Seattle Genetics: A Cancer Niche Too Small

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SEATTLE ( TheStreet) --Let's examine the short thesis on Seattle Genetics ( SGEN), which also perfectly illustrates an important point about short selling, generally.

Last August, Seattle Genetics received FDA approval for Adcetris -- an anti-CD30 monoclonal antibody linked to the anti-cancer drug monomethyl auristatin E (MMAE) -- for the treatment of relapsed or refractory Hodgkin's lymphoma (HL) and systemic anaplastic large cell lymphoma (sALCL). Adcetris is a good treatment option for patients within the labeled indication and management deserves applause for getting the drug to market.

Unfortunately, there's a problem: Adcetris sales estimates are too high. HL and sALCL are rare cancers with extremely effective initial therapeutic options, leaving few patients for the Seattle Genetics to treat. Usually, when a drug misses Wall Street estimates, the stock price of the company selling the drug falls. I believe Adcetris sales will fall short of Wall Street estimates, causing Seattle Genetics' stock price to tumble as well.

Before I dig deeper into Seattle Genetics, I want to focus on that shadowy coalition with nefarious intentions which secretly controls global markets -- otherwise known as the shorts. Insert sarcastic sneer here.

For the unfamiliar, short selling -- or "shorting" -- is a way to bet that a company (or nearly any other asset) is overvalued. An investor borrows and sells shares, promising to "return" those shares at a later date (the details are more complex, but that's the gist.) If the share price declines, the investor covers (buys and returns the borrowed shares) and pockets the difference for a profit.

Missteps can be costly; a short has a maximum profit of 100% (an asset's value can only decline to zero), but unlimited downside. Unlike a long position, a short that moves in the wrong direction also becomes larger, thereby compounding the pain. As yet another perk, short sellers are often ostracized for daring to question management's vision.

To be clear, those who illegally manipulate stock prices in either direction -- whether at a hedge fund, bank, mutual fund, or elsewhere -- should be caught and punished. Rather than focus on this tiny subgroup of criminals, doe-eyed optimists blame the shorts for nearly any unwanted outcome. Sadly, this practice isn't new. In the 17th century, the Netherlands banned short selling when an investor's bet against the Dutch East India Company went awry. Regulation would have been the better answer. Napoleon Bonaparte linked shorting with treason, banned the practice, and imprisoned offenders. A few years ago, prominent U.S. politicians lambasted short sellers for causing the financial crisis. (Global overleverage, mispriced assets, and governmental policies that encouraged bad decisions were legitimate targets apparently too nebulous.)

This long-standing demonization of short selling ignores reality. Even quality assets like the cancer drug Adcetris can be undervalued, fairly valued, or overvalued at any given point in time. Admiring Seattle Genetics' regulatory accomplishment shouldn't require loving the stock too, however.

Some executives obsessively assail short sellers publicly, which is often a red flag indicating shorts sellers are onto something. The best management teams don't worry about shorts. They focus on their business with the confidence and understanding that in today's extremely liquid markets, even massive short positions have little impact on a company's long-term prospects. Over time, fundamentals are what make or break a stock. In fact, CEOs should actively seek to meet with the shorts; convince a skeptic and you've created a new shareholder.

I've had my say in defense of short selling. I also realize that most people's negative view of short selling isn't going to change. Shorts are, and likely always will be, vilified unfairly. I do feel a little better with that off my chest.

Back to Seattle Genetics and Adcetris: Every year, 8,800 Americans develop and 1,300 die from Hodgkin's lymphoma (HL), according the National Cancer Institute's Surveillance, Epidemiology and End Results (SEER) database. HL is very sensitive to traditional chemotherapy, so front-line treatment produces objective responses (tumor shrinkage) in roughly 80-90% of patients; most patients do not require further therapy for years, if ever. Patients that relapse usually receive high-dose chemotherapy combined with autologous stem cell transplant (ASCT), a procedure that replaces unhealthy cells with healthy ones. This combination yields durable responses in many patients, with three-year progression free survival rates of 50-60%.

Adcetris employs a neat drug-delivery technology to kill cancer. The antibody portion of Adcetris attaches to receptors found on the cancer cell. Once attached, Adcetris' toxic drug payload is cleaved off inside the tumor cell where it can maximize efficacy and limit toxicity.

In relapsed HL, the Adcetris data are encouraging and clearly warranted FDA accelerated approval. Nearly a third of Adcetris-treated HL patients experienced a complete response (CR) and another 40% had partial tumor shrinkage (a partial response, or PR). Results in sALCL were even better: 59% of patients had a CR and 27% qualified as a PR. Seattle Genetics must still prove Adcetris' clinical benefit in a confirmatory Phase III trial, which the company will start later this year.

Seattle Genetics reported Adcretris sales of $33.2 million in the fourth quarter 2011, the drug's first full quarter on the market. Despite pent-up demand and patient rollover from an expanded drug-access program started before Adcetris' approval, fourth-quarter sales still slightly missed the most bullish investor expectations. I suspect this is the first evidence that the "on label" market for Adcetris is far smaller than the 8,000-9,000 patient estimate offered by management (and regurgitated, predictably, by bullish Wall Street analysts.)

Let's do our own math. The 1,300 people who die of HL every year are Adcetris candidates, though many may be too sick to treat (despite structural manipulation, the drug has serious side effects.) Assuming middle-of-the-road efficacy and using the SEER estimates, 1,320 HL patients will fail front line-treatment. Second-line therapy will elicit responses from roughly half of this group, leaving 660 additional Adcetris-eligible patients per year. Even if we add another 500 patients relapsing from prior years and the relapsed sLCL indication (a disease far more rare than HL), it's hard to see how this market is larger than 2,500 patients.

Adcetris costs $115,000 for a course of therapy, which suggests a total market potential of less than $290 million. Even if Seattle Genetics grabs 60% of the market, U.S. sales would peak at less than $175 million over the next few years -- well below bullish projections of nearly $260 million. Adcetris has yet to be approved in the more price-sensitive European market, but if or when it does, Seattle Genetics will receive a tiered mid-teens royalty on sales from its marketing partner Takeda.

The abrupt departure of Seattle Genetics' top sales executive Bruce Seeley last month is another datapoint that implies all might not be sanguine inside the company's commercial operations. Although executives leave for a variety of reasons, the company's SEC filings and an interview with CEO Clay Siegall suggest Seeley was pushed out of his job. Making an executive change to a critical sales position early in a drug launch is almost always a bad sign. Sudden transitions like this raise execution risks that investors should not ignore.

I expect U.S. Adcetris sales to grow modestly over the next six months and then flatline around $165 million. Given the company's $1.7 billion enterprise value (which subtracts $331 million in cash from the market capitalization), it's hard to believe Seattle Genetics shares would weather a miss of that magnitude.

Bullish investors counter that Adcetris use will expand to earlier treatment in HL and other indications long-term. For these reasons, some optimistic Wall Street analysts project U.S. Adcetris sales of more than $550 million in 2017. I'm skeptical. Despite interesting early data, Adcetris' high price makes use of the drug difficult to justify against inexpensive, effective chemotherapy regimens. Seattle Genetics also unexpectedly found new, severe side effects of Adcetris treatment late last year -- pulmonary toxicity when combined with the anti-cancer drug bleomycin and a rare, often fatal brain infection known as progressive multifocal leukencephalopathy, or PML. Although unlikely to limit late-stage use, these side effects add to my skepticism about expanding to earlier treatment.

Let's turn to the Seattle Genetics' antibody-drug conjugate (ADC) platform and drug pipeline. Although I don't have any specific gripe with Seattle Genetics' early-stage compounds, the long history of research-and-development failures -- at least seven, by my count -- for ADC and related earlier platforms suggests this technology does not reliably produce viable drugs. Seattle Genetics has also had development partnerships and technology collaborations with multiple biotech and pharma companies over the years ( Genentech actually licensed and abandoned the same drug -- dacetuzumab -- twice over a ten year period). As far as I can tell, not one of these collaborations has produced a marketed drug. Finally, the science supporting CD30 overexpression in other cancers is less clear than in HL and sLCL; this reduces Adcetris' chances of success.

Now, if you will excuse me: those hidden, magical levers that control the global stock markets don't pull themselves.

Disclosure: Sadeghi-Nejad has no position in Seattle Genetics.

--Written by Nathan Sadeghi-Nejad in New York.
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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