A little optimism from Vertex (VRTX)

OK, so I'm sick of writing about mistakes and bad news this week. Who better to counter all the bad stuff I've written about in the last couple days than Vertex Pharmaceuticals. VRTX, one of only two stocks in my portfolio to double this year so far (the other being Google, no surprise) released some more good news today.

This is already baked into the stock, but their most critical drug candidate is moving into Phase II following more great results that indicate it is hugely effective against Hepatitis C in just 14 days of treatment. The phase II trial will be examining a possible twelve week treatment cycle that they're thinking might actually cure HCV -- more info in their release, and you can visit their website to hear the more detailed webcast if you're interested. I've written about Vertex before and in more detail, and everything I said then still represents my opinion today -- I'm not buying any more at the moment, but if I didn't have a full position yet I would certainly consider it.

Vertex has doubled already this year because of the great results of their first phase 1 study on this drug, which is currently called VX-950, and the good news continues. Regardless of the fact that this has already doubled, it's worth thinking about the fact that this disease which affects millions of people has no appealing or really effective treatments at this point, and it's possible that the addressable market for HCV will approach 10 Billion dollars annually by the time it's approved (assuming it is approved) in a few years. And in this case unlike many others, we get to see fast-moving trials thanks to the relatively short treatment cycle.

Be wary -- there are possible competitors in the pipeline, notably one from (if I remember correctly) Schering Plough. In my opinion, the market is more than large enough for several drugs if they're effective, but Vertex has burned folks before so any hint of bad news could drop the shares pretty fast.

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Cautionary Tale (DWRI)

Anyone worth his salt can write about his fabulous successes -- but don't the experts always say that we learn more from our mistakes?

It sure appears that Design Within Reach (DWRI) has been my biggest investing mistake in quite some time -- and the worst part is, I should have seen the writing on the wall back when I made my first purchase. If I could have just been a reader of my post about purchasing DWRI instead of the author. I look back at it now and see too much enthusiasm. Too much personal appreciation for the products and the concept, not enough attention paid to the competition, the marketplace, or the financials.

To be fair to myself, all of this is much clearer in hindsight than it was at the time, a mere four or so months ago when I opened my (thankfully small) DWRI position. But if I had been more cautious about making the purchase, I might not have pulled the trigger.

And you know what? I'm not going to sell.

Of course, if I had any significant amount of money invested in DWRI I would sell to free it up -- but I'm looking at a stock that was already down 60%, and has now fallen a further 40% this evening in the crazy after hours trading. After this freefall, it's hardly even worth paying the commissions, even though I would get some satisfaction from drawing a little slash through the DWRI in the top right corner.

I won't even post the chart here -- it's too depressing, it looks like something Alberto Tomba would muscle his way down to win the gold medal in the downhill.

No, unless I have a compelling tax reason to close this position, which I opened up around $18, I'm going to hold onto it and force myself to gaze upon this mistake right up near the top of my portfolio (damn alphabetical order!) and remind myself to think thrice before buying into a newly public company or a company whose product I personally like.

Sure, it's great (and Lynchian) to buy into companies that you have a personal interest in. I find most of my investments interesting, otherwise I might as well buy an index fund. But it's important not to let my personal interest cloud my assessment of the company's prospects.

And the other reason I'm keeping DWRI as a cautionary tale is that I need to remind myself to buy in bites -- not to try to swallow a full position in a company during my first enthusiasm at finding and researching what looks like a quality investment. With DWRI I thankfully followed that rule and bought just a partial position, and things went quickly downhill as it became clear I was wrong about the business so I never re-upped. Phew.

I'm still not sure what went wrong with the DWRI business plan -- I think it's a combination of a lot of things. Maybe the marketplace wasn't as big as I thought, and I definitely underestimated the amount of competition -- not just from other big companies, but from niche local retailers, Design Within Reach is surrounded by high-end designer shops at the top, Crate and Barrel and Ikea at the bottom, and lots of other contemporary furniture sellers that are online or otherwise trying to build a national presence. I think they have an advantage over some of them, but clearly it's not enough of one or they're doing something else dramatically wrong. They even seem be be cannibalizing themselves, as their dramatic growth in showrooms has coincided with significant slowing in growth of higher margin online and catalog sales.

Their company line is that the online and catalog presence is a marketing cost, and the showrooms are the real focus -- I'm not sure I think that's a great idea. The rapid showroom buildout has been quite expensive and is expected to continue for some time -- at least, unless this beating from the stock market causes them to change their plans.

Maybe it's just poor source planning or bad luck -- they're dependent on European manufacturers, so the weak dollar was a problem and then the costs of shipping became a problem with high fuel prices.

But here's where I stop -- I should have taken the risks more seriously, and, as I've learned more over the last month or so, and especially with the disastrous earnings and guidance issued today, I was just plain wrong about this business and management. I've been wrong plenty of times before (see WOLF for the second-worst example), and I'll be wrong some more, but hopefully for different reasons.

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Shanda trouble (SNDA)

Well, today it looks like Shanda (SNDA) has joined Netease (NTES) in the Chinese internet gaming doghouse.

These two seem to be at different points in their evolution -- Netease seems to be plateauing with their hottest games, while Shanda is well over the plateua with MIR II, whose use has already declined pretty significantly. And likewise, my Netease shares are still up a good 20% or so since my purchase, but even though I've averaged down once on Shanda I'm still significantly underwater on that position. I've written at greater length on both of these companies in the past and mostly believe in their continued growth, even though it's starting to look like the online gaming market in China is going to be nearly as fast-moving and hit-driven as Hollywood -- my last Shanda writeup is here, and a rather more optimistic Netease writeup after their last earnings release here.

I think both still look good to hold long term -- NTES because of their diversification and solid product pipeline in addition to their current slate of proven games that should continue performing well for a while, SNDA because they are just ramping up development now for several casual games and, hopefully early next year, a few new big MMPORPGs that could be hits. SNDA's secret sauce is their hardware/software offerings, including an Intel entertainment PC box that folks will use with their home TVs -- that could either be a money pit or a huge hit, I don't understand Chinese consumer culture well enough to know. But with the rapidly increasing Chinese internet audience and the increasing demand for entertainment content of all kinds in Chinda, I think the rising tide will do a lot to lift all boats in this sector -- especially these two companies that, though quite new to US markets, are old, experienced, diversified and large in comparison to most of their competitors in the marketplace.

I'm relieved to see Shanda's 10% or so drop today more than made up for by Rofin-Sinar (RSTI), Intuitive Surgical (ISRG), FARO (FARO -- which has had a ridiculous yo yo of a summer and fall but sure recovered a lot of the post-earnings drop today), Universal Display (PANL), and a few other good performers in the portfolio. That's the joy of diversification, I suppose -- SNDA and NTES haven't caused me any real short-term pain because others are taking up the slack.

Both SNDA and NTES are trading at very small premiums to the market -- that makes some sense because of the risk and volatility, but if you want growth this is significant growth potential at what I consider a significant discount for patient investors. I own and will hold both, though I think I'm overcommitted to this volatile sector and don't plan to buy any more at the moment, even at these low prices.

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Clobberin' Time (MVL)

As the Thing, the Fantastic Four's largest and most orange member, says, "It's Clobberin' Time." Marvel Entertainment (MVL) released earnings this morning and the 2006 earnings forecast was shockingly bad, sending the shares down about 20% immediately.

Ouch.

This is obviously a little surprising, but the fact that their earnings for this past quarter were down from the previous year should not have been at all surprising -- no one expected Fantastic Four to have the same impact as the 2005 megahit Spiderman 2, so the fact that their earnings fell year over year was not surprising, nor was it particularly bad in my opinion. Companies that rely on hits are always going to have choppy earnings.

No, what was really bad was that the first impression is that the company basically wrote off next year entirely. They projected earnings of well under half this year's earnings (in a pretty wide range of 37-52 cents/share, following this year's expected $1.02 a share minimum), saying that licensing and toys revenue will likely be difficult next year.

I expect a large part of the reason for that is that we'll be in a long lull between Spiderman movies, and Spiderman is inarguably the king of the licensing roost -- but still, projecting this kind of dismal earnings for a year in which they're releasing two movies that have pretty high expectations (Ghost Rider with Nicholas Cage, and X-Men 3) seems very unsettling.

Peter Cuneo made it clear in this morning's conference call: "our toy forecasts, frankly, are very low for '06"

What else did we learn from the call?

F4 licensing income is going to be worse than originally expected. Other licensing was frontloaded into this year as they extended or renewed more than usual, especially the video game agreement (with Microsoft? They'll release details on that very soon) which brought in $50 million this year in earnings but should bring in actual cash flow annually. That tradeoff between the video game agreement and F4 licensing is why they made their numbers this quarter and will do so this year.

That also means that cash flow is expected to be much better than earnings next year, according to the call -- $70 million, versus a projected $38-53 million in net income.

Marvel has also authorized a big repurchase in common stock, but they're borrowing to do this. That is a significant commitment to the long-term potential and they certainly believe that this will be immediately accretive to EPS, and I tend to agree with that assessment, but it does concern me a little that they're adding debt to do this repurchase given the substantial debt they're already taking on to produce their own films in 2008 and beyond. Definitely something to keep an eye on.

The key reaction I got from the conference call was "very defensive". Defensive about the potential income from next year's movies, extremely defensive about toy and other licensing income. They seem to be incorporating some extremely pessimistic assumptions about consumers going forward, as well as some extremely conservative projections of the popularity of the X-Men 3 and Ghost Rider toys.

Changes are definitely afoot for Marvel, but they're going to take a few years to develop. The toy license is up for renewal at the end of 2006 -- which means that 2007 will bring some significant changes to one third of Marvel's business, and with the 2008 movies having more significant impact on the bottom line their could be some really dramatic changes to the way we think about Marvel in the coming years.

Avi Arad, head of Marvel Studios, was not very specific in the call but did say that current licensed films are moving forward well (including F4-2 and Spiderman 3), and they are going full speed ahead with the slate of self-produced films for 2008 but will wait to see which looks most promising for first release as scripts and talent are identified.

So what do I do with these MVL shares? I still think their self-produced films can be a huge boost to income, and I still think their slate of films over the next two years should drive better toy and licensing revenue than they're expecting. I appreciate that they have lowballed the projections because they want to be very conservative, but I hope they're aiming high while guiding low.

I'm going to hold the shares that are now sitting at a small loss, and if the market accepts their projections about 2006 performance and continues to beat the stock down, I'll have to reassess and see whether I think buying more shares makes sense. I see at least one blockbuster hit in each of the next two years (Xmen 3 and Spiderman 3) which I think will help drive licensing performance higher, and I'm hoping that the toy problems they've had this year can be resolved and the segment performance will improve. The downside seems awfully limited to me, I see no reason to sell.

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Still EXEL-lent

Well, as I had been mentioning I might do for a week or two, I bought some more EXEL today. I had been assuming the earnings release would be a non-event, as it was, and that I would be able to buy at roughly the same price anytime prior to their release of data next week on a few of their phase 1 compounds ... oops.

That turned out not to be the case, as the company strongly implied in their conference call that there would be good news in the preliminary trial results we'll see next week. That, I imagine, is the reason why I had to pay almost 10% more than I could have paid last week for my shares. Still, I'm happy with a long-term hold of EXEL at this price.

Bought more EXEL today, November 7, at $8.66. That brings my average cost for my EXEL holdings to roughly $8.11, and I now own what I consider a full position for a risky biotech play like this one.

I last wrote at length about Exelisis back when they did a round of conference calls, including one at the Banc of America conference (my writeup of that call is linked here). There really isn't any news out since that writeup, but there is clearly a feeling in the air that something is coming. That feeling was fed by the earnings call in which the upcoming data release was mentioned several times -- one has to imagine that they wouldn't emphasize that preliminary data release so much unless the data was going to be in some way pretty significant.

And since these are all cancer drugs, significant performance in phase 1 trials might well move the market. I can't say whether or not we've already had that move, or whether the news will be enough to even support this recent post-earnings share price performance. But I do think that this company's deep pipeline and excellent (and creative) financing will move them into the big leagues of biotech eventually. It may be with the three drugs we'll hear something about next week, or it may be one of the other eight compounds in trials or some of the other projects that are still in the clinic. But the odds favor something successful for a company with this scientific track record and reputation, and something successful against cancer would be big news, as we have seen with all the recent biggies from Genentech, Imclone, and others.

So I'll be waiting along with the rest of you to see what the news is, and hoping that the CEO didn't lead the market to expect too much (these are, after all, still phase 1 drugs -- Vertex excepting (and VRTX is, by the way, now up 100% for me -- joining Google as the only ones with that distinction in my current portfolio), we shouldn't see those causing dramatic stock advances very often). I've grown to really like this company's management, and everyone loves their pipeline -- soon we'll have a better idea of whether or not those feelings are misplaced.

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