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The Case for Shorting Elan Into Upcoming Alzheimer's Trial Results

In 2005, Axonyx announced the late-stage failure of phenserine, a compound intended to both inhibit acetylcholinesterase (like Pfizer's Aricept) and reduce amyloid beta. (I was long Axonyx when phenserine failed; it's still a painful memory.)

That same year, Myriad Genetics heaved Flurizan -- a decades-old anti-inflammatory drug that lowered amyloid beta in preclinical studies by "modulating" an enzyme called gamma secretase -- into Phase III trials. Foolishly, Myriad ignored an equivocal Phase II study, as Elan has done with bapi. Flurizan failed in mid-2008 and was scrapped.

In mid-2010, Eli Lilly's (LLY - Get Report) gamma secretase inhibitor semagacestat also failed spectacularly. In a 2,600-patient trial, semagacestat recipients actually did significantly worse on cognitive and activities of daily living scores -- critical tests of efficacy -- than those fortunate enough to receive placebo. As a bonus, drug-treated patients also had an increased risk of skin cancer. Yikes.

Lilly brushed off the semagacestat catastrophe as unrelated to solaneuzumab -- another amyloid beta-targeted antibody nicknamed "sola" -- which the company rushed into Phase III trials despite unimpressive early data. (Sola had no positive effect in a small Phase II study.) Results from the sola Phase III trial should be available later this year, around the same time as Elan's bapi results.

My skepticism about the amyloid beta hypothesis is further deepened by a 2008 case report published in the Lancet. In this paper, investigators present long-term follow-up from a few patients in a Phase I trial of Elan's AN1792, an amyloid beta-targeted vaccine that failed in 2002 due to side effects. The authors' conclusion is unambiguous: "Although immunization ... resulted in clearance of amyloid plaques ... this clearance did not prevent progressive neurodegeneration."

So where does this leave investors? Let's consider how much value Wall Street assigns to bapi and sola. I will ignore Johnson & Johnson -- which is large and loved enough that investors will likely absorb failure without flinching -- and focus on the others.

The timid-but-tempted should consider Pfizer. Despite controlling 50% of bapi economics, Pfizer shares include little value for the drug and management has remained cautious. Meanwhile, the company has solid fundamentals, a low multiple, interesting R&D portfolio, and attractive dividend. I would be an owner (though not for the Alzheimer's program per se).

Elan is the best target for those looking to be short. Management expects 2012 revenues of slightly more than $1.2 billion, up modestly from 2011. Assigning a multiple of 4.5 times sales -- which seems fair given the longer-term threats to the company's multiple sclerosis drug Tysabri -- yields $5.5 billion in value. Let's add $500 million for other pipeline candidates and net cash. This rough calculation suggests that Elan shares could fall 30-40% on bapi failure. Positive data would send the stock up by at least 50%, since Elan owns 25% of the drug. Given the extremely low probability of success, I would short a manageable position size of Elan and consider options for downside protection. Risk-averse investors should avoid Elan entirely.

Lilly is trickier since it has more moving parts and shares haven't moved as much. I am inclined to remain uninvolved. Even if sola failed, Lilly could boost earnings by reducing bloated expenses and continue to pay the company's hefty dividend. Shares would likely drop 10-15% on sola failure, but it doesn't seem worth paying 3% in dividends over the next six months to be short now. I would be more compelled for short Lilly at prices meaningfully above $40 per share.

Finally, industry's stubborn efforts to fit amyloid beta's square peg into the Alzheimer's round hole raises an important question: Why do investors so often let companies squander resources on flawed drug candidates without repercussions? As an example, Lilly's management has for years paid lip service to innovative R&D while investing in copycat drugs and faulty ideas; meanwhile, shares have declined by 50% since 2002. Executive incentives are misaligned by massive paychecks and the imbalanced risk-reward of "if it works" thinking. Even for the dividend-obsessed, R&D dollars are precious and investors should more aggressively demand change when the lessons of history are ignored.

Disclosure: Sadeghi has no positions in Elan, Pfizer, Eli Lilly or or any of the other stocks mentioned in this article.

Nathan Sadeghi-Nejad has 15 years experience as a professional health-care investor, most recently as a sector head for Highside Capital. He has worked on the sell side (with independent research boutiques Sturza's Medical Research and Avalon Research) and the buyside (at Kilkenny Capital prior to Highside). Sadeghi-Nejad is a graduate of Columbia University and lives in New York. You can follow him on Twitter @natesadeghi.
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