May Day! May Day! On Monday, Warren Buffet said: “My general feeling is that the recession will be longer and deeper than most people think. This will not be short and shallow.”
Wednesday morning, the Commerce Department gave the advance estimate for March quarter real GDP: +0.6%. That follows an identical +0.6% in the December quarter. The build-up in inventories that helped March quarter GDP will be a drag on the June quarter, but the tax rebates will help, and GDP could be either slightly positive or slightly negative.
It’s hard to have any recession, much less a long and deep one, if GDP won’t go down for even one quarter. Almost as hard as having a bear market, like the one so many pundits say we are in, when the indices refuse to go down 20%. For the record, from the highest close to the lowest close the Dow Jones Industrial Average fell 16.1% and the S&P 500 fell 17.8%.
The bears get to barely claim the NASDAQ Composite for their case since it dropped 20.2% thanks to its 2169.54 low close on March 10. Unless things go to hell in a hand-basket pretty quickly, it will be obvious to one and all that we’re experiencing a correction in the bull market, not a bear market. And rather than a long and deep or even a short and shallow recession, we are in a slow growth period. Still, it’s more fun for pundits to talk about recessions and bear markets than corrections and slow growth. So you can expect to hear more jabber for the next six months or so. Then lagging consumer confidence will switch gears and everyone will say it’s safe to buy stocks again — 20% higher than where they are today.
That is the most likely scenario, by far. The alternative is that the S&P 500 fails at 1440 and the rally since mid-March turns out to be a mere retracement in a real bear market that eventually takes the S&P 500 down to 1180 or so. That’s a low probability, given the huge amount of liquidity the Fed and other central banks worldwide have pumped into the global economy, but I can’t take it off the table until we see a solid close over 1440.
After that, with over $4 Trillion-with-a-capital-T in cash on the sidelines, the old highs at 1555 on the S&P 500 and 14000 on the Dow are going to collapse like mobile homes in a Florida hurricane. In addition to the sideline cash, NYSE short interest is over 16 billion shares, an all-time record. These are the folks betting on a recession and a bear market, and it’s starting to look like they might be wrong. A rising short interest in a market that won’t go down is a potentially explosive scenario. A close over 1440 is going to hurt them, but the close over 1555 is the killer. Bear markets don’t set new highs, and when bull markets resume, they drive short sellers out by forcing them to cover at higher and higher prices. Sideline cash plus heavy put buying and high short interest are just as few of the drivers for a parabolic upturn during the next 10 months.
The Fed Is Done, Now It’s Up To The Stock Market
The Fed came through yesterday with another quarter-point Fed funds rate cut to 2.0%, and I think that should mark the end. All the Fed does is follow the two-year Treasury rate, and that jumped from 1.24% at the panic low on March 17 up to 2.38% yesterday. The free market is already saying the worst is over, and the negative yield curve you heard so much about last fall as a recession predictor is now positive. Funny how the recession crowd doesn’t mention the shape of the yield curve anymore.
As you know, my new market forecasting tools pretty much nailed the March turn date. The next big downturn should start around April 19, 2009, from much higher levels. I know it sounds ridiculous to pinpoint the date so far in advance, but these tools are working and I want to share the exact forecast with you. The S&P 500 will be around 1900 by then, and maybe up to 2200 if we get another parabolic finish like 1999 to this bull market. Our current stocks will do extremely well in that environment, and some will do well even during the two- or three-year real bear market due to start next April. I call them Winners No Matter What, and for new recommendations, I am looking only for these kinds of stocks that can go considerably higher in a market that could be cut in half. Typically, I find them in cost-saving capital spending, the Internet, alternative energy, biotech and medical technology. Today’s Winner No Matter What recommendation is a potential 10-bagger and comes from the medtech area.
Shine a Light
Mick Jagger, Keith Richards, Charlie Watts and Martin Scorsese all have at least two things in common. One is their involvement in the new documentary on the Rolling Stones’ career, Shine A Light. The other is that they are all in the age bracket most susceptible to skin cancer and its precursors. As a card-carrying member of the Slow Irish Skin group, I have a great interest in this topic myself. (We blue-eyed, blond Slow Irish are descended from Irish women too slow to escape the Viking invaders, which I always say accounts for my abominable 100-yard dash times.)
Skin problems range from actinic keratosis, the small red spots that develop with age, to basal cell cancers, Bowen’s disease, squamous cell cancers and then the biggie, melanoma. Thanks to my lifelong love of convertibles, I’ve personally experienced each of the first four, but don’t ever expect to get the Big M. That’s because scientists in Australia, where one out of every two adults gets some form of skin cancer, have learned that while sun exposure increases actinic keratosis, basal and squamous cell cancers, it actually is protective against melanoma. This comes as a shock to a lot of people, including some American dermatologists who have not kept up with the research.
Melanomas are cancers of the cells that produce melanin, which is the pigment that colors our skin, hair and eyes. It is a somewhat unique cancer because it grows very rapidly, yet one’s prognosis is very closely tied to the stage at which it is discovered. The depth of a lesion’s penetration is an indicator of its severity. Melanoma caught and treated at Stage 1, where the lesion is less than one millimeter deep and therefore confined to the outer layer of skin, has a 95% five-year survival rate. But melanomas that are diagnosed at a later stage, after the melanocytes have grown through the skin and its underlying fat and traveled to sites beyond, are deadly. Stage 4 has about a 15% five-year survival rate. Even though the majority of skin cancers are basal cell and squamous cell (both serious but far less fatal), melanoma causes 79% of skin cancer deaths, according to the American Cancer Society. There will be about 54,000 new cases of melanoma this year, a number that has grown 50% in the last 35 years.
Source: Electro-Optical Sciences
Dermatologists are trained to find oddly-shaped or colored spots, and then decide whether or not to biopsy them. They do pretty well, too. But as the above chart suggests, missing small spots early on can be a disaster for the patient, and of course the smallest ones are the hardest to see. Experts can identify about 85% of all melanoma lesions, but even they find only 70% of the smallest ones. Yet identifying the small ones, those less than six millimeters wide, is crucial for better patient outcomes.
False positives — thinking something is a melanoma that is not — subject the patient to an unnecessary biopsy. Dermatologists perform about 40 unnecessary biopsies for every melanoma found. False negatives put the patient at great risk. Here are some admittedly extreme examples:
Source: Electro-Optical Sciences
So, what is “MelaFind?” MelaFind is a noninvasive melanoma diagnostic device based on an optical reader that uses 10 different wavelengths of light to “see” about 2.5 millimeters into the skin. It then uses image processing software to identify the characteristics of the lesion, and analyzes the characteristics using expert system rules to classify the lesion as either a probable melanoma that should be biopsied, or probably not melanoma. The reader is hand-held, with a touch-sensitive screen to make it easy to use. It takes three minutes to “read” a suspect area. The information on each patient is stored on a proprietary media card for later reference and comparison. Instead of getting results in five to seven days from a lab, the patient gets the diagnosis in 10 seconds in the dermatologist’s office. The doctor can print out the results and immediately counsel the patient.
The first devices in the field of dermoscopy, also called epiluminescence microscopy because it lights and magnifies features on the skin’s surface, simply combined good lighting with a modest magnifying lens in a handheld device to allow dermatologists to better view and evaluate features like mole shape and color.
The next generation uses a high-quality camera to record images of a patient’s moles, so the dermatologist can track and evaluate changes over time. The leading product is MoleMax II, an Austrian device priced low enough to use in individual practitioners’ clinics.
The latest development are third generation devices like MelaFind that use image analysis through computerized border selection and lesion color detection, compared to established diagnostic criteria to predict whether observed spots are cancerous. The first of these was SolarScan from an Australian startup, Polartechnics, which is approved in Australia. SolarScan established their diagnostic criteria by observing and questioning dermatologists, which is a traditional way to create a rules-based expert system. MelaFind shines their 10 wavelengths of light, each of which penetrates to a slightly different depth, on a spot to look for the chaotic or disorganized cell structure that is typical of a cancerous tumor. Disorder in how its cells are assembled is a consistent sign of the out-of-control growth that characterizes cancer. MelaFind moves beyond human understanding of order and disorder, using statistics to calculate if and how a region of cells is in disarray. It is a more advanced and efficient system than SolarScan, and I believe will prove to give a more accurate diagnosis.
Some form of dermascopy already is the standard of care in many other countries, but oddly enough not in the United States. That is about to change, and already some U.S. doctors are using first and second generation dermascopy, with excellent results.
Electro-Optical Sciences (MELA) invented MelaFind, took it through two Phase II trials, and is now wrapping up Phase III. In the first Phase II trial, 28 of 352 lesions were melanomas and MelaFind identified all 28. In the second Phase II trial of 562 lesions, MelaFind identified 53 of 54 melanomas. In both studies, MelaFind did approximately twice as well as dermatologists without the equipment. I cannot recall another Phase II medical device trial that showed 98.8% accuracy.
The Phase III pivotal trials are being held at seven centers in Florida and the Southeast, San Diego, Chicago and Pittsburgh. They have diagnosed 765 patients with 1,052 lesions, and found 80 melanomas. The trial endpoints include identifying 92 of 93 biopsy-confirmed melanomas, with an improvement compared to the study dermatologists of p=.05 (less than a 5% chance that the improvement is merely random). The Phase II trials had p values under .0001, so the Phase III study is easily powered for approval at this level of patients.
Market research showed that most dermatologists see an average of 150 patients a week, and would be expected to use the MelaFind 33 times a week. “High biopsiers” said they would use it 44 times a week on average. Interestingly, their nurses predicted MelaFind would be used 70 times a week. That is probably because dermatologists think a biopsy just takes a couple of minutes, not remembering that a nurse spends about an hour per patient setting up the room and equipment, cleaning up afterward, and counseling the patient on wound care and expectations.
Electro-Optical Scientific expects to sell MelaFind on the basis of saving the doctor time to do other, more lucrative procedures. Their numbers show a dermatology practice can net an additional $150,000 a year per dermatologist, after the expenses associated with MelaFind. The device itself will sell at a fairly low price, because the real money is in the media cards, which provide HIPPA-compliant patient data storage in an easy-to-print form.
The company became public in November 2005, raising $21 million at $5 a share. They did a private placement in November 2006 to raise $13 million at $5.70. A second private placement in August 2007 raised another $11.5 million at $5.75. They still have about $20.9 million in the bank or over $1 per fully diluted share.
They have been granted expedited review by the FDA and have a Special Protocol Assessment, where if they hit their endpoints they get approval. I expect them to conclude the clinical trial shortly and file for approval for MelaFind by midyear. That will move the stock up. But I have been involved with these camera-and-film model medical device companies before, and typically the stock comes back down during the early device shipment phase. The company wants to put 400 devices in the field the first year, using a sales force of 10 to 12 people. They then want to ship 800 in the second year and 1,200 in the third. But due to the length of time it takes to convince doctors to give it a try and then train them, someone on Wall Street will always be disappointed. The devices also carry a low profit margin, because the company doesn’t want the price of the device to be an issue when the profits are in the “film,” in this case the media card. So that’s another knock on the stock.
Plus, they have to convince the payers — Medicare and the health insurance companies — to reimburse doctors for the cost of the MelaFind procedure. That shouldn’t be too hard. The U.S. spends about $1.5 billion a year treating skin cancer, and hundreds of millions of dollars of that are for biopsies that don’t successfully identify melanoma. MelaFind can save close to one million biopsies a year, and that should make Medicare and the insurance companies happy to reimburse for the MelaFind scan.
After that the company hits the point where a lot of devices are installed, dermatologists are telling each other that they work and make money for the practice, “film” sales are accelerating and profit margins are increasing. That’s when Wall Street gets really excited.
For a company like MELA, that can mean this kind of pattern: Today the stock is around $6. When they file for approval, the stock will trade to $8 to $9. After FDA approval, it will trade to the $10 to $12 area, maybe a little higher. But then it will go quiet and drift off during the initial shipment phase, perhaps back down to $8, maybe all the way back to $6 if a negative Street report comes out. From there the big move will begin, slowly at first, that can carry it up to a billion dollar market capitalization — $60 a share — over a couple of years.
What drives such a big gain? There are over 11,000 dermatology practices in the United States. Electro-Optical is targeting one MelaFind in just over 10% of those practices by the end of the second year of shipping. Assuming the device is used on just 50 patients a week — not the 70 patients the nurses are predicting — revenues will be about $200 million a year in two years. In five years, MelaFind should be in at least 30% of all dermatology practices (I would not be surprised if patients demand it), generating $600 million a year in sales. After-tax margins should hit 7% at the two-year mark and max out at 15% at the five-year mark. Assuming some modest further stock sales, that translates to 78 cents a share in two years and $5.00 a share in five years. Although medical device stocks at similar stages of development often sell for 50X earnings, I am using a 30X multiple on 78 cents to get to a $23 target price. At the five-year mark, a terminal multiple of a modest 20X would give us a $100 stock.
The way I like to invest in these is to have a core position and a trading position. The core position should be whatever you would be comfortable holding through the whole up-and-down process that can eventually lead to a 10-bagger or more. Then establish an additional trading position, which might be from 50% to 100% of the size of your core position. Buy both positions now, and then sell the trading position after they file for approval. Buy it back when and if the stock drifts off, and sell it again after approval. Buy it back after the initial disappointment with the sales growth hits, and then hold both positions for the 10-bagger.
Electro-Optical Sciences is a “Winner No Matter What” recommendation because aging baby boomers are developing more melanomas, dermatologists need help to catch them at an early stage and to make the biopsy decision, and the company’s sales and earnings are not sensitive to the economy, interest rates, the falling dollar, consumer spending weakness or any of the other current or foreseeable negatives. The company has a tiny market capitalization, under $100 million, and was almost unknown before they presented at the Cowen HealthCare Conference on March18. Insiders own 19.7% of the stock and have bought over 230,000 shares in eight separate transactions during the last six month. I want you to buy MELA up to $7, with a $12 first target after FDA approval, and a $60 long-term target.
Biotech MegaShift
Affymetrix (AFFX) reported the poor quarter they pre-announced last Thursday, and I said I wanted to review the conference call before taking the stock off Hold. Of the $8 million revenue shortfall in product sales, about two-thirds came from pharma customers cutting budgets for traditional gene expression products. But genotyping products continue to grow rapidly, as do diagnostic products and reagents. Overall, the company expects to grow this year while they introduce their new expression products, and then have a stellar 2009. They continue to trim costs to protect the bottom line during the product transition.
There is no doubt that AFFX stumbled in the last couple of years and was late in a key technology cycle against Illumina. But they are in several high growth markets like diagnostics and genetics, with new technology and a leaner company. They have a big customer base that thinks highly of the company’s products and customer service. New products will be in customers’ hands in the second half of this year, and they have $600 million in cash to develop and market new products. Given the low current valuation of the stock, this is a real turnaround opportunity — low risk, high reward. I’m moving AFFX back to a buy, with a $15 buy limit to reflect the current trading range, and an unchanged $35 target by April 2009.
Amgen (AMGN) also reported last Thursday, with results just above the consensus, and reaffirmed its 2008 revenue guidance range of $14.2 billion to $14.6 billion, with pro forma earnings from $4.00 to $4.30. On the conference call, they said they are working with the FDA on the label changes for Aranesp and Epogen that came out of the March 13 meeting. The advisory committee showed strong support for Aranesp in chemotherapy-induced anemia, and thought that this option should be made available. There was a lot of commentary at the meeting about the need to have physician discretion, so I don’t expect the label to have strict limits on when and when not to use Aranesp. It is more likely to have advisory language. They also said Enbrel sales growth is offsetting some of the decline in Aranesp and Epogen, as is international sales growth of most of their other products. It was a good, solid call. They’ve postponed the June 6 business update meeting until they have the final label information and also some clinical trial data for denosumab, their postmenopausal osteoporosis drug that looks like a big winner.
At 10X this year’s earnings, Amgen is incredibly cheap. Buy the Amgen January 2010 $40 LEAP (WAMAH) under $10 with a $20 target.
QLT (QLTI) reported $11.9 million in sales and a four cent per share pro forma loss. I was looking for $26 million in sales and a couple of pennies positive on the bottom line, but the shortfall is not what it seems. The company has decided to sell all its QLT USA operations — Eligard for prostate cancer, Aczone for the treatment of acne vulgaris, and the Atrigel drug delivery system — and now lists them as discontinued operations. Visudyne sales grew 10.6% in North America, where the competitive situation has stabilized, but fell 48.5% in Europe as Lucentis builds the same kind of market share it got in the U.S. more than a year ago. These negative comparisons should come to an end later this year.
In the meantime, QLTI has reduced headcount 45%, and in addition to selling the three USA products the company is selling their headquarters in Vancouver. They had $120.0 million in unrestricted cash at the end of March, plus another $122.4 million restricted that is posted as a bond in their patent lawsuit appeal. They have $172.5 million in convertible notes that can be put back to them in September 2008, and they are getting ready to handle that. Their strategy is to stick with Visudyne, wait for the combination studies to come out and show that Visudyne plus Lucentis (or any of the other anti-epithelial growth factor drugs like Macugen) are the right way to treat age-related macular degeneration. Then they will ride the sales curve back up and go back into a growth mode. This is the right strategy, and I don’t want to sell QLTI here. The company is forecasting Visudyne sales of $145 million to $160 million this year, with a 20% share of the profits to QLTI. Buy QLTI up to $6 for my $12 target.
Rochester Medical (ROCM) reported record sales of $9.2 million and pro forma earnings of four cents a share. That is deliberately lower than last year’s eight cents, as Rochester builds up its sales and marketing operations to take advantage of the coming October change in Medicare reimbursement for hospital-caused infections. Medicare will no longer reimburse, and 40% of these infections are in the urinary tract, related to catheterization. Rochester’s drug-eluting catheter slashes infection rates.
The company got a nice bluebird when Medicare changed their reimbursement policy on April q to permit an intermittent catheter user a maximum of 200 catheters per month instead of four. Hospitals had to reuse catheters before the change, but now they can just buy new ones from Rochester. On the conference call, management estimated a complete changeover from reusing catheters to always using a new, sterile one (as is the practice in Europe) would add $4 million to $5 million to the top line just from current customers.
Branded sales are growing 25% or more, while private label grows around 18%. “Rochester” branded products are up to 66% of revenues, and that is where the company is spending its sales and marketing dollars. Sales and marketing expense is up 67% year to date versus last year, pursuing opportunities in both the U.S. and Britain. Although R&D is not up much, they’ll have new products across the product line towards the end of 2008, into 2009.
The next court date in the litigation against Covidien and Novation won’t happen until December. Of course, the defendants could (and should) settle anytime. ROCM remains a Top Buy all the way up to $20 for my $40 target after the October 1 Medicare reimbursement rules kick in.
Sequenom (SQNM) reported first quarter revenues of $10.6 million, up 7% from last year. As previously announced, sales of MassARRAY systems in the U.S. were on the weak side, probably due to the same factors that impacted Affymetrix: Delays in the funding cycle and economic uncertainty. Several high probability U.S. system sales were delayed in the last couple of weeks of the quarter, and only 12 system sales were booked. They lost 19 cents a share compared to 11 cents last year. But they also announced a Central and South America distribution deal with Invitrogen, including their first sale of a MassARRAY system into Brazil for use in developing biofuel from sugarcane.
The non-invasive prenatal genetic tests program is moving along well. They can do a direct genetic assessment for Down syndrome, and some preliminary performance data on an internally developed test showed the ability to detect with 95% sensitivity (Down syndrome is present) and 99% specificity (Down syndrome is not present).
Management reaffirmed 2008 guidance for revenues between $50 million and $53 million, up about 30% from 2007. They’ll have a net loss of $30 million to $33 million, and burn $26 million to $28 million in cash. On the conference call, they said several of the delayed sales have closed and the rest will — none was lost to competition.
Management will be presenting at the Rodman & Renshaw Fifth Annual Global Healthcare Conference on May 19, and also do a European investor relations road-show. They’ll also hold two analyst days focused on the noninvasive prenatal diagnostic assays. One will be on June 3 at the 14th Annual International Conference on Prenatal Diagnostics and Therapy in Vancouver. The second will be held in September in New York.
I think SQNM will bounce back quickly from the first quarter U.S. revenue disappointment, so I am moving the stock back to a buy under $7 while maintaining the $12 target.
ViroPharma (VPHM) reported Vancocin sales up 3.9% year-over-year to $50.9 million, but earnings fell to 22 cents a share from 31 cents last year as they grew the sales force and spent development money on Camvia, their stem-cell-transplant prophylactic treatment formerly known as maribavir. The company expects Phase III patient enrollment to end this month, with Camvia data leading to a filing for approval in 2009. They expect Vancocin sales of $210 million to $235 million this year.
VPHM has a total market capitalization of $636 million, and $599 million in cash. So Wall Street is saying (1) Vancocin is worth only $37 million, (2) Camvia is worthless and (3) ViroPharma maangement can’t be trusted to do an intelligent acquisition or in-licensing deal that will create a future for the company after generic Vancocin finally hits the market. All three of those assumptions are wrong, which gives you an outstanding opportunity to buy VPHM up to $12 for my $25 target.
Content on Demand MegaShift
Akamai (AKAM) reported pro forma earnings hit 41 cents a share, up 49% and ahead of the 39 cent consensus. They now have 2,672 customers, up 8% year over year, so they clearly are booking a lot more business per customer. That’s a reflection of the growth of the Internet and, especially, video over the Net.
On the conference call, management said they saw robust year-over-year growth across all their key vertical markets, with solid growth even in an uncertain macroeconomic environment. They think the year will remain strong for them, and I wholeheartedly agree. On their last earnings call they guided for revenue growth between 26% and 30% for 2008, to between $800 million and $825 million. Based on the March quarter, they now say they are tracking toward the mid- to high-end of that range.
On the last call they also guided for pro forma earnings of $1.65 to $1.70 per share. They now say they’re tracking to the high end of that range or slightly above, so they raised their earnings guidance to $1.68 to $1.71. That implies net income growth of 29% to 32% for the year — in a stalled economy! Buy AKAM up to $36.
QuickLogic (QUIK) reported after last Thursday’s close, and I got the numbers into last week’s Radar Report. On the conference call, they said they are booking revenues and getting design wins in new smartphones. They are working not only with handset manufacturers, but with the cellular service providers that often dictate what features they want in a new phone. QUIK made a timely shift into what they call the “prosumer” market for high end electronic products that come in a variety of flavors, all based on one basic design. They really are in the right place at the right time and, unlike SiRF Technology (SIRF) with a similar strategy, QUIK is executing well. QUIK remains one of my favorite stocks and a Top Buy up to $4 for my $8 target.
New Economy MegaShift
Cnet Networks (CNET) also reported after the close last Thursday, booking $91.4 million in sales and a three cent pro forma loss. On the conference call they said they have made good progress on their business model change and are getting good traffic growth. They are still having trouble monetizing it, and that was one reason for the Yahoo deal. They expect an additional $100 million over the next three years from the Yahoo relationship. Management guided for 6% to 10% revenue growth in the June quarter to $100 million to $104 million, on which they can breakeven. The consensus already was looking for $103.3 million and a one cent profit, so their guidance was in-line. For the year, they said they would do $440 million to $460 million and three or four cents a share. I would say if they can’t stay on that track, the Board will sell the company. CNET still has great Web properties and a low valuation, so the risks are low and the potential if they can turn it around or sell it for a fair price is high. Buy CNET up to $9 for my $17 target.
Security MegaShift
Packeteer (PKTR) remains a hold for another week or two to see if we get a higher offer than Blue Coat’s (BCSI) $7.10 a share. PKTR is a hold with a $10 target to leave room for a higher offer.
SiRF Technology (SIRF) reported after the close last Thursday. The conference call with Dado Banato as interim CEO certainly was an improvement. The Chief Financial Officer also is resigning, effective May 8. Dado said the June quarter will be another weak one, and it is possible the second half won’t show the usual seasonal strength in personal navigation devices. He is setting the bar way low, as I would expect him to do. The stock should be bottoming right here. Buy SIRF up to $8 for my $20 target after Dado brings in a great CEO to straighten out the company.
Print This Post
