Investors are understandably eyeing pharmaceutical stocks right now – the pharma industry has returned an average of 5 times more than the S&P 500 in the last quarter. And some of the biggest growth has been in the small-cap space. But while most investors clamor to snatch up shares of drug makers, one pharma stock you should avoid is sending the wrong signal. Here’s why you shouldn’t buy shares of Synta…

Synta Pharmaceuticals (NASDAQ: SNTA) is a development-stage bio-pharmaceutical company. Currently the company has 3 candidates past pre-clinical studies. STA-9090 is what is known as an Hsp90 inhibitor, which for those of us without medical degrees means that the drug is targeted to prevent and possibly reduce the spread of cancerous tumors.

This drug is just now entering Phase 2 clinical trials. The second drug is Apilimod, a treatment targeting rheumatoid arthritis, also just entering Phase 2. Finally there is elesclomol, an “oxidative stress inducter” for cancer treatment, specifically metastatic melanoma, a form of skin cancer. Synta has other compounds under development, but as most are in pre-clinical stages, there is no reason to discuss them at this point.

Elesclomol is a sad story for Synta, despite it being the reason why the stock perked up on my Magic Formula radar. The company entered a joint development agreement with GlaxoSmithKline (NYSE: GSK) in 2007, and the drug progressed well through Phase 1 and 2 clinical trials, and Phase 3 (the final stage before submission) was scheduled to complete in 2009. In February, Synta received results that showed elesclomol was producing lower overall survival rates than no treatment, causing the FDA to put the drug on clinical hold. Glaxo saw this result as a death sentence for the compound, and terminated the joint venture in September.

With the termination, Synta recognized nearly $115 million of previously deferred revenue on the income statement in the just-completed Q3 (deferred revenue is cash already received but not yet recorded on the income statement). This has pushed the company’s trailing 12-month operating profits way, way past anything sustainable and has led to an earnings yield over 60%, and return on capital over 1,300%!

Clearly, this is a one-time event and not something we can rely on.

Looking at Synta’s results absent this windfall, they are grim. The company started operations in 2001 and has never produced any marketable drugs. The only way they continue to operate is through financing such as the 2007 IPO and preferred stock offerings, as well as a few minor licensing milestone payments and government grants. In 2005 and 2006, there was no revenue at all!

As a result, Synta has been unprofitable for its entire existence, accumulating a deficit of over $400 million dollars. With elesclomol a failure, the future is even darker. Speculating on anything before Phase 3 is risky business.

The disappointing thing is that until this one-time payment falls 4 quarters behind, it’s likely that Synta will continue to occupy a space in stock screens as a stock worth looking at. Avoid this one at all costs – it might even make an interesting short candidate right now: typical annual cash burn is near $50 million and that’s about all the company has left in its coffers.

Don’t get burned by this unattractive pharma stock…

Sincerely,
Steve Alexander
MagicDiligence.com

December 11, 2009

Steve Alexander

Steve Alexander is the founder and editor of MagicDiligence, an Internet-based research and recommendation service focused on finding the best opportunities from Joel Greenblatt's Magic Formula Investing screens.  By fundamental research of growth potential, competitive position, and financial health, his picks have vastly outperformed the market at a success rate far exceeding that of most mutual funds.  Prior to this, he was a successful independent stock investor for over 10 years.

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