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Don't Bail on Biotech

We see opportunity as fleeing investors trigger an irrational sell-off.

Lauren Migliore, 11/04/2011

The biotechnology sector has been hit especially hard as investors flee high-risk assets amid recent market uncertainty. Compounding this heightened risk aversion is increased concern regarding product concentration for one-drug operations and the ability of development-stage biotechs to access equity markets in the wake of plummeting stock values. Furthermore, Dendreon's DNDN announcement that sales of prostate cancer drug Provenge will come in well under the market's initial expectations for the year caused a ripple effect throughout the sector as investors dumped shares of firms nearing the launch of other highly anticipated drugs. Investors also appear to be unloading shares of unprofitable biotechs with dwindling cash balances on the concern that volatile market conditions will limit firms' ability to raise capital.

We think the market's indiscriminate sell-off of risky assets presents attractive risk/reward trade-offs for investors who can handle the ride. Specifically, market overreaction has pushed shares of Dendreon, InterMune ITMN, Exelixis EXEL, Savient Pharmaceuticals SVNT, Vanda Pharmaceuticals VNDA, and MannKind MNKD to attractive levels, in our opinion. With the exception of MannKind (which enjoys the financial backing of billionaire entrepreneur Alfred Mann), all of these biotechs have at least a year's worth of cash on hand, which should provide them with more flexibility to wait and tap the equity markets under more favorable conditions.

Dendreon: We think the market's overreaction to the firm's commercialization troubles presents a buying opportunity. In its second-quarter results, the company withdrew its sales guidance for Provenge (often referred to as the "world's first cancer vaccine"), causing shares to plummet 65% overnight. The drug is one of the most expensive cancer treatments on the market, and concern over its high price tag prompted the Centers for Medicare & Medicaid Services to conduct a national coverage analysis for the drug during the last year. Although Dendreon received a favorable ruling in June, it seems the company has done a bad job educating physicians about Provenge's coverage status, and persistent reimbursement uncertainty has resulted in stagnant sales. Although we have significantly lowered our sales forecast for the company's sole marketed product, we think Provenge remains an important treatment option for prostate cancer patients. Provenge has demonstrated the ability to meaningfully improve survival without the toxic effects of chemotherapy. The novel immunotherapy has been shown to extend median survival by 4.1 months in clinical trials, putting it on par with some of the most efficacious cancer drugs, like Roche's RHHBY Avastin. The steep sell-off in Dendreon's shares is unmerited, in our opinion.

InterMune: Dendreon's announcement that Provenge sales would come in well under the market's initial expectations caused a ripple effect throughout the biotech sector as investors dumped shares of firms nearing the launch of other highly anticipated drugs. With its stock price falling 25% since Dendreon's announcement, rare-disease-focused biotech InterMune has been no exception. Despite securing the blessing of a Food and Drug Administration advisory panel, InterMune received a complete response letter for lead drug Esbriet, which is for the treatment of idiopathic pulmonary fibrosis. However, the firm received marketing authorization for Esbriet in Europe at the end of February, and we expect the drug to contribute meaningfully to revenue next year. With the potential for orphan-drug exclusivity and a critical unmet need among patients, we think Esbriet can claim a hefty price tag and garner InterMune blockbuster sales once it eventually reaches the worldwide market. InterMune plans to conduct another Phase III trial to support domestic approval. We think the drug eventually will clinch FDA approval considering the lack of treatment options for the disease, its prior regulatory approval in Japan, and its demonstrated efficacy in one of two Phase III trials. Esbriet could hit the U.S. market by 2014, potentially propelling the firm to profitability that same year. We believe Esbriet has the potential to generate $2 billion in peak sales once it makes it to market worldwide.

Exelixis: Exelixis' shares have been under pressure since Bristol-Myers Squibb BMY decided last year to pass on co-development rights to Exelixis' lead drug candidate cabozantinib. Bristol instead chose to focus on its own late-stage oncology pipeline rather than broaden the scope of cabozantinib's development plan. Exelixis shares have fallen more than 40% since this summer as investors shed high-risk assets and register their concern about the firm's lack of funding support for cabozantinib, especially following the firm's inability to secure a Special Protocol Assessment from the FDA. Yet promising data released after Bristol's decision reinforced our optimistic assessment of cabozantinib's potential, and we think retaining exclusive rights could turn out to be a net positive for the firm if it is able to partner cabozantinib under more attractive terms further down the development timeline. In a midstage randomized discontinuation trial, Exelixis reported that cabozantinib demonstrated broad activity across multiple tumor types. Most significantly, cabozantinib demonstrated a very high disease control rate and reduction in bone lesions in patients with metastatic castrate-resistant prostate cancer. Bone metastases are the primary cause of prostate cancer morbidity and mortality, and cabozantinib appears to have a differentiated mechanism of action through simultaneous effects on both soft tissue and bone metastases. This benefit is distinct from any other agent: Chemotherapy has a modest impact on survival but no impact on bone disease, while bone-targeted therapy fights lesions but does not deter cancer progression. We expect Exelixis will conduct multiple regulatory filings for its lead drug. If successful, we think cabozantinib could bring in more than $1 billion in sales for prostate cancer alone.

Savient Pharmaceuticals: Higher-than-expected costs, uncertainty around the firm's European plans, and a 500-point decline in the Dow sent shares of Savient tumbling following its report of second-quarter earnings. We have lowered our fair value estimate, but we still think the sell-off has created a buying opportunity. Our revised fair value has pushed back the firm's break-even point to 2014 due to higher selling, general, and administrative costs, lowered our United States peak sales for the firm's gout treatment Krystexxa to $500 million from $600 million, and lowered the chance of a European partnership to 25%. With no commercialization experience and Savient's attention focused elsewhere on selling its business, Krystexxa's launch was destined for a slow start. However, we do not think the slow launch necessarily signals a lack of demand for the treatment. Savient has faced a number of mostly temporary setbacks that have delayed Krystexxa's launch, but we expect them to dissipate during the next year. Savient is now fully staffed with its salesforce, managers, and marketing team for Krystexxa, and we think the firm's attentions are now solely focused on the drug.

Vanda Pharmaceuticals: A surprise approval following a nonapprovable letter from the FDA and a new commercialization deal with Novartis NVS propelled Vanda's stock price from $1 per share to nearly $15 per share in May 2009. However, since then, the stock has fallen dramatically as investors have registered their disappointment with Fanapt's slow start and the product concentration risk of Vanda overall. Although sales growth continues to track below our expectations, we believe Fanapt has not been given enough time to gain traction in the market. The drug demonstrated good efficacy and a favorable side-effect profile in trials, and we think it eventually will make it into the prescribing rotation of doctors accustomed to cycling schizophrenia patients through multiple drugs. In the near term, we expect prescription growth in the U.S. to be supplemented by Fanapt's expansion abroad. In addition, we think Fanapt's growth trajectory could be further enhanced by approval of a long-acting formulation of the drug. A long-acting injectable formulation has the potential to boost efficacy and compliance for patients and could represent an important new treatment option. Vanda also announced that it has expanded its clinical development program for remaining pipeline candidate tasimelteon. If trials prove successful, we think tasimelteon potentially could add to revenue as soon as 2013. The firm's existing valuation near cash levels implies minimal sales of Fanapt, limiting the potential downside for investors. We think the upside remains significant should Fanapt gain traction or Vanda's remaining pipeline drug sees approval.

Lauren Migliore is a stock analyst with Morningstar.

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