Sonus Is Undervalued At $4 - Call Options Are Attractive

The Internet is a wonderful thing. I don't know where I'd be as an investor without it. It has done tremendous things for the individual investor, like discount brokerages, infinite amounts of information, and stock-picking ideas. Yesterday, Adam Feuerstein from The Street.com wrote an article about Sonus Pharmaceuticals (SNUS) and I was intrigued, so today I'm going to take a look at it.

Feuerstein thinks that the stock could double if its Phase III data for its breast cancer drug TOCOSOL Paclitaxel (TocP) comes out positive next month. That makes sense, considering that is a common outcome for small biotechs with positive Phase III results. Sonus, however, seems to have a bullish buzz surrounding it and Feuerstein isn't the only one. Why is this?

For starters, I want to give you an idea of the buzz. First, the call option open interest for November is outstanding. There are over 26,000 contracts open in November calls, while there are only 5,700 puts open. To me that's a pretty big contrast considering this data could make or break the company. (In comparison, there are only 450 open call contracts for October expiration) Usually, small biotechs with make-or-break data coming out have a lot of investors going both ways. This one doesn't seem to, despite the downside possibility. Secondly, there is very low short interest on Sonus' shares. There are only about 700,000 shares held short (less than 2% of shares outstanding) as of August 15, which was even lower than July. This is weird to me, especially for a small biotech with a make-or-break the company date coming up.

Lastly, the Yahoo! Message Board activity is interesting. I usually look at message boards to get an idea of how many investors there are on each side of the fence. There usually isn't a whole lot of useful information. But, Sonus' board seems different. For one, there is a significant bullish tone coming from almost all posters. Also, I found a great piece of information that really helped me in my own research. The bullish buzz seems great, right?

Yes, except for the fact that the stock has tanked. Sonus' second quarter results were not as good as Wall Street expected, and the stock has hit a 52-week low since. However, this doesn't make sense to me. Sonus doesn't have any products at market yet, so earnings shouldn't matter. Apparently, investors took note because the company didn't recognize as much revenue from its collaboration with Bayer, and investors felt that it wasn't a good sign going forward. But, again I don't think that matters. The only thing that matters is whether or not Sonus can get TocP to market.

So, for me to make sense of all the hype, I found a fair value for TocP. I liked what I found. TocP has the potential to be safer and just as effective as other chemotherapy drugs. One competitor, Abraxane, should earn about $300 million in sales this year, according to Feuerstein. So, if TocP earned peak revenues of around $300 million, I found that the drug is worth about $5.60 to Sonus. My fair value estimations also found that the drug is worth about $8.50 if the results are positive and the company files a new drug application.

My conclusion? Sonus is undervalued at $4. The bullish tone is a little scary to me because it seems almost over the top, considering the stock continues a downward slide. However, I like the fact that analysts and biotech followers like Adam Feuerstein are pretty optimistic on the drug's chances. Also, I like the fact that this one drug alone could be worth more to the company than the stock is currently trading at. I am going to recommend Sonus (SNUS) as a buy here, with a price target of $9 by the end of 2007. However, with a make-or-break date coming up, I would suggest buying call options as the way to play Sonus. The October calls are cheaper than November, but clinical trial data dates can get delayed on occasion, so I'd wouldn't load up on October calls. The company has said that the data should be released in late September.

Disclosure: I do not have a position in SNUS