Investing in small-cap companies requires a pretty strong stomach for volatility. Today's case study in motion sickness is Noven Pharmaceuticals (Nasdaq: NOVN), which happens to be one of my favorite companies. Noven specializes in transdermal drug delivery technology (involving the delivery of drugs through the skin) for the estimated $3 billion worldwide hormone replacement therapy (HRT) market.

Noven has four drug patches on the market, including Vivelle-Dot, a stamp-size estrogen replacement patch for women, and Combipatch, the first and only two-drug patch ever approved in the United States. Noven markets its Vivelle and Vivelle-Dot products in the U.S. through Novogyne, a 49%-owned joint venture with Swiss drug giant Novartis (NYSE: NVS). The joint venture also recently reacquired the U.S. rights to Combipatch, which had previously been licensed to Aventis (NYSE: AVE). Novartis also owns the marketing rights to the patches outside the U.S.

Brian Graney wrote a column about Noven back in May, one week after the stock took a 32% dive, dropping to below $17 a share on news of a delay in Noven's anticipated drug patch for Attention Deficit Hyperactivity Disorder (ADHD). Since Brian's article was published, the stock recovered its lost ground and then some, rising to almost $40 a share in late June on optimism for continued strong growth in the company's core drug patches and anticipation that Novartis would be launching the combination patch in Europe.

Noven took it on the chin again on Friday, August 3, dropping from $37 at the close on Thursday to under $19 on Friday after announcing financial results for the second quarter. The second-quarter earnings weren't bad, considering a) Noven was bearing full taxes for the first time this year, b) the amortization costs associated with Novogyne's acquisition of the rights to Combipatch, and c) the increase in sales and marketing expenses at Novogyne required for the launch of Combipatch.

Pre-tax net income showed strong growth, up 30.5% to $4.7 million. Reported net income dropped to $3.2 million from $3.5 million year-over-year, and diluted EPS came in at $0.14 vs. $0.15 the year before. Novogyne had revenues of $20.9 million, up from $15.8 million the year before on strong sales of Vivelle and Vivelle-Dot and (one infers) modest sales of Combipatch since its launch in May.

During the quarter, Noven recognized $3.1 million in earnings from Novogyne, compared to $3.3 million last year. In short, nothing in the second-quarter earnings per se would justify anything like a 50% sell-off in the stock. So, why did the market drop Noven like a hot rock covered with man-eating fire ants? 

What's going on in Europe?
The problem was the guidance provided by Noven's management. The questions centered on international (primarily European) sales. Novartis has the international marketing rights to Noven's patches, which, for the purposes of confusing stock analysts, are marketed as Menorest (Vivelle), Estalis (Combipatch), and Estradot (Vivelle-Dot).

Noven's management noted that European product orders from Novartis didn't materialize as expected, and revised the full-year forecast to pre-tax operating income growth of 25% to 30% and a full-year EPS of between $0.40 and $0.45, down from consensus estimates of around $0.60 per share. This compares to last year's adjusted EPS figure of $0.34 per share. Revenues are now expected to be "modestly higher" than last year's.

Noven's management was not well informed as to the reasons behind the shortfall in product orders from Novartis, but made the rather ominous statement that part of Noven's expected growth in 2002 was to be from Europe, and that revenues in 2002 could be relatively flat without some performance from Novartis. 

Strangely, Noven's management didn't appear to know much about the plans Novartis has for its products in Europe. In fact, they seemed a little mystified as to why orders didn't materialize. Considering that approximately 60% of Noven's product revenue comes from outside the United States, this is disconcerting news. One would think that it would be well worth the company's time to book a plane to Basel yesterday. On the conference call, Noven managers did note that they had already scheduled some face time with Novartis, and we hope this will result in better information flow between the two companies.

The failure of orders to materialize from Novartis is doubly mystifying when you consider that Novartis made two announcements concerning Noven products the same day earnings were released. The first was a Novartis press release announcing the application for Estradot in the EU under the mutual recognition procedure, which would allow Novartis to market the product in all EU countries. (The patch was recently approved in the Netherlands, which will act as the Reference Member State.)

The other announcement was a product development agreement between Noven and Novartis relating to the development of product enhancements to the Combipatch/Estalis line. Noven will be responsible for development and technology, and Novartis will handle the clinical and regulatory duties.

It would be a big surprise if Novartis wasn't fully committed to the Noven products, considering that the Swiss drugmaker a) paid $20 million to acquire the European rights to Vivelle-Dot in November, b) paid, as half of the Novogyne joint venture, $32.5 million to acquire the Combipatch products in the U.S., and c) signed the above-mentioned product development agreement. In short, everything Novartis has done seems to indicate that the company is increasingly committed to marketing Noven's products. 

There are a couple of possible explanations. It could be that there is a timing issue; Novartis may want to clear the pharmacy shelves of its older products, Estraderm and Menorest, before launching hard with the new Noven products. Or, Novartis may be awaiting full regulatory approval of Estradot so that it can market the two Noven patch products together. 

Though it was overshadowed by the ominous "guidance" provided by its management, there was some good news for Noven:

  • The company professes to have "high confidence" in its ADHD patch, and expects a new Phase 3 trial to begin in the fall. Noven hopes to file a New Drug Application in mid 2002, and looks to launch before the school year of 2003.
  • Potential competitors have been experiencing regulatory difficulties, with Berlex being the latest to receive a non-approval letter from the Food and Drug Administration for its combination patch. This gives Noven a bit more breathing room.
  • Management noted that Novogyne sales for July were "by far" the highest sales in any month in the company's history.

If the questions surrounding Novartis and its intentions are cleared up, it would appear that this latest sell-off will be another overreaction to bad news. Assuming that Novartis puts some muscle into the Estradot and Estalis products in Europe in the second half, things could look up in a hurry for Noven. On the other hand, this is the second piece of negative news for the company this year -- any further disappointment could see the stock trading in the single digits.

Noven's stock has been one wacky ride the last year and a half -- starting at about $30 in early 2000, crashing back to under $7 in April of that year, rocketing to a high of $64 in November, and then bouncing around like a pogo stick this year. I want to emphasize that this kind of volatility isn't that unusual for small-cap companies -- it's closer to the norm. That's why I like to keep a list of my favorite small companies in a "watch list" portfolio. Every once in a while, the market serves one up at a price that's just too good to pass up.

As for Noven, my guess is that it will recover from this latest setback, and if it does fall into the low teens or single digits, I'll be tempted to buy the stock. As long as it stays where it is, however, I'll just be watching and waiting.  

Zeke Ashton does not own shares of Noven Pharmaceuticals or Novartis, although he does recommend visiting Basel in the summer. Check out Zeke's profile to see his holdings. The Motley Fool is investors writing for investors.