Friday File pt. 2: Real Money Portfolio Update

by Travis Johnson, Stock Gumshoe | August 10, 2018 4:15 pm

Checking in on The Trade Desk, Ligand, and a new speculation

Ligand (LGND) started us off on Monday with a huge “beat and raise” quarter — which was already at least partly in the works, since they had raised expectations earlier and made a big deal with WuXi Biologics to amend a license agreement in exchange for a $47 million up-front payment… but they did exceed my higher expectations, again, and they said plenty of optimistic things about their two lead royalties, anticipating that both Kyprolis and Promacta will become “blockbuster” drugs this year (that means a billion in sales, so that’s just essentially forecasting that both of those drugs will see sales growth in at least the 20% neighborhood for 2018). That optimism and the “beat and raise” drove the shares up close to 10% more, though they’ve stabilized a bit in the past couple days.

And after the earnings announcement, news came out that Ligand is planning to acquire small drug developer Vernalis (public in the UK) for about $43 million in cash. Vernalis is a “structure-based drug discovery biotechnology company,” and was in the process of putting itself up for sale, so this is not a huge surprise or that big of a deal.

So what does Ligand get? A portfolio of 8 “fully funded partnered programs” with pharmaceutical and biotech companies, and a R&D operation that is much larger than Ligand’s existing employee base but is also essentially “break even” — they have collaboration agreements that generate $8 million a year, and they spend about that much doing the work… but they also get the potential to add to their portfolio of “shots on goal” from this R&D work that could lead to royalties or milestone payments, along with a bunch of early stage preclinical programs that could be partnered or sold along the way. Vernalis also has about $36 million in cash on hand, so this deal ends up being awfully close to break-even for Ligand as well — which probably means that the assets are not obviously appealing to other acquirers.

So this looks like essentially a nothing deal at this point — which is good. It costs Ligand very little, it might end up generating some incremental revenue in the coming years if compounds are found, and the company can essentially pay for itself just by chugging along as it has been. Might be just the kind of operation that can benefit from having a finance-minded person running the show instead of a science person, which has been the “edge” that Ligand has over some competitors — they’re not looking for a brass ring or a breakthrough therapy, they’re looking to manage the drug discovery and development process in as cost-efficient a way as possible, while still keeping a little taste of the back-end returns… including the long-term royalty windfall if one of those drugs does end up being a big hit. They haven’t had a new hit in a long time, but hope springs eternal.

Interestingly, the one investment bank that has steadfastly stood by Ligand and called it a “buy” even when short-sellers were circling and the stock was at crazy valuations in past years, finally downgraded the stock — bumping the rating down to “neutral” and raising the price target to right about where the stock stands this week, $250 per share.

That appears to be simply a valuation call — Roth Capital has been willing to keep expanding the multiple over the years as earnings rose and as they made new deals like the OmniAb acquisition (or this new Vernalis one, though that’s small and took place after the downgrade), but they said that the current valuation levels make the shares “increasingly speculative.”

So I guess you can throw a “duh” in there. Ligand has been increasingly speculative almost every quarter for the past five years, so making a call on exactly when that growth in the PE ratio might stop, or when the speculators might take their profits and cause the stock to roll over, is a guessing game. They do still think Ligand is doing things right, just that the valuation is a bit kooky — here’s another quote from the analyst:

“The company’s business model of leveraging platform technologies for back end royalties is working well in the current strong market for biopharmaceuticals. Further, the risk profile is superior in the event of clinical or marketing failures. We consider LGND among the best managed companies that we cover.”

I don’t disagree with that. And I don’t disagree that the valuation is a bit kooky, either. I’m just not selling… not until the business starts to do worse, or the stock starts to collapse and hits my stop loss. The valuation has been kooky almost since day one, and it might fall apart… but if I sold this momentum stock whenever it got a silly valuation I would have sold it at $60 in 2013. Sometimes you need to let the market have fun with a growth stock as long as the top line numbers keep improving, and accept that you’re not going to be able to call the top. Ligand’s Tradestops stop loss trigger is now at $180, and if you want to be more conservative a 20% stop loss would be right around $198. I’ll keep letting it bounce around and won’t worry much as long as its above those levels. Promacta and Kyprolis will continue to be the line items to watch as Novartis and Amgen report sales each quarter, though milestone payments are growing to be more meaningful as the portfolio of products hits the 130s and development continues to happen here and there… no sign yet of the next big royalty contributor, though a couple smaller new ones have emerged to help a little bit (Evomela and Baxdela) and a third could be added to that group if Brexanalone from Sage Therapeutics gets approval for postpartum depression — their PDUFA date, by which a FDA decision is expected, is December 19.

*****

And speaking of big quarters, The Trade Desk (TTD) added to our crop of gigantic “beat and raise” quarters this summer when they beat the forecasted earnings by about 35% and also increased their guidance for the year, again. They seem to really be benefitting from their investments in technology and their position as a major player in “unconventional” digital ads in streaming video and audio, as well as by not being under the control of either Facebook or Alphabet.

The optimism of management really filtered through on the conference call, and I suppose that had a lot to do with the incredible surge the stock had this morning, up 35%… which is obviously a little crazy, sending a company from a $3.5 billion valuation to a $5.3 billion valuation in the course of a few hours. I don’t know if that’s sustainable or not, but I like the progress they’re making in building this business, it is extremely scalable and still very small relative to the size of their addressable markets, and I’m holding on and enjoying the ride. Here’s what founder/CEO Jeff Green said that got my attention:

“Our strategy of being the best platform for media buying and not owning or arbitraging media is more valuable today than it ever was. In the last three months, even more of the top 200 worldwide advertisers signed up on our platform. In the last 12 months Ad Age’s top 50 worldwide advertisers increased their spend nearly 100% more with us this year than last. That positions us very well for continued growth, not only for 2018 but in 2019 and beyond.”

If you’re interested in The Trade Desk, I’d urge you to check out the conference call from this quarter (transcript here[1]) — Jeff Green does a great job of laying out the opportunity he sees, and explaining where The Trade Desk creates value for its customers.

The huge opportunity that I think gets missed by some folks is what Trade Desk calls “Connected TV” — essentially, a bet that the replacement for linear TV advertising will be… TV advertising, but in the hundreds of different streaming and “over the top” services that are available and being developed for both traditional TVs and mobile devices. Think ad-supported services like Hulu or the ads sold on other “apps” on your smart TV — that’s where growth is phenomenal, with connected TV ad spending increasing 21X in the first quarter of 2018 over the comparable quarter of 2017, and it’s still growing like crazy, doubling from the first quarter to the second quarter this year. Combining cord-cutting with cost-conscious consumers means that television still needs a strong ad-supported model, even if it’s not the traditional cable bundle anymore, and The Trade Desk is getting a head start on being the platform for buying and analyzing connected TV advertising. This might be enormous — television is that last major advertising platform to really “go digital”, and it’s still huge, with traditional TV and “connected TV” together sucking up close to half of global ad dollars (and global advertising is still a fast-growing market, even though current spend is something like $700 billion a year).

That doesn’t mean TTD will go straight up, necessarily — we’ve seen what happens when they have a bad quarter or disappoint, with the stock falling from $65 to $45 last fall, but their major new product introductions appear to be very successful and the tide is certainly rising as more money floods to digital advertising (and, to some degree, looks for non-Facebook and non-Google alternatives). This one has more than doubled for the Real Money Portfolio now, in less than a year, but I think there’s a decent chance that they’re just getting started.

There’s no rational valuation argument to be made, because all these bets are being placed on the company’s ability to continue to beat-and-raise each quarter and continue to ramp up growth, which is inherently difficult to guess at even for the best analysts (and for management itself), since the shares just blew by most of the 12-month price targets that analysts had. So if you bet on this one do count on some volatility — and it’s a momentum stock whose business could change quickly, so minding the stop loss here is probably a good idea. I give this one a lot of room because of the massive volatility, but am watching the $75 level for a stop loss now (that’s about 40%, depending on where it closes today). With this kind of underlying business growth and the huge potential because of the size of their market, I don’t want to risk cutting it off at the knees if it has another bad quarter… but you don’t want to ride a momentum name down to zero if the business begins to really falter, so you’ll have to make your own call on the stop loss that works for you (which might be, “no stop loss,” a decision I make for some of my holdings).

*****

Probably because I haven’t had enough to do with my portfolio as I enjoy sitting on growing cash balances, I did get into some silliness this week — specifically, I followed up on the successful (so far) pairs trade in Estre Ambiental (ESTR/ESTRW) to do something quite similar with another blank check company (they’re also called SPACs, Special Purpose Acquisition Companies) that has a pending deal in place, Stellar Acquisition III (STLR), which is trying to buy a company called Phunware that is essentially a cloud/app developer with what appears to me to be an opportunistic “me too” project involving a blockchain token.

Here’s what I did, in case you’re playing along at home (this is an illiquid one, so these prices may not be available — and there aren’t necessarily available borrow shares to short every day):

Short Stellar Acquisition at $10.42, roughly the current price. That means I borrowed shares and sold them, pocketing the $10.42 per share… with the knowledge that I have the obligation to buy those shares back to return them from whence they were borrowed, which means I need to keep cash in the account to cover that obligation. This part of the trade benefits from a falling price, since if the stock falls to, say, $8 I could buy them on the open market at $8 to return them and close out the short, enjoying a profit of $2.42 per share.

Bought Stellar Acquisition 2023 $11.50 warrants at about 16 cents. These are warrants that will kick in and become live if and when Stellar completes its acquisition of Phunware, with a five year term that begins as soon as the deal is signed. SPACs always come with warrants, they’re the way that the sponsor and the early investors get a little bonus for tying up their money for two years with no promises that the folks managing the blank check company will find something good to buy. This is a highly levered bullish position at just 17 cents, so anything over $11.67 is profit — it’s pretty unusual to get long-term warrants on a growing tech company, so there’s some long appeal here as well.

The real risk, as I see it, is that the deal doesn’t go through, and the SPAC cash gets returned to shareholders — then my short bet might make perhaps 5-10 cents per share, which will partially cover the long warrant position (if funds are returned to shareholders, which is what happens if a SPAC fails, those shareholders should get about $10.20 or so)… but I’ll still lose a little money.

If the deal does go through, I expect the stock to be extremely volatile and news-driven, but I think the stock likely has some serious downside if the market is weak and/or cryptocurrencies are weak, so I went into this mostly because I was interested in a short position that was so easy to hedge because of the low cost of the warrants… but because the warrants are so cheap, I have an overweighted coverage position in warrants that will more than cover my short position if the stock rises above $12 or so.

So as was the case with ESTR, this is a possible long-term position that really starts to be profitable if STLR has a 20%+ move in either direction — the enemy for this position is a flat stock or a failed deal, but even in that case the loss is small. Probably not worth the time I spent dickering around with this trade, mostly because it’s an extremely illiquid stock, but it was fun… and it might make a strong return if it works out. My maximum loss, if the stock lingers around $11 or so for five years, is about a third of a percent of my portfolio, but the maximum likely loss (if the deal doesn’t go through and the SPAC dissolves) is about a tenth of a percent.

Estre Ambiental (ESTR), the somewhat troubled Brazilian trash hauler that I’m similarly speculating on, hasn’t yet reported their next quarter, by the way, following the (finally) completed 2017 results of a couple months ago, so I don’t know whether their next move is up or down. Given the current price around $8, I’m more likely to make money if it keeps falling, and the warrants are of vanishing utility at this point… I’ll let you know if and when I decide to do anything with that position. Given the continued weakness in Brazil in general, aided by political nuttiness, the short call here will probably keep winning — particularly because the business is done entirely in Brazilian Real, and that currency is down almost 20% against the dollar just since January (it did bounce back a big recently, but the decline seems to have started anew). Brazil’s currency is not as much of a disaster as the Argentina Peso or the Turkish Lira so far this year, but it’s pretty close.

I like these smaller ideas, where a relatively small “real” risk can generate a meaningful return, and where a long-term warrant can cover a short position to remove the risk of a blowout loss (if you’re short a stock, your theoretical loss is infinite — and there’s real risk that the stock could double overnight on a takeover bid or something and you’d be stuck having to buy back your shares at a crazy price… a warrant would surge in that case, so that covers the “upside risk”) — but they’re fairly hard to find. You need a stock that can be shorted fairly close to the warrant strike price, and you need a low cost warrant, which means it’s likely to be a very illiquid stock or one that most folks don’t have much interest in. That’s the case with most SPACs, but most of them have too much optimism built into the warrant price so the risk of loss for a pairs trade like this is a bit higher.

Such trades aren’t easily followed by folks, so I’m sorry about that (mostly because they’re very illiquid, and you can’t quote on thousands of shares or warrants being available at the current price), but for those who are looking for something to do when few long-term ideas are presenting themselves, or for a relatively low risk way of hedging a short bet for a small cap stock where options aren’t available, SPACs can provide some interesting options.

Endnotes:
  1. transcript here: https://seekingalpha.com/article/4197467-trade-desk-ttd-ceo-jeff-green-q2-2018-results-earnings-call-transcript?part=single

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