What to buy? Gamble on biotech stocks

The regulatory approval process for new drugs is Byzantine, lengthy, and unpredictable. Single stocks are, for outsiders at least (even insiders can be surprised), almost pure bets. But one can still profit from the usual fact that the winnings are often much larger than the possible losses…

Such an approach would involve taking a portfolio of relatively small biotech stocks (stocks that will more than double when they pass a regulatory hurdle, big stocks have much less chance in doing that). Such a portfolio creates a situation in which the gain of the winners would more than compensate the loss of the losers (the maximum loss is limited to their stock price, of course)

However,if all loose, even that strategy will fail, so one has to have a relatively broad portfolio (we’ll have another article on that later). The approach by the author below is actually much more aggressive, and therefore much more risky, but also potentially much more profitable. It’s to play them sequentially, and have a winning streak. Everything (even the timing) has to be perfect though..

His way to deal with the risk is to make a small initial investment only, which is an interesting approach, we have to say. We would certainly advice against betting the bank on a biotech stock, to be honest..

Dendreon (DNDN) we’ve already written about, earnings are about a year away, providing they can jump the final regulatory hurdle, which seems all but secured by now. The other two companies are new here.

A Biotech Triple Play: Dendreon, BioCryst and Arena

Michael Murphy

There’s only one thing better than catching a big stock market winner like Dendreon (DNDN), and that’s letting your profits ride on two or three winners in a row. Even though not one of the seven Wall Street analysts following Dendreon had a buy on the stock before the recent announcement that the final Phase III trial of the company’s Provenge prostate cancer drug was a clear success, we had it listed as a Top Buy for many months and subscribers rode it from under $5 to over $20. I’ve recently asked them to sell some Dendreon and buy a position in BioCryst (BCRX) before a pending announcement planning to sell the BioCryst this summer, and to buy Arena Pharmaceuticals (ARNA) before its September announcement of the second Phase III lorcaserin obesity drug trials.

Dendreon paid off 4-for-1. I expect BioCryst to pay off about 3-for-1 from current levels (it was 4-for-1 at the time I recommended it to subscribers). Then I expect Arena to pay off about 6-for-1 from current levels. All of these are small, development-stage biotech stocks without any approved product. But the power of a triple play is that one can invest an appropriately small amount of money in the first idea and then let it ride to substantial potential profits. Just $2,000 invested in Dendreon in March turns into $144,000 by the end of the year if I have calculated the payoffs right. Even if you missed Dendreon, $2,000 invested in BioCryst turns into $36,000 by the end of the year just from the double play of BCRX and ARNA.

I am still very bullish on Dendreon (see my recent article) and expect to tell subscribers to take profits on Arena early next year and go back into Dendreon before Provenge is approved in the first half of 2010. But they should be able to buy a lot more shares than they sold.

Why Did Dendreon Work?

Dendreon was mispriced in large part because Wall Street did not like the CEO of the company. He was viewed as too promotional and, in some quarters, as trying to end-run the FDA by going through the Biologics division instead of the Oncology division. Even though the statistics on Provenge were good, and got better with the passage of time, their mistrust gave the short sellers ammunition to keep the stock depressed with rumor after rumor – until the numbers came out.

Why Will BioCryst Work?

Wall Street never liked the previous CEO and distrusts the company’s main drug. Peramivir is an antiviral originally promoted for the avian flu (H5N1). As that threat faded into the background (although I expect it to return, as discussed below), the company began talking about peramivir for seasonal flu (H1N1). It followed two clinical development paths, an intramuscular (IM) injection in the outpatient setting, and an intravenous (IV) infusion in the hospital setting. About 200,000 seasonal flu patients are hospitalized every year, and about 20,000 die.

I never had much hope for the IM program, and after a series of problems, that program seems to have come to an end with the release of the latest data on May 8. Although IM peramivir reduced the number of hours a patient was ill, the difference from placebo was not statistically significant.

My original expectations for the IV peramivir program were that it would prove useful in Phase II testing, and then the government would add the antiviral to the national stockpile program without waiting for Phase III results. I expected BioCryst to share the stockpile spending in the U.S. and overseas with already-approved Tamiflu and Relenza. However, the H1N1 virus has mutated to develop immunity to Tamiflu, and that mutation constituted about 14% of the virus samples in 2007, 78% in 2008, and may be approaching 100% now. So the stockpiles of Tamiflu are not much use against the current “swine flu” outbreak (H1N1, Type A) and might be equally useless against a combination of avian flu and “swine flu” that would be as virulent as avian flu and as easily transmissible human-to-human as swine flu.

Consequently, at the same May 8 announcement that its latest IM clinical trial had failed, BioCryst management said that 10 days earlier the government had contacted them to evaluate peramivir for Emergency Use Authorization. Management said they had been engaged since then in 24/7 contact and negotiations, and that the company’s manufacturing facilities has already been inspected. The government ordered 1,000 doses right away. As I semi-facetiously told my subscribers, that’s enough to protect the most important people in the world, in their opinion – Congress, the Supreme Court, the top levels of the Executive Branch and, of course, upper management of the FDA.

BioCryst has been developing peramivir under a $104 million grant from the Department of Health & Human Services (HHS). HHS knows the numbers on the drug. I expect the Emergency Use Authorization to be granted in the next six weeks, followed by substantial orders in the 500,000 to 1,000,000 dose range. Tamiflu costs about $50 a dose, but it is an injectable, not an IV infusion that reasonably would be priced higher. I would not be surprised if the course of treatment for peramivir is in the $250 range, but even assuming half of that, the initial stockpile order could be worth up to $125 million for BioCryst. The company has a $1.4 billion market capitalization at current prices. With the cash in hand to finish Phase III IV trials and ongoing cash flow from additions to the world’s antiviral stockpiles, I think the stock can trade up to a market capitalization north of $4 billion.

Why Will Arena Work?

Like Dendreon, Arena Pharmaceuticals has a CEO that Wall Street views as overly promotional. Like Dendreon, the stock is heavily shorted – 18.1% of the float as of mid-April – even though it is in low single digits and has a drug that both works and will be approved. Like Dendreon, only one more Phase III trial lies between them and approval, and all that trial has to do is be not much worse than the virtually identical successful Phase III trial the company just reported. Like Dendreon, it has a very small market capitalization, only $260 million compared to Dendreon’s $400 million in early March. Also like Dendreon, there are repeated misstatements in the media and on Wall Street about the company, such as that its drug did not meet the FDA requirements for approval, or the company is about to run out of cash. Frankly, I hope the bears continue their drumbeat until after we can cash in our BCRX shares and roll into ARNA at the current low prices.

Arena, of course, is bringing the obesity drug lorcaserin through trials. It is essentially a safe form of fenfluramine that does not cause heart damage. Fenfluramine was the “fen” in fen-phen. The other half of that combination, phentermine, is widely prescribed today as an anti-obesity drug, but it is not especially effective. Neither was fenfluramine on its own. Lorcaserin delivers meaningful weight loss on its own with a low side effect profile, even without a rigid diet and exercise program. It therefore has good patient compliance, which is one of the real-world factors that contributes to a successful drug. It will undoubtedly be combined with phentermine in a new lorca-phen weight loss combination that will become the talk of the cocktail circuit, just as fen-phen did.

It is difficult to tell how large the market for lorcaserin and lorca-phen will be. In terms of numbers, eventually about six million people took fen-phen. Americans are more obese now than they were 15 years ago, and I do not know how lorcaserin will be priced. An effective obesity drug is certainly a multi-billion dollar blockbuster on a worldwide basis, and drug companies often sell for about six times revenue. My 6-to-1 target for ARNA gets the company up to only a $1.5 billion market capitalization, which seems awfully low for a successful drug of this size.

So there you have it. Development-stage biotech stocks are inherently risky, so you deal with that by making only a small investment up front. Then you focus on stocks Wall Street does not like, preferably heavily shorted, where the science is sound and the final hurdles are about to be jumped. You invest sequentially to roll the profits from one into the stock of the next, hopefully still at a price depressed by short sellers and rumor mongers. And then you wait a short time for the event that will cause a wholesale revision in the Street’s attitude. We are following this triple play closely at NewWorldInvestor.com, and I will update this article in the comments section if anything changes dramatically.