Thursday - March 30, 2006

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In our most recent interview with senior pharmaceuticals analyst Jason Napodano, CFA, we discussed the strong valuation plays that can be made in Big Pharma companies. Today, we wanted to look at some of the small-cap biotech firms that show the most promise.

Which small-cap biotech stocks are most interesting to you at this time?

I’d like to first just say that when it comes to biotech, I don’t like to pinpoint just one or two stocks. For me, I take more of a basket approach, and, by the way, I’d advise investors to do the same when considering investing in this market.

That said, one biotech company I really like right now is called ACADIA Pharmaceuticals (ACAD). This company has two phase II drugs with three indications. The first drug is called ACP-103, which is developed for psychosis associated with schizophrenia as well as psychosis associated with Parkinson’s disease treatment. Parkinson’s disease, as you probably know, affects motor functions that affects a person’s ability to walk or move; it’s what we call a neuromodulator disease. The treatment for Parkinson’s is called dopamine replacement therapy, as dopamine is a neurological transport. But the problem with this treatment is that roughly 30% of patients who receive dopamine replacement therapy experience psychosis associated with excess dopamine. This leads to hallucinations, delusions, hearing voices, that sort of thing.

So although getting Parkinson’s disease is obviously bad, the treatment is also really bad for about a third of its patients. ACADIA is developing ACP-103 to both enhance treatment by way of helping improve motor functions and also reduce the psychosis. In effect, this drug is a Parkinson’s disease treatment treatment. And because psychosis-related problems represent a large market, there is a very large opportunity for this drug here. Positive phase II data came out early this month, and I’ve even spoken to a company representative earlier this week. They’re expecting to move to phase III trials later this year, and I am expecting good things there, as well.

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Zacks Equity Research continued...

This same drug – ACP-103 – is also being tested for the treatment of schizophrenia that’s not Parkinson’s related. It essentially does the same thing: brings down and normalizes dopamine levels in the brain to reduce hallucinations and so forth. Another drug developed by the company – ACP-104 – is also being tested in the treatment of psychotic episodes associated with schizophrenia.

This is an enormous market. At $20 billion in sales, anti-psychotics represent one of the largest markets in the pharmaceutical industry. If ACP-104 is successful as a treatment for psychosis, or if ACP-103 is successful as an add-on therapy, then ACADIA’s sales numbers will be huge! This is what’s exciting about ACADIA – it’s only got a market cap of around $350 million, but with a couple big hits here, this stock could wind up being a 10-bagger, based on how large this market is.

Major players in the schizophrenia market – Johnson & Johnson (JNJ), AstraZeneca (AZN), Eli Lilly (LLY), Novartis (NVS) – are all enormous companies; they represent some of the top ten pharma companies worldwide. So, if you take, for example, JNJ’s schizophrenia drug Risperdal, that company might decide to make ACP-103 a potential add-on treatment and either become partners with ACADIA or simply buy the company outright.

Which would be more likely in a case like this – licensing a particular drug or buying the whole company?

It’s interesting. The more a company like ACADIA stays under the radar with its data remaining good, the better the chance of a straight buy-out. The more people discover this company’s potential and the stock rises, the less of a chance for a buy-out. Right now, a major pharmaceutical company could definitely buy ACADIA for under a billion dollars. But three, four months down the road if the company’s market cap goes up significantly, and suddenly a major player has to fork over $2 billion for it, they may not want to pay that much.

So the big pharma company might just say they’d rather just license and market the drug, which would give ACADIA, say, $20 million and 20% of sales. That’s still a good place to be as an investor in shares of ACAD. Assuming the remaining trials for the company’s drugs turn out well, I see some sort of partnership unfolding. JNJ or Lilly could obviously sell ACP-103 a lot better than ACADIA could at this point. What eventually will happen remains to be seen, but either way, from an investor’s standpoint, you’re probably going to win.

What are some other small-cap biotechs on your radar right now?

Another similar company to ACADIA is Arena Pharmaceuticals (ARNA). Both of these are Southern California central nervous system-oriented biotechs with small market caps. Arena has a drug in phase II trials being developed for obesity. Now, the obesity market may just be the most underserved, underpenetrated large market in the industry. What’s more, we haven’t seen any successful drug candidates for the treatment of obesity since Phen-Fen. And all that drug did was cost Wyeth (WYE) $16 billion in legal liabilities.

This drug candidate, called APD-356, has demonstrated that over 12-18 weeks patients can lose 8-10 pounds. This is significant. With a normal routine of diet and exercise, users of this drug can drop an additional ten pounds in three months. We see a huge market opportunity here.

Arena’s other phase II candidate is APD-125 for the treatment of insomnia. Though the insomnia market has come a long way with drugs like Lunesta and Ambien, it affects a very large number of people without many drugs on the market. This is partially because drugs like this are messing with large levels of serotonin in the brain, and the FDA is not always so comfortable with that.

This company is still flying under the radar, as its drugs are still in phase II testing. For a lot of people, once they read phase III testing is successful – boom – they buy the stock. But I like to look at phase II drugs that already have a proven history, and I like to recommend these stocks a bit ahead of the game. Because once ACADIA and Arena are trading at $40, $50 per share, it’s probably going to be too late.

So would you say that once a candidate is in phase III testing, a lot of the value is already gone from the stock?

Not necessarily. In the case of Renovis (RNVS), it’s currently undergoing a phase III trial for its candidate NXY-059, which is being developed for treatment of stroke. This drug has already been licensed to AZN. Currently, only one drug on the market is approved for treatment of stroke: Activase by Genentech (DNA). However, this treatment is used in less than 5% of people with strokes due to the fact that the efficacy and safety are not very good.

NXY-059 has shown good efficacy, tolerability and safety in its most recent trial. The Street has kind of ignored this, though, because it wasn’t an efficacy trial, it was a safety trial. But I don’t think they should ignore data like this. With stroke patients, safety is a big issue. These people may have motor problems or cardiovascular difficulties. The last thing they need is to take a drug that no one’s sure is 100% safe. We’re still waiting on the phase III efficacy of the drug, but previous tests had provided encouraging results.

This is another enormous market. Stroke is second only to coronary artery disease as a cause of mortality in the developed world. Renovis has a $650 million cap right now with a potential $1.5-2 billion drug on its hands. This is definitely a potential one-hit wonder. The drug could generate $1 billion in sales shortly after entering the market. AZN will be responsible for 80% and give a royalty payment – a sizeable figure – to Renovis. This company stands to make a lot of money.

What about ViroPharma? For weeks, you were perhaps the only sell-side analyst with a Sell on the stock, and now you’re one of only a few turning positive on it.

ViroPharma (VPHM), at this time last year, was less than $2 per share. The company has an antibacterial drug that treats the pathogenic bacteria C. difficile (CDAD), which causes diarrhea among patients taking certain antibiotics, called Vancocin. Sales of this drug have been really great, and the stock shot up from $2 to over $20. But last November, generic drug companies reported that they were considering making a generic version of Vancocin, which has no patent. The only protection Vancocin has from generic competition is that it’s very complex and difficult to make, and would take years of clinical testing to create.

In early March, I downgraded ViroPharma to a Sell. In my report, I acknowledged Vancocin was indeed difficult and complex, but not out of the realm of possibility for a generic company to eventually get a handle on. And as this is ViroPharma’s only currently approved drug, I felt the shares were overvalued. Then, just a couple weeks ago, the FDA announced that it would entertain the idea to help streamline the process of creating generic Vancocin, and the stock tanked. Shares fell all the way to $11, and right around there I upgraded VPHM to a Hold.

Even with the risk of generic Vancocin – which, instead of possibly hitting the market by 2010 would still be at least a couple years away – fair market value of ViroPharma, I feel, is around $16. Technically and under normal circumstances, this would mean I would change my recommendation to a Buy. But after a capitulation such as this – a stock falling from $20 to around $11 – shares almost never go right back up. Right now I’m waiting for things to settle, and we’ll see what happens after a couple weeks or so.

When considering small-cap biotech, what should investors be paying close attention to?

There are three things I would consider: 1) be careful not to be buying hype. I can’t stress enough how important it is to steer clear of biotech companies that have more hype than facts, so pay attention to a company’s fundamentals and pipeline, 2) make sure your entry point is wise. Biotech is very risky, as everyone who bought shares of ViroPharma at $20 knows, and 3) always have a reasonable target in mind. What are your goals? If you bought ViroPharma at $8 because you were bullish on Vancocin, were you still so bullish when it got to $20?

Not that any of this is really easy. Biotechs move more than any other stocks in the market, and can go up or down 50% in one day on a single piece of news. So you’ve got to know when to get in, when to get out, and pay close attention the whole time in between.

Jason Napodano, CFA is a senior analyst covering the pharmaceutical industry for Zacks Equity Research.

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MORE FROM ZACKS EQUITY RESEARCH...
 

Analyst Blog - NEW!

Get real-time market insights from Zacks Equity Research Analysts. See their latest posts, click here.

 
BULL OF THE DAY

Digital River (DRIV) - Raising Earnings Expectations. For full Zacks research report, click here.

 
BEAR OF THE DAY

Overstock.com (OSTK) - Price Inflated from "Short Squeeze." For full Zacks research report, click here.

 
EARNINGS TRENDS

Earnings Growth Expected to Slow

After 15 straight quarters of double digit growth, earnings are expected to slow to a still healthy 9.1% rate in the first quarter. More...

 
ZACKS INDUSTRY OUTLOOK

Zacks Industry Rank for the Week of Mar 27

Steel-Producers has a Zacks Industry Rank of 2.29 and seven Zacks #1 Rank stocks. More...
 

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Zacks.com features a free investment simulator where our customers can prove their stock picking skills to the rest of the world. In these articles we will share with you the insights and recommendations from Top Simulator Players. Learn more about the current Zacks Challenge at: http://at.zacks.com/?id=2514.

 
mholman

This week Zacks has the pleasure of introducing Mark Holman (aka: mholman), who sports a solid Zacks Challenge portfolio that is currently in fourth place, garnering an overall return of roughly 150% since Jan 3.

This technical stock picker trades on a short- to medium-term basis and is a fan of derivatives as evidenced by the option transactions that dominate Mark’s portfolio. Some of his plays include options on Intuitive Surgical, Inc. (ISRG), Google (GOOG), Overstock.com, Inc. (OSTK), General Motors Corp. (GM) and Genentech, Inc. (DNA). Click here to check out more of this player’s recent trades.

The Zacks Challenge participant, who is an avid reader of a very wide range of investment books, said that his use of derivatives stemmed from the belief that they are an efficient way of expressing a directional view while having better control over risk. “They allow for much greater leverage than trading underlying equities. I also trade futures, options on futures, and Forex,” noted Mark.

When considering an underlying security or a direct purchase of a stock, what does this market watcher look for?

“Generally speaking, I am interested in stocks that have a fairly wide following and the volatility to move a significant amount in a short period,” answered Mark. He added that he looks for momentum stocks that are undergoing a change in trend, either an acceleration in the current trend or reversals. The savvy investor is not one for throwing darts at the board. His system includes technical screens, followed by topical and fundamental research, then he weighs out the risk/return possibilities and looks for an options strategy to express his directional view.

But what about when it comes to selling?

According to this Simulator contender, “trades are like buses, there is always another one coming along.” Without getting attached to any one trade or investment, Mark considers the amount of time spent in a position and the degree to which a stock has moved toward a potential target zone of support or resistance. In other words, “if after a reasonable period of time, the stock does not move in the desired direction, then the capital is usually better employed somewhere else.”

The Zacks Challenge contestant is unbiased in his trading, there are no favorites here. This market enthusiast seems more concerned with the technicals, research and momentum. “I don’t think I have a favorite type of stock or any favorite names, other than I tend to trade mid/large-cap more than small-cap. I don’t have any particular preference for a particular sector or industry,” commented Mark.

Where does he go for research?

This successful investor does his research online. Mark referenced realmoney.com, Wall Street Journal, Barrons, Investors Business Daily, Value Engine, Schaeffers Research, Washington Post and the New York Times as some of the places he visits on the Internet.

Mark also makes use of Zacks.com on a daily basis. Among other features, he listed the Profit from the Pros newsletters, the Bull and the Bear of the Day, the Zacks #1 Rank (Strong Buy) and Zacks #5 Rank (Strong Sell) stocks, Featured Experts and Timely Buys as some of the links he is always clicking on.

Intrigued by his investment style and successful strategies, Zacks pressed further and inquired about the “big winner.”

Mark’s reply? A short position in Intel (INTC) via puts and a long position in Diamonds (DIA) through calls. He explained that the Intel position was expected as it was ahead of earnings and he was anticipating a negative reaction in the stock. The Dow (Diamonds) calls were a bit more unexpected as that position was initiated as a hedge against a very negatively positioned portfolio.

Mark’s Outlook and Advice.

The Zacks Challenge competitor indicated that he was cautiously bearish. He envisions the possibility of a summer correction in the neighborhood of 5% to 10% and sees the year ending within 5% of current levels.

The seasoned investor had a lot of sound advice for novice investors. “Everyday teaches you something new about the markets and whenever you think you have finally mastered trading, get ready as the market is about to humble you once again. There is no one right way to make money in the markets but the most important thing about trading is to find a style that agrees with your personality. It is very individual and one size does not fit all,” imparted Mark.

 
Stock Challenge from Zacks- Do You Have What it Takes?

Sign up now for the new Zacks Stock Challenge. New game starting April 2006.

Its free. Its fun. It's the place to show your investing prowess. The best stock pickers will be rewarded with thousands of dollars in prizes. Learn more at  http://at.zacks.com/?id=2671.

Trade Options? Then sign up for the Zacks Options Challenge at http://at.zacks.com/?id=2672.

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Zacks.com is proud to share with you some of the best trading strategies that truly allow you to Profit from the Pros. Today we highlight...
 

Profit Tracks: Growth and Income

This Profit Track looks for stocks that are paying dividend yields of greater than 8% along with other attractive fundamental attributes. Although this screen is based on a long-term and lower risk approach to investing, it has consistently beaten the S&P 500.

Here are four stocks that make the grade for the Growth and Income Profit Track:

American Capital Strategies, Ltd. (ACAS) has a current dividend yield of 9.14%. In mid-February, ACAS reported fourth-quarter earnings and declared a first-quarter regular dividend of 80 cents per share, which is a 10% increase over the first quarter 2005 regular dividend of 73 cents. The company estimated paying the following quarterly dividends per share for the remaining three quarters in 2006: 82 cents for the second quarter, 83 cents for the third quarter and 84 cents for the fourth quarter. The fourth-quarter earnings totaled 80 cents per share, which outperformed the previous year’s 74 cents. Continue your research on ACAS at: http://at.zacks.com/?id=2354.

Novastar Financial, Inc. (NFI), a residential lender and mortgage Real Estate Investment Trust, is yielding 17.42%. In late February, the company released financial results for the fourth quarter, which included the declaration of $5.60 per share in 2005 dividends, including $1.40 in the fourth quarter. NFI also noted that dividends for 2006 are expected to total at least $5.60 per share. Novastar stated that 2005 demonstrated the value of having both portfolio and mortgage banking businesses for its shareholders. Continue your research on NFI at: http://at.zacks.com/?id=2355.

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TIMELY BUY of the WEEK continued...

Southern Copper Corporation (PCU) announced fourth-quarter earnings of $2.86 per share in late January. The Zacks #1 Rank (Strong Buy) company surpassed analysts' expectations by almost 9%. Net sales increased 14.1% year-over-year. Southern Copper, which is yielding 13.87%, also declared a dividend of $2.75 per share. Continue your research on PCU at: http://at.zacks.com/?id=2356.

Trustreet Properties, Inc. (TSY), the largest real estate investment trust focused primarily on the restaurant industry, posted fourth-quarter funds from operations ("FFO") of 36 cents per share after adding back principal amortization on capital leases. The earnings result matched analysts’ expectations. The report for the fourth quarter was issued earlier this month, and a few day prior TSY declared a monthly dividend of 11 cents per share. The company satisfies the criteria for this Profit Track with a current yield of 8.81%. Continue your research on TSY at: http://at.zacks.com/?id=2357.

To see the full list of stocks that currently pass this winning screen, go to: http://at.zacks.com/?id=2358.

All the Profit Track strategies were created and backtested using the Research Wizard software from Zacks Investment Research. If you like this screening strategy, but want to narrow down the list of stocks and even improve the performance, then you should start a free trial to this powerful stock picking tool. Learn more about the Research Wizard free trial offer and our new special report “Top 10 Stock Screening Strategies” at: http://at.zacks.com/?id=2359.

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SCREEN OF THE WEEK

Winning Ways

Kevin Matras goes over a screen that was up over 60% last year: http://at.zacks.com/?id=2360.
 

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Here you'll discover a Zacks #1 Rank stock hand selected by Ben Zacks to outperform the market over the next 30 to 90 days. This week's Timely Buy is...

 
Thomas & Betts (TNB)
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Thomas & Betts Corporation (TNB) engages in the design and manufacture of electrical connectors and components used in industrial, commercial, communications, and utility markets worldwide. The company operates in three segments: Electrical; Steel Structures; and Heating, Ventilation, and Air-Conditioning (HVAC). The company sells its products directly, as well as through distributors, mass merchandisers, catalog merchandisers, and home improvement centers.

The company reported an excellent fiscal-fourth quarter earnings report. For the 12 months ended Dec. 31, the company reported 2005 revenues of $1.7 billion, up 11.8 percent from $1.5 billion for 2004. 2005 earnings were $113.4 million, or $1.86 per share, compared to $93.3 million or $1.57 per share in 2004. For the fourth quarter, the company reported net income of $25.8 million, or 69 cents per share, well ahead of the 54 cent consensus estimate.

Management attributed the strong performance to strong sales growth and double-digit segment earnings, as well as the company's ability to get a handle on costs. "We successfully offset higher material and energy costs, further improved operating efficiencies and delivered very strong operating cash flow," said Dominic J. Pileggi, Thomas & Betts chairman and CEO, in a statement.

TNB's management has shown that it is determined to reduce debt as well as increase cash flow. The company generated $157 million of free cash flow in 2005, which gives it more latitude for share buybacks or increased dividends. TNB also retired $150 million in debt, and ended the year with a debt/total capitalization of 27%, which is quite manageable.

Over the past 60 days, 2006 estimates have increased 7% to $2.45 per share. The company has exceeded estimates in each of the past five quarters by at least 9%. Despite the stock's excellent recent performance, it is still attractively valued at 18.4x next year's estimates. This is slightly above the company's long-term growth rate of 15%. The stock has been a superb performer, recently hitting a series of new highs, and up from a 52-week low around $27.

OTHER TOOLS FROM ZACKS

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At the heart of Zacks Investment Research is the Zacks Rank investment philosophy that continues to vastly outperform the market. Our Zacks #1 Rank (Strong Buy) List has produced the following results for investors:

• +32.5% average annual return since 1988 versus +11.8% for S&P 500
• Outperformed S&P 500 in 17 of the last 18 years
• +43.8% total return from 2000 to 2002 - the worst bear market in over 60 years.
• +18% in 2005

And just as importantly, our #5 Ranked stocks (Strong Sells) have alerted investors as to which stocks to dump from their portfolios to avoid unnecessary losses.

To truly take advantage of the Zacks Rank, you need to first understand how it works. That's why we created the free special report; Zacks Rank Guide: Harnessing the Power of Earnings Estimate Revisions. Download a free copy now to prosper in the years to come, by visiting: http://at.zacks.com/?id=2350.

Or view the full list of Zacks #1 Ranked stocks at: http://at.zacks.com/?id=2351.

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We hope you enjoyed this issue of "Profit from the Pros", And we look forward to visiting with you again next week.

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Charles Rotblut, CFA

Senior Market Analyst
Zacks.com

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Disclaimer: Past performance does not guarantee future results. Investors should always research companies and securities before making any investments. Nothing herein should be construed as an offer or solicitation to buy or sell any security.

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