After a 26% Gain in 3 Months – Stepping to the Side on Angie’s List

After reaping a 26% gain short-selling ANGI (NASDAQ:ANGI) over the past 3 months, I have decided to buy-to-close.

Similar to when I last closed my Angie’s List short in December, board members have been making small open-market purchases. Until the business model changes, nothing really will here either, but in the past, board member open market purchases have been a good short-term indicator of a bounce. The stock subsequently rose 50% from December thru January.

I also believe that the recently installed Chairman could finally light a fire under management. The firm laid off 97 sales employees and re-structured the commissions system earlier this month. Perhaps this was an admission that the current business model is unsustainable? Time will tell.

During a period when most Internet sector stocks have risen to ludicrous heights, ANGI has been a great short for me. The stock is down 50% since I my short position in October, but I believe the board shakeup could portend changes to the Angie’s List subscription model. For now, I move back to the sidelines.

Adding Verizon (NYSE:VZ)

Six months ago, I threatened to switch to AT&T if  Verizon did not offer me lower rates. The customer service representative politely told me to kick rocks. When the customer service representative would not budge, I pulled the manager card. When the manager didn’t budge I resigned myself to expensive cell phone bills and hung up. I should have invested immediately. That is serious pricing power.

I am adding a position in Verizon Wireless (NYSE:VZ). There has been a lot of publicity about Berkshire Hathaway’s recent stake. I am honestly a bit ashamed to drag along after Buffett and Paulson. I was confident that I could find a better investment in the space, and Bezeq came pretty close. Ultimately, my telecom investment was about safety. VZ’s numbers are fantastic and reassuringly consistent. Cell phones today are as necessary to the average Joe as water or electricity. This is essentially a utility stock, which pays a dividend of 4.26% currently, and which consistently generates a high free cash flow yield of over 7%. VZ’s gross margin hovers around 50%, with an operating margin that stays in the high teens. The current Price/Free Cash Flow multiple is 8.02, well below it’s main rival AT&T, which is trading at a P/FCF of 14.55.

By altering its capital structure, Verizon takes on more debt at historically low rates, and sheds itself of a significant drain to dividends. Assuming that Verizon can continue to generate strong Operating Cash Flow, this act should increase Free Cash Flow Return on Invested Capital from a historical range of 8-11% to over 15%! If Verizon stays true to its history shareholders will see dividend hikes in the future. This is a classic value investor play.

I also looked hard at Vodafone (NASDAQ:VOD), but opted for the proven track record at Verizon. I think VOD has fantastic potential in the emerging markets, but I am worried about regulation in Europe. VOD also has a spottier track record of returning cash to shareholders. Lately, management has been quite generous with dividends, but I wonder if they can keep it up. I may invest in VOD in the future, but prefer to keep my options open for now. Price/Free Cash Flow appears low at 5.26, but whether management will invest or distribute cash wisely is another question altogether. Historically management hasn’t used free cash flow effectively.

My other prospect was Bezeq, the Israeli Telecommunications Company (TLV:BEZQ). The firm has declining sales volume in a fleshed out market. On the positive side, they pay a very attractive 7.9 % dividend after foreign residence tax, with a payout ratio of 100%. Bezeq appears to have a headlock on the local communications market (cable, internet, and cell phones) despite government-mandated market reforms. P/FCF here is also attractive at 6.55. What scares me away from Bezeq is the possibility of currency fluctuations. The whole point of a Telecom investment to me was to find a safe place to park some cash. VOD could work because of its international diversification. Verizon works because I live in the U.S.

It also helps that Verizon and AT&T represent a duopoly. Some investors have been skittish to invest because of the debt load. I would ask them to try going a day without their cell phone. Better yet, try to negotiate a discount.

Short Oramed Pharmaceuticals (NASDAQ:ORMP) – The Smell Test Fails

Ticker ORMP
Market Cap $95.75M
Short Interest 15.8%
Current Price $9.63
Fair Price $6-7
Implied Gain 30-40%

First off, thank you to the MDs and Pharma classmates who helped to explain the intricacies of the clinical trial and drug patent process.

On April 28th, I opened a short position in Oramed Pharmaceuticals. My investment goals are to go long in the best 10% of investments available in the market, and to short the most disreputable 1%. Shorts represent less than 5% of my investments, but they are often some of the most interesting investments.

Oramed is billing its Phase 2b drug as a novel delivery mechanism for oral insulin. The truth about Oramed is that it is solely floated by retail investors who are not aware that Oramed is plagued by:

  • Questionable Science
  • Intense Competition
  • Bad Management
  • Wolves of Wall Street Pumping the Stock

Questionable Science

 

Obstacles and Solutions to Oral Insulin Delivery

Obstacles and Solutions to Oral Insulin Delivery

The diabetic market is huge, representing over 300 million patients worldwide. Several major pharmaceutical firms have attempted a solution to the problem of oral insulin delivery without success. Pfizer lost millions in R&D wrestling with this problem. Novo Nordisk (NVO) is currently conducting Phase 2 trials with small-cap partner Merrion Pharmaceutical, and is in a better financial position to move to Phase 3 than Oramed. 

Oramed has claimed positive results in Phase 2 Trials in 2008,2009, and 2011, without progressing to Phase 3

It turns out that ORMP has been announcing positive Phase 2 trials since 2008. Typically, Phase 2 trials last 2-3 years. The long delay appears to be due to reformulations and FDA push-back. Prominent Healthcare sector analysts have heavily criticized the scanty Phase 2 clinical results provided by ORMP.

ORMD_Clinical

The Street’s Adam Feuerstein called the data posted above “completely worthless“. Diabetic Investor, also quoted by Feuerstein, is a blogger with 20 years of experience monitoring the insulin treatment industry. Diabetic Investor had this to say:

“Oramed has proved essentially that they can do more studies, WOW. They haven’t proved their miracle drug is better than existing medications or that patients using this miracle drug experience fewer side effects or achieve better outcomes. All they have proved is that this one week study – a whole seven days- was that they could do more studies which will hopefully last more than a week.”

A great example can be found here. In each case where a statistically significant p-value is noted, a careful reading reveals that the trial involved less than 30 people. Hence, the p-values on this poster are probably not worth the ink they were printed with. This is questionable science at best.

Other questions revolve around the pill treatment plan and pricing. The company is only offering the pill as a supplement to injections around mealtime. Three pills a day would cost roughly $100 at current insulin prices. Current insulin injection treatments cost about $100 a month. There is obviously a huge pricing disparity here.  Why would diabetics double their treatment expenses for greater expense and minimal gain?

Oramed data posted in December reveals that Type 1 diabetics were only absorbing 2 of 200 units of insulin from each pill. The trial was not statistically powered, with only 24 patients enrolled, but assuming the results are legitimate, a diabetic would have to take 10-30 pills per day to receive the same level of treatment as injected insulin. The firm is now promoting ORMD-0801 as a mealtime supplement to injected insulin. I have trouble believing that many diabetics would be willing to pay for such a product.

Furthermore, dosage is a serious issue with insulin. Too high a dose can cause hypoglycemia. If Oramed were to improve the efficacy of ORMD-0801, it would run the risk of making patients comatose. Perhaps this explains why Oramed has had such a long slog to get FDA approval.

Trial sizes tend to correspond to the potential market size of the end-product. Niche drug producers will sometimes conduct small Phase 2 trials involving between 20-60 test subjects, but diabetes is a huge treatment market, with millions of patients. It is not uncommon to see Big Pharma enrolling two or three hundred patients in insulin trials. Oramed has the cash to burn, and they know Novo Nordisk is also in Phase 2 trials, yet they spent less than $2M on R&D last year.

Despite requests by analyst for relevant data, Oramed continues to recycle the same press releases and data, while at the same time, spending hundreds of thousands of dollars worth of stock options on shady stock promotions. The firm could have boosted its R&D by at least 20% if they had reallocated their “investor relations” stock options to R&D efforts.

One thing investors should look for in a biotech firm is patents. Ideally, investors want lots of iron-clad patents. The meagre four patents which Oramed has revolve around the formulation of its drugs. Here are the ingredients for ORMD-0801 according to the U.S. patent.

The key ingredient is also licensed by Novo Nordisk, one of the world's largest producers of insulin

The key ingredient is also licensed by Novo Nordisk, one of the world’s largest producers of insulin

Each of these ingredients could be purchased at a local drug store, except for SNAD, which is also licensed by a major competitor. This is not a robust patent portfolio.

Intense Competition

Novo Nordisk, one of the world’s largest producers of insulin, has standing agreements with Emisphere over SNAD. Oramed has hinted at Novo Nordisk as a possible acquirer of ORMP. Unfortunately Novo’s CEO has stated publicly that they have no interest in acquiring Oramed, because they doubt Oramed’s methodology. Competition doesn’t end there either. Each of the companies in the space below is working on novel forms of insulin treatment. Biocon purchased Nobex a few years ago. Novo Nordisk has a licensing agreement with Emisphere for SNAD (ORMD-0801’s sole ingredient not currently found in drug stores). Novo Nordisk is also partnered with Merrion Pharmaceuticals to develop basal oral insulin treatments, and reported positive Phase 1 results last spring involving 84 patients. Phase 1 is a long way from Phase 2, but the results were statistically significant and are therefore, arguably more trustworthy than any of the data that Oramed Pharmaceuticals has supplied.

Comps

Bad Management

At first, the large equity stake which the CEO has in the company impressed me, but digging into the price he paid for stock options puts a different slant on things entirely. A great way to check the quality of a firm involves the price at which the company sells its stock options to company insiders. Here is a quick options pricing comparison between Oramed (gleaned from the 10-K) and the average of four other biotech start-up firms:

Black Scholes Options Calculations
ORMP Typical Competitors
2013 2012
Expected option life (years) 5.75-6 5.5-5.75 6-6.5
Expected stock price volatility (%) 64.35-75.46 76 95
Risk free interest rate (%) 0.92-1.01 0.83-1.0375 1.5
Expected dividend yield (%) 0 0 0

Black-Scholes takes a few factors into account.

  • Current underlying price
  • Options strike price
  • Duration
  • Implied volatility
  • Risk-Free Interest Rates

The net effect of ORMP lowering the duration, volatility, and risk free interest rate results in a lower options price for insiders. Using the most recent 10-K, the average price of options for insiders was $5.61.

No one on the management team has worked at a successful start-up. The COO and CFO both worked at publicly traded penny-stock companies which popped and then plummeted back down to penny-stock status.

Josh Hexter COO BioLine RX

Josh Hexter COO BioLine RX

Yifat Zommer CFO at a subsidiary of IIS

Yifat Zommer CFO at a subsidiary of IIS

Nadav and Miriam Kidron

Nadav and Miriam Kidron

The CEO is the son of the Chief Scientific Officer (CSO). The CSO recently sold all of her shares ($1.6M worth of options) in ORMP in April, very close to the most recent clinical trials announcement. The CSO selling out is equivalent to a Chief Technology Officer at a tech company selling their stake. It doesn’t engender confidence in the long-term prospects of the company or the product.

“She’s the chief scientist. I just went for the ride to do the business side,” — Reuters interview with Nadiv Kidron CEO of Oramed.

Ehud Arbit

The Chief of R&D, was dismissed from two separate hospitals within the U.S. — Sloan Kettering and Staten Island Hospital — for operating on the wrong sides of patient’s brains. What is a neurosurgeon doing heading up the R&D efforts for an oral insulin firm? A promising biotech firm would have someone with pharmacy or biotech experience in this role.

Wolves of Wall Street Pumping the Stock

Oramed discloses in the 10-K that they have paid 4 “investor relations firms” with large quantities of stock warrants which vest inside of a year. This is not something that reputable companies do, and should be cause for alarm.

One of the firms receiving such warrants is Aegis Capital. Aegis puts a fair price for the stock at an astounding $30. The firm had to double the standard drug approval probability estimates for Phase 2 drugs from 35% to 60% used by Wall Street to get to such a lofty number. $30 would be an impressive feat indeed for a firm with no track record of success, Phase 3 progress, Big Pharma partnerships, or strong patent portfolio. The New York Observer also has a great article about ORMP’s penny stock promoters.

My favorite Oramed stock pumper has got to be Sharon Di Stefano. Sharon has an impressive resume, having worked at multiple pump-and-dump shops including: Meyers Associates, Sky Capital, H.J. Meyers and Co, and Josepthal and Co. Whereas even Aegis estimated that ORM-0801 would not reach market until 2021, Sharon believes that Oramed’s pill will hit the market in 2017, and that the stock is worth $66. You can read some of the amazing replies to her assertions on Seeking Alpha.

Valuation

Giving Oramed the benefit of the doubt, assuming that in 2021 we will see a marketable pill capture some sliver of the total diabetic market, we still end up with a fair value less than $7/share.

Assuming the firm captures 1% of the addressable market

Assuming the firm captures 1% of the addressable market, and receives international royalties

DCF

Analysis of the potential for a very expensive, ineffective pill with below-average chances of making it to market in 7 years reveals that this company is not worth more than $7 a share. The tangible book value of the company is around $3/share currently and would seem to be the only real valuation floor for such a company.

My short-term target price is somewhere in the $6-7 range.

Risks

Acquisition — The likelihood of acquisition is very low here. Big Pharma already went through the oral insulin space with a fine-tooth comb and cherry-picked the promising companies.

Continued Stock Pumping — Unfortunately, timing is always hard with a short. Eventually investor expectations will come crashing back to a fair value, but in the meantime we can expect continued press releases and stock promotion from management. This is an important short-term risk, but minor in the long-term.

Oral Insulin Success in Near-Term — “I’m not going to hold my breath on this one.” Me neither. Perhaps in 7-10 years we will see a marketable product. I do not regard ORMD-0801 as a serious contender in the space at this point. If statistically powered data with statistical significance were to appear, then Oramed might merit revaluation. Currently there is no proof that ORMD-0801 is any better than a placebo.

Conclusion

Questionable science, intense competition, a terrible management team, and circling wolves of Wall Street do not bode well for investors in ORMP.

Injected insulin has improved to the point where once-a-week treatments are possible. Meanwhile, ORMP’s clinical trials have yielded statistically insignificant results. In the most recent Phase 2 trial ORMP admitted a “formulation issue … that resulted in diminished and inconsistent release of study drug.” 33% of the study patients were compromised. The firm states that they will be conducting a large-scale statistically significant study later this. The CSO states that:

“We look forward to moving ahead with our planned U.S. Phase 2b trial in individuals with type 2 diabetes which will investigate ORMD-0801 over a longer treatment period and which will have statistical power to give us greater insight into the drug’s efficacy.”

In the meantime, she has sold her entire stake in the company.

If and when Oramed’s oral insulin showed any actual efficacy, Novo Nordisk could simply leverage its existing licenses and partnerships with Emisphere and Merrion, throw hundreds of millions of dollars at the problem, and beat Oramed to market. Oramed’s management team has to know this. Additionally, the SEC has recently made inquiries into ORMP as well, forcing Oramed to restate some of the claims posted on their website.

It is possible that this is all coincidence, that Oramed’s science is sound, that their management team has integrity, intelligence, and energy. It is even possible that Oramed has a blockbuster product on its hands. Given all the points mentioned above, the likelihood of this being true is slim.

I sent Oramed the following question via their website to try to clarify some of the firm’s decisions:

“I am researching your firm as a potential investment, and wanted to clarify a few questions I have.

1. Can you explain your Insider Black Scholes Options Calculations from the 2013 10-K? What is the basis for the risk-free rate quoted? Why is the expected stock price volatility lower for 2013 than 2012?

2. Was there an explicit reason that the CSO sold most of her shares in the company in April of 2014?

3. What strengths does the Chief of R&D bring to your firm’s oral insulin research?

4. Can you disclose the names of the four investor relations firms mentioned in the 2013 10-K? Is Aegis Capital one of them?

5. Which companies (or more broadly, what sort of companies) would you argue might be interested in partnering with you on your leading candidate drug ORMD-0801?

Thank You,”

If I receive a response, I will be sure to post an update, but for now Oramed Pharmaceuticals does not pass the smell test.

Is the Stock Market Over-Valued, Fully-Valued, or Under-Valued?

Pundits have been arguing 3 very disparate views on the market. General consensus is that this year’s stock market returns will not equal last year’s 30% rally. The divergent perspectives are outlined below.

Will skepticism keep a healthy check on bull market overvaluation? This would seem to be a fair point. Bubbles only happen when most investors forget about risk. You cannot argue that we are in a bubble if everyone is yammering about the danger.

Is Buffett right? Are markets back to a fair valuation after years of cheap investment opportunities? Possibly. No one can argue that P/Es are cheap. Several famous value-oriented hedge fund managers -including Seth Klarman- returned money to clients over the past year.

Are markets 50-70% overvalued due to cheap global monetary policies such as the Yellen Put? Will the market stagnate as a result? Monetary policy should be concerning, especially for older investors with lower investment timelines. Stagnant markets can happen. You only have to go back to the 1970s to witness a largely flat decade.

Corporate Profit Margins at Historic Highs

One of the more interesting Bear arguments revolves around corporate profit margins.

Corporate After-Tax Profit as a % of GDP - Bears Love This Chart

Corporate After-Tax Profit as a % of GDP – Bears Love This Chart

Profit margins for U.S. corporations are at historically high levels. Bears think that a mean reversion is in order.

What the Bears fail to factor in is computerization. TI believe the Digital Revolution is a permanent economic upgrade 10 years ago, most of us did not have cell phones. Now we use them to efficiently navigate from point A to point B, to interact with co-workers, to pay our bills.

Perhaps the closest historical comparison we can make is to Great Britain during the Industrial Revolution. I found a very interesting paper detailing the effects of the Industrial Revolution on profit margins. Initially, wages were stagnant, inequality rose, while profit margins doubled. Returns on capital increased in proportion, as new technology investments paid off handsomely. A feedback loop ensued as corporate profits helped to balloon GDP. Sound familiar?

The next 50 years represented a high-water mark of prosperity for the British Empire. Wages eventually caught up, while profit margins stabilized at these new, higher levels after some rather minor mean reversion. Looking at the data from the industrial revolution, it seems clear that corporate profit margins could climb even higher, by as much as 1-6%.

Takeaways

Corporate profit margins, while high, are supported by fundamental improvements in efficiency thanks to the Digital Revolution.

Every market valuation argument has an implicit time-value attached. Hedge and mutual fund managers have to outperform not just every year, but every quarter. Thus market valuation outlooks tend to be skewed to the short-term. This makes some sense if you are trading into and out of companies every week.

However, even in this case we should be basing our estimates on individual stock valuations as well as the scope/scale of opportunity sets. So market valuation really shouldn’t matter much unless you run a macro-driven fund. The scope of opportunity sets has certainly shrunken, but I think there still may be pockets of undervaluation out there.

To anyone not pulling their money out of the market in 10 years, over/under-valuation debates are largely irrelevant. It shouldn’t matter to us what the market is doing in 10 years, or even 20, unless we plan to retire soon. If you ignore market valuation and use dollar-cost-averaging to invest in an ETF or more than 10 individual stock names for the long-term (20-50 years) you can count on the following:

  • Your dividends will compound the money you put in
  • The value of your portfolio will be much larger than the value of your original investment

Portfolio Update: ANGI Short Back On, Closing out Long HSBC Position

I have decided to close out my long HSBC position after the firm posted terrible earnings this morning. It is becoming clear that the firm’s new compensation structure is not effective. Additionally, I feel that my positions in Banco Santander and J.P. Morgan represent better long-term holdings. I am not unhappy with a relatively flat return over the holding period (3% since an initial position in 2011), but there are certainly lessons to be learned.

Initial Thesis

The initial mid-2011 HSBC thesis revolved around the bank possessing stronger margins and higher ROE than Banco Santander, while at the same time being undervalued to peers. Price/Tangible Book Value was particularly attractive at 1.04. The dividend also paid over 4% at the time. London had a strong reputation as a center for international finance, and HSBC was well-respected within the space. I liked several European banks at the time, and thought investing in both HSBC and Banco Santander would spread the risk of increased regulation between countries. I also liked HSBC for its Asia focus in particular.

What Went Wrong

Regulations imposed on British banks have altered the landscape a bit. To workaround the current compensation rules, HSBC has misaligned employee compensation using stock options. Asian earnings have not grown enough to offset other geographic trends. No catalyst exists on the horizon the drive the stock higher.

The Takeaway 

I failed to evenly split my investment between Banco Santander and HSBC. Had I done so, the gain from SAN would have outweighed the lag from HSBC. As it stands, I put about 2X the investment into HSBC, because I felt that it was a less volatile play. I was right that it was less volatile, but it also under-performed the sector, and the compensation changes have hurt rather than helped. Thankfully, Banco Santander looks to be performing well. As punishment for a bad trading idea, I will be placing the money from the HSBC sale into a passive ETF for the long-term.

ANGI Short Back On as of April 30th

Short interest in ANGI has decreased, while ANGI’s results have been as terrible as always. The song remains the same:

  • Bad Business Model
  • Accruals-driven Earnings/CFO
  • Insiders Selling Out
  • “Independent” Board Members Leasing Buildings to ANGI
  • Massive Deferred Revenue
  • Growing Accounts Receivables w/Inadequate ADA
  • Large Amount of Prepaid Expenses
  • Significant Short Interest
  • Several customer-related lawsuits
  • Marketing Spend per Customer Acquisition > Lifetime Revenue Per Customer
  • Negative Book Value

I am confident this business will fail, it is only a matter of time and will be shorting for as long as I can do so without having to borrow at high rates.

Synta Pharmaceuticals (NASDAQ:SNTA) – A Heavily Discounted Biotech Investment

Synta Pharmaceuticals (NASDAQ:SNTA) is a yet-to-succeed firm in the Biotech space with a Phase 3 candidate drug designed to treat cancer. Synta’s lead anti-cancer drug candidate, Ganetespib, has been studied in over 800 patients in more than 25 clinical trials. In preclinical models, Ganetespib inhibits a molecular chaperone called Hsp90, essential to the function of many of the most fundamental drivers of cancer cell growth and proliferation. Ganetespib is currently in Phase IIb/III FDA trials.Ganetespib utilizes a proprietary HDC delivery platform to deliver drugs to cancer cells. The company bills it as “Targeting the molecular chaperon in cancer”.

 

Image

Synta represents a unique opportunity because of its history. It’s initial HSP90 candidate failed in Phase III trials, burning shareholders and forcing the company to reformulate. Shareholders have seriously discounted the company’s potential in relation to other Biotech firms. The recent departure of a lackluster CEO prompted a recent sell-off as well.

Timeline of Drug Phases

Timeline of Company-Sponsored Drug Phases

 

 

Competing Hsp90 Candidates

Pharmaceutical Company Anti-Cancer Therapy Last Known Therapy Status
Astex Pharmaceuticals (ASTX) AT13387 Phase 2
Biogen (BIIB) BIIB021, BIIB028 Suspended
Debiopharm/Curis (CRIS) Debio 0932 Phase 1/2
Esanex SNX-5422 Restarted
Exelixis (EXEL) XL888 Suspended
Infinity Pharmaceuticals (INFI) Retaspimycin HCI Terminated after failed trial studying NSCLC
Kyowa Hakko Kirin (OTC:KYKOF) KW2478 Phase 1/2
Myrexis (OTCPK:MYRX) MPC-3100, MPC-0767 Suspended
Novartis/Vernalis (NVS) AUY922 Phase 2
Samus Therapeutics PU-H71 Phase 1
Synta Pharmaceuticals Ganetespib Phase 2b/3

Major Fully-Funded StudiesIndustry professionals are feeling confident about Synta’s drug as well. Multiple health-care organizations are funding their own studies of Ganetespib Most recently the EU, has decided to fund a $100M trial. In total, Ganetespib has the largest clinical study group ever assembled in the space (over 700 patients). Clearly the firm does not want to take chances with another Phase III failure. The amount of partnered organizations signals a clear interest from academia.

Partnered Institutions

Partnered Institutions

Interestingly, the heaps of data being provided are scaring investors away, leading them to the wrong conclusions about the drug and it’s efficacy. Seeking a blockbuster wonder-drug, investors are hesitant to invest in a firm which has accepted the reality that Ganetespib will do best when paired with other drugs. This is only an incrementally better cancer treatment than what is currently on the market, because of this the market is substantially discounting the sales potential. The stock has approximately a 40% short interest, with no clear thesis I have been able to discern other than momentum.

Short Interest

Short Interest

On the flip-side, insiders have been major purchasers, accumulating over $40M worth of shares in the past 6 months.

Note the miniscule sales to purchases

Note the miniscule sales (invisible here due to tiny size) to purchases

Here are some conservative sales estimates. We assume that Ganetespib only succeeds with androcarcinoma patients, a tiny subsect of the total addressable cancer market.

2013 2014 2015 2016 2017 2018
Ganetsib Sales 0.00 0.00 55.00 75.00 495.00 650.25
    Growth % 0.00 0.00 5,500.00 36.36 560.00 31.36
International Royalties 0.00 0.00 0.00 5.00 10.00 15.00
Collaboration Revenues 0.00 0.00 5.00 10.00 15.00 10.00
Grant Revenues 0.00 0.00 0.50 0.50 0.50 0.00
Total 0.00 0.00 60.50 90.50 520.50 675.25
New Cases Cancer per Year % NSCL % Androcarcinomas Market Share Est Customers Price Per Customer Revenue Per Year Est
500000 0.85 0.3 0.15 19125  $     34,000  $                            650

Now we turn to one of the more interesting sides of Biotech valuation. Because these companies are generally unprofitable, we derive the likely probability of drug approval and multiply that probability by the total potential cash flow to yield what is considered to be a fair value for the company.

Here are the generally prescribed probabilities of FDA drug approval at various phases.

Pre-Clinical Phase I

 Phase II

 Phase III

 Final

 1%15%35%60%90%

I have assigned much lower probabilities than the generally used examples. I feel Synta merits a more conservative estimate because of its past failures. Additionally, cancer treatments generally have a tougher time getting FDA approved. Even with the lower probabilities, sub-GDP terminal growth rates, and a WACC of 14%, SNTA appears to be significantly undervalued.

Discount Rates
Terminal Growth Rate 15.00% 16.00% 17.00%
2.50% 12.50% 13.50% 14.50%
2.00% 13.00% 14.00% 15.00%
1.50% 13.50% 14.50% 15.50%
Fair Value          
  Approval Probability Terminal  Enterprise Fair Value Per Share Gain
Bear Case 0.25 3,172.21 1,613.75 1,649.28  $ 4 -1%
Base Case 0.4 3,301.68 1,749.82 1,785.35  $ 7 71%
Bull Case 0.5 3,440.75 1,900.09 1,935.62  $ 10 132%

Most analyst estimates are around $14/share. The investor willing to take on the substantial risks of this stock could triple their money. The risks are substantial and should not be downplayed.

  • Lack of partnerships signal may signal that drug companies are not thrilled by drug prospects
  • Previous formulations of HSP90 treatment failed in Phase III trials – Management is mitigating this risk with large-scale randomized trials designed to better target sub-segments of patients which yield greatest efficacy. Previous trials have already provided scads of patient data points.
  • Company may need to issue more shares to continue to fund operations, resulting in shareholder dilution (modeled into DCF)
  • As a drug class, HSP90 inhibitors have yet to achieve regulatory approval. Furthermore, the development history of competitor HSP90 inhibitors includes the emergence of hepatic, cardiac, and ocular toxicities as a result of formulation issues, but also presumably, in part, as a consequence of the on-target mechanism of action. If Ganetespib is unable to maintain an acceptable safety profile and/or demonstrate meaningful enough efficacy in clinical trials, the drug may not receive the regulatory approval necessary to become marketable.
  • Change of focus from mono-therapy to combination treatments are a bad sign for orphan status, but risk is priced in already
  • There are several companies with clinical stage Hsp90 inhibitors, many of which have lead development programs in advanced lung cancer. Additionally, multiple companies are developing drugs in NSCLC that may compete with HSP90, or alter the standard of care before Ganetespib reaches the market. Some of the companies competing with Synta have substantially greater resources and development capabilities.

The best way to hedge this risk is to diversify it away. I remain long in SNTA, PETX, EPZM, and BIND. At least one of these companies will likely fail. One or two others will probably do OK. One of them may go to the moon. I feel that SNTA may in fact be one of the safer plays, because the market has severely discounted past failures. I regard the CEO leaving as a potentially good thing. He displayed a tendency to zealously exaggerate drug potentials, and Glassdoor.com reviews were largely negative towards him in particular. Positive clinical results by the end of 2014 could propel this stock upwards over the next couple years.

Lessons for the Stock Market from Snowboarding

Having just returned from a trip to Vail, Colorado for some beginner snowboarding lessons, I can’t help but make a few comparisons to another interest of mine: investing.

In snowboarding you fall a lot, and it hurts. All it takes is one downslope tumble and suddenly you are on your back with what feels like a keg of TNT exploding inside your skull. Having the wherewithal and grit to hop back up is important. Nobody wants to fall, but you have to go out expecting it to happen, and do what you can to minimize the probability of such occurrences.

Doing what seems contrary often works best. It can be scary to be rocketing down a hill, but losing control of your faculties is the real concern. As you point the board downhill you pick up speed. Your body instinctively leans back onto your back leg, your body thinks that this will slow you down, but that is patently false. All leaning back does is surrender any control you had to the slope, and now you really are in danger. When things seem scariest, your first plan is often the wrong one. What you really should be doing is leaning forward, into the speed, to retain control of your snowboard. This is the only way you can eventually turn the board and slow down, but it also runs contrary to what our body is telling us.

Our instincts are sometimes irrelevant to modern-day situations. The world has changed quite a bit in the last 10,000 years, yet our primal fears have not kept pace. Things like snowboarding and investing did not exist then. Hence what seems mechanically counter-intuitive on an emotional level is the intellectually correct choice.

It does make sense to quit at some point, to pump the brakes and unstrap our feet from the board. The big questions investors should ask are:

  1. How long is our slope?
  2. Where are we?

Most importantly, be prepared to fall and to get back up.