Onyx Pharmaceuticals: Good Reasons for Raising Capital, Investors Overly Concerned

by: Raymond Chung, CFA
Last Wednesday Onyx Pharmaceuticals (NASDAQ:ONXX) announced that it was going to raise additional financing by selling as much as 4.6 million shares and $230mm in convertible notes. The euphoria from the company’s recent successful Phase 2 breast cancer results were quickly forgotten, as the stock plunged more than 20 percent in two days. Investors were taken aback as why a company with more than $450 million in cash would need an additional $370 million. Visions of a buyout by Bayer AG, its 50/50 Nexavar (approved for kidney and liver cancer) collaborator were replaced with images of a potentially large and dilutive acquisition. It didn’t matter that earnings were much better than expected, especially since previous investor criticism has focused on the company not dropping enough sales down to the bottom line.

Instead of condemning Onyx about how nothing good can possibly happen from having more cash one should think about the future challenges Onyx may face. In fact, it could be argued that managing the success of Nexavar could be Onyx’s largest quandary. Understandably, investors want to ride the growth of Nexavar for as long as they can, but management cannot do that. Biotech and pharmaceutical companies need to think longer term than shareholders, given that the average drug development timeline is 10 years. Such companies also probably prefer steady growth rather than quick short-term upward spurts. If cynical investors took the view of management they might understand why Onyx’s recent capital raise is warranted. Here are a few possible reasons:
Bayer is an Unreliable Partner

In contrast to Onyx, Nexavar contributes very little to Bayer’s financials. Nexavar sales represent less than 2 percent of overall Bayer sales. Given the congruent 50/50 split in profits Bayer is probably even less motivated to put in the 110 percent effort necessary to bring Nexavar to international stardom in a timely fashion. For the last few quarters Onyx has attributed slow international uptake of Nexavar for liver cancer due to commercialization, marketing and reimbursement issues. While part of this may be true given any new treatment, much of the international responsibilities actually lie with Bayer. Let’s also benchmark Bayer’s progress with the fact that liver cancer is more predominant overseas. Moreover, most liver patients are identified in the advanced stages, thus these patients have few therapeutic choices and typically live less than a year. It's hard to believe that demand for Nexavar would not be high. However, Bayer rather than taking full advantage of having the wind at their backs would rather swim against the tide. Bayer actually seems more interested in developing a competing compound to Nexavar (Sorafenib). On May 15, 2009 Onyx filed a suit against Bayer for trying to bypass its collaboration agreement and seize for itself a compound discovered jointly, Fluoro- Sorafenib. As the suit states and illustrates:

Just after the suit was filed, Bayer announced its Phase 2 DAST trial for kidney cancer was successful enough to move onto Phase 3. Interestingly DAST is the compound in Figure 3, or as previously stated Fluoro-Sorafenib.

Onyx should be very suspicious of Bayer’s intentions, as Bayer clearly wants sole profits from this promising compound. Unfortunately Bayer does not understand that a good business relationship is a windfall for all. Bayer underestimates the intangible value-added of good teamwork. For reference, a large part of Avastin’s success can probably be attributed to strong commitments by both Genentech (DNA) and Roche. Bayer clearly is not the kind of partner needed to optimize Nexavar’s potential. Onyx's lawsuit against Bayer could be the beginning of the end for this collaboration. Onyx is not the small speculative biotech company it was when the collaboration agreement was signed in 1994, and it is no longer in high need of Bayer’s assistance.

Onyx’s cash war chest could give it some “creative/outside the box” solutions to address this marred relationship. For instance, the company could do any combination of the following: buy back some of Nexavar’s rights; trade the mature and competitive kidney cancer indication for another; find a new partner for international sales, and/or build its own China dedicated sales force (since China represents more than half the annual worldwide liver cancer cases). In summary, with lots of cash, the Nexavar collaboration agreement could be restructured.

Avoiding the “Pfizer dilemma” Takes Long Range Strategic Planning

The term “Pfizer dilemma” is used to describe a situation where a company has a blockbuster, like Lipitor, that represents such a disproportionate portion of the firm’s profits that the blockbuster eventually becomes a crutch for the company and/or stock price. Pfizer (NYSE:PFE) is a victim of its own success, like many other pharmaceutical and biotechnology companies who rely mostly on one lead horse. Eventually most great drugs mature, and as a result, experience a declining growth rate only to ultimately face generic competition and direct competitors. If a public company waits too long before planning for the maturation of its lead horse, the new superstar necessary to keep the company growing may not appear for an average of 10 years if at all. Companies must act early and cannot presume that they have enough time.

To replace a blockbuster, another blockbuster or multiple smaller therapies must be discovered simultaneously. This is no small feat, and even more difficult if you own a mega-blockbuster, like Lipitor. Currently Gilead (NASDAQ:GILD), with their robust HIV franchise, is the best example of a company that understands this challenge. The company has been acquisitive and aggressive in building its pipeline. For example, in 2006 Gilead bought Myogen for $2.5 billion and this year plans to buy CV Therapeutics for $1.4 billion. Individually these acquisitions might be dilutive, but as a whole Gilead shareholders probably feel better about life after HIV.

If Nexavar can achieve similar market share in liver as it has in kidney, attaining multi-billion in sales should not be difficult. Because of the continued growth of Nexavar, Onyx is in a position of strength and shareholders should be rewarded in the next several years. However, it would also be timely for Onyx to use excess cash to diversify its revenue stream. In fact Onyx should be applauded for proactively planning ahead and not riding Nexavar’s coattails, as no one ever knows when the lead horse becomes a pony.

Cash Does Not Burn a Hole in a Pocket, Raise It When You Can

As the most recent financial crisis has suggested, companies should not be punished for excess cash. In fact many cash-rich companies have been handsomely rewarded with robust stock prices. This makes sense as the more cash a company has the larger its investable opportunity set. Many drug development companies are still having financing issues and large pharmaceutical companies are constantly fine tuning their drug development plans. Given good management, having more choices, should generally lead to better strategic investments. In this particular case investors also fail to see how volatile or range-bound ($10-$60) Onyx’s stock price has been over the last 5 years. Management just received a huge jump in stock price due to its Phase 2 breast cancer results, and Onyx might desire to opportunistically raise cash while the environment is positive. Management, like many of us, cannot predict whether the next big move in the company’s stock price is “sell the news” or “buy the news”. In this case maybe “a bird in hand is worth more than two in a bush.”

Big Picture: Let the hot money and those banking on an acquisition do their thing. Raising capital now is rational, and there could be worse problems than having to worry about too much cash. Nexavar is still a multi-billion dollar drug in the making, which is hard to find these days. Even without new indications the enormous growth potential of Nexavar cannot be ignored. There are 600,000 new liver cancer cases per year worldwide, and current Nexavar market penetration is minimal. Furthermore, new Onyx leadership has so far focused on increasing profitability and making attractive business development decisions. Long-term investors should use this correction to add to their positions.

Disclosures: Long Gilead and Onyx stock; Long Onyx August calls and will sell before expiration.