Don't Let This Biotech Dig Its Talons Into Your Portfolio

Jul.31.12 | About: Talon Therapeutics, (TLON)

With widely followed approvals for obesity medicines from Arena Pharmaceuticals (ARNA) and Vivus (VVUS), cancer therapies from Onyx (ONXX), a rheumatoid arthritis drug from Horizon (HZNP), and a triglyceride lowering drug from Aramin (AMRN), this has been an exciting summer for biotech drug approvals. Investors who profited from the run-ups to these binary events may be seeking the "next trade" in the biotech space. Today we go over a lesser followed stock, Talon Therapeutics (OTC:TLON) that has an FDA approval date of August 12, but that investors actually might do best to avoid.

About the Drug

Marqibo is a liposome encased version of Vincristine, a generic chemotherapy drug first developed in the 1960s. In theory, encasing the drug in a liposome causes it to diffuse more slowly in the blood stream allowing more of the active agent to reach the tumor and decreasing toxicity. Talon is seeking approval for Marqibo for treatment of Philadelphia negative Acute Lymphoblastic Leukimia (Ph-ALL) in patients who have relapsed more than once and who are not responsive to further treatments (relapsed refractory disease state).

During their phase II trials, Marqibo demonstrated about a 15% complete response rate in these patients. Not a homerun by any stretch, but, given that the only other treatment option for these patients is sending them home to die, many patients would probably take a shot even if it is only 15%. According to this article, there are about 500 Ph-ALL relapsed refractory patients every year. Not a huge market by any means. Talon estimates that this indication represents a $100 million revenue opportunity. Given a 500 patient population, that revenue estimate is likely on the uppermost end of the realm of possibility.

Talon obtained orphan drug status and fast-track approval consideration from the FDA due to the lack of other treatment options for these very sick patients. The orphan drug status grants seven years of market exclusivity even though Vincristine is a generic drug. Accelerated approval can be granted to drugs after phase II trials provided that a phase III confirmatory trial is likely to demonstrate real clinical benefit for the new medicine.

In march an FDA advisory committee voted 7 to 4 with 2 abstentions to recommend accelerated approval for Marqibo. Subsequent to this, Talon announced in May that FDA had delayed its decision on Marqibo by 90 days.

The problems with owning Talon

There are a number of problems that investors should be aware of prior to holding TLON in their portfolio.

First, the advisory committee vote was not a slam dunk. 7 to 4 on the surface sounds good until you contrast it to ONXX whose drug Kyprolis, had an 11 - 0 advisory committee vote in favor of approval (Kyprolis was approved on July 20th). Seasoned biotech investors know that the comments the panelists make are just as much a factor as the vote itself. To gauge for yourself what the panelists may be thinking, you should read the meeting minutes (pdf) or the transcript of the meeting (pdf).

In this particular case, the majority of the doctors voting yes voted so not because they thought Marqibo was a great drug, but more because in the specific population of relapsed refractory patients, there just is no other treatment option. In order to receive full approval, Marqibo will have to demonstrate clinical benefit compared to Vincristine itself in the phase III confirmatory trial. The advisory committee doctors were pretty evenly split on whether or not the phase III trial would be a success. Talon has obtained a special protocol assessment from the FDA regarding their phase III trials which means that if they do hit their trial endpoints full approval is a slam-dunk, but the doctors on the committee expressed doubts about Talon being able to enroll enough patients to sufficiently power the study through completion.

The real problem is management

Even if FDA agrees with the majority of the advisory committee, there is a deeper reason to avoid TLON. Management is simply incompetent when it comes to corporate finance. In 2010 the company (then called Hana Biosciences) struck an investment deal for "up to $100 million in investment" from Deerfield (DF) related entities and from the private equity firm Warburg Pincus (WP). Some Talon longs have speculated that "Warburg Pincus really knows what they are doing so TLON is eventually going to do well." This is pure bunk. A quick look at the capital structure of the company shows that management brought a knife to a gunfight in the negotiations that resulted in this investment agreement. Here are the more salient points:

DF and WP invested in the series "A" convertible preferred stock of the company. Issuance of preferred stock is a common practice amongst development stage biotech companies since it lets them incentivize investors to do a financing round at a time when cash is difficult to raise. The details of the terms of the preferred stock need to be well understood by holders of the common because the preferred stock is senior to the common in all dealings including buyouts and bankruptcy.

The Series A deal terms include: a 9% per year interest rate, liquidation preferences, anti dilution provisions, registration rights and a sweetheart of a conversion price. The Table below breaks down the preferred stock of the company:

Preferred Stock Series Shares Issued Conversion Price ($) Shares of common issuable per share of preferred Total common issuable upon conversion
A1 400,000 0.736 135.86 54,347,826
A2 110,000 .30 333.33 36,666,667
A3 30,000 .35 285.71 8,571,428
Total Dilution (shares) 99,585,921
Click to enlarge

Because of the 9% annual interest rate accrued over two years on the series A1 and over 8 months on the series A2, the actual number of shares currently issuable is actually higher than that listed in the table. In addition to this, DF and WP have the right to purchase up to 600,000 additional shares of the series A3 preferred stock for up to 1 year after any of Talon's products receives FDA approval. That represents another 171.4 million shares of common stock that could be issued on top of the 99 million in the table.

Striking this deal was an egregious error on the part of management, and the holders of TLON common stock are the ones who will eventually be hurt by it.

The float of TLON is just 21 million shares (it was 84 million a few years ago before a 1 for 4 reverse split). Note that, in the original investment agreement struck with WP and DF, the conversion price for the A1 was 18.4 cents. It was subsequently increased by a factor of 4 to account for the reverse split. Furthermore, the company was supposed to get an increase in authorized shares from 350,000,000 to 600,000,000 approved by July 9th of this year to avoid a lowering of the coversion prices of the A2 and A3 preferred. It is unclear at this time whether or not this approval has been obtained. When WP and DF decide to convert their preferred shares to common, the float will balloon to 121 million shares. It may not happen right away, but it will happen.

To add insult to injury, TLON and their private equity overlords snuck in a provision to the company's charter that allows all classes of shares to vote together in votes about increasing the authorized shares of the company even though Delaware law typically calls for holders of each class of shares to vote separately. Furthermore, WP has 5 board seats. Even though TLON trades publicly, they are effectively owned and controlled by WP and DF.

Steven Deitcher, Talon's CEO recently commented that "the company has access to $57 million to market Marqibo". This $57 million number comes from the 600,000 shares of series A3 preferred ($100 per share initial selling price) less the 30,000 shares already sold for $3 million on July 3rd. This statement indicates that Talon is perfectly comfortable tapping in to the series A3 at the expense of more dilution for the holders of Talon common stock. When management publicly states that they are ready to dilute you to such a large extent - watch out!

Conclusion

Putting all of this together, TLON's true share count is close to 121 million shares right now, and could expand by another 171 million shares should the company decide to "access $57 million to market Marqibo". Their drug got a half-hearted nod from the oncology advisory committee and only has, at best, a $100 million per year market potential under the current indication.

Talon originally asked FDA for priority review of the Marqibo NDA when they filed for accelerated approval in July 2011. FDA did not grant the priority review. Here is what Talon disclosed in a regulatory filing about this series of events:

We believe the FDA's determination that our NDA did not qualify for priority review may reflect a reduced probability that the agency will ultimately grant accelerated approval of Marqibo.

Management believes the accelerated approval process might not be going their way. Note, this disclosure happened in May - 2 months AFTER the positive advisory committee vote and around the time that FDA asked for more information and extended the Marqibo PDUFA date by 90 days.

The company is effectively controlled by Deerfield and Warburg Pincus; therefore holders of the common have no influence on the future direction of the company.

We see little to no upside for the stock as long as management continues to do financings that are extremely disadvantageous to holders of the common stock.

Disclosure: I am long ARNA. The author has no position in TLON based on the results of DD, which are shared in this article, and has no plans to initiate a position in the coming week. Investors should conduct their own analyses and reach their own conclusions prior to buying or selling stocks.