Too Good to Be True? Proceed With Caution on These 2 Biotechs

Tune in to this health care edition of Industry Focus for a look at two small biotechs that sound exciting -- and may in fact prove to be the next big thing -- but which currently face enough challenges that most Fools probably won't want to rush in.

MannKind (MNKD 0.97%) and Orexigen (NASDAQ: OREX) each have a promising new drug for a major indication. Join us to find out what's exciting, and what's troubling, about each of these companies as they seek to launch what they hope will be blockbuster drugs.

A full transcript follows the video.

Michael Douglass: Are these two biotech stocks too risky to buy? This is Industry Focus.

Hi Fools, health care analyst Michael Douglass here and I'm on the phone with our long-time, I guess at this point, Industry Focus health care contributor, Todd Campbell from New Hampshire. Todd, how's it going?

Todd Campbell: It's going really well, Michael, it's going well. How about with you?

Douglass: Pretty well. It's been a good week thus far; a busy week. I'm sure everybody else feels that way too, as you start gearing up for spring. There's always, it seems, a lot going on. Certainly, for those of us watching biotech and health care it has been a busy few weeks as we get through the back end of earnings season and to a fair amount of new data being reported.

Today, what we wanted to talk about for folks is just a little bit about looking at biotech stocks with an interesting story and with a lot of people who are really behind them, then parsing through how we think about deciding whether something's a little bit too risky or not too risky for us.

Of course Todd, you and I come at this from different places. We're different ages, we're at different points in our investing careers, but I would actually be shocked if we didn't come into agreement on these stocks because I think in both cases there are risk factors that, at least for me, make them very much wait and see.

But let me not give too much away! Which do you want to talk about first, MannKind or Orexigen?

Campbell: Let's talk about MannKind first. Both of them are roller coaster stocks! We could pick either one, but MannKind is as good as any to begin.

You made a great point. I think one of the things we can do as Motley Fools is to help investors understand that great opportunity in promise doesn't necessarily result in great opportunity in delivering on profit.

That's something that we're seeing with MannKind. It's got what could arguably be a great drug. Afrezza is an inhaled insulin. That's a very, very different delivery system than has been used for decades.

Previously, when diabetics get to a point that they require insulin, it's taken via injection. That can be an onerous situation for many people. If you have needle-phobia, the prospect of having to inject yourself multiple times a day probably is not something that you love!

So the concept for Afrezza was great. Let's develop something that you can just breathe in, like an asthma inhaler, if you will, and deliver the insulin that way.

While that is a great idea, it's been very difficult to get that product to market. So far, it just launched commercially this quarter, so we don't know what the commercial success or non-success is yet for the drug.

But there have been some rumors and innuendos suggesting that maybe the uptake so far isn't fantastic. Time will tell on that.

But this is a great opportunity for us to talk to people and say, you can have a big indication like diabetes, with 29 million Americans that are diagnosed and 2 million more Americans getting diagnosed every year. You can create a drug that fits an unmet need as far as a new delivery system, but that doesn't necessarily guarantee that the stock is a good investment.

Douglass: Yes, and one of the interesting things I think is just how highly valued MannKind stock became at one point. The market cap at one point was about double what it is today.

When you get to the sort of valuation where it's really stretched, my rule of thumb is beyond 7-10x sales -- although I've violated that for some companies that I'm really personally excited about -- it does start making you be like, "Oh gosh, it's priced for perfection."

And sometimes you're going to get perfection, but when you're thinking about risk adjusted returns for these riskier stocks; stocks like MannKind, that really have most everything riding on one drug, you have to have a really attractive risk/reward profile for that to work out in your favor.

Campbell: Yes. You really need a lot of things to go right for MannKind from here, and unfortunately for shareholders, that hasn't been what's been happening for the company over the last 5-10 years.

Douglass: Right.

Campbell: Afrezza was rejected by the FDA the first time around. They required additional trials because MannKind had changed the inhaler device, so they said, "Okay, we need to bridge that data, so you need to run a new trial." That cost them a lot of money. As a result, they ended up with a lot of debt on their balance sheet.

One of the things I like to look at -- this is something that Motley Fools can also look at on stocks that are interesting to them -- is the current ratio.

The current ratio basically shows you how liquid the company is, how able it is to make good on its financial obligations if short term creditors come knocking. Typically, if you're 1.0 or below that's scary, and with Mannkind, you're at like a 0.5-0.6.

It's got $200 million in liabilities, and that's after you take into consideration the fact that because of some accounting nonsense you've got to include some of the money that was given from Sanofi (SNY 1.34%) to MannKind to license the drug, etc., etc. -- which is also important.

A lot of bulls will point out and say, "Hey, MannKind lined up Sanofi. Sanofi's got Lantus, one of the biggest-selling diabetes drugs out there." Who's to say that Afrezza isn't a top-selling drug?

But the reality is that you still have so many question marks with the balance sheet, with not knowing what the uptick really is for this drug, that it just poses too much risk for the average investor.

Douglass: Yes. We were talking about this a little bit before we went on air, but MannKind feels a little bit like it's in the "show me" phase.

For me personally -- now this isn't necessarily true for everybody. Some people really thrive on the not knowing which way something's going to go and saying, "It's probably more cheaply valued because of that. Now's the time to strike."

For me, I am very willing to give up one of let's say three potential doubles on a stock or something like that, while I'm waiting to see if the business model actually works, while I'm waiting to see if the drug is actually going to pan out.

I think when a company has something really big and life-changing occurring, that just really implicates the entire business model, for me I tend to want to wait until after I know that that's working, and pay more of a premium because I know that that's working, because then I am a lot more confident that I'm not going to lose everything.

To some extent that's my investment style. I don't have, I think, as thick of a skin as a lot of people in biotech do. But again, maybe that's a good thing.

Campbell: Well, yes. If MannKind had gotten Afrezza through the FDA without a hiccup, if its balance sheet was good, if we had gotten initial reads that suggested that prescription volume was there ... but none of those things have happened, so the stool is wobbly. Until that is sturdy I think you have to just, like you said, sit and wait and see.

Douglass: Yes. One thing I always say when folks are like, "Yes, but look at the opportunity. This drug" -- this is not MannKind's case, but "this drug in Phase 1 could be life-changing."

I'm like, "Yes, but if it's going to end up being an industry shaker, a real true disruptor, there's plenty of time for that to happen."

There's going to be a lot of money to be made on the way, and it's probably worth giving up that first potential double, or first few potential doubles even, to make sure that that actually is sustainable and that's actually going to work, and that the data actually bear out this wonderful story that we really hope does pan out. Does that make sense?

Campbell: Absolutely.

Douglass: Yes. All right, cool. MannKind, I think probably a little too risky for both of our tastes right now. Let's talk about Orexigen a little bit. Different, but kind of related.

Campbell: Yes, they're kind of related. Basically, this company has a drug called Contrave that is approved to help reduce weight in people who are clinically obese. Of course obesity is a major cause of diabetes, so in that way they are! It's also a major cause of heart disease.

This is a very important issue and as a result, ahead of the launch of this drug and ahead of the launch of some other weight loss drugs that were approved in 2012 by its competitors, a lot of people thought this was going to be a billion-dollar blockbuster opportunity for these companies, that doctors would be lining up to prescribe these drugs to patients that were either overweight or obese, and there's a lot of them.

The CDC says that 34.9% of Americans are clinically obese. That's an unbelievable number.

Douglass: Yes, that's huge.

Campbell: The CDC also estimates that our spending on obesity is about $147 billion a year, when you include all of the related complications that can come from it, so this is a major issue that needs to be addressed, and Contrave is a drug that can help people lose weight.

In trials, patients lost a little bit better than 4%, a little bit less than 5% on average in the trial, when combined with exercise and diet changes and the like. That's great, but you know what? It's not that big of a difference between that and Arena's (ARNA) drug or Vivus' (VVUS) drug or Novo Nordisk's (NVO 2.49%) drug. They're all kind of similar.

That's why what happened last week with the stock was really so intriguing and moved the stock so much. Last week what happened was the company announced in an SEC filing that it had been awarded a patent on Contrave that extended its protection until 2034, and that that patent was based on interim data -- 25% completion of the data -- so there's a lot of room for error here.

It said that people who were taking Contrave had fewer strokes and heart attacks than people who were taking placebo. Now, that could potentially be a huge differentiator. It could theoretically mean that doctors begin to use this drug much more broadly.

Douglass: Right, and before even that, why that is such a huge opportunity is because we really haven't seen the uptick in these anti-obesity drugs. We really just haven't seen it at all.

There have been a lot of theories; perhaps it's because of worries about fen-phen, which used to be an obesity fighter that just had awful side effects and doctors are just gun-shy ever since then. Or perhaps because they're waiting to see cardiovascular outcomes, or perhaps it's because doctors don't want to do a pill for it ...

There have been a lot of different theories about it. I just wanted to draw that part in.

Campbell: Yes, there are a lot of worries out there, and I don't think that it's wrong for these worries to exist because you are talking about obesity, and obesity and heart disease do go hand in hand. You don't want to take additional risk and expose these patients to the risk of cardiovascular events.

That's why this finding was so surprising, because the study had been designed to show that it didn't increase, and now all of a sudden we're discovering that not only did it not increase, but maybe it reduced it.

But again, huge grain of salt with this, because it's based on 25% completion of the interim analysis of the data from this trial. Anything could happen at the 50% completion, at the 100% completion; we don't know.

As a matter of fact, the FDA was apparently not happy with this data getting released because they view it as being far too premature for this information to be out there in the public domain. They're afraid that people are going to see this and think, "Oh, I can use this to reduce my risk of stroke," when that really has not been proven yet.

Douglass: Yes, and even more than that, one of their concerns appears to be that this might actually influence the trial itself; essentially, as reported by The Wall Street Journal, that people who are in the trial might suspect that they're on placebo instead, and discontinue from the trial.

That of course would have big negative effects on the trial actually being able to report good data. Obviously, if you lose part of your patient population, that's really not a good thing.

There are a lot of concerns, and the FDA has definitely made very clear that they are very displeased, and let's face it, there's a lot that they could do. It may be that what they do is just a strongly worded letter. It could be fines. They could even pull Contrave, revoke its marketing application -- although people seem to think that that's maybe less likely than some of the others. It's of course impossible to predict.

Campbell: I think to pull it they'd have to show that there's some risk to the patients, and I don't think we've really necessarily seen that. Obviously there should be some repercussion. I don't know if it's going to be a fine, I don't know maybe if it's going to be a letter.

The FDA had previously also said to the company, "You're going to need to do another trial anyway, because we're not really convinced that the data isn't going to be somewhat skewed by public releases that you've done in the past," meaning right around their approval last September.

So they're going to have to do another trial anyway, and who knows if this data holds up between now and then.

For that reason, despite the fact that maybe you could argue, "This is a drug that's on the market. It did $6.5 million in sales during its first 10 weeks on the market." That's still only a $30 million a year drug. This is small.

It's got a slightly better balance sheet than MannKind, but you know what, again, way too many risks for the average investor to go out and chase this stock.

Douglass: Right, because unlike MannKind -- where we're sifting through tea leaves and stuff like that and don't really have a lot of good, hard data -- with Orexigen they've already got a quarter on the market; and it wasn't a very good quarter!

And of course now this. There are concerns about that data maybe really shouldn't have gotten to people who weren't directly involved with the data committee. There are lots of questions there, and also the fact that, let's face it, predicting what a regulatory authority will do is not as easy as some would have us believe.

It's kind of a big question mark right now, what will end up happening.

Campbell: Absolutely, and you can just imagine the legal beagles at different firms are probably looking at this company and saying, "Hmm. I think maybe we could go after them for this, if shares head lower and people lose money."

Yes, there are a lot of question marks here.

Douglass: Yes, and that's the thing. For me, again, there are a lot of small biotechs that have a lot of promise and even, I think, in a risk-adjusted fashion have a lot of promise.

You and I have talked before about Portola (PTLA), which I think is a really, really interesting stock. There are a number of other relatively small cap biotechs that are interesting, but these two ... they've been in headline, really high interest for biotech investors for a while, but I think that for me they're both stay-aways as well.

Todd, as always, thanks for your time and your insight. It's always a pleasure to talk to you. Folks, drop us an email at [email protected] -- that's "hc" for health care -- @fool.com, and let us know what you think. Shoot us a question if you have one in mind, and we'll be happy to answer it on air and share our take.

If there's a biotech or a health care stock, an insurance company -- even a hospital -- that you are curious about and want to learn a little bit more about, we're always here to help. That's the core part of The Motley Fool's goal. We are here to educate, amuse, and enrich.

I also want to note, folks, as we always do try to note, folks who are on the show, and of course The Motley Fool itself may have positions in stocks mentioned. I don't, in any that we've mentioned today! I think Todd owns Portola.

And of course The Motley Fool may as well, so never make an investment decision just based on what you hear someplace. Always do your own due diligence. Thanks much all! Check back to the fool.com for all of your investing needs, and Fool on!