Biotech: Analyzing the unanalyzable

By Bill Fleckenstein

Regular readers know that I have championed very few (i.e., Advanced Micro Devices (AMD, news, msgs) and 3Com (COMS, news, msgs)) long ideas other than precious metals and currencies in the last few years, due to my various macroeconomic concerns.

Despite my belief that the economy and stock market are headed for trouble, I'm going to discuss an investment I have made, though one which is not GDP-sensitive.

Nastech: sniffing potential opportunity

It's a company called Nastech Pharmaceutical (NSTK, news, msgs), whose niche is the intranasal delivery of drugs. I have been following it for a number of years, as a friend of mine sits on the board (though I only recently made a sizable investment). Whether owning Nastech makes sense for others is something only they can decide after doing their own research. But I'll briefly sketch out why I have a position in the stock.

Let me first note that it took me quite a bit of time and effort to understand the nuances peculiar to the drug delivery business -- one of them being the scant flow of information (as well as the reason for it) about their various projects. It's nearly impossible for the average person to understand the science behind biotechnology and drug-delivery companies (or pharmaceutical companies, for that matter). Consequently, the idiosyncrasies of this industry complicate an already formidable challenge.

A molecular medley

What follows are my thoughts and perceptions about the various major "programs" at Nastech, which are PTH, PYY, IN insulin and RNAi.

• PTH, a parathyroid hormone, is on the market as the best bone-growing osteoporosis drug, with sales of about $500 million per year in a daily injected format. Last February, the company announced a deal with Procter & Gamble (PG, news, msgs), which could be worth as much as $577 million in milestone payments, as well as significant royalties, to develop and commercialize PTH as a nasal spray. The collaboration seems to be moving ahead smoothly. Nastech management expects, as they stated on the most recent conference call, to receive milestone payments of roughly $22 million, spread out over the course of calendar 2006.

• PYY is a potential treatment for obesity. This compound raised many questions when Nastech took it back from Merck (MRK, news, msgs) in early March. That development caused Nastech shares to plunge from $23 to $14 -- as folks concluded that either Merck didn't believe in PYY or Nastech didn't have the ability to deliver it (an idea that was refuted in the press release announcing the deal), or both. However, it's interesting that Merck recently filed for a patent application in Europe for PYY, in combination with another obesity compound. And, on May 31, Pfizer (PFE, news, msgs) announced its own upcoming PYY trials. Perhaps nothing will come of PYY. But to have already concluded that certainly seems premature. Nastech will begin Phase II trials this summer.

• IN (intranasal) insulin is what it sounds like. I would expect to see news (hopefully positive) in the next few months, about the Food and Drug Administration and a 505B2-filing approval pathway. Constructive developments could also be forthcoming regarding a couple of other projects that have previously been the subject of feasibility studies.

• RNAi is a newly discovered method of very selectively eliminating a single protein out of the more than 30,000 proteins in the body. If the protein eliminated is related to a disease, then RNAi could be an exciting new treatment. The key technical problem with RNAi is delivering the compounds to a specific location, something Nastech has focused on over the last year. Last February, Nastech announced the acquisition of an MIT-spinout company named Galenea. Nastech plans to take a Galenea-developed product and combine that with its own RNAi technology, to develop a therapeutic to combat influenza and potentially bird flu. To quote from the Nastech press release that accompanied its announcement: "Galenea's lead RNAi product, G00101, has demonstrated efficacy against multiple influenza strains, including avian flu strains (H5N1) in animals. Nastech expects to work closely with the NIH, CDC and FDA to accelerate G00101 development, given the urgent need for influenza therapeutics."

Intriguing blueprint of a biotech

Nastech hopes to find a major partner to fund the development of an RNAi therapeutic approach to fighting flu. To me, that business strategy has a lot of merit. In short, I think that the management of this company has a very credible game plan to attempt to capture the upside of its various programs, while simultaneously mitigating the risks.

And, if PTH is a success, management will go a long way toward doing just that. For example, the P&G milestone payment alone would make Nastech nearly break even on a cash-flow basis this year. In fact, a local biotech analyst has estimated that if PTH clears the FDA, Nastech could be worth more than $20 a share, based on a discounted cash-flow model, as it nears approval. Therefore, the success of PTH could eventually mean that whatever upside accrues from the non-PTH programs I've described, or others, one essentially gets that upside for free, given the recent share price of roughly $14.

In the pipeline, versus baked in the cake

Will Nastech be successful? I wish I knew. There are many hurdles to surmount between here and the marketplace, and many things could go wrong. Trying to analyze a biotech company before its products have gone through trials is a bit like trying to lasso a column of smoke. An investment in Nastech is inherently speculative, and the vagaries of stock-market-related issues can certainly impact its valuation. Thus, while on the one hand Nastech doesn't have any economic baggage, it remains subject to the whims of Mr. Market.

And, on top of being speculative, biotech investments are also somewhat binary.

Nothing happens for periods of time, and then something does happen, which radically changes people's opinions -- either for better (as in the single-day rise from $8 to $13 in September 2004 when the Merck PYY deal was announced), or for worse (as we saw in March). Thus, biotech stocks tend to drift, before moving violently. I think that is what folks ought to expect from Nastech: It's going to be a boring stock to watch, except for those days when news moves it a whole bunch.

But my assessment is this: Nastech's market valuation now is about $300 million. If I compare that to the size of the markets it's addressing and consider the way management has structured operations to help mitigate the risky nature of its business, the risk/reward proposition is very compelling.

Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily "Market Rap" column on his Fleckenstein Capital Web site. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of CNBC or MSN Money. At the time of publication, Bill Fleckenstein was long Nastech Pharmaceutical and 3Com.