Upside Exposure Is on Sale for This Biotech

The Story of MannKind
MannKind (NasdaqGM: - ) is a great example of a bimodal payoff--at some point in the future we expect the shares to trade either near zero or at a big number. The firm's lead candidate, an inhaled form of insulin known as Technosphere, is being tested in Phase III clinical trials. MannKind first fell below our Consider Buying price in May when it reached almost a 50% discount to our fair value estimate. The stock has recently traded down even further, due to concerns that potential large pharmaceutical partners may steer clear of inking a deal until pivotal Phase III data is on the table.

In calculating our fair value estimate for MannKind, we use an 80% probability that Technosphere insulin will be approved, and we assume that the firm could launch the drug in the year 2010. More than 8 million Americans either inject insulin or are poorly controlled on oral diabetes drugs, and the prevalence of diabetes is growing at three times the rate of the general population. With numbers like these, it's easy to see why there's a multi-billion dollar market for easier treatments that can provide better control of this potentially debilitating disease.

We think Technosphere insulin has consistently shown signs that it not only improves upon its struggling predecessor (Pfizer (NYSE: - ) and Nektar's (NasdaqGS: - ) Exubera), but also that it has the potential to provide better control of glucose levels than the most advanced forms of injectable insulin. Package that with the convenience of a small inhaler and the product's potential to prevent gain, and we think Technosphere could achieve peak global sales north of $4 billion in 10 years.

Using Options to Capture MannKind's Upside
Here's where the options come in. Because we probability-weight our sales forecasts for unapproved drug candidates, our fair value estimates actually incorporate calculations of the expected value of the Technosphere insulin, using two scenarios: approval or failure. However, we also know that the stock is unlikely to trade at our fair value estimate a few years from now, it will either trade at a price corresponding to approval, or trade at a price corresponding to failure. The option market tends to price options as though the stock price is most likely to remain at today's price--with probability falling off in both directions. This provides us with a deal, because we know that either a big number or a near-zero number is a far more likely scenario for MannKind's future stock price. In addition, call options on the stock pay off big in the event of approval and only expire worthless in the event of failure, which limits the losses to the price of the options.

We also have a pretty good idea of the timing of the likely stock move, making the investment well-suited to options. We should see key data for Technosphere insulin starting in the middle of 2008, and new data should continue to trickle down to investors all the way through to MannKind's application for Food and Drug Administration approval, planned for late 2008. Therefore, by January 2009, MannKind could have solid Phase III data in its hands, a global pharmaceutical marketing partner, and Phase II data for product candidates that are currently only in the earliest stages of development. Incorporating this scenario boosts our fair value estimate to roughly $35 per share, and since we expect the passage of time to raise the value of shares by our cost of equity, this should bring the share price north of $40.

By taking a look at prices for calls that expire in January 2009, we see that call options with an exercise price of $20 cost less than $2 per share. In the event Technosphere passes Phase III, the options would be worth $20 ($40 - $20), or 10 times what we paid for the options. In the event it fails, the options would likely expire worthless. However, we think the likelihood of approval is 80%, and an 80% likelihood of a 10 times payoff is a pretty good bet. The expected value of the bet is $16 (80% * 20), which is a 700% return for a $2 bet over 17 months, or a 333% annualized return.

There are many ways the investment could fail. Technosphere insulin could fail and the options could expire worthless. Also, MannKind could be acquired by a large pharmaceutical firm before January 2009 for less than $20 per share; in this event, the call options would remain out of the money, and the options would again be worthless. However, despite the risks to the stock reaching its full potential, we see this option strategy as worth the (significantly lowered) risk it entails.

In future articles, we'll explore other pharma and biotech option opportunities, such as how to use the option market to take advantage of blockbuster drug potential at Vertex Pharmaceuticals (NasdaqGS: - ) and Keryx Biopharmaceuticals (NasdaqGM: - ).

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