It was announced this morning that Berkshire Hathaway’s National Indemnity unit would be buying the US assets of Swiss reinsurer Converium for $95 million in cash and $200 million in assumed debt.  The unit has $1.06 billion in reinsurance liabilities. It is unclear how much worth of reserves are included to back up the liabilities.

Converium had run into serious trouble in 2004 when it discovered a $500 million shortfall and stopped writing new insurance in America. The company needed to sell this asset to a strong buyer in order to improve its credit rating. The circumstances of the deal would imply that Berkshire is buying this at a fire sale price, but even with the rosiest projections, this will be barely material to a company the size of Berkshire. What this should do is further improve the results of a reinsurance unit already poised to have a great year with dramatically increased premiums and no major disasters.

Bank of America(BAC)’s announcement today(10/11) that it would offer 30 free trades per month to customers with combined balances of $25,000 or more was greeted by investors in online brokers with a stampede for the exits. E*Trade(ET) and TD Ameritrade(AMTD) were both trading down around 10%, and Charles Schwab(SCHW) was down more than 5%. Bank of America’s announcement comes just days after the launch of Zecco, a new online broker which also offers free commisions. Past attempts at commissionless sites(i.e. freetrade.com) have failed to take market share and have been shut down.

At least for the moment, the market believes this is different. And it is. Bank of America is a behemoth, having relationships with over 50 million American households, 40% of which will already qualify for free trades. ETrade can scarcely afford to eliminate commisions; commision revenue consistently exceeds net income.

So what’s an online broker to do? Relax.

When discount brokers emerged and online stock trading was America’s new national pastime in the late 1990s, it was a widely held belief that full service brokerages would be forced to cut commisions or face the disappearance of their business. Despite the fact that commisions haven’t been cut these companies are at record stock prices and making record profits. Apparently, commision costs aren’t the only factor driving investor behavior. Full service brokerages also began to shift clients towards non-commision based fees, charging many customers a flat percentage of assets.

The market’s reaction is overdone. ETrade, Ameritrade and Schwab already face lower-priced competitors and have continued to grow. For most investors, the difference between $13, $7, and $0 is not sufficient to motivate them to go through the hassle of switching brokers if they are otherwise happy with the service they’re receiving.
Commisions will not disappear overnight. There is a cost to executing trades, and everyone, even Bank of America, needs to pay it. If brokers aren’t making money off commisions, they’ll need to make it up elsewhere. Whether that’s through higher margin interest rates, lower interest paid on cash accounts, or additional fees, remains to be seen. Commisions have been consistently falling for the past 10 years, and online brokers have only become more profitable. Is that a guarantee that continued drops will not reduce profit? No, but Bank of America’s move is the beginning of the end. After all, you can’t get cheaper than free.

Disclosure: I have no positionin BAC, ET, AMTD, or SCHW

“Everybody else is doing it.”

Inspired by recent option backdating scandals, and the criminal leak investigation at Hewlett Packard(HPQ), Warren Buffett sent out a memo to his top managers at Berkshire Hathaway(BRKA), reminding them of the importance of ethical behavior. Buffett said that while bad behavior is inevitable,

we can have a huge effect in minimising such activities by jumping on anything immediately when there is the slightest odour of impropriety… Berkshire’s reputation is in your hands

…..

A lot of banks and insurance companies have suffered earnings disasters after relying on that rationale. Even worse have been the consequences from using that phrase to justify the morality of proposed actions

Buffett acknowledged that “everybody else is doing it” is a “seductive argument”, but said use of the phrase should be a “huge red flag”.

Despite some bad press resulting from General Re’s sale of “earnings smoothing” reinsurance products that didn’t invlove a real transfer of risk, Buffett has a well-deserved reputation as an ethical businessman, and one whose track record doesn’t seem to have been hurt by his unwillingness to do anything he wouldn’t feel “comfortable about being printed on the front page of our local paper.”

Buffett made use of a similar policy when he briefly became CEO of Salomon Brothers in the wake of a scandal that threatened to sink the firm. Unfortunately, too many others base their behavior on what they feel they can get away with. The Hewlett Packard board is a case in point. Even after details of the scandal came to light, they allowed Patricia Dunn to remain on the board. Though Dunn finally resigned, the board members who showed such terrible judgement are still there.

Investors should follow Mr. Buffett’s lead. Companies that behave well should be assigned a valuation premium; those that don’t get it, like Hewlett Packard, should be trading at a discount to compensate for the risk of future scandals.

Read my Basket of Biotech Introduction

Anesiva(ANSV) is a company that focuses on the development of pain management products. The company is tiny, with a market capitalization of just $135 million, and has no revenues. As of June 30, the company had $67 million in cash, but the company is spending $14-15 million per quarter and will have only $35-40 million left by year end. Adding in $30 million in committed equity financing, the company has sufficient capital to operate until year-end 2007 at the current burn rate.

What prospects does the company have for increasing the value of its pipeline by the end of 2007?

1. Zingo
Zingo, until recently known as 3268, is Anesiva’s closest product to a market. Zingo is a fast-acting local anesthetic which Anesiva is planning to market for pediatric venous access procedures. The company has already completed phase III pediatric trials and has stated that it will file a New Drug Application with the FDA in September or October of 2006. Unlike competing products which are primarily creams, Zingo is not messy to apply, and is effective in 1-3 minutes as opposed to 15-60 minutes. Zingo has an opportunity to both take away business from existing drugs, and, because of its ease of use and fast action, to expand the percentage of venous access procedures which make use of an anesthetic. As the company has not partnered this drug, it will be responsible for all marketing costs and receive all products. While this is not a blockbuster, if approved, it could be sufficient to support development of additional products. Revenue could be seen as early as late Q2 2007, or sooner if the signing of a partnership results in milestone payments.

2. 4975
4975 is a drug that’s further away from the market, but shows much greater potential. A long lasting, non-opoid, site specific analgesic, 4975 can provide pain relief for weeks or even months with a single treatment. Successful Phase II trials have been completed in several indications, including post-surgical, total knee replacement, and elbow tendonitis. While there is still significant risk that this will not make it to market, the size of the opportunity will allow for rapid stock appreciation as this advances towards approval.

3. 1207
A treatment for neuropathic pain, the company is currently planning a phase I trial. Not much here yet, but additional data could have an impact.

Anesiva’s pipeline webpage also lists Avrina, an anti-inflammatory drug that had been tested in early trials for eczema, but development appears to have stopped, and I would be shocked if any value were created from this.

Anesiva’s history is a cautionary tale of the danger of investing in development stage pharmaceutical companies. Anesiva came public early in 2004 as Corgentech. At the time, the company had a promising compound in Phase III to treat vein graft failure, with which it partnered with Bristol Myers Squibb(BMY). It also had development programs in inflammatory diseases and cancer. When its lead candidate failed, the company retrenched and eventually merged with private AlgoRx Pharmaceuticals. AlgoRx was the developer of Zingo, 4975, and 1207. Earlier this year, Corgentech changed its name to Anesiva to indicate its new focus on pain relief.

At today(10/05)’s close of $6.73, I believe this makes sense in our basket. The data that has already been released seems sufficient to support approval of Zingo, and the huge potential market for 4975 could result in big gains as it progresses through the clinic.

Read my Basket of Biotech Introduction

What other stocks should I include in the basket? Comment below, or email investor at inelegantinvestor dot com

Disclosure: I own stock in ANSV

Investing in development stage biotech companies is risky business. We’re talking about companies with no material product revenues, high cash burn rates and fairly high failure rates. At the same time, successful drugs can generate huge returns. And if you can find a stock that gives you a 500% return, that supports a lot of failures.

An effective strategy here begins with realizing that it is nearly impossible to predict the success or failure of a given drug in development. At any time during trials, a drug may fail to show efficacy or may be found to be too dangerous for use. The company may be insufficiently funded to complete development. The FDA may choose not to approve the drug or require additional costly trials. Even once the drug is approved, there may prove to be no significant market for it, or other competing drugs may show greater efficacy and limit sales.

Given this, we can come up with a set of characteristics to look for in a development stage biotech, and buy a basket of such stocks meeting our criteria. We know we won’t hit a home run with all of them, but if we can manage to succeed with some and bail out of others before we lose 100%, we can ensure a good rate of total return.

Questions to ask when evaluating development stage biotechs:

1. How long will the company’s cash last?
Developing drugs is expensive. Running clinical trials is expensive. Launching a new drug is expensive. Will the company be able to move drugs forward in the pipeline with existing cash to the point where additional equity or debt can be sold, or a partnership entered into with a larger drug company to fund development?

2. Does the company have multiple drug candidates?
Is the company betting its entire future on one drug, or are there multiple drugs with promise in the pipeline? One-drug companies are coin tosses; a failure in a trial will often mean the end of the company.

3. Do the company’s drugs address a market need?
The drug may get approved, but as with any other product, there may not be a market for it. It may target too small a niche, not be cost-effective compared to older drugs, or address a condition that people are willing to tolerate without treatment.

4. How soon might the company expect to begin marketing a product?
If we’re still 5 years away from having a product in the market, we’re probably too early. If product revenues aren’t close, are there any potential milestone payments coming up? Releases of new study data that might lead to a partnership?

5. How enthusiastic is the market about the company?
Has the market already decided that the company’s new cancer drug will be a blockbuster even though it’s only in Phase I? We’re not looking for $1 Billion plus market capitalizations unless a substantial portion of it is in cash.

In light of all this, I plan to post a series of short writeups over the next few weeks on small biotech companies that I feel look interesting and can be bought using a basket approach to mitigate the risk of each individual company. Each of these is highly speculative and carries a substantial risk of significant losses, but I believe that in the aggregate they offer an attractive opportunity.

I have to admit, sometimes I can be a bit of an ambulance chaser. One of the guiltier pleasures I indulge in my search for stocks is a periodic check of top percentage losers. Here’s a list of stocks owned by legions of hopeful investors who were wrong. Very wrong. In a single day, 10, 20, 30, even 50 percent of their investment- wiped out. Humbling as this is, I’m not here to dwell on the vanity of man. I’m here to find the glimmers of hope that remain in the ashes, dust them off, and if they appear to have value, place them in my own pocket.

Quest Diagnostics(DGX) was down 17.90% today(10/3) to $50.00 after announcing that it had lost a long term contract with UnitedHealth Group(UNH). UnitedHealth opted to give the 10 year, $3 Billion deal to a smaller rival, Laboratory Corporation of America(LH). Quest revealed that United Health had accounted for 7% of its buisness, and was its largest customer.
Though Quest did not address Q3 performance which it will be releasing on 10/19, the current contract runs through the end of the year, so impact on 2006 numbers should be minimal.
Quest did not release any information on what impact this will have on 2007. Though Quest will continue to be under contract to UnitedHealth in 2 small markets, and will continue to compete for non-contract work, it is probably reasonable to assume a worst case in which 7% of Quest’s revenue disappears.
Though Quest gave no guidance on earnings impact, they did reveal that margins on UnitedHealth business were not significantly different than the rest of the business. Without knowing what percentage of costs are fixed, it’s difficult to estimate what the earnings impact might be. It’s almost definitely greater than 7%. Jeffrey Loo at S&P lowered his 2007 EPS estimate $0.05 to $3.38, but I haven’t seen the report and it’s difficult for me to see why he sees the impact as so minimal, unless he believes that Quest will initially retain more of this business on a non-contract basis. Quest is set to earn (according to their guidance of 9/6) between $2.95 and $3.05. With next year’s estimates previously showing 10-15% earnings growth, and assuming a drop of 7-10% in earnings from the loss of UnitedHealth business, it’s hard to see how Quest can grow earnings by more than a few percent.

Quest has been making small, focused acquisitions of companies that manufacture propietary tests. In July, it purchased Focus Diagnostics, a maker of tests for diseases such as Lyme Disease, SARS, West Nile Virus and Herpes Simplex Virus, for $185 million in cash. Last month, it purchased Enterix, which produces a test for colorectal cancer, for $43 million in cash.

Quest’s liberal use of cash may be some cause for concern. In addition to acquisitions, the company has spent significantly to buy back shares. In the first 6 months of 2006, the company bought 4.6 million shares for $254 million. During the same time period, the company reissued 3.2 million shares for employee benefit plans, so despite the big outlay, the share count is not getting much smaller. The company also pays a $.10 quarterly dividend at a cost of nearly $20 million per quarter. At the same time, the company’s long term debt continues to hover above $1.2 billion.

Quest trades at 16.7 times 2006 earnings, and the company seems on track to earn at least as much next year, for a forward P/E of under 16.7. Obviously, there’s risk here as the numbers are unclear.

Quest isn’t an expensive stock, but at this point, for me at least, the potential reward doesn’t support the risk. While the stock is likely to move higher, the uncertain earnings impact of the Quest deal, questions surrounding the company’s ability to continue to grow earnings at a 10-15% rate, and questions surrounding balance sheet and share dilution are keeping me away.
Disclosure: I own none of the companies mentioned(DGX,LH, UNH)

A friend of mine, having heard me rant several times about the impending doom of Blockbuster(BBI), sent me an article from everyone’s favorite source of fake news, The Onion. The article, entitled “Struggling Blockbuster Eliminates Rental Fees,” contemplates a desperate attempt by Blockbuster to retain customers by eliminating all charges and even paying customers for renting videos. It concludes:

Miami resident Scott Patterson, however, was only one of many consumers who said they were unimpressed with Blockbuster’s new offers, including “Two-Dollar Tuesdays,” in which customers are handed $2 cash for every new release they rent. “I don’t know,” Patterson said. “Something about that place just rubs me the wrong way.”

The problem in a nutshell. The service Blockbuster offers is quickly becoming so unattractive that customers might not come even if they were paid to do so.

The video rental market has faced steep declines in the face of mail-based subscriptions and pay-per-view. The emergence of internet-based delivery will accelerate this trend. Netflix(NFLX) already has over 5 million subscribers who pay a monthly fee to rent DVDs by mail. Netflix’ turnaround is quick and its selection dwarfs that of your local Blockbuster store. The only disadvantages: you won’t always get your top choice of movie and some amount of planning ahead is required. That’s okay though, because your local cable company has vastly expanded the number of movies available for you to watch immediately without leaving your couch.

Blockbuster’s only advantage here is the exclusive window studios continue to give to DVD sales and rentals before they make their films available on Pay-Per-View. However there have been signs that this is eroding and it is inevitable that Pay-Per-View and Internet will soon have movies available as soon as they are released to DVD.

Making matters worse for Blockbuster is that those consumers who have opted to sign up for a subscription service tend to be high-volume movie watchers. Casual renters have no need for such a subscription service.

Blockbuster has responded with its own subscription service which has garnered 1.4 million customers, but will have difficulty competing given the twin albatrosses of $1 billion of debt and a $2 billion liability for store leases. Besides that, the mail-based subscription business will come under pressure from the “instant gratification” formats of cable and internet delivery.
Blockbuster has attempted placing more emphasis on DVD sales, but has difficulty competing with behemoths such as WalMart(WMT), Best Buy(BBY), Amazon(AMZN) and Costco(COST).

As valiantly as it may try, Blockbuster cannot cut costs fast enough to regain sustained profitability. There is no new product or service they can leverage their retail footprint to sell. A failed 2002 experiment with another doomed retailer, Radio Shack(RSH), is instructive in this regard.

Carl Icahn has taken a stake in the company and agitated for change, but I’m unclear as to what value he hopes to unlock. One need only look at Movie Gallery(MOVI) to see where Blockbuster will end up. It is the rare company that can successfully transition when its core business becomes obsolete. Blockbuster looks to be of the more common variety of company that can’t make the transition.
Disclosure: I own none of the companies mentioned in this article

In an earlier post, I warned that Hewlett Packard(HPQ) should be sold it as it had only gone up in the face of increasingly bad news. More than a week later, the stock has finally begun to descend(down $1.91 to $34.87 on 9/21), but with the news continuing to get worse and clear questions unaddressed, the stock continues to be too dangerous to own.

After much hesitation, it was finally announced last week that Patricia Dunn was stepping down as Chairwoman, but she continues to remain on the board. This depsite new allegations of additional questionable investigative techniques including an attempt to install spyware on a reporter’s computer.

More recently, the Washington Post reported that CEO Mark Hurd was involved in the investigation. Hurd has been credited with turning the company around, and his alleged involvement casts doubt on HP’s continued turnaround. California Attorney General Bill Lockyer had complained early Thursday that HP had stopped cooperating in his investigation, but his office later reported that cooperation had resumed. Hurd has also agreed to testify before a Congressional committe next week on the matter.

Reuters reports that Lawrence Bossidy has called on the entire HP board to resign, and I second that. As long as there are no changes, and those who executed such incredibly poor judgement are still at the helm, there is too much risk here to justify owning this stock.

Disclosure: I own no HPQ

Update: Dunn resigned effective immedaitely Friday afternoon(9/22/06). This is certainly a positive sign, but it’s not enough. The board that allowed this to go on, and allowed her to stay on for weeks after these disclosures, needs to follow her.

Kevin Kelleher agrees and his eloquent article is a must-read. Meanwhile, the chorus of Wall Street analysts continues to be positive on the company.   They still seem content that this scandal has run its course.  It’s unclear why the believe this, and oddly, they seem unconcerned that those whose poor judgement allowed this to go on are still in decision making roles at the company.  So much for the renewed focus on business ethics.

Like all investors, I’m always looking for a chance to buy a dollar for eighty cents. Rarely though, have I found a company where the value is as easy to understand as is the case with Cadus Corporation(KDUS).

Cadus is a tiny company with a market cap of only $19.7 million at today(9/21/06)’s close of $1.50, yet it has cash and equivalents of over $24 million. In addition, the company owns several hundred thousand dollars of marketable securities, mostly in Sequenom(SQNM) While unusual, Cadus is certainly not the only company with cash exceeding market value. What is unusual is that the company has no debt or other liabilities, and is cash flow positive. The company has no employees(even the CEO is a consultant), leases nothing more than a storage space, and the interest on the cash hoard plus its one small revenue stream more than covers expenses, leaving a small profit.

Cadus was formerly a biotech company engaged in research and development until it sold all research assets to OSI Pharmaceuticals(OSIP) in July 1999. OSI continues to pay $100,000 per year in a contract that continues until 2010 to license Cadus’ patent portfolio. The portfolio is also licensed to another, undisclosed company which may extend the agreement for $250,000 per year once the current term expires this year. There are also potential milestones if drugs based on Cadus patents move towards approval. The company has done nothing substantial to monetize these assets, and it is probably reasonable to assign them a value of zero, and allow any upside to be a pleasant surprise.

One potential area of concern is ownership. Carl Icahn controls the company by virtue of a 38% stake. Icahn originally invested in Cadus in a private financing in 1993. He later purchased ImClone(IMCL)’s stake in 1995 which helped fund ImClone’s development of Erbitux. Icahn continues to be involved in ImClone, having just become a director and called on the Chairman to resign as a result of poor performance.
Oddly, though Icahn is well-known for taking stakes in companies and forcing changes to unlock value, nothing has been done to unlock value at Cadus despite years of Icahn control. The company claims in its 10-K that

The Company is presently seeking to use a portion of its available cash to acquire or invest in companies or income producing assets. To date the Company has not been able to identify an appropriate acquisition or investment and there can be no assurance that it will do so. There also can be no assurance that acquisitions or investments by the Company will be profitable.

Cadus has a large loss carryforward and could prove an attractive merger partner for a small, profitable company.

Cadus faces limited downside given its large cash position. Value could quickly be unlocked if the company decided to liquidate, found an appropriate merger or acquisition target, or unexpectedly monetized its dormant intellectual property. That is, if Carl Icahn finally decides to pay attention to the stock he already owns.

Disclosure: I own KDUS. I own no IMCL, SQNM or OSIP

There’s an old scam where an enterprising prognosticator sends out many thousands of his newsletters unsolicited. Being a friendly chap, our prognosticating protagonist personalizes his newsletters. Choosing a binary event, perhaps a football game, or the direction of a particular stock index that week, he predicts for half of his recipients one outcome. Ever eager to please, for the remaining half, he predicts the opposite outcome, guaranteeing a customer satisfaction rate of 50%, on par with cable companies and far exceeding that of the President.

Our entrepeneur, not one to be deterred by a 50% churn rate, dashes on, dropping his disgruntled readers and sending out an additional set of personalized missives to the gruntled ones. After repeating this several more times, the intrepid CEO of our fledgling enterprise becomes alarmed by his dwindled customer base and embarks on a restructuring plan. Those customers who remain are asked to send substantial remuneration in order to consider receiving these money-making predictions. Having received an improbably long series of correct predictions many are happy to oblige. All is well until subscribers realize that performance has suddenly worsened. Ideally, by the time this happens, our visionary has retired and is comfortably ensconced in his well-appointed mansion.
This came to mind when I heard about the dramatic and sudden reversal of fortune at Amaranth Advisors. The Greenwich, Connecticut-based hedge fund reported to investors this week that its fund had fallen 50% since August as a result of a highly leveraged long position in natural gas. After spiking to $7.50 in August on fears of a Gulf hurricane cutting production, natural gas has steadily fallen to yesterday’s close of $4.88, near 2-year lows.

There are 9000 hedge funds out there, and most of them are run by people who have had good track records- but how many of these track records reflect skill(and are reproducible), and how many reflect luck(which will run out)? Hedge fund managers are self-selected from those who have had success, but I suspect that many of them aren’t any more prescient than our scammer. They’re the coin flippers who’ve gotten 10 heads in a row, and given the huge amounts of leverage in use, I think we will continue to see additional falls from grace.

If you’re going to fail anyway, you might as well fail spectacularly. Amaranth didn’t quite fail in spectacular fashion, but only because the bar was set so high by the 1998 collpase of Long Term Capital Management. Anytime the Fed begs banks to bail you out because your failure may trigger a collapse of the global financial system, you’ve definitely failed spectacularly(and if you haven’t already read it, When Genius Failed, Roger Lowenstein’s account of LTCM, is a must-read for every investor).

While perhaps not spectacular, the failure has had a major impact on the market. The sheer volume of positions Amaranth has been forced to unwind have exacerbated the problem, pushing down natural gas even further. Amaranth continues to liquidate positions, and as it does so, natural gas will continue to drop.

Natural gas will stop its fall when Amaranth’s liquidity crisis ends. This will happen in one of several ways. Amaranth will liquidate everything and close up shop, sell enough to restore solvency, or sell distressed assets to a buyer with greater liquidity. Bloomberg reports that another hedge fund, Citadel Investment Group, is in talks with Amaranth to take over open energy trades. Were this to happen, Citadel would be in a position to sit on trades and close the book over time, removing downward pressure from the market.

Natural gas prices would appear to be near a bottom and should rise somewhat once this situation is resolved. In order to take advantage of this, there are several stocks with a natural gas focus in North America that are good buys, but my favorite is Cimarex(XEC).

Cimarex is an oil and gas exploration company with all of its activity in the United States. The product mix is 70% natural gas and 30% oil. Cimarex has historically not hedged but announced in August that it had begun hedging natural gas, locking in about 15% of production above $7. At yesterday’s close of $35.02(within $1 of the 52-week low and well off the high of $47.80), the company has a P/E of 7 against last year’s earnings. With oil and gas prices down it’s likely that profits will decline as well, but even at 2004’s level of $3.59 per share, the P/E is below 10. Of course, this is offset somewhat by higher production levels than last year given the mild Gulf hurricane season.
Cimarex has been very successful in developing new wells. In 2005, the company drilled 382 wells with a remarkable 88% success rate, resulting in the replacement of 183% of production. The company has announced that it will be spending $1 billion on exploration and development this year up 50% from last year’s number. So far the company has continued its high success rate(134 wells with an 89% success rate in Q2). 60% of the company’s acreage is undeveloped so there are plenty of remaining opportunities for growing the already impressive proved reserves 1.4 trillion cubic feet equivalent.

Cimarex is poised to perform well even with oil and gas prices below current levels. The company recently instituted a dividend, has been buying back stock and paying down debt. Would I bet the house on it? No, Amaranth shows the danger of that. But if you can buy at these levels and have the wherewithal to wait out(and perhaps buy on) any further drops, I believe you will be amply rewarded.

Update:

According to CNBC, Amaranth has transferred its entire energy portfolio to Citadel and JP Morgan Chase(JPM).  There’s still a lot of volume to unwind, but now that we’re out of crisis mode, the natural gas market should settle down.
Disclosure: I own XEC