Money For Nothing? This Stock Pick Makes It Possible

A version of this article ran inMorningstar Opportunistic Investoron June 18. We subsequently purchased Myriad Pharmaceuticals (MYRX) for about $4.50 per share. We think the stock is still cheap today.

We talk about spin-offs, an often-overlooked and potentially very lucrative corner of the investing world, regularly in our newsletter, Morningstar Opportunistic Investor. For those unfamiliar with the topic, a spin-off is basically a piece of a larger company that is "carved off" and becomes independent. Often, these are small and hard to analyze, creating all sorts of investment opportunities.

One such opportunity occurred on June 15, when Myriad Genetics (MYGN), a company specializing in gene-based cancer diagnostics, spun off its uninspiring pharmaceuticals division, Myriad Pharmaceuticals (MYRX). Normally, we wouldn't have cared. The pharma division, which is essentially a speculative biotech, has immaterial revenues and no products in Phase III development, and it is burning cash. As a result, we didn't pay much attention to this deal during the last few months. However, we believe the dynamics of the spin-off have created a very compelling opportunity.

The Deal
The spin-off was very simple. One share of Myriad Pharmaceuticals (MYRX) was delivered per four shares of Myriad Genetics (MYGN). MYRX received about $188 million of cash from its parent and will have next to zero liabilities. There are no contingent liabilities or tax issues.

Right after the spin-off, MYRX dropped like a stone, from a high of $7.50 to less than $4 at some points. Today, the entire company is worth about $115 million to Mr. Market. Careful readers will notice that this is a fraction of its net cash balance of $188 million--is there really free money for the taking?

How did this happen? It turns out, the conditions of this spin-off were extremely conducive to causing a major mispricing.

First, MYRX is minuscule compared with its parent, which then had a market cap of about $3.5 billion. MYGN investors frankly didn't care about the pharma business, because it didn't matter to MYGN's future. We perused a few sell-side reports, and not one bothered to come up with a decent fair value estimate for the tiny pharma division. Second, the parent is a solid, profitable business, whereas MYRX has so far been a disappointing money-loser. In fact, one common investor concern is that pharma's heavy research-and-development spending was clouding the parent company's true earnings power. Removing this burden makes MYGN's income statement look much better. Third, the investor bases of MYRX and MYGN weren't compatible, and MYGN is frankly a much-more-desirable property. The list of MYGN's largest shareholders is dominated by index funds and firms with a large cap and/or growth bent. For example, Fidelity was the biggest shareholder by far, with a teens-percentage stake. Some of the funds that hold MYGN probably wouldn't be able to hold MYRX shares because it falls outside of their mandates. We expected many of these institutional holders to liquidate their holdings in the months following the spin.

Thus, there was really no reason for anybody to like MYRX or even care about it. Many people probably sold their shares on reflex, and some institutions may have been forced sellers, almost halving the stock in three days.

The Drug Pipeline
We won't spend much time on this, as we freely admit that our understanding of the science is patchy. However, understanding the nitty-gritty of the science is not critical to understanding MYRX's investment merits. Nevertheless, here's our take.

The most important opportunity is cancer treatment, through a drug called Azixa. We expect Phase II results in late 2009. Azixa is currently being tested on an aggressive type of brain cancer and a type of aggressive melanoma that has metastasized into the brain. However, the technology may prove effective for a variety of tumor types. The reason for focusing on the brain is that the drug demonstrated an ability to naturally concentrate itself there, providing greater therapeutic benefits.

The cancer types Azixa targets have very few other treatments, but competition may be arising soon. Two other drugs developed along a similar theory (vascular disrupting agent) are currently in Phase III trials, with results expected in 2011. These two new drugs are being tested on different cancers than Axiza (such as lung, breast, and so on), but if they prove efficacious, they may eventually be approved for additional cancer types or doctors may use them off-label. Furthermore, there are a few competing products developed using different theories targeting brain cancers and melanomas. We expect results from these around 2011, as well.

Besides its cancer drugs, MYRX also has two prospective HIV drugs--Vivecon and Bevirimat. Both compounds are similar in nature and are still in the early stages of development. The HIV landscape is very competitive with established therapies and some generic competition. The compounds are also becoming more complex adding to the cost of development and risk.

 

What's It Worth?
We can't take for granted that any negative cash-flow company is worth something. It's possible for such companies to burn through their cash slowly and eventually die. However, we don't think MYRX deserves to trade for such a large discount to cash.

MYRX is burning cash, but not rapidly. The company has about three years of cash left, and we'd bet that can be stretched if necessary. MYRX is also not a one-hit wonder. Instead, it has three main compounds focused on two large therapeutic areas, and results start coming in during the fourth quarter of 2009. Thus, we have a ready-made catalyst in the next few months to close the valuation gap.

MYRX's image was tarnished last year when it dropped its only Phase III drug, Flurizan (an Alzheimer's disease drug), because of efficacy issues. However, Flurizan's target disease and technology have nothing in common with MYRX's other drugs. Some biotechs develop a raft of therapies based on a single theory or technology--the failure of one would speak very loudly for the prospects of the others. In this case, we think the various drugs' results would be largely independent of one another, and the Flurizan failure need not be an indelible stain on the firm's future.

To believe MYRX should trade for a significant discount to cash, one must not only believe that its past R&D dollars had been wasted, but also that it will waste its future R&D dollars. The market apparently believes in this, but we don't see any good reason to do so. Granted, developing drugs is a risky and often fruitless task, but we don't see MYRX systematically throwing its money down the drain.

Empirically, it's also rare for a biotech to trade significantly below cash. A recent screen showed that among 127 U.S.-traded biotechs with market caps above $50 million, only one--Facet Biotech (FACT)--trades for below cash.

The biggest challenge of course is to value the drug pipeline. We don't claim to be experts. However, we feel confident in saying that the pipeline at the very least has a small positive option value. Given the massive uncertainty, it's probably impossible to accurately value these things. But we know that the target markets are fairly large, and that if approved, these drugs would probably sell well--easily several hundred million dollars each a year. As a low-ball guess, we value this call option at $50 million. It doesn't take heroic assumptions to get to this number.

Thus, when combined with the cash, we think the company is very conservatively worth somewhere around $240 million, or roughly $10 per share. If the results later this year are good, that value may increase dramatically.

Game Plan
We purchased MYRX at about $4.50 per share, versus a current price of $4.85. We wouldn't be surprised if this story works out relatively quickly, as the stock converges on cash value. If this happens, we'll probably trim our holdings back. The key event in the next year is the Azixa results in fourth quarter of 2009. If the results are bad, we'd probably be sellers, unless the stock is still trading for a huge discount to cash. However, if the results are good, we expect to make a lot of money, and may hold onto our position. Good results open up a lot of interesting strategic possibilities for MYRX, including joint ventures and partnerships with major drug companies. We'll probably have to do a lot of blocking and tackling when the time comes, but we'll worry about that when we get to that point and gain some visibility.

If you liked this article, here isanother samplethat we recently published, highlighting a compelling stock opportunity.

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