Kite's Short Interest Reaches Troubling Levels

| About: Kite Pharma (KITE)
This article is now exclusive for PRO subscribers.

Summary

Kite Pharma's short interest approaches 10 million shares.

Short Interest tops 22% of float.

Days to cover = 10 days.

Shorts may have overstayed their welcome.

There is an aspect of Kite Pharma's (NASDAQ:KITE) stock traders and analysts have been ignoring, and it could work significantly in favor of those that are long Kite shares: the number of shares held short. The latest short interest report from Nasdaq, dated 1/13/2017, shows short interest in Kite is a whopping 9,645,010 shares, which is an enormous 22.51% of the float. Days to cover, a measure of the time it would take to buy in those short shares at current average daily volume, stands at 10 days. And the number of shares held short has been on an upward trajectory, almost doubling from February of 2016, when the number of shares held short was 5,736,037.

The explanation for such a high short interest number is basic and obvious. Some traders are betting against the success of Kite and its KTE-C19 CAR T prospects. Looking for alternative explanations for such a high short interest number falls flat. For example, if one were to look at Kite's call options and hypothetically assume all the open interest in every call option series was dedicated to a synthetic long straddle position (long two call options, short 100 shares of stock), this would only account for 505,350 shares of short stock. By the same token, if one assumes all put option activity were dedicated to synthetic short straddle positions (short two puts, short 100 shares of stock) this would only account for 1,107,600 of short stock So these explanations, aside from being highly unlikely, don't work.

In fact, there is an enormous bet against Kite's stock price. But why, and is this a good bet? Certainly, one can understand the negative opinions swirling around the entire pharma sector, given the negative tweets from President Trump regarding drug pricing and the industry's tendency to manufacture in other countries, something President Trump wishes he could end with a snap of his small fingers. But in these two regards, Kite is "a Trump stock!", as Jim Cramer would say.

Since the President's recent meeting with leaders of big pharma, the administration has started to show awareness that not all pharma is created equal. There is a huge difference between the companies whose business model depends on raising the prices of old established medicines, and those whose innovative research and development leads to new treatments and cures for killer diseases. Kite is on the cutting edge of innovation. The Administration will most likely take a more hands-off approach to pricing controls on innovators like Kite.

President Trump even hinted at wanting drug companies to renegotiate and raise prices overseas to soften the blow of lower prices in the U.S. While this would be difficult for companies that have already existing contracts with European health systems, Kite will be able to negotiate from scratch in their dealings with Europe. Also, Kite is based in the United States, with its only manufacturing facility in the good ole Beach Boy territory of Santa Monica, California. (Do I hear "Trump stock!"?)

More likely, the large short interest in Kite is a straight bet against good 6-month follow-up data to their encouraging 3-month data on their ZUMA-1 study of KTE-C19, or a bet against FDA approval sometime in 2017. The ZUMA-1 study showed that 39% of patients were in complete remission at the 3-month mark, with subgroups within that population having even better outcomes. When the 3-month data was released, limbic traders latched onto news that 3 patients in the study died, and incorrectly interpreted this as approval-killing news. Panicked selling ensued, helped along with end-of-year tax selling and a more uncertain outlook for the industry as a whole.

What was overlooked in the panic was the very respectable complete remission rates and life-prolonging effects of this treatment on patients whose prognosis without KTE-C19 was as good as "bupkis"- a Yiddish term an old option-floor trading friend of mine used to use on days when he made nothing. More level heads used the selloff to place more positive bets on KITE. The stock is now back close to where it was before the 3 month data was released. And day traders, whose bias has been to try to work the stock down, are now being met by large institutional purchasers.

The same selloff is unlikely to repeat itself when the 6 month data is released. Even if the CR rate drops some (as expected in trials such as this), as long as the side effect profile remains manageable and many more people's lives are prolonged, the prognosis for approval remains intact.

If the FDA does not approve KTE-C19, the borrowers of those nearly 10 million short shares will be handsomely rewarded, as the stock may drop to around $25 or so from $52 today. Evidence of this magnitude of decline can be seen studying the Juno stock analogue (NASDAQ:JUNO). When the FDA put a clinical hold on Juno's lead CAR-T candidate, JCAR015, in early July 2016 Juno fell from the $40 area to around the $27 area. Later in November, when the company abandoned its lead candidate, the stock fell further to the $20 area. This despite the fact that Juno, like Kite, has other promising CAR-T candidates in its pipeline.

Clearly, relinquishing the lead in the race to market a CAR-T therapy is met with investor contempt. I assume that a non-approval of Kite's KTE-C19 would lead to a similar selloff, as Novartis or even Juno try to retake the lead in the race to market. This is a worst-case scenario, but I'm giving the shorts the benefit of the doubt.

But there is a strong argument that betting against Kite is a poor bet. I think the odds favor approval, given the strong relationships the CEO, Arie Belldegrun, has with government agencies and personnel; his know-how to navigate the approval process; the smart build-out of delivery infrastructure (which the FDA weighs in its approval deliberations); the encouraging life-prolonging data so far revealed; and the pole position KITE maintains in the CAR-T space.

Even if you give no more than a 50-50 chance of approval, there is a strong argument that betting short is still a bad bet. The valuation of KITE is very low. Is there anyone that doubts a large pharma company that wants to improve its oncology offerings would pay at least $5 billion in a buyout for an innovative oncology company that is first to market with a game-changing medicine with annual sales that could peak at $1 Billion to $2 Billion, according to The New York Times, and whose pipeline promises other applications for KTE-C19, and other novel cancer treatments?

Mr. Trump's promise to allow repatriation of overseas dollars would make this outcome even more likely. And does anyone doubt that Mr. Belldegrun and company haven't already planned their profitable exit strategy in less than two years?

If there is a buyout at $5 Billion, the stock price could be $100, a nearly $50 move from here. If the FDA doesn't approve KTE-C19, the stock will drop, and could get cut in half, a $25 move down. Even if you assign a 50-50 probability of each outcome (which is extremely generous to the shorts), which side do you want to be on?

The effect of a high short interest number on the stock will reveal itself when and if good news is released. A short-squeeze will exaggerate the price and duration of the normal effect of good news. When I was a member of the Pacific Exchange and an options market maker I saw these kinds of short squeezes occasionally develop in stocks whose short interest was high and speculative, and where minor good news caused excruciating pain for the shorts.

Although I freely admit that prognosticating the outcome of a regulatory approval is almost as difficult as predicting the outcome of a jury trial, there is enough evidence, so far, to make those betting on a higher stock price for Kite a sound bet.

Disclosure: I am/we are long KITE.

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.

Additional disclosure: Current position includes stock and options.