And Two More After That...

Those aren't the only ongoing clinical programs at Targacept. The company also has its TC-6987 drug in Phase 2 studies in both asthma and diabetes. Data from both studies are expected at some point in the first half of 2012. This a very new approach to these diseases and likely a long-shot for the company, but the size of the asthma and diabetes markets is huge and it would likely not be hard to find interested parties to partner for pivotal studies if the Phase 2 data is strong enough.

Balancing Opportunity And Cost

While Targacept is in solid shape today from a cash perspective (management expected to end the year with about $240 million in cash), Phase 3 trials are famously expensive. Targacept certainly has the funds to wait to see the outcome of the schizophrenia trial and AstraZeneca will be funding those trials in Alzheimers.

If TC-5619 shows enough efficacy to merit a Phase 3 study and/or if TC-6987 likewise shows enough efficacy to lead to further trials in asthma or diabetes, the company could face some tough decisions. AstraZeneca would presumably be interested in TC-5619 for schizophrenia, and the company has certainly shown its willingness to stand by Targacept's therapy platform despite numerous clinical setbacks. Still, investors cannot completely rule out the possibility that the company may have to try to go it alone in one or more of these drugs and raise the funds to sponsor further clinical development.

Failure Isn't The End

Just a few months ago, it looked like Targacept may have held the keys to a valuable platform therapy based around nicotonic receptors. With another clinical failure in hand now, though, the Street has soured on this stock to the point where it believes management will only destroy value by pursuing additional studies.

That seems a bit extreme given AstraZeneca's apparent willingness to continue its relationship with the company. Admittedly, the cost of Phase 2 studies in Alzheimer's is modest relative to the huge potential of an effective drug, but it could have walked away entirely if it didn't believe the drugs had some chance to work. Likewise, there are reasons to worry about the company's patent estate (patents for TC-5619 and AZD-3840 start expiring at the end of the decade), but that hardly seems to be a topic of discussion today.

A Sharper Risk/Reward Trade-Off

Given the dismal history of clinical drug development in schizophrenia and Alzheimer's, it's hard to be optimistic about any of those opportunities. That said, a long-shot is not the same as no shot and Targacept at least bears watching until data on TC-5619 are available. Likewise, this stock is basically a binary outcome at this point – if schizophrenia and Alzheimer's indications work out, the stock is a multi-bagger from today's price, while more clinical failure (coupled with cash consumption) will push this close to worthless.

Targacept may not be the best risk-return tradeoff out there today, but the company is not as hopeless as a negative enterprise value would suggest.

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