Wednesday, November 25, 2009

Biotech Stocks - Beware of The Covered Call Trap


Years ago when I worked in retail brokerage, I knew a broker at another firm, who specialized in pitching covered call plays. He would explain to clients how with covered calls you take your profits upfront and the premium you just collected gives you a nice cushion to the downside. Say you buy stock ABC at $10 and sell the $10.00 strike calls for next month at $2.00. If the stock price at expiration is at or above $10, your calls are assigned at $10 - you break even on the stock, and you keep your $2 premium for each of the calls, for a 20% profit. Even if ABC is down a bit, say at $9.50 at expiration, you still make money. The calls expire worthless, you are down $.50 on your ABC, but you still have your $2.00 from the call you sold, so your profit is $1.50 and you get to sell the calls against your ABC again next month. The only way you can lose money is if the stock is down more than the $2.00 per share you collected for each call. My fellow broker would promise clients to minimize a potential loss by putting a stop loss order for ABC at $9.00 and buy the depreciated calls back if the stock ever dropped to that level.

Sounds like a good plan right ? I mean, how can you lose ? With the calls yielding 15% or 20% per month and minimum downside risk, this broker looked like a market genius signing up several new clients every day. Unfortunately, back then and to this day, there is no free lunch in the market and stocks that have high-yield calls are always the stocks with very high price volatility. The broker would pick the stocks with the most expensive calls, not bothering with what the companies actually did, because he "knew" he can always sell them if the price dropped 5-10%. By this method, his clients often ended up owning biotech stocks, which as an industry are not only some of the most volatile, but the absolute worse for selling covered calls against.

I know of no other industry, where a single announcement could literally make or break a company. An FDA decision or the results of a pivotal experimental drug study routinely cause 50% moves in either direction. And since these announcements are usually made pre-market or after the market close, your $9 stop loss order will kick in when the market opens the next day, and your stock is already down from $10 to $5. Of course, you have to buy the calls back first before you sell your ABC at $5, otherwise you'd have the calls naked. Hopefully by the time you close your call position, the stock ABC has not dropped further down to $4. Yes you still have $2 profit on the call, but you just lost $6 on the stock, so overall you're down $4 or 40%. Of course if you had bought ABC on margin, you just lost 80% of your investment.

Selling covered calls against biotech stocks was a recipe for disaster then and it remains so today. Below are 3 recent examples, that devastated the covered call sellers.

Take a look at Poniard (PARD) which was trading around $7.00 all day on October 27. The December $7.50 calls were selling at $2.50. The calls yielded 36% over less than 2 months !!!! However this supposed boon for covered call sellers, turned into a bust when PARD opened at $1.77 on November 16th (down from $7.58 at the close of the previous day). The $2.50 call premiums collected, were small consolation for the $5.23 ($7.00 - $1.77) loss on the stock.

Or let's say you bought Osiris (OSIR) at $14.50 on September 02, and sold the Sept $15 calls for $2.50. Wow, that's 17% yield in 2 weeks ! However, just 6 day later, on September 8, OSIR opened at $7.40....That's a $7.10 loss on the stock (less the $2.50 you made on the calls) a loss of $4.60 or 32%.

And here is another - GTX Inc (GTXI) traded around $12.50 on September 21. One of the bests calls to sell was the November $15.00 which was selling for $2.80. Just 10 days later, the stock opened at $5.80 on November 2nd, a $6.70 loss on the equity for those who bought the stock at $12.50 (less their profit of $2.80 on the call of course).

In the above examples I have quoted the opening prices the days the stocks collapsed as these were not gradual declines over several days giving investor a chance to get out, but overnight changes of value, that could not be avoided even if you had a stop loss order in place or were watching every tick in the price during market hours.

Covered calls is a conservative strategy and in fact is the only use of options allowed in IRA accounts, but could bring disaster when not used wisely. Limit your covered call selling only to blue chip companies, that you already own. These calls will yield 1-2%, but stock price declines tend to be small and gradual, giving you plenty of time to take a small loss and get out. Don't be tempted by the expensive calls of risky companies, and NEVER sell covered calls on Biotechs.

Disclosure: The author purchased $2.50 calls on PARD after it collapsed to its current levels.

Tuesday, November 24, 2009

PARD - Azimuth Opportunity Bets on Poniard's Survival. Should you ?

I was poring over Poniard Pharmaceuticals' past press releases and financial reports this weekend, wondering how close this Biotech really was to shutting its doors forever. Things certainly did not look rosy.

Last Monday, November 16 the company had announced that the pivotal Phase 3 trial of its lead drug Picoplatin on relapsed and progressing cases of Small Cell Lung Cancer (S.C.L.C.) had failed to meet primary endpoint. The news cause the stock to open at $1.77, down form a close of $7.58 on Friday, wiping out 77% of the company's market cap in the blink of an eye. The next day, it bounced back by 35%, closing at $2.48 on positive news for the drug's Phase 2 Trials in the treatment of colorectal cancer - a nice pop, but hardly a consolation for those investors owning the stock at $7 or $8.

Devastating news are common in the Biotech industry, but what made the story much worse is the company's financial condition, creating serious doubt whether Poniard will be able to fund the drug's upcoming trials. The company reported cash and marketable securities totaling $40 million at the end of the September quarter. PARD has an $18 million loan on its books that requires the company to maintain cash reserves at least equal to the outstanding balance on the loan. Total expenses for last quarter were approximately $10 mln, a $2 mln decrease from same quarter last year, and expected to decrease further as the testing of Picoplatin is now in its final stages. The company has no revenues and no approved drugs selling in the market.

It is common for small biotechs to partner up with established pharmaceutical giants for the development of a specific drug. The larger partner would help fund the studies and FDA approval expenses in exchange for the lion's share of the profits if the drug is approved. However, so far Poniard had been unwilling or unable to enter a partnership for Picoplatin. Analysts speculated that CEO Jerry McMahon was waiting for the results of the pivotal Phase 3 trial in Small Cell Lung Cancer, to put Poniard in a stronger negotiating position in a potential partnership agreement.

As I saw it, while researching PARD this weekend, the small biotech found itself with a major setback in its Picoplatin experimental trials, no funding partner, and hardly any cash to continue the studies on its own. I consider this very unfortunate as the drug Picoplatin is not without potential.

Picoplatin is currently in Phase 2 studies for Colorectal Cancer and Metastatic Prostate Cancer. As Tuesday's press release on colorectal cancer studies showed, Picoplatin's efficacy is comparable to that of commercially available drug Oxaliplatin, with much less side effects. Seven patients who were on oxaliplatin, chose to discontinue the study due to neuropathy vs. zero patients taking picoplatin. If picoplatin is safer than an already approved drug, then chances for its own approval seem pretty good. Of course, before PARD can file the NDA (New Drug Application), a Phase 3 trial will need to be completed on a much larger patient population, and safety and efficacy further evaluated. And here is where Poniard's cash shortage comes in to put a wrench in the works.

Then this Monday, November 23 Poniard announced it will be able to tap its existing equity financing facility and raise $7.4 mln through the sale of 3.5 million shares at the discount price of $2.15 to Azimuth Opportunity. Azimuth has bought minority stakes in numerous development stage biotechs in the past. These registered stock deals are similar to PIPEs, or private investment in public equity, and allow the companies to avoid the time consuming and sometimes pricier route of secondary public offering. While investors were aware of this funding option, where PARD can sell up to 60 million shares to Azimuth as long as the stock price is not below $3, the current depressed stock price made accessing the financing seem impossible. Azimuth's purchase of Poniard's stock will allow PARD to fund its clinical trials and business operations through mid-2010, CEO McMahon said.

While the sale obviously dilutes shareholder equity by increasing the float by appoximately 10% and has a short term negative effect on the price, it is a relief for Poniard's long term investors. It buys PARD more time at a crucial moment, when many like myself wondered if all is lost.

As expected when a company sells new stock below the market price, the PARD has slid from the open of $2.50 on Monday to the levels of Azimuth's discounted purchase price of $2.15 today. I expect it to remain in the $2.15-$2.20 range for the next few days. If the stock holds the $2.15 support level, it will be seen as a positive sign. Short of additional positive news, appreciation will be a somewhat uphill battle in the next couple of weeks, as Azimuth will be looking to book some profit from its investment and sell some of its just purchased PARD stock into rallies. However this profit taking will not hold the price down for too long, as the investor's 3.5 mln shares can be easily drowned in a good news day such as last Tuesday, November 17th when near 36 mln shares traded pushing the price 35% higher.

And really, a lot can and will happen with Poniard in the next 6 months. A positive event such as securing a new line of credit, entering a partnership agreement for Picoplatin, a takeover announcement or continued positive results from the clinical studies can each send the stock flying. Of course, another major clinical results disappointment, can make securing any new financing out of the question, so certainly Poniard's executives have not a minute to waste.

So is there a play here ? Investors, not opposed to the occasional small-stakes speculation can buy the stock here and ride the swings with Poniard. I think it is very likely we will see PARD at $2.50 or even $3.00 within a month or two even without major positive news. At this point, you would be smart to take profit on 1/2 or 2/3 of your position. Reversely, a drop below $2 without any actual negative news would signal a very bearish short-term view of PARD, and you should protect yourself by putting your Stop Loss at the $2.00 level.

Personally, I'm somewhat bullish on PARD short term, and believe in this case options provide a better risk/reward than owning the stock. I bought the December 2.50 calls, which are selling for $.20 today. A $.35 move of the underlying PARD back to the $2.50 level, will value the calls at .$50 (ask) - (delta is .83), with the bid at $.40, giving me 100% gain. At that point my plan is to sell 2/3 of my calls. I will likely leave about a third of my calls open as a sort of a free lottery ticket, in case of a positive announcement by the company. I'd give it a better than 50/50 chance I'd double my money with the calls and maybe a 5% or less chance of 300% or 400% gains.

In addition, I sold the March $2.50 puts at $1.00. This is my bet that PARD will still be around, come the spring, which now with the funds raised through the equity sale seems more than likely. Even in the absense of major news, if PARD remains at current levels in the next few months, note that the price of the put today consists of $.65 time value, which will slowly erode down to nothing by expiration. So whether the stock is up or unchanged in 3 months, I will be profitable. Selling naked puts is often described as almost as risky as naked calls, as the stock can potentially go down to zero, at which point the put buyer will sell a worthless stock to me that I must buy at $2.50. However I will buy the puts back quickly for a 10-15% loss if the stock breaks below $2.00, as I have no intention of riding PARD down to zero in the unlikely event that the stock price deteriorates further from the current fire-sale price levels.

Remember that the above described option positions are high-risk plays and you may lose you entire investment in them. Do not risk more than 5% of your portfolio in all speculative positions such as these combined.


Disclosure: The author is long the December $2.50 calls and short the March $2.50 puts.

Saturday, November 21, 2009

ISIS -Tuesday's Drop Presents a Nice Buy Opportunity



Shares of Isis Pharmaceuticals (ISIS) dropped about 17% on Tuesday, November 17 to close at $11.12, down from a previous close of $13.40. The selloff was a reaction to Isis and partner Genzyme(GENZ)'s presentation for Mipomersen Phase 3 Trials data for treatment of HoFH during at the American Heart Association's scientific sessions the same day. The results of the study appear very promising, with a 25 percent reduction in LDL-cholesterol after 26 weeks of treatment, vs. 3 percent for placebo patients. In fact, some patients even showed a "very impressive" 70 percent or 80 percent reduction, so why the negative reaction of the market ?

The main price trigger here was not the apparently glowing results of the treatment which were known since May of this year and already priced into the stock. The selloff was mainly caused by Isis announcing it will seek FDA and EU approval for the drug by mid 2011, as opposed to second half of 2010 as previously expected. In addition, a smaller factor was, as one analyst put it "the potential risk of liver damage to patients." I will address both matters below, and explain why I feel this is an overreaction which presents a Buy opportunity for those willing to dig a little deeper.

Potential Risk of Liver Damage. 12% of the patients treated with Mipomersen exhibited elevated levels of liver enzymes above 3 times ULN (upper limits of normal). One patient whose levels were up to 8 X ULN was released from the study. Elevated liver enzymes are monitored as an early warning for potential liver damage. However I'm not sure how much of a real price factor this data should really be viewed as, considering these results were previously disclosed (and priced in) and they are simlar to previous Mipomersen tests.

I am not particularly worried about this becoming a threat for the FDA approval of the drug either. For starters, all but one of the patients (50 out of 51) were already taking (and continued to take during the trial) maximum doses of cholesterol-lowering statins and in addition 3/4 of them were also taking common cholesterol meds such as Lipitor, Zetia and others. Add a very high dose of Mipomersen - 200 mg to this cocktail, or any other drug for that matter, and elevated liver enzymes should not come as a huge surprise. When the study ended after 26 weeks of treatment, patients' enzyme levels dropped back with no evidence of any liver damage.

HoFH (homozygous familial hypercholesterolemia) is a rare genetic form of the FH condition, characterized by very high cholesterol levels since early childhood, causing severe risk of heart problems and limited life expectancy for patients. Even if the risk of potential liver problems proves to be legitimate, for the people living with the daily threat of a heart attack and death, this potential risk it is not exactly a deal breaker.

Isis is also currently conducting a Phase III study on heterozygous FH, which is the much more common and much milder form of FH, affecting 1 in 500 people worldwide. It is possible that this patient population, taking lower doses of statins, will be able to tolerate the same dose of Mipomersen with reduced number of cases of elevated liver enzymes. The results are expected in Q1 of 2010. In addition, another Phase 1 study on the rare HoFH form patients is to begin in Q1 with varying times of application per week of Mipomersen, with the goal of comparing efficacy and tolerability for 30 mg daily injection, a 70 mg injection three times a week, and a 200 mg weekly injection (same as current study), each compared with placebo. This is to be followed by a longer study with varying doses of the drug. It is not uncommon that a lower dose could be just as effective, yet much safer for patients.

The Delay of the FDA and EU application. I agree that the 6 months to a year delay is a just cause for some time discount on the stock, however a 17% one is highly exaggerated, especially in the current very low interest rate environment. I believe it is not the actual number of months of delay investors reacted to on Tuesday, but a fear of some hidden undisclosed reason for the delay. Let's not forget that in this hair-trigger industry, a delay of trial results or FDA decision by just a few days often leads to huge selloffs, later to be made up by big rallies if the news is positive when it does finally come out.

It is true that this Phase 3 trial was the last of 4 studies concerned with the rare HoFH form, and striclty from a medical point of view, Isis should be ready to go ahead with the FDA new drug application. However, there are several Mipomersen studies in 2010, which show the company's intention to explore the possible application of the drug in additional cholesterol markets and also to find the best dosage in terms of both efficacy and tolerability. Studies on the much larger HeFH population (read: larger market for the drug) are scheduled through 2010. Also the company is testing Mipomersen application for treatment of hypercholesterolemic patients at high risk for coronary heart disease and results of the Phase 3 are expected in mid 2010. In addition there is the study mentioned 2 paragraphs prior on varying times of application per week, which is only in its first phase of trials and will not see the results of Phase 3 until probably early 2011 (my estimate), as some of these are 26 weeks studies.

Botom line - Mipomersen works for HoFH patients, in fact quite spectacularly in some cases. There are potential risk of liver side effects, but many drugs do in high doses. Now that it is proven the drug is effective for this high-risk but rare condition, Isis is looking into other much larger closely related markets and continuing to tweak with the perfect dosage in terms of both tolerablity and efficacy before submitting the FDA application. For my money, the much more common and milder HeFH-form patient population is a much more lucrative market and makes it worth the delay. The treatment of HeFH is practically a given in terms of efficacy, since Mipomersen is now proven for the very hard to treat HoFH form.

ISIS continued ability to fund the upcoming studies. Obviously Isis has numerous studies planned for 2010, so given the large expenses associated with them, some may question whether the company will be able handle this spending load and what it would mean for the stock price if the company fails to do so. The industry is chock-full of single-drug startups with no revenues, which need to rush filing the FDA application in an all-or-nothing bet before they run out of money. Isis, on the other hand, can well afford to continue the studies a bit longer, for the benefit of identifying the most lucrative market and the best dosage and application method of their promising new drug.

Isis is one of the veteran companies in the business with several drugs already approved and being distributed commercially through partnerships with major pharma companies. Isis has licensing and royalties revenues of almost $90 mln for the first 9 months of 2009 with 130% operating margin. The company has $612 mln in cash reserves, with just $140 mln debt. In addition, Isis partner in developing Mipomersen - Genzyme (GENZ), one of the blue chips in the industry with a large treasure chest, will certainly not allow studies on this promising drug to be abandoned due to lack of funds.

How to play this opportunity. I believe that a long position at the current price level should be able to gain 20% plus in the next 2-3 months with little downside risk. We may see (although unlikely) another test of the 52-week low at $9.90 from almost a year ago, however considering that this company has $6.22 cash per share, and about a dozen other drugs currently being developed and tested in its pipeline, a drop below $9 is extremely unlikely. I would hold the stock up to and sell right before the next study release in early 2010, as these events and the market's read & reaction can be highly unpredictable (as shown this Tuesday). Biotech stocks tend to uptrend in the expectation of events, and I believe ISIS will do just that, especially relative to the current low price level.

Disclosure: The author, following his own advice, has a long position in ISIS as of Friday, November 20, 2009.

Sources: Reuters article from Tuesday Nov 17, 2009 11:28am EST

The posts on this blog are the author's opinions and do not constitute an offer to buy or sell securities nor should they be considered investment advice.