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How Mighty Is Isis?

The biotech soars on promising drug results, but can its fundamentals endure?

It appears that some investors in Isis Pharmaceuticals (ISIS) successfully uttered the magic incantation, "Oh zephyr winds which blow on high, lift me now so I can fly," as shares of the California biotech last week soared 35% in the three trading sessions after Wednesday's close.

Last week's move came as a result of favorable analyst reports ahead of expected data at the American Heart Association conference this week.

Sunday night, Isis released the phase II results of cholesterol drug ISIS 301012, sending the stock sharply higher Monday. Investors cheered the efficacy and safety profile, with some calling ISIS 301012 a potential blockbuster.

However, as with most biotech stocks, it's important to separate hype from reality. Investors should also take the time to examine a biotech company's balance sheet and capital structure before plunging in on news of the latest and greatest drug, no matter how promising the potential.

Does It Work?

Yes, the results strongly suggest

it does. As a single agent, ISIS 301012 lowered low-density lipoprotein (LDL) between 12% and 62% depending on dosage. When the drug was combined with statins (a common cholesterol-lowering agent), LDL ranged from an increase of 4% to a decline of 51%. Leerink Swann's Joseph Schwartz says ISIS 301012 is "poised to emerge as the most potent LDL-lowering cholesterol drug ever."

At this point, efficacy doesn't seem to be the issue.

Is It Safe?

The answer to that is not so simple, although you wouldn't know it from listening to the company or sell-side analysts. In Isis' press release, it stated the drug demonstrated a strong safety profile and was well tolerated.

But one area investors should keep a close eye on is liver toxicity. The threshold of liver function that is usually cited during the testing of drugs is three times the upper limit of normal (ULN) of the enzyme ALT. Drug companies don't want to see their test subjects go above three times ULN. Of the 40 patients who received the drug, two experienced greater than three times ULN, while eight fell into the two-to-three-times ULN category.

Isis CEO Dr. Stanley Crooke stresses that readings were taken on a weekly basis (vs. monthly in other studies) and that it's more important to look at the figures compared with the numbers of readings (roughly 1,100) vs. the number of patients. He adds, "If you take the average person off the street and run liver enzymes on them weekly, over a period of three months, you will find multiple times when their liver enzymes might be up."

The Street seems to buy into this line of reasoning. However, not everyone is taking the numbers at face value. One hedge fund manager who is short Isis and requested anonymity counters the CEO's argument, stating, "The incidence of ULN readings increases significantly at higher doses, which is evidence that suggests a drug effect."

He says it's important to note that liver toxicity is a cumulative effect, and that is why he's particularly interested in the two-to-three-times ULN numbers, considering that the trials were short -- five weeks and three months of dosing.

Comparatively, phase III trials for cholesterol fighters such as

Bristol-Myers Squibb's

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Lipitor involved thousands of patients over a longer time period. Since high cholesterol is a chronic condition, the money manager is concerned that with readings already in the two-to-three-times ULN category after such a short time, more patients may cross the threshold with continuous use of ISIS 301012.

Expect Dilution

It's no secret that Isis will need to raise money in the future. Crooke believes "it's factored in by knowledgeable people who invest in biotech companies."

Isis has a $200 million shelf offering on file with the

Securities and Exchange Commission

, meaning it can offer up to $200 million of common stock in the future. At Monday's closing price, that would add about 16 million shares. Of course, there's no guarantee Isis will use the entire $200 million or that it would take place at current prices -- but it's more than likely the company will tap that source eventually.

Isis has already secured funding from several groups that will lead to dilutive events. In May, Azimuth Opportunity Ltd. committed to buying $75 million worth of stock or 14.5 million shares, whichever is reached first, by December 2007. To date, Azimuth has spent $20 million on 2.7 million shares. At Monday's closing price, the agreement would dilute the shares by another 4.4 million by this time next year.

The company also created a special financing instrument with Symphony Capital Partners in April. Symphony invested $75 million to create Symphony GenIsis for the purpose of funding ISIS 301012 through phase IIb trials in patients with high cholesterol and two diabetes drugs. The funds in Symphony GenIsis are reflected on Isis' balance sheet as part of cash.

As a result, Symphony GenIsis owns the intellectual-property rights to the drugs. If Isis wants the rights back, it must to pay Symphony $195 million within four years, a compounded annual growth rate of 27%. One third of that figure can come in the form of stock. Symphony was also granted five-year warrants on 4.25 million shares at $8.93 a share. That's expensive cash. It makes me wonder why Isis couldn't find a cheaper source of funds.

Isis also has $125 million worth of convertible bonds. Come May 2009, the bonds will be converted into 7.5 million shares. Even before the company raises more money, Isis is looking at 16 million additional shares, or more than 20% of the current 75 million outstanding.

Many sell-side analysts see Isis turning a profit in 2010 or 2011. However, the hedge fund manager questions the analysts' models, particularly the shares outstanding. At profitability in 2010, A.G. Edwards estimates there will be 91.8 million shares outstanding, while Needham & Co. models for 90.5 million. Leerink Swann sees 91.3 million when Isis turns a profit in 2011.

Only Cowen & Co. is being realistic, according to the manager. Analyst Joshua Schimmer expects there to be 111 million shares outstanding in 2010, 116 million in 2011 and 125 million in 2012, at which point, he believes, Isis will be in the black. Cowen has a banking relationship with Isis. Cowen and A.G. Edwards make markets in Isis securities.

The manager questions not only the math but the motives of the analysts. "Isn't it interesting that these analyst errors happen just when three firms initiate right at the same time, the week before Isis presents their data and they're going to need to be raising money?" he asks rhetorically. A.G. Edwards, Leerink Swann and Cowen all initiated coverage on Isis last week with buy ratings.

As I emphasized in

my column on Dynavax, investing in biotech is not just about how effective a drug candidate may be (especially in Phase 2 trials). You're buying a stock, not the rights to the drug itself. Items like dilution and profits matter once the hype dies down. ISIS 301012 could end up being a life-saving drug. But shares of Isis could cause investors a case of agita along the way.

In keeping with TSC's editorial policy, Lichtenfeld doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.

Marc Lichtenfeld was previously an analyst at Avalon Research Group and The Weiss Group and a trader at Carlin Equities. He holds NASD 86, 87, 7 and 63 licenses. His prior journalism experience includes being a reporter/anchor for On24 in San Francisco and a managing editor of InvestorsObserver, a personal finance Web site. He is a graduate of the State University of New York at Albany. He appreciates your feedback;

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