Dendreon Q3 Earnings Preview: Can the Company Overcome the Odds?

One of the most controversial companies in the biotechnology sector today is Dendreon (NASDAQ:DNDN). To some, the company represents the worst of Wall Street, an overhyped company with an overhyped product that has cost investors huge sums of wealth. And to others, Dendreon is a company that is deeply misunderstood, and whose true value has yet to be realized. Since the company went public over a decade ago, its stock has been a battlefield between these two opposing forces.

Dendreon’s stock soared from 2009 to 2011 as optimism regarding Provenge, the company’s unique prostate cancer therapy, grew. And the stock fell sharply as that optimism proved to be excessive. Dendreon has failed to ramp up sales of Provenge in a meaningful way, and the results of that can be seen in the stock’s chart, shown above. But, with shares hovering near $4, has the pessimism surrounding Dendreon become too much? With over 30% of the company’s float sold short, the situation is ripe for a short squeeze. And with the company set to report Q3 2012 earnings on October 30, there may be an opportunity for traders to profit.

Setting the Stage

If an investor were to look at Dendreon’s results for Q2 2012, and they had never heard of the company, they would be likely to assume that the company is on the right path. After all, sales of Provenge came in at $79.964 million, up 66.11% from a year ago. And the company’s net loss narrowed to 65 cents per share, down from 79 cents a year ago. But, if that investor were to look at expectations for Provenge when it was launched, they would likely be disappointed. For fiscal 2012, the current consensus forecast calls for Dendreon to post a loss of $2.64 per share.

While that may not be outrageous for a biotechnology company in the process of launching a new product, Dendreon was expected to be posting solid profits by now back when Provenge was first launched. Earnings forecasts for Dendreon had called for earnings of almost $2 per share for fiscal 2012 back in 2010, and they have been steadily declining ever since.

As Medivation (NASDAQ:MDVN) and Johnson & Johnson (NYSE:JNJ) have launched their own prostate cancer therapies, Xtandi and Zytiga, many investors see them as being the death knell of Dendreon. However, it may be too early to write the company off. CEO John Johnson is working hard to turn the company around, and the company’s Q3 results will allow him and his team to update investors on their restructuring efforts, and where Provenge stands in the market.

Q3 Earnings: Things to Watch For

The Reuters consensus forecast is for Dendreon to post a loss of 86 cents per share in Q3. And while the headline numbers (both for EPS and sales of Provenge) are important, they are not what investors need to be focused on. Right or wrong, Dendreon faces a large amount of doubt regarding its ability to survive as a standalone company, and the company needs to disprove such doubts on its Q3 conference call. Specifically, there are 4 issues that need to be addressed:

1. Sales force turnover: On its Q2 call, Dendreon admitted that increasing turnover in its sales force had negatively affected results. CEO John Johnson stated that sales in markets where there was significant turnover saw sales drop 30% sequentially relative to markets without such turnover issues. He stated that there should be stabilization in the third quarter, and he should provide an update on this issue when Q3 earnings are released. Credit Suisse (which has a neutral rating and $6 price target on the stock) says that this issue is fixable, but that the “window is closing.” Because of the complex logistics of infusing Dendreon, the firm believes that physicians need more assistance from Dendreon than they would if it was a simpler drug, and that if the company is unable to fix the issues within its sales force, that physicians may simply move on from choosing to utilize the drug.With Xtandi now approved, and Bayer set to file for approval of its own prostate cancer drug by the end of 2012, there may be increased “poaching” of Dendreon sales representatives, an issue that the company needs to prevent.
2. Competition: Perhaps the biggest issue facing Dendreon is the assumption that Provenge is inferior to other prostate cancer therapies. Analysts put pressure on Dendreon’s executives on its Q2 conference call to discuss the impact that Zytiga had on the quarter’s results, and now that Xtandi is approved, and with Zytiga’s PDUFA date for pre-chemotherapy use of December 15 fast approaching, this pressure is likely to intensify. Dendreon, from CEO John Johnson on down, needs to unequivocally reiterate its view that Dendreon is a complimentary therapy, and that these new prostate cancer drugs are not competitors, but rather partners in the goal of fighting prostate cancer. Joe DePinto, Dendreon’s head of commercial operations, stated this multiple times on the company’s last conference call: “We see this product [Zytiga] as complementary, we see them to be used as more and more therapies come out in this space. Patients will be able to have the benefit of multiple therapeutic options and we see the importance of the sequencing and what’s occurring in sequencing out in the market both at the podium, at major meetings, as well as what we are hearing when we talk to physicians as being an important component. We also believe that in that sequencing story Provenge as an immunotherapy should be sequenced up front prior to Zytiga. We are also seeing in the marketplace is that as competitors or additional products enter this space, the noise increases, more patients get screened and this is better for patients and also better for us, because those are the patients that are identified earlier at asymptomatic patients that would be ideal to start on Provenge therapy.” As more men receive screenings for prostate cancer, thanks to increased awareness, more cases can be caught early, the ideal time for Provenge to be used. Dendreon needs to make this point clear, and also tell both analysts and investors that the physicians using Provenge are using it in conjunction with other therapies. Aetna recently expanded coverage, citing the medical necessity of Provenge in patients where their prostate cancer has spread, but not yet reached the liver. CEO John Johnson also stated that Zytiga did not take share from Provenge in the pre-chemotherapy market, and that the issues the company saw in Q2 were internal in nature, and therefore fixable.
3. Cash & capital: Dendreon continues to burn cash, with $95.925 million burned away in the second quarter. And while the company does have $435.236 million in cash & investments as of the second quarter, that balance will have been depleted further during Q3. And with over $520 million in convertible debt already on the balance sheet (it is due in 2016), investors are likely anxious to know what kind of plans Dendreon has in place if it needs to raise new capital. Will the company sell shares? Or will it continue to issue debt? Tying into this is the issue of Dendreon’s COGS. A key part of Dendreon’s current financial troubles stem from an unusually high cost of goods sold. In Q2 2012, the cost of producing Provenge was 77.198% of its revenue, and the company has been working on bringing that percentage down. The company is closing one of its manufacturing facilities, and alongside other restructuring initiatives, cost of goods sold as a percentage of revenue is set to fall below 50% once these initiatives are completed. Investors should examine Dendreon’s cost of goods sold for Q3 carefully, and management needs to outline how far along they are in driving that percentage down. The last, and perhaps most important financial aspect that the company needs to discuss is cash flow. Dendreon has said that it expects to achieve positive operating cash flow once both its restructuring initiatives are complete and U.S. sales reach $100 million. An update on these forecasts would be welcome, for sustainable operating cash flow will give Dendreon more breathing room to invest in expanding the market for Provenge.
4. Zytiga combination trials: Perhaps to illustrate its view that Zytiga is a complimentary drug, as opposed to a competitor in the clearest way possible, Dendreon is currently planning on trials to examine the medicinal efficacy of a treatment that combines both Zytiga and Provenge. Dendreon has said that enrollment of patients will be complete by the end of the year, and Mark Frohlich, the company’s head of research and development, has said that clinical data will be out in early 2013. Dendreon should discuss these trials in more detail when it reports Q3 results, and provide an update regarding its timetable for reporting clinical data.

There will almost certainly be a great deal of volatility in Dendreon’s stock after earnings are released. The fact that over 30% of the float is sold short only adds to the potential. Investors who wish to trade this earnings release, and have a high tolerance for risk, should simply buy (or short) Dendreon outright, based on whatever beliefs that they have. But, for investors more averse to risk, there is a better way to trade this report. And it involves the use of options.

Options Trades: Limiting Profits, but Also Limiting Risk

When used improperly, options can indeed be a surefire way to large losses. But, when used appropriately, options offer investors a way to minimize their risk while still preserving an opportunity to profit. Investors who wish to add options to their Dendreon trade will need to use November 17 options, for they are the nearest options that provide investors the opportunity to have exposure to the company’s Q3 earnings (the closes options expire on October 26, 4 days early).

This approach allows investors to cap their losses, while still allowing for some upside potential. The table below will show trades that include the sale of covered calls, as well as trades where only protective puts are bought. Investors can adjust the trade to suit their individual preferences. The assumption is that investors already have exposure to shares of Dendreon (the prices below are accurate as of the close of trading on October 24). For the sake of simplicity, the trades will be highlighted using 100 shares and 1 options contract for both the call and the put (the trade can be multiplied to fit each investor’s need)

Dendreon Q3 2012 Earnings Options Trades

Conclusions

As the strike price of the put is increased, maximum losses shrink. But, the tradeoff is that Dendreon’s stock will need to rally more and more for investors to breakeven. This table presents a few of the more noteworthy options trades that investors can execute to hedge their exposure to Dendreon. The use of options allows more risk-averse investors to still have exposure to a potential rally in shares of Dendreon, all while minimizing risk. With over 30% of the company’s float sold short, a short squeeze is possible if Dendreon posts good results, and has positive things to say on its conference call. Investors who utilize options will be able to gain exposure to that, all while minimizing their risk should Dendreon continue to show an inability to accelerate sales of Provenge and dispel the doubts about its competitive position and viability.