SciClone Pharmaceuticals: Not Ready For Prime Time

Market corrections provide a superb opportunity to reinvigorate your watch list of potential stock buys. The leaders of the next market rally will be, for the most part, new names. Few past leaders regain their former market-leading glory. Personally, I peruse the stocks with the highest relative strength.

Using the IBD database, I focus on the issues with a minimum RS of 95. These are the stocks that have outperformed 95% of their peers over the past year (the mrq has a 40% weighting). These are the issues that investors are holding onto, despite negative market action. Many of the new leaders will come from this pool. Intuitively, this makes sense.

The screen I ran today produced 101 stocks. In addition to some current leaders, there were many lesser-known issues and some completely unknown firms (at least to me). One issue that caught my eye was SciClone Pharmaceuticals, Inc. (NASDAQ:SCLN). I had not looked at this company for some time, so I decided to check it out.

At first pass, it looks great. Over the past eight quarters, EPS growth has averaged 72% (albeit a bit uneven) and sales growth has averaged 45%. An added bonus is that sales growth is accelerating. ROE was 30% in FY'11 with no debt. Market cap is a modest $400M. This looks like a superb undervalued growth story. Could the market be this inefficient? I decided to take a closer look. Unfortunately, I found a couple of major warts.

Red flag #1 is the cash flow. For FY'11, the CF Ops was ~$29.5M versus earnings of ~$28.5M. The CF/NI ratio of 1.04 is below the 1.2 minimum I use for credible investment candidates. This is not catastrophic, though, but true growth stocks with healthy businesses generate buckets of cash. Companies delivering the results that SciClone is posting routinely have CF/NI ratios of two, three or higher.

Red flag #2 hit me right between the eyes. The company is currently under investigation by the U.S. Department of Justice (DOJ) and SEC for potentially violating the Foreign Corrupt Practices Act (OTCPK:FCPA). The principal issue is whether company representatives provided inappropriate incentives to Zadaxin customers. This is certainly an investment killer.

Most (97%) of SciClone's business is in China. Their lead product, Zadaxin, accounts for almost all (93%) of their sales. Zadaxin is a branded drug used to treat Hepatitis and some cancers. Management projects that Zadaxin will provide the bulk of the company's revenue for at least another two years. The 2012 revenues are forecasted to grow 25% versus 2011.

These numbers seem to reflect the reliance on superior sales execution because there are a number of Chinese firms selling the generic equivalent of Zadaxin for one-fifth of the price. There is also additional downward price pressure from regulators. Reimbursement was recently reduced 14% with more reductions likely going forward. An aggressive sales forecast in a highly competitive cost-restrictive environment puts substantial pressure on the sales force to deliver results. How will they pull this off?

Red flag #3 is the current stock repurchase program. In October of last year, the Board authorized $20M for the program. It spent $3.5M by year-end. In May, the Board authorized an increase in the program to $30.5M. It has spent $10.5M to date. What is wrong with this picture? Let me count the ways.

1. SciClone is a micro-cap high growth (supposedly) company with 18 marketed products (after the NovaMed acquisition) and another 10 products in various stages of regulatory approval. It operates in a highly competitive market. How in the world can a stock buyback program be more valuable than investing in sales & marketing, product development and/or R&D?

2. There is a high risk that SciClone will incur a financial penalty when the SEC/DOJ investigation ends. Should it not establish a reserve for this?

3. Incredibly, in its 10-K under "Liquidity and Capital Resources", SciClone states that it will continue to explore alternatives for financing to provide additional flexibility to its operations management and that the unavailability of such financing could have a negative effect on its business. I know this is boilerplate, but if it held on to the $30M, it would certain mitigate any hiccups in financing. This defies logic.

I do not recall ever seeing a micro-cap company, especially a medical products firm, diverting scarce capital for a share buyback program. High growth medical companies are voracious cash consumers. SciClone recently acquired another company, increased its sales force by one hundred, faces intense competition with their flagship product, will launch multiple products this year and beyond and it has announced aggressive revenue targets. Yet, all of these issues apparently take a back seat to buying shares.

The red flags have the upper hand with this one. Best to stay away and deploy one's hard-earned cash elsewhere.

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