Navarro’s Big Economic Picture

This was a horrible week for the markets.  As Market Edge aptly summarized it: “The market ran into some rough headwinds last week as Yahoo (YHOO) lowered its third quarter sales forecast and a soft report from the Philly Fed sent stocks lower across the board. The DJIA lost 79 points on Thursday, it's largest single day decline since early August as traders began to question the odds of a soft landing for the economy. For the week, the DJIA lost 52.67 points (-0.46%), as it closed at 11508. The NASDAQ snapped a seven day winning streak on Tuesday as it lost 13 points for the session on the heels of Yahoo's negative sales forecast. The index was able to recoup it's losses on Wednesday but Friday's sell off pushed it lower, closing below it's 200-day moving average. For the period, the NASDAQ lost 16 points (-0.75%) and ended the week at 2218.”

My thinking right now is that this could be a good time to move to the sidelines for a bit.  Sure, everyone is hoping for an October rally to make the year a good one.  On the other hand, historically, October has been the cruelest month in the stock market – at least when it comes to a crash-big correction scenario.  I don’t want to use the “C-word” quite yet because the market crosscurrents are just too confusing to predict a Black Friday scenario.

On the bullish side, oil and commodity prices are moderating, supply side indicators like factory orders and the ISM remain moderate to strong, and earnings have not be a huge disappointment.

On the bearish side, clearly, the economy is slowing down.  The housing sector is in freefall, the auto sector is soft as a ripe mango, the inverted yield curve is screaming trouble, income is stagnant, consumer debt remains problematic, and geopolitics has turned Uncle Sam into a punching bag for the likes of Hugo Chavez, the madman running Iran, and seemingly all of Islam. 

Still, of all the years since 9/11, this one is shaping up as the one most likely to feature a big October move down in the markets – what a lot of technicians believe is the correction this market never – and should have -- had.  Stay tuned – and watch your cash.

This Week’s Market Movers
I’m hard pressed to find something likely to float – or sink – the market’s boat this week.  Both new and existing home sales come out early in the week and consumer confidence and sentiment as well, but I don’t think there will be enough surprise in any of these reports to move the markets in a big way.  This is a good week just to watch the price and volume action and pay special attention to indicators like the TRIN and VIX which will give you a better sense of what’s going on.

Portfolio Shorts and Longs 
The evidence continues to mount that German companies are making plenty of dough even if the German economy still remains sluggish.  These companies are capitalizing on the forces of globalization and while German workers are not benefiting, shareholders in German companies are.  My stock this week is therefore a reload on the exchange traded fund for Germany, EWG.

Vaino’s Biotech Corner: Imclone Implosion?
 
Trading Imclone (IMCL) stock ended up buying Martha Stewart a trip to the Big House a couple of years ago.  Imclone sells Erbitux, an antibody that has proven highly effective in helping to treat many forms of cancer.

Erbitux has been approved for use in combination therapy (with irinotecan) to treat colon cancer and also to treat squamous cell carcinoma of the head and neck.  Erbitux works by binding to epidermal growth factor receptors (EGFr), which inhibits tumor growth.  Currently Imclone is conducting over a dozen Phase 3 clinical trials to expand uses of Erbitux in oncology.  This is a good product.  In addition, Imclone also has four early stage clinical trials of different potential drugs underway.

Now, Imclone receives pretty much all of its revenue from the sales of Erbitux.  The drug itself is distributed through Bristol-Myers (BMY), and Imclone receives 39% of annual net sales in North America.  In 2005 this amounted to $161M.  For sales outside of North America, they receive revenue from Merck KGaA, which in 2006 is expected to amount to 6.5-7.5% of net sales. 

Erbitux represents at least two thirds of Imclone’s revenue.  While they do have other drugs in development, in a best case scenario they will not see revenue from them until at least 2010.

Note that IMCL dropped 13% on August 10th when plans for a sale of the company were scuttled.  According to their interim CEO (their previous CEO was fired in November 2005 after just over a year on the job):  “The board concluded that the alternatives available, including bids received for the acquisition of the company, did not match the value potential of ImClone Systems as an independent company."  Or maybe those bidders saw trouble down the line.  Here’s the trouble:

Last Tuesday (Sept 18), a judge in Manhattan ruled that the Erbitux patent is owned by some Israeli scientists from Yeda Research, I expected the stock price to plummet.  After all, losing patent rights to your major revenue stream has to be a serious blow.  However, the stock is down less than 3% since then.  I find this surprising. 

Imclone does have a few choices in the wake of the decision.. It can appeal.  However, the judge ruled that the plaintiffs claims were well-documented and that Imclone’s witnesses were less credible that those of Yeda.  How much impact the incarceration (on an unrelated matter) of Sam Waksal, the former CEO and founder of Imclone, may have had on this credibility issue is hard to say.  It is difficult to say how successful an appeal might be.

Imclone could also seek to invalidate the patent, but that’s a tough road to take.  Another possibility is to try and enter into a licensing agreement with Yeda.  That makes sense to me.  It would cost Imclone a few percent of revenue, but they would still be in business.

Imclone is also being sued by MIT, which alleges that Imclone copied a cell line to produce Erbitux.  In denying Imclone’s petition for summary judgment the judge noted “There is a gaping hole in Imclone's argument.”  According to Imclone, this matter will now proceed to trial. I have to admit, I’m a bit confused reading the case.  The judge (2006 U.S. Dist. LEXIS 52600) granted MIT’s motion for summary judgment, which, it is my understanding, should end the proceedings.  This could also be very bad news for Imclone

My confusion is that all the above scenarios ought to decrease the stock price.  A stock price is expected earnings divided by risk.  So if they license from Yeda, earnings will decrease (note, Imclone already shares a good portion of revenue from Erbitux so even a few percent will be significant) and the share price should drop.  If they litigate, this increases the risk, which should also cause the price to drop.  Neither of these has happened.  The stock is essentially flat.  I think this has to change.

Now, news that Carl Icahn (who bought 14% of the company) had been elected to the board of Imclone may have helped buoy the price---he does seem to be good at investing, and is seeking some changes in chairmanship of the board.  I’m not sure changing Captains after The Titanic hit the iceberg would have helped much.

This is where it gets interesting. In 2005, Amgen (AMGN) initiated a Phase 3 clinical study for treatment of colon cancer by Panitumumab, an antibody that does the same thing as Erbitux.  They will likely file an NDA soon.  Further trials, to treat the same indications for Erbitux, are either planned or underway.  Erbitux is the only realistic competitor for Panitumumab. 

On the same day a judge awarded sole ownership of Erbitux patent rights to Yeda, Amgen announced it had licensed the rights to this same patent from Yeda. What this says about Imclone’s potential to extract any licensing rights from Yeda is speculation.  It would certainly be in Amgen’s interest to prevent this, and I’m pretty certain this was not lost on the lawyers in drawing up the contract.

My take is that Imclone is entering a world of hurt.  Once the market realizes it (84% of the stock is held by institutional investors) the stock will be bear food.

Peter Navarro is a business professor at the University of California-Irvine, and can be contacted at pn@peternavarro.com. Matt Davio is a managing partner at the hedge fund, Red Rock Capital Fund, and be contacted for hedge fund services at redrock@peternavarro.com.  Andrew Vaino is a Ph.D. chemist currently teaching at The University of Maine.

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