A High Risk-High Reward Biopharma With Two Pending Catalysts

Biotechs with pending clinical trial results or New Drug Applications can generate astronomical returns for investors that get in early. Positive Phase III results for Acadia Pharmaceuticals' (NASDAQ:ACAD) pimavanserin, for example, have catapulted the stock more than 980% in less than a year's time. On the flip side, biopharmas with critical failures in their drug pipeline are generally hammered by the market. Earlier this year, for instance, Aveo Pharmaceuticals (NASDAQ:AVEO) and Dynavax Technologies (NASDAQ:DVAX) both received Complete Response Letters from the Food and Drug Administration in regards to their leading clinical candidates, and consequently, their respective share prices have been pummeled. Playing biopharmas with pending catalysts is undoubtedly a high risk/high reward type of trade, so it's best to know all the potential risks relative to the rewards before plowing ahead.

Zalicus - A biopharma with two pending catalysts

Zalicus Inc. (ZLCS) is a developmental-stage biopharma with two pending catalysts for its leading clinical candidate Z160. Specifically, the company has announced that they expect to complete data collection for two Phase II trials for chronic neuropathic pain indications lumbrosacral radiculopathy and postherpetic neuralgia respectively, with top-line results to be announced in late 2013. Z160 is a first in class, oral, state dependent, selective N-type calcium channel blocker that has the potential to be used for a wide variety of chronic pain conditions. Last month, Zalicus also received Orphan Drug Status from the FDA for Z160 as a potential treatment for postherpetic neuralgia.

The potential market size for Z160 as a treatment for neuropathic pain should easily top a billion a year. To back up this assertion, the current market leader in the neuropathic pain market, Pfizer's (NYSE:PFE) Lyrica, is on track to break the $2B mark this year alone, and has shown steady growth since its initial launch in 2005. Moreover, sales of Eli Lilly's (NYSE:LLY) Cymbalta for neuropathic pain are also expected to exceed $1B in 2013, showing the strength of this rapidly growing niche-market. Compared to Zalicus's small market cap of approximately $156 M, Z160 thus offers investors a potentially outstanding reward going forward.

Mr. Market has yet to notice Z160's value proposition

While Zalicus is up more than 80% year-to-date, speculative investors, by and large, haven't jumped into this stock with both feet. Namely, the average volume for ZLCS is well shy of 2 M shares per day, despite the fact that company was recently priced around $1 a share prior to its 1 for 6 Reverse Split yesterday. Moreover, the company's market cap still remains demonstrably south of its peers currently performing advanced Phase II trials, e.g., Novavax (NASDAQ:NVAX), Inovio (NYSEMKT:INO)-just to name a few. Essentially, biopharmas with pending top-line Phase II results tend to hover closer to $300 M instead of $100 M in terms of market cap. Based on these comparisons, Zalicus would appear to be undervalued by at least 40% prior to the announcement of its pending Phase II results.

With such a dramatically undervalued market cap, the question potential investors must answer is, why has Zalicus failed to attract the attention of the broader market? I believe the answer to this question is relatively straight-forward but it is critically important for investors to understand.

The answer is that Zalicus is essentially broke, and has a deficit topping $350 M due in large part to the failed development of the company's previous leading drug candidate Synavive. By my estimates, Zalicus only has about $14.5 M remaining in cash and cash equivalents (see hyperlink above), yet is burning nearly $2.5M a month. As the company states in their latest 10-Q, Zalicus only has enough money in the till to keep operating to about February 2014. The message is clear: Zalicus will have to rely heavily on its $25 M purchase agreement with Lincoln Park Capital to keep the doors open, and even this amount won't give the company nearly enough cash to perform a pivotal Phase III trial for Z160-assuming one or both of its current Phase II trials are successful. Even more problematically, a failure of both Phase II trials will undoubtedly be the end of Zalicus; a double failure at this junction will sink the stock and make it nearly impossible to finance the remainder of its drug pipeline. Overall, the serious problems with Zalicus's finances have kept the lid on investor enthusiasm thus far.

Value creation scenarios based on Z160

The risks associated with Zalicus are not exactly a mystery. I believe the company has chosen to perform two Phase II trials simultaneously in order to give themselves the best shot at keeping the business alive, and this strategy gives investors a potentially huge payday waiting in the wings. While the rumor mill about a potential partnership post-Phase II for Z160 has been going strong of late, I believe there are two potential scenarios that could play out if Z160 indeed reports top-line results in the 4th Quarter.

Frankly, Zalicus cannot advance Z160 on its own without wiping out current shareholders. Although the 1-for-6 reverse split has given the company some breathing room to stay listed on the Nasdaq, the size of the offering necessary for a "go it alone" strategy would crater share price; to do so would essentially put a black mark on the company in terms of shareholder trust. Remember, management is supposed to create value for shareholders.

With that in mind, I believe that are two ways for management to maximize shareholder value if Z160 has positive Phase II results. Firstly, there is a strong potential for a lucrative partnership with substantial upfront milestone payments. For example, Pfizer has shown a great deal of interest in locating novel pain medications, and even states on their website: "Pfizer is interested in partnering with innovative collaborators to develop novel and differentiated medicines to address the needs of patients suffering from pain." Secondly, I believe strong Phase II results make a buyout of Zalicus by a real possibility. Big Pharmas have shown no hesitation in snapping up promising pain medications at the Phase II stage, and even paying a hefty premium for pain medication pipelines. The reason is that the pain medication market is growing by leaps and bounds, with some of the top pain meds coming off patent protection.

What's the potential pay-off if I buy now?

As I stated above, Zalicus is already undervalued by as much as 50% based on prevailing market trends in the biotech sector. Even so, I expect the stock to move closer to its peers in the weeks ahead of any data announcement in the 4th Quarter, giving shares of ZLCS a potential upside of nearly 100% solely as a run-up trade. The potential future valuation will subsequently depend on the strength of the Phase II results. Both trials have decent sample sizes (n = 140), are double-blinded and placebo-controlled, meaning that safety and efficacy results should be decent indicators of larger Phase III trials, and the drug's potential for commercialization.

Based on the market size for pain meds (see hyperlinks above), I believe clear-cut Phase II trial results showing that Z160 is safe and efficacious easily earns the company a minimum market cap of $600 M through either a partnering deal or a buy-out. From current levels, Zalicus would thus appear to have a minimum 300% + upside if Z160 reports the expected top-line results. By contrast, if Z160 turns out to be a dud, Zalicus is probably a goner due to its troubling financial situation. Zalicus is thus an unequivocally high risk-high reward biotech.

Disclosure: I am long ZLCS, ACAD, PFE, LLY. 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.

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