Stocks with a high short interest can signal that something is fundamentally wrong with the underlying company. By the same token, short-sellers aren't always correct in their assessment of a company, and their mistakes can lead to a rapid upward movement in share price through a so-called "short squeeze."
Shares of biopharma Exelixis (EXEL 0.22%) got hammered earlier this year when the company's late-stage trial for its flagship cancer drug cabozantinib was allowed to proceed to its final analysis as a potential treatment for metastatic castration-resistant prostate cancer. Wall Street wanted to see the trial halted early for efficacy reasons given the diversity of new prostate cancer drugs hitting the market in recent years.
Put simply, the Street thinks cabozantinib will have a tough time gaining market share against the likes of Johnson & Johnson's (JNJ 0.22%) Zytiga, Medivation (MDVN) and Astellas Pharma's Xtandi, and perhaps to a lesser extent Dendreon's (NASDAQ: DNDN) Provenge. What's particularly noteworthy is that short-sellers have actually increased their position since the stock cratered in March, now holding close to a whopping 27% of outstanding shares.
Does Exelixis have the firepower to force shorts to cover?
One reason cabozantinib could still be a major revenue driver for Exelixis is that the prostate cancer market has been unfortunately growing rapidly since the 1970s. Perhaps as a consequence of this large and growing market, both Zytiga and Xtandi have posted stellar sales increases since their respective commercial launches. In the first quarter of this year, Zytiga posted $512 million in sales and Xtandi garnered a little over $172 million worldwide. Dendreon's Provenge even raked in close to $70 million for the quarter.
So while cabozantinib's early trial results weren't as positive as investors hoped, if the drug shows some effectiveness and gets approved it would still probably do well enough to make an immediate impact on Exelixis' bottom line, especially in light of the company's market cap of $658 million. Add in the fact that Exelixis has a number of other ongoing clinical trials, and that cabozantinib is already approved as a treatment for thyroid cancer, this climbing short interest becomes even harder to understand.
So why is short interest still rising?
I think there are a couple possibilities to consider. First, Exelixis' losses have continued to mount as the company moves closer to a top-line data read out for cabozantinib's COMET-1 late-stage trial. The company reported a loss of $74.6 million in the first quarter of 2014, up nearly 40% from the same period a year ago. With roughly $400 million remaining in cash and cash equivalents, Exelixis has a fair bit in the bank -- but perhaps shorts are betting that a dilutive capital raise will occur, causing shares to fall further.
On the more speculative side, shorts may be betting that COMET-1 reports negative trial results later this year. I think this is unlikely given that the trial could have been halted earlier due to futility, but it's important to remember that the unexpected happens more often than not in clinical trials.
Foolish wrap-up
While Exelixis' rising short interest is certainly noteworthy, keep in mind that short-sellers have been piling into a host of small-cap biotechs this year. One prevailing view is that clinical-stage biopharmas have risen too fast over the past two years, making them ripe for a pullback. Now that the pullback appears to have come and gone, we may soon see less pressure from short-sellers in smaller biotechs such as Exelixis. If not, they risk the possibility that COMET-1 posts stronger than expected trial results later this year, which could help Exelixis regain Wall Street's affections.
