Ken Kam's Best Ideas Blog

Investing in biotech can be the most rewarding investing you do. You’re helping to finance new drugs that help people who are sick, and sometimes dying. And those drugs, once successful, more than repay your investment.

But you have also have to try to figure out whether a developmental drug is likely to be a silver-bullet treatment, or something more like snake oil. Even with the best intentions, many simply won’t work out -- and particularly small companies may only have a few drugs in the pipeline.

There are no guarantees, but Elan is a good case study in why investing in biotech stocks is both so hard and so rewarding.

First the hard part

It takes a long time to bring a new drug to market. In Elan's case it took 12 years to move Tysabri (a drug for multiple sclerosis) from initial idea to an approved drug. Needless to say this is far longer than most people's investment horizons, especially those on Wall Street.

During those 12 long years, there were literally no sales -- zero, nada -- but there were lots of expenses. In cases like this, Wall Street's style of financial analysis often boils down to dividing the cash on the balance sheet by the expenses to estimate when the company will run out of cash -- a fact that is interesting but not insightful.

The problem is that the value of a drug candidate is not on the company's financial statements. It's in the clinical trial data. If the clinical trial data says that the drug is effective against a disease that affects a lot of people, there will be lots of money available to continue development. If the clinical trial data is negative, then it might be worth nothing, which by the way, is what's on the balance sheet.

Clinical trial data can often mislead investors because the FDA requires most clinical trials be designed to compare the new drug against a placebo. Since no patient who is benefiting from an existing drug would enroll in a clinical trial where there is a good chance of being put in the placebo group, it is typical for clinical trials to limit enrollment to patients who have already failed all existing treatments and thus have no alternative -- usually a small subset of patients who have the disease. As a result, many investors and Wall Street analysts underestimate the revenue potential of new drugs because they assume that when it's approved it will be limited to this small subset. However, once a drug wins FDA approval, the decision of whether to use it only after everything else has failed is left to the doctors and the patients. If existing drugs have side-effects, or are not that effective, few patients will want to try everything else first before the new drug.

Why its so rewarding

For a stock to have the potential to double in two years, the conventional wisdom about its value it has to be wrong in a significant way. Since biotech companies cannot be valued the same way Wall Street values most companies, Wall Street often gets it wrong thus creating lots of opportunities for investors who are willing to do some homework.

When a new drug works, it's value to patients is the main driver of the stock price rather than the plethora of things that are generally brought up in discussions of other kinds of stocks. In Elan's case, the decisions of MS patients will ultimately drive the stock's price. I think its fair to say that no MS patient's decision on whether to use Tysabri will be affected one way or the other by the level of interest rates, the outcome of next year's election, the price of oil, or any of a number of other things that investors typically lose sleep over.

Why I still like Elan

When I first put Elan in my Strategy Lab portfolio in December of 2005, Elan was trading at about $13. The Company had had to pull Tysabri off the market earlier that year after 3 patients came down with a potentially fatal complication. The stock which had been trading near $30 dropped to a low of $3 when all of Wall Street seemed to agree that Tysabri was never going to return to the market.

In reaching this conclusion, it seems that Wall Street forgot to seek the opinions of any MS patients. When I emailed the 1,500 Marketocracy members who owned Elan in their model portfolios, I got over 500 responses and about 100 of them were from MS patients. When almost all of them told me that they would switch to Tysabri if it reduced the number of relapses by 50% even if there was a 1 in 1,000 risk of contracting a potentially fatal complication. After hearing that, I felt confident enough that Tysabri would return to the market to buy the stock. It soon became the single largest holding in the Masters 100 Fund.

When it comes to biotech stocks, it pays to listen to patients instead of Wall Street analysts. Elan is now trading at $22. It has not quite doubled yet, but Tysabri revenues are just starting to ramp nicely. In the most recent quarter, Elan and Biogen sold $93 million of Tysabri, more than 11 times last year's revenue for the same quarter. Tysabri is currently used by only 17,000 MS patients. Since there are over 400,000 MS patients in the North America and Europe, there is a good chance that growth will accelerate in the coming quarters.

In addition, during their conference call Elan announced that their Phase III clinical trial protocal for Bapinezumab, a drug for Alzheimer's disease that they are developing with Wyeth, has been approved by both the FDA and CHMP the regulatory agency for the European Union. Alzheimer's affects 4 million people in the U.S. alone, so Bapinezumab is a much bigger opportunity than Tysabri, but it has a ways to go before there are any revenues. Still, this is a very big milestone, and I am surprised that Elan's stock has not moved much as a result.

Carl Icahn enters the picture

Carl Icahn seems to have more impact on Elan's stock price right now than clinical trial news or sales results. About a month ago, Carl Icahn announced he had acquired a stake in Biogen and talked as if he wanted to buy the whole company. Two weeks ago, Biogen retained Goldman Sachs and Merrill Lynch and put the company up for sale.

What's this got to do with Elan? Biogen owns 50% of Tysabri's profits. The agreement between Biogen and Elan says that in the event of a change in control at Biogen, Elan has several options:

1) Buy out Biogen's 50% share at a "market price."
2) Sell its 50% interest to the new owners of Biogen at a "market price."
3) Continue the agreement as is with the new owners.
4) Renegotiate the contract with the new owners.

Wall Street seems to have come to a consensus that since the choice of which option to take is up to Elan, Elan can only end up better off as a result of a change in control at Biogen. As a result, Elan's stock has been on the upswing lately.

Reading between the lines

I think you can tell a lot more about people's true intentions by looking at what they are doing (and have done in the past) than by listening to what they are saying.

Carl Icahn's track record tells me that he is proabably not interested in running Biogen but in breaking it up. I think this is the key to understanding Carl Icahn's plan. Others believe that the change in control provision that Biogen has with Elan for Tysabri, and a similar provision in the agreement they have with Genentech for Rituxan greatly complicates Carl Icahn's plan to take over Biogen. However, if Icahn's objective is to break up the company, the change in control provisions actually work in his favor. Who better to sell Biogen's crown jewels than to the companies that already own the other 50% of the same drugs?

Putting Biogen in play forces both Elan and Genentech to come up with a value for Tysabri and Rituxan. If Elan and Genentech value Biogen's half of Tysabri and Rituxan more highly than the market currently does (which I think is likely) then Carl Icahn stands to make a lot of money.

I think Elan's decision to engage Lehman Brothers to advise them supports this view. The Lehman Brothers analyst has been consistently wrong on Elan for the past 2 years. He currently says Elan is worth $12 a share, 45% below where it is trading. Why in the world would Elan want to hire these guys to advise them? Because if you want to buy Biogens half of Tysabri, you want the guy who thinks that Tysabri is not worth anything to be negotiating on your behalf.

It's interesting that Biogen has engaged Goldman Sachs because Goldman had been one of the more bullish firms on Elan with a $29 price target. So, in this negotiation, Goldman will argue on Biogen's behalf that Tysabri is worth a lot, and Lehman will argue on Elan's behalf that it's worth nothing. If they can reach agreement on a number that is higher than what the market currently accords Biogen for its half of Tysabri, then a transaction will occur in which Elan will purchase Biogen's half of Tysabri at a price that the market will initially regard as to high.

These negotiations will cause some big movements in Elan's stock, but I think it is just the sideshow. The real reason to invest in Elan is because of the benefit that Tysabri brings to increasing numbers of MS patients, and the progress they are making on Alzheimers.

In my research on Elan, the opinions I have found most valuable are those of MS patients. If you have had to make the decision about whether to use Tysabri, I would love to hear from you. Click on the "Comment" button to tell me your story.