Inovio - Dilution And Catalysts Make It A Promising Short

| About: Inovio Pharmaceuticals, (INO)
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In a previous article I suggested that investors shouldn't get too excited about individual snippets of news from Inovio (NYSEMKT:INO), as the company has a long history of similar news that ends up going nowhere. A few days later, respected analyst Adam Feuerstein made similar comments as well as giving a brief appraisal of the company's technological prospects.

At the time of my article, the stock was trading at a market cap of >$500M - though I opined that even $200M would have been a generous valuation. The stock subsequently fell nearly to my target, but now has bounced back to $460M. (Apparently Y Charts hasn't yet updated the number of shares outstanding.) The question then is: has anything changed in the meantime?

INO Market Cap Chart

INO Market Cap data by YCharts

Clearly not the science. The company's only scientific release since the Aug 6th price spike was one regarding its malaria vaccine in pre-clinical animal trials. Instead, the real changes are investors' new excitement due to the company presenting at two conferences next week, and an SEC 10-Q filing which sheds more (damning) light on the company's proclivity for dilution. The combination, in my opinion, sets up a great short sale opportunity, having both fundamentals and catalysts working for it.

Let's look at the substantive issue first, viz. the new information in the 10-Q (dated August 9, 2013).

Dilution, Dilution and More Dilution

ATM Sales

The first interesting item we learn is that subsequent to June 30, 2013, the company once again tapped its ATM, selling 4,248,455 shares for a net $6.1M (which averages to $1.49 per share when considering estimated gross proceeds).

Why is this interesting? Well, to hear longs tell the story, the company is poised for a huge breakthrough in the treatment of a number of widespread and devastating diseases - breakthroughs that will catapult the company's share price to well over $5 in the very near future. Yet obviously the company has the best insight into whether or not that's likely, and they're choosing to sell shares at $1.49.

But - one might counter - maybe the company is just satisfying the need for a little extra capital to ensure near-term liquidity? As appealing as this idea might be, it's simply not plausible since the company just did a large financing in March 2013 wherein it sold 27,377,266 shares and 13,688,633 warrants for about $14M. (In the financing, a unit, consisting of one share and a half warrant exercisable at $0.7936, was sold for $0.55).

Indeed, we can confirm the company's NON immediate need for cash by looking at the balance sheet during the past several quarters. The table below shows the company's quarterly current assets - (current liabilities less the warrant liability) for each period since March 2012. (Note that while the warrant liability is technically a current liability, it would never cost the company cash because when the warrants are exercised, the company receives cash. Thus I've subtracted the warrants from the total current liabilities). By the end of Dec. 2012 the company had net current assets of ~$10M, so one can understand the March 2013 financing. But subsequent to it, the company was sitting on net current assets of ~$25M. Why sell shares via the ATM at ~$1.49 UNLESS you believe that you're selling them above true value?

The ATM agreement was for total gross proceeds of $25M. As shown in the table below, that leaves about $7.4M in possible future sales. Given the current share price of $2.43, don't be surprised to learn that much of the remaining $7.4M has been used resulting in a further expansion of the share count. (e.g. if the remaining amount were used at an average $1.50 per share, they'd be issuing another 4.88M shares.)


The latest 10-Q also reports that subsequent to June 30, 2013, 5,273,392 warrants were exercised for $5.3M in proceeds (average price of ~$1.01). This information, combined with a perusal of the various SEC filings associated with the company's many financings, gives us a little more insight into potential future dilution.

Consider first this table from the 10-Q which shows the warrants outstanding as of June 30, 2013 (and Dec. 31, 2012).

As we'll discuss in more detail in a moment, the warrants from the March 2013 financing weren't exercisable during the period from June 30th to August 9th, and the average price of exercise is well below the $1.40 exercise price of the Jan. 2011 warrants - so likely none of these were exercised. Moreover, given that the 2009 merger warrants are expiring first, I'd assume that the bulk of the exercises came from them with only a small remaining number coming from the Dec. 2011 warrants. If that's right, then in round numbers, we can estimate that there are ~5M of the Dec. 2011 warrants still outstanding. This is of interest because these warrants are callable. Here's the relevant verbiage from their filings, with my emphasis:

In December 2011, we completed an underwritten public offering relating to the sale and issuance of 7,699,712 units to certain institutional investors, consisting of 7,699,712 shares of common stock and warrants to purchase an aggregate of up to 5,774,784 additional shares of common stock. These units include the partial exercise of the underwriter's overallotment option of 962,465 additional units at the public offering price. The units consist of one share of common stock and 0.75 of a warrant to purchase one share of common stock, at a purchase price of $0.5195 per unit. The warrants have a term of five years and an exercise price of $0.65 per share. We may call the warrants if the closing bid price of our common stock has been at least $1.30 over 20 trading days and certain other conditions are met. We received net proceeds from the transaction of approximately $3.7 million, after deducting the underwriter's discounts and other offering expenses payable.

In my previous article. I indicated that I expected many warrants to be exercised during the first price spike. That was proven true, given the disclosure of 5.2M warrants having been exercised. But it might have been even more had the spike lasted one more day - and thereby satisfying the warrant call provision. For fun, here's a graphic of the last trading spike, where I've numbered each day the closing bid is above $1.30. (The price data is available here).

After missing the mark by a day, the stock is back on a 12 day run at prices over $1.30. I've included another figure below to help get a sense of the quick trading spikes this stock makes and to show that this latest spike is on decreased volume relative to the initial spike - a fact which to me indicates reduced strength.

Given that the warrants are likely to be exercised at some point, and that the company carries them as a liability on the balance sheet, my expectation is that company would call the warrants at its first opportunity to do so. That means that if the stock trades north of $1.30 for 8 more days, we can expect the share count to balloon by another 5M or so shares. The potential calling of these warrants is one catalyst that should help a short position.

There's more to the warrant situation, however. The warrants issued during the March 2013 financing weren't exercisable for 180 days after their sale. Here's the relevant information from the company's 424B5 SEC filing:

The warrants are exercisable on or after the date that is 180 days after the date of issuance and will terminate on the date that is 180 days after the fifth anniversary of the date the warrants are issued.

The 424B5 filing is dated March 7, 2013 which puts the first day of possible warrant exercise at about Sept. 3, 2013. Perhaps I'm too cynical, but it strikes me as potentially more than a coincidence that this latest price spike coincides with that date (see the chart above). Or to put it another way, in order to ensure the ease of future financings, it might make business sense to allow those who participate in corporate financings to exit their warrant positions at elevated prices. Perhaps that's a factor in the stock's current exuberance?

If so, then when the company issues its next SEC disclosure, we can expect to learn that many of the 13.6M warrants from the March 2013 financing have been exercised. This potential increase in the number of shares outstanding should also weigh on the stock price, again supporting a short position.


The final aspect to the dilution story is the potential for options exercises. The company doesn't break options out quarterly, so we have to refer to the 10K to get the data. (Note however that the company does document the total number of options outstanding each quarter and the June 30th figure is 18,397,962, i.e. 2M greater than the 10K data below).

As of Dec. 31, 2012, there were 11.8M options exercisable at prices below $2 (with the average below $1.32). Don't be surprised to learn that many of these have been exercised during the latest price spikes.

Summary of Potential Dilution

To summarize then, there is a substantial number of potentially dilutive derivatives and financing tools outstanding which could weigh heavily on the stock in the near future. This is particularly true since 13.6M warrants only very recently became exercisable, and if the stock trades above $1.30 for another 8 days, there's (in my opinion) a likelihood of another 5M shares being issued as part of a warrant call. The table below summarizes this data:

Now lest you're skeptical that the company would actually issue so much dilution so quickly, I'd point out that over a single year, from the June 2102 10-Q to the June 2013 10-Q, the company increased its share count by 40%! (i.e. by 54.9M shares from 134,968,394 to 189,903,446). Issuing dilutive shares just seems to be part of the company's DNA.

Buy the Rumor, Sell the News

Ostensibly, the current price spike is due to the company being scheduled to present at two conferences in the coming week (see the message boards for details). These are the two conferences:

Rodman & Renshaw Annual Global Investment Conference

Inovio Presentation

Tuesday, September 10, 2013

11:15 AM ET


Stifel Nicolaus Weisel Healthcare Conference

Inovio Presentation

Thursday, September 12, 2013

10:55 AM ET

On its own, this type of run up to an event (or in this case two closely spaced events) is a classic short opportunity, consisting of a proverbial buy the rumor, sell the news situation. My guess is that a max price for the stock will be seen by Friday morning at the latest, with longs no longer having an upcoming event to pin their hopes to.

Trading and Portfolio Position

Let's put all this together in terms of a trading plan. I'm currently short INO with about 5% of my portfolio at an average basis of ~$2.35. I'm treating this as two distinct groups of shares, 2/3's are "trading shares", while 1/3 is allocated to my long-term "short portfolio". Let me explain.

Position Size

First off, though I think the potential gain here is 50% or more, the stock is very volatile and there's no way to predict the top in any very short-term move. Thus I'm limiting my exposure to 5% of my portfolio in order not to get stopped out if the spike continues further.

Trading Shares

I really like this trade because it has fundamentals and several catalysts going for it.

At Friday's closing price of $2.43, the stock trades at a market cap of a whopping $580M fully diluted. Moreover - as evidenced by the company's very recent choice to sell shares at $1.49 via its ATM - the company probably also considers today's stock price as being substantially above its true value.

In terms of catalysts, there are three short-term events which should mark a peak and fairly rapid retracement. From closest to furthest out we have the probable ongoing exercise of a good portion of the 13.6M warrants that were issued in the March 2013 financing, and which (coincidentally?) became exercisable at the start of this price spike. Next we have two conference presentations which are over this coming Thursday and which might provide a "sell the news" event. Finally, if the stock continues to trade above $1.30 for the next 8 trading days, there's the likelihood of another ~5M shares being issued via a warrant call. Thus there are many reasons to think that the current price spike should be in a full retracement mode by the end of two weeks at the latest. My plan is to cover my trading shares with scaled orders ranging from ~$2 to about $1.30. (You might wonder why, if I think the shares will ultimately trade much lower, I'd be covering any shares at all? The answer is that: 1. the borrow is expensive and 2. covering on a quick retrace maximizes annual returns.)

Finally, please note that given the likelihood that warrants are being exercised in size right now, I've chosen to establish my position before the conference event. But for anyone who's more risk averse, shorting on Thursday afternoon might be the better play.

Addition to Short Portfolio

Previously I've mentioned that I'm beginning to build a longer-term short portfolio (see this article for some details). One of my reasons for doing so is that I feel that over the past two years - and over the past six months in particular - the market has gotten overheated generally. One sector that's been especially frothy has been biotech (see the chart below showing INO, the biotech index and the Nasdaq over the past six months). Yet as of yet I have no exposure to biotech in the portfolio. Given its specific over-valuation and its status as a lower tier biotech, I think Inovio makes a good first entry into this longer-term portfolio. As a result I'm planning on keeping one third of my position until the stock drops to a fully diluted market cap of ~$175M. Currently that would mean a price of ~$0.75 which is still 36% above the price of the March financing (not even including the warrants) - a time at which the company still had high hopes for the ChronVac phase II trial (see my earlier INO article for details).

Disclosure: I am short INO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.