The Street Sweeper

About the Author The Street Sweeper

Sonya Colberg joined TheStreetSweeper in early 2012 as a senior investigative reporter after racking up an impressive pile of journalism awards for her past work at two major daily newspapers. For example, Colberg recently won top honors – recognized by the Society of Professional Journalists and the Associated Press alike – for her performance in the tough investigative reporting field. During her long and decorated career, she has walked away with major prizes for her in-depth coverage of business and healthcare as well. A fearless reporter with incredible writing skills, Colberg has now teamed up with Melissa Davis – another award-winning journalist who serves as senior editor of TheStreetSweeper – to deliver hard-hitting coverage of risky stocks to the investment community.

La Jolla Pharmaceutical Company (LJPC): Lost Opportunity, Insider Questions Should Chop Valuation By Well Over Half

by Sonya Colberg

The market has recently blasted La Jolla Pharmaceutical Company (NASDAQ:LJPC) shares to mystifying levels, thanks primarily to insider buying. But that insider’s stock trades previously sparked a market manipulation investigation that left him unscathed and his broker sanctioned.

That key inside buyer is La Jolla’s chairman of the board, Kevin C. Tang. Mr. Tang, is also managing partner of Tang Capital, a firm named by the Securities and Exchange Commission as a relief defendant in a 2009 lawsuit alleging insider trading, fraud and deceit in securities trading. That lawsuit resulted in a $382,024 fine against Tang Capital’s founder Chen Tang.

Mr. Kevin Tang, Tang Capital and several of his other entities own 2.6 million shares or ~16 percent of La Jolla’s stock.

The company hasn’t responded to our request for comment but investors may find other viewpoints here.

This situation makes us think of Shark Tank star Kevin O’Leary’s comment:

“When you’re an investor, you can look at the quantitative and qualitative elements of an investment, but there’s a third aspect: What you feel in your gut.”

There’s a bad feeling in our gut about La Jolla. And here are some quantitative and qualitative reasons why…

The Tang connection

La Jolla director Kevin Tang ordered trades that spurred an investigation into market manipulation. On appeal, the SEC upheld findings that Mr. Tang’s broker engaged in a manipulative scheme and caused his brokerage firm’s books and records to be inaccurate.

Mr. Tang and his long-time broker friend Edward Brokaw testified about how the stock broker carried out Mr. Tang’s orders for several big block trades of Monogram Biosciences.

At the time, Mr. Tang was not yet a La Jolla director and his hedge fund owned ~3.3 million shares of Monogram and ~18 million CVR units that May in 2006. Mr. Brokaw and his family also owned ~215,000 CVR units.

The rather fascinating November 2013 SEC document describing the case that the broker regulatory group, FINRA, built against Mr. Brokaw is here. We hit the highlights below:

“Take the ******* thing down … a dollar?”

Here are some entertaining, and telling, out-takes from recorded conversations, plus background:

“The next trading day, May 22, Tang gave Brokaw another order to sell two blocks of 50,000 MGRM shares, again with one block each near the open and close, and again to sell them quickly and aggressively.

One of Brokaw’s assistants, William Ewing, relayed the order to trader David Zitman …

During that telephone conversation, Ewing told Zitman that Tang wanted to sell Monogram’s stock “hard” at the opening of the market and then began to explain that Tang “owns the rights . . . They’re pricing the rights off the stock . . . .”

At that point, Ewing testified, Brokaw, who was listening to the call, signaled for Ewing to “knock it off” by swiping a hand across his throat.

Ewing therefore told Zitman, “Sorry, sorry, enough said, I’m not, that’s, I’m not supposed to be going into that. Anyways, he’s trying to, he wants to sell.”

Zitman entered the morning order into the firm’s computer system to be executed by the equity trader. Zitman then called Brokaw to confirm the trading instructions.

During that conversation, Zitman asked if he should “[t]ake the f[—]ing thing down (inaudible) a dollar?” Brokaw replied, “Yeah, 50 cents, yes.”

Zitman pressed, “He wants it to be done-and if I take the thing down to $1.50 and it bounces back to $2, he doesn’t care?”

Brokaw confirmed, “No, right.”

Tang’s order was subsequently executed in increments at prices declining from $1.95 to $1.91.”

Mr. Brokaw pushed traders to “hammer” Monogram stock for as little as one penny. He explained to a trader that lowering Monogram’s stock price would increase the value of Monogram’s CVRs. He described the trades as a battle of “good versus evil.”

“He could ******* be going away for a long time doing that.”

The next day, Mr. Brokaw received Mr. Tang’s orders to again sell 50,000 shares of Monogram stock at the open and close of the market. This was his third block order in four days. Mr. Zitman sprang into action again, but not without expressing concerns about Mr. Tang’s suspicious orders.

The scene is described below, along with more recorded conversation:

“Zitman entered the order, which was filled within seconds of the market open at an average price of $1.88. Zitman called Brokaw to confirm the sales, and Brokaw told Zitman to sell another 50,000 at the close.

At 3:50 p.m., Brokaw confirmed the order again with Zitman, telling him that Tang wanted him to execute the order “with a minute to go and spread it out a little bit . . . hit the bids . . . .”

This heightened concerns for Mr. Zitman, who raised questions about the legality of Mr. Tang’s orders:

Zitman: What, he’s trying to mark the close? (Note: “Marking the close” by buying or selling shares near the close of the market is considered one sign of a market manipulative practice)

Brokaw: Yeah.

Zitman: You should, you should-he, he could f[—]ing be going away for a long time doing that.

Brokaw: Really?

Zitman: Yeah. You can’t mark the close. It’s f[—]ing illegal.

Brokaw: Eh, I didn’t think so.

Zitman: Yeah, f[—] it, I, no. I’m not marking the close for him.

Brokaw: No, no, no.

Zitman: I’m not giving up my f[—]ing license.

Brokaw: No, no, no, me neither. No, just sell 50 on the close.”

Orders refused when staffers speak up

A couple of other traders expressed concerns about the rationale for Mr. Tang’s trades.

One trader even took the matter to the firm’s compliance officer, who said, “It doesn’t sound right. We’re going to – I don’t want you trading or transacting in Monogram with that client going forward.”

Mr. Zitman and Mr. Brokaw later discussed Mr. Tang’s “suspicious” trades:

“According to tape recordings of that conversation, Brokaw responded that “they’re a little worried about the way the orders are coming in, and . . . I said . . . I hear you, but you know what? This is the way this guy wants to trade.”

Zitman expressed concern that the trades could nevertheless “be construed as a little bit suspect,” to which Brokaw replied, “[Y]ou know what? It’s a free country.”

Zitman responded, “No, it’s not. That’s my issue. Someone could walk in here and say, hey, you have a pattern of selling the first minute and selling the last . . . minute.”

When Brokaw replied, “So what?” Zitman explained that ‘there could be a compliance issue.'”

Mr. Tang testified in his buddy’s disciplinary hearing that, if the CVRs (contingent value rights, which are like options) were fully valued at the end of the pricing period, his Tang Capital Partners fund would hold CVRs worth more than $16 million.

As for Mr. Tang, here’s the kicker described in the SEC document…

“Unlike the hearing panel, which did not find credible Tang’s testimony about his reasons for the seemingly manipulative trades, the NAC credited Tang’s testimony about his trades.

“The NAC thus found that FINRA staff had “set forth insufficient evidence proving that [Tang’s] transactions were manipulative.”

On appeal, the National Adjudicatory Council reversed Mr. Brokaw’s market manipulation finding by FINRA but did find Mr. Brokaw violated his ethical duty by not adequately questioning Mr. Tang’s orders.

Ultimately, Mr. Brokaw was fined $30,000 and his broker license was suspended for one year, until January 2015.

Mr. Kevin Tang’s transactions ultimately lacked sufficient evidence to prove they were manipulative. But the deal certainly doesn’t pass the sniff test.

Damage control saves stock price

We contend Mr. Tang’s funds’ recent purchases of La Jolla shares is damage-control. He is well aware that La Jolla was forced to drop its previous lead drug candidate after a lupus nephritis study bombed in 2009. The stock price bombed, too.

The stock was delisted and moved to the OTC Bulletin Board on March 4, 2010. A transfusion in the form of aprivate stock offering the following May barely revived the company, followed by a 1-for-100 reverse stock split. It ultimately took a 1-for-50 reverse stock split in January 2014 for La Jolla to return to the NASDAQ.

The chart below graphically shows what happened to La Jolla’s stock after its 2009 drug candidate got shelved. The stock lost nearly 90 percent of its value, plunging to $0.26 per share.

(Source: Morningstar)

The chart below shows what happened recently when its latest top drug candidate got shelved May 8 and the market learned that Mr. Tang’s fund had jumped in and bought stock June 22 and June 26.

(Source: Morningstar)

Established institutions are not very interested

But when we ask who else is buying, we hear crickets. Though many Class A institutional funds have been rushing to add biotechs to their portfolios, their interest in La Jolla has been scattered and minimal – shown here.

While some small institutional types have bought recently, share-wise, there have been a lot more positions sold out than new positions established in La Jolla.

(Source: NASDAQ)

Also, let’s take a look at a NASDAQ stock consultant chart that summarizes … yikes! … where La Jolla stock stands in regard to bullish and bearish trends.

(Source: NASDAQ)

Clinical candidates? Just one – and not all it’s cracked up to be

La Jolla pulled the plug on its pair of star candidates when it couldn’t address FDA’s rigorous requirements (and why was the company caught off-guard that the product would be held to – gasp – expensive FDA standards? Maybe it was trying to squeeze every dime out of average shareholders while hyped hope persisted). The drop to one candidate is nicely described, here.

Interestingly, the key booted product is the kidney disease candidate GCS-100 whose rights La Jolla acquired in 2012 from director Kevin Tang’s and CEO George Tidmarsh’s former company. So that boot must have been hard to swallow.

Regardless, La Jolla is now hitched to its only clinical-stage product, LJPC-501, for hypotension or very low blood pressure.

La Jolla is now recruiting patients for a phase III study to determine if LJPC-501 increases blood pressure. The study is expected to be complete in September 2016.

More red flags join the pile at this point.

Analysts apparently haven’t changed their price targets to reflect the loss of GCS-100. In the chart below, also note there’s likely little upside considering that La Jolla shares are trading ~$31 – right in the middle target range of $28-$33.

(Source: Yahoo Finance)

The problem is that the analysts’ price targets erroneously assume the former leading candidate, GCS-100, is alive and well and likely to reach commercial success …not booted to the curb.

An analyst report released to clients at the end of March notes high commercial potential for the booted product. And “limited commercial” potential for the remaining product, LJPC-501.

An interesting side-note describes some limitations, noting mortality benefits or strong cost/benefit rationale are key to doctors accepting the drugs – “particularly with effective, cheap, generic hypotensive alternatives” available.

The Jeffries report states its $25 price target is based on $17 per share for LJPC-501 and $8 per share for the shelved product.

So, what happens if the dropped product is erased from the equation?

La Jolla stock then winds up with a $17 price target – well below the current ~$31 per share!

Even $17 per share is too high – The potential market is just too small

Even a $17 share price assumes the drug will enter an overly optimistic vision of the market and enjoy an unusual degree of success.

We believe the market is rather small for LJPC-501 because, if approved, the drug would be useful only in special cases because there are so many cheap, effective alternatives.

Some analysts consider the peak sales opportunity in CRH (catecholamine-resistant hypotension) at ~$280 million and higher.

But we see the peak CRH market opportunity at a fraction of that … $59 million.

Some analysts estimate 50 percent penetration – more reasonably 10 percent, we believe – even a Jefferies report states “Overall, physicians view current armamentarium of hypotension drugs as adequate in treating severe hypotensive patients.” Yet some really bullish analysts estimate 116,000 patients, while we’re estimating 75,000 to 105,000 max.

Also, if it clears clinical trials, LJPC-501 might find some use in limited, special cases of cirrhosis of the liver. Cirrhosis patients can develop potentially fatal conditions such as bleeding, sepsis or hepatorenal syndrome(NYSE:HRS), resulting in progressive kidney failure and sometimes death. But we have to remember, this iffy HRS use is years away because enrollment in the early Phase 1-2 study is just occurring.

Nevertheless, we’re estimating 115,000 patients, 10 percent market penetration, a $10,000 cost (an improbable guesstimate with all kinds of insurance questions) and 35 percent chance of success in this HRS application.

This puts the cirrhosis use market opportunity at about $40 million.

So combined, the real potential valuation of La Jolla’s remaining drug is ~$100 million.

Even without removing erroneous assumptions, terrible earnings estimates

Shareholders’ earnings estimates look pathetic, even before accounting for the lost candidates. Check out the estimates below:

(Source: Yahoo Finance)

Not surprisingly, those estimates are backed by an equally pathetic earnings history:

(Source: Yahoo Finance)

Looming conversion of 8.2 million shares of preferred stock into common stock poses extreme dilution to today’s shareholders.

When the company converts preferred stock and lucky insiders exercise it, the current 15.2 million shares available for trading would shoot to 23.4 million shares.

This means a ~35 percent dilution to today’s shareholders. So the value of today’s $31 stock would be diluted to ~$21.

And the company states it “may choose to raise additional capital due to market conditions or strategic considerations, even if we believe we have sufficient funds for our current or future operating plans.”

Thus swinging the ol’ dilution hammer again.

Conclusion: Don’t be Cinderella

“Let investors make informed decisions,” an exasperated analyst said of the La Jolla situation.

Indeed, La Jolla struggles with a potential market of under $100 million (who knows whether the drug will even get past trials and the FDA?) and an aggressive insider whose trades sparked a market manipulation investigation – that ultimately left his broker buddy sanctioned, holding a suspended broker’s license and a much lighter wallet.

Stock offerings, private offerings and reverse stock splits have propped up a comatose La Jolla time and again. And, as forewarned, today’s prices could easily cough up another dilutive stock offering.

Indeed, this sucker’s grossly overvalued relative to the cash it could possibly ever generate.

It’s kind of like what Warren Buffett said about how investors sometimes “drift into behavior akin to that of Cinderella at the ball.

“They know that overstaying the festivities – that is, continuing to speculate in companies that have gigantic valuation relative to the cash they are likely to generate in the future – will eventually bring on pumpkins and mice.”

Kick off your glass slippers and run before they bring on the pumpkins and mice … and this stock disintegrates to a very generous ~$10 per share.

Important Disclosure: The owners of TheStreetSweeper hold a short position in LJPC and stand to profit on any future declines in the stock price.

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