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Biotech's Latest Loser May Make for a Great Trade

By Dr. George Huang
Wednesday, December 19, 2007

Doctors wrote up nearly 50 million prescriptions for sleeping pills last year.
With pills costing $3 to $5 a pop, it's a $3.7 billion business. Ambien, the king of sleep aids, will bring home more than $1 billion in sales to Sanofi-Aventis (SNY). Lunesta isn't far behind – sales should reach at least $600 million on the year, making up a big chunk of parent company Sepracor's (SEPR) revenues.
Until recently, it looked like a newcomer was ready to challenge these drugs' dominance. Indiplon, by Neurocrine Biosciences (NBIX), worked better: It knocked people out faster and kept them asleep with fewer of the creepy side effects that have plagued other prescription sleep aids (Ambien's been known to cause sleep eating and sleep driving).
But, back in May 2006, things started to go wrong for Neurocrine and its lead drug...
The FDA handed the company an "approvable letter." Approvable letters basically say that the FDA will approve a drug... so long as certain conditions are met. In this case, the FDA asked for more data on the drug's safety and efficacy. Investors panicked, and dropped the stock from $50 to about $20.
One month later, the drug's Big Pharma partner Pfizer (PFE) returned full rights over Indiplon to Neurocrine, taking its financing and marketing muscle with it. Once again, the stock got pummeled... this time to less than $10 per share.
Then, last week, Neurocrine received a second approvable letter. The FDA wants two more costly clinical trials. Neurocrine shareholders got a 40% haircut on the news and have been watching the stock drift lower since.
At this point, I don't believe Indiplon will ever be approved in the U.S. But that doesn't mean Neurocrine is worth nothing...
A lot of money can be made trading biotech stocks after the FDA hands out its infamous approvable letters. Inevitably, investors panic, sometimes dumping stocks that still have plenty of value. My research has shown that by investing in certain biotech companies that have suffered an FDA setback, investors can make as much as 25% in three months and more than 50% in a year's time.
But I have four questions to answer before I decide I'm looking at a no-brainer trade:
  • Are there more drugs in the pipeline? (In other words, is this company a one-trick pony?) 
  • Does management have experience bringing new drugs to market?
  • Is the FDA's request reasonably achieved? 
  • Is the stock cheap? 
Let's take a look at Neurocrine. For one, the company has only $50 million in debt and about $155 million in cash. If it makes the right decisions, that should be more than enough cash to keep the lights on for two or three years while it follows up on its pipeline...
Right now, the company has a drug for endometriosis (a disease of the uterus) in Phase IIb clinical trials. Results are expected in mid-2008. Also, it has drug compounds in collaboration with GlaxoSmithKline (GSK) for anxiety and irritable bowel syndrome, which are in the Phase IIa testing stage.
And if all goes well in trials, these drugs should have a bright future... CEO Gary Lyons worked at biotech giant Genentech in the early '90s and was responsible for the commercialization of Genentech's first two products, Protropin and Activase, which were some of the earliest biotech drugs to market.
But a promising pipeline and seasoned management aren't enough. Two things would need to happen before I considered touching the stock...
1. It's time to put Indiplon out of its misery. The drug has already been tested in more than 7,500 patients, at a cost of more than $100 million. Another two trials for the drug, with several thousand more patients, would cost as much as $50 million.
The company might as well throw this cash in the garbage if it decides to initiate more trials. Hopefully, Neurocrine's management takes this chance to prove itself wiser than that.
2. The stock has to get even cheaper. If we remove Indiplon, and the associated cash burn, from Neurocrine's valuation, the company has an intrinsic value of about $170 million, or around $4.50 per share... That's at least 3% lower than where it closed last night.
As my colleague Rob Fannon explained in his essay on drugmaker Dendreon, it's crucial to be on the right side of the equation when you're investing in biotech.
It's not time to buy yet, but keep an eye on Neurocrine. Shares are near fair value. If management takes the right path, the stock could see some big gains quickly.
Good investing,
George Huang

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