Wednesday, 12 October 2016

A Pharmaceutical Unicorn: A Smallcap That Can Sustain Its R&D Through Internal Cash Flows

With biotech and pharmaceutical stocks getting smashed recently, it is time to go bargain hunting in this sector once again. The last time we did this, readers experienced a nice gain on Portola Pharmaceuticals, Inc. (PTLA). On August 24 we recommended a buy on PTLA in the $20's, providing readers with a 15-20% gainer in a little over three weeks as we recommended they take some profits on September 16. PTLA is back down to our original buy zone so if you want to revisit it, now would be a good opportunity. If you look back at our report history, we have had a string of successful picks. This is backed up having acquired 56 followers since August 22, the date we added a follow functionality to this blog along with around 1,400 followers on Twitter. If you want to be the first to read our reports, we recommend that you follow this blog by clicking the follow button on the left side panel.

Now back to our latest pick. Once again the market has gifted us a cheap pharmaceutical company with huge upside - one that we consider to be a pharmaceutical unicorn - in Supernus Pharmaceuticals, Inc. (SUPN). SUPN is highly oversold after releasing positive results from its Phase IIb Clinical Trial for SPN-812 in children with ADHD, dropping from over $26 to $21.50 in a 1.5 day beat down since Tuesday morning largely due to weakness in the health care sector. We think SUPN will quickly recover to $25 for another easy 15-20% for our readers. But if you want to hold onto it longer, SUPN can easily rise to $50 or above. And here are the reasons why:

1. It can fund all of its studies and other research and development costs with internally generated cash flows. It has no need to finance which makes it a true unicorn in the pharmaceutical industry. There are plenty of peers around a billion dollar market cap that have to dilute and finance to continue their research. SUPN is not one of them.

2. Institutional ownership is high. Ridiculously high. So ridiculously high that pretty much the only float out there is being lent for shorts. This stock is ripe for a short squeeze at any time. Have a look for yourself:

99.08% institutional ownership! Despite the stock having a strong year, institutions as a whole have actually increased their holdings in SUPN. Existing institutional shareholders increased their net position by 3.6 million shares while new shareholders added 2.8 million versus only 1.3 million worth of shares sold from institutions completely exiting their positions over the three months of Q2. That leaves a little less than 1%, or 500,000 shares for retail investors to buy. That's what has been making the stock so volatile on relatively low volume. The short interest is 2.7 million shares. While that's only a little over 5% which is small for a pharma company, given the context of SUPN being a profitable pharma company that could be a disaster-in-waiting for shorts.

After having talked about institutional ownership, let's go back to the main thesis of this report, that SUPN can fund its R&D through internal cash flows. First off, the company clearly states as such in its Q2 financials filed with the SEC:

"We believe with continued increasing levels of net product sales, we will have sufficient resources to finance our operations, including the increased R&D expenses for our clinical programs. We expect to incur significantly increased R&D expenses to support the development of SPN-810 and SPN-812 including the late stage trials for SPN-810 and SPN-812."

But you don't really need this message to understand that SUPN is a self-sustaining junior pharmaceutical. Just look at the Q2 income statement:

Revenue increased 44% to $50.4 million in Q2 and 48% for the first six months of the year, driven by increased sales of the company's two epilepsy drugs. Operating income increased 239% to $10.4 million for the quarter and 142% for the first half of the year. Even if the company was to stagnate at around $50 million sales per quarter (and the trend suggests it will continue to grow), there is plenty of cash available to support the R&D for the three remaining products in development:

EPS was 20 cents for Q2. Analyst estimates average out to $1.37 EPS for next year. Considering the company's rate of growth, a quarterly EPS averaging 35 cents next year appears to be quite achievable and results in a 16 P/E ratio which is extremely cheap for a company in SUPN's position.

Here's the thing - EPS doesn't even tell the full story. SUPN is spending on R&D, something that other biotech and pharmaceutical companies do, and they get a bullish valuation despite the heavy cash burn. If SUPN was to spin out into two companies - one with the epilepsy drugs and the other with its pipeline, the operating company would get a higher valuation thanks to the stronger EPS while the prospective company would get a positive valuation based on pipeline potential.

Put another way, if SUPN decided to halt the studies on the three prospective products. R&D would likely fall by 75% with salaries declining at least 10%, probably more. Had SUPN spent only $3 million on R&D and $24 million on SG&A in Q3, it would have reduced costs by $10.2 million, doubling operating profit and doubling EPS to $0.40.

How much does the $1.37 EPS estimate for next year bake in costs to support the pipeline? $50 million? We think that is a reasonable estimate given the $10 million in proposed savings in Q2. If SUPN could reduce costs by $50 million simply by giving up on the pipeline, that is an extra $1 added to their EPS, or $2.37 in total. That would lead to a forward P/E of 9, a ridiculously low number for a growing pharmaceutical. So why should we punish SUPN for choosing to spend internal cash flows on its pipeline? It makes absolutely no sense.

SUPN is truly a unicorn in the pharmaceutical world:

1. It can sustain R&D investment in its pipeline from internal cash flows.
2. It is trading at a cheap 16 forward P/E multiple, or very cheap 9 forward P/E multiple if we exclude spending on its pipeline.

Is there any wonder that institutions have been buying SUPN to the point where they own basically all of the float?

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