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INSM: A value investment proposition with tremendous upside

|Includes: Insmed, Inc. (INSM), MRK
When looking at potential investments, one needs to primarily look at two items Risk vs. Reward.
Simply that can be expressed by the potential downside times the probability of the potential downside materializing versus the potential upside times the probability of the potential upside materializing.
Insmed, a small biotech company, run up more than 15% yesterday on results from an independent research study on its drug IPLEX and its potential in treating symptoms of ALS, also known as Lou Gehrig's disease. It is our view that in light of these very encouraging results, there could be a lot more upside to the stock, while the downside is still limited by the large cash position the company has. What the new test results changed is raising both the potential upside and the probability of this upside. The company's balance sheet provides protection from any downside.
But let's start with most of people who are invested or follow the stock already know.
The Downside:
The downside in the stock is very limited. At yesterday's close of $0.98, the company has a market capitalization of $127 MM. A quick look at its balance sheet will reveal basically no debt and a net asset position of around $120 MM, all of which is in very liquid form (cash & safe, marketable securities). The strong balance sheet position of the company is a result of the sale of its follow-on biologics unit to pharmaceutical behemoth Merck (NYSE:MRK) a year ago for cash. During the last 9 months or so (and after the failed drug IPLEX drug trial for Muscular Dystrophy - more on that later), the stock at times traded at a discount to the company's cash position.

We deem that this was because of two primary factors. Anti-takeover poison pills in the company's charter, preventing any corporate raiders from buying the company for less than its pieces were worth, chopping it up and selling and a relative lack of confidence in the management's ability to act frugal and not squander its cash war chest. While the first factor is still present, after three consecutive quarters, the management team has demonstrated that it can maintain a minimal cash-burn rate of $0.01-$0.02 per quarter while re-examining the strategic direction of the company. That provides confidence on the street and has basically created an effective floor in the stock price around $0.80 - $0.85, a small discount to its net cash position.
It is our conclusion therefore that the downside is small from this point on as management has proven itself and the stock has a solid floor price.
The Upside:
But let's look at the potential upside, because this is the reason why INSM ran from $0.85 to trade over $1.00 yesterday before closing at a solid $0.98.
To provide a little background, following the aforementioned sale of its follow-on biologics division and IPLEX manufacturing facility to MRK in February 2009, Insmed had very few items on its pipeline. It was in the middle of conducting trials for IPLEX in the treatment of Muscular Dystrophy. These trials disappointed in June 2009, resulting in the stock going practically overnight from over $2.00 to trading for less than cash on hand. As a result of the disappointed results, it seems that the company abandoned its tests for IPLEX for the treatment of MS, at least for now.
However, IPLEX had been approved as an "Investigation New Drug" by the FDA for the treatment of ALS, a disease with no known cure and with currently only one other similar drug in the market treating its symptoms (and not so well). For the sake of brevity, I am not going to delve into the specifics of ALS at this point but I will state that there are approximately 20,000 patients with ALS in the United States and about 5,000 are diagnosed each year, keeping the figure constant as this is a terminal disease that kills 50% of patients within 3 years.
That said, and considering that IPLEX generates the manufacturer approximately $100 in net profit per dose, at one dose per day per patient, if the treatment were to be approved by the FDA, the potential net profit from 20% of the people diagnosed receiving it would be $100 x 365 x 4,000 = $146 MM per year. At a P/E of 12, the market cap of the company would be $1.7 BB or a stock price equivalent of $13.
Now, there are clearly a lot of hurdles to overcome before such a scenario materializes and honestly the probability of such is relatively low. We estimate such probability at this point at approximately 20% which gives us a fair market price for the stock of $13 x 20% + 0.90 (cash) = $3.5. FDA approval is not even on the table yet and even if the drug does get FDA approval, it is very expensive to supply and manufacture and could face issues when it comes to insurance and medicare underwriting.
All that said, the independent study released yesterday considerably raised the probability of formal studies to be conducted towards FDA approval for use of IPLEX in treating the symptoms of ALS and the market took notice. Although this was an independent study, the results are solid and should encourage the company to pursue formal trials for the drug. At minimum, the study proves that IPLEX has a lot of potential in treating ALS symptoms and even if INSM might decide it does not have the capital to see it through commercialization, the drug alone can be valued in excess of $200 MM at current stage by a large pharma. Not to mention that INSM has an established relationship with MRK and MRK currently owns the facility where IPLEX was originally manufactured. Therefore we do feel that the runup could continue and take the stock in the $1.75 - $2.00 area.
A little about the study:
The study was conducted by ALS worldwide, a non-profit advocacy group that played a crucial role in forcing the FDA to give IPLEX IND status via several legal battles. The study was on 10 patients who received the drug under the IND FDA regime and volunteered to participate. Dr Michael Schafer, head of ALS worldwide conducted, controlled & monitored the study.
Positive highlights:
Over the 30-week trial, a 9.3% overall improvement in symptoms outlined by the Practice Parameter of the American Academy of Neurology
Over the 30-week trial, critical function (swallowing) showed a 25% improvement
No adverse effects (the current drug by Sanofi-Aventis has a lot of documented side effects)
Remarkable parity between the apparent responsiveness of the individual patients compared to the aggregated group of patients at large.
No permanent patient withdrawal from drug use or study, even though they were able to do so at any time
Small amount of patients
No double blind placebo controlled study

Disclosure: Long INSM