Some Slippage Ahead Of The Election 11/4/16

*** The following is a slightly paraphrased reprint of an Inter-Issue Commentary that was published for subscribers of Nate’s Notes on October 29, 2016, and reflects our opinions of the stock market and all stocks mentioned as of that date. ***

Though “flat” is probably the best word to describe the action we have seen in the overall market for the past several weeks, if one takes a slightly shorter-term view, it can be argued that many stocks (and, therefore, many of the major indices as well) have started to slide as we head into the election next month.

That being said, though the shorter-term trend may be “down,” very few stocks (and indices) have actually broken through the bottom of their medium-term trading ranges, and, in addition, as you can see in the Eyebrow Levels table below, four out of five of the major indices I use to gauge the health of the overall market are still giving us a green light to remain more heavily invested in stocks.

Unfortunately, however, as has been the case for almost a year-and-a-half now, the BTK biotech index is continuing to underperform the rest of the market by a wide margin… and this trend is only getting worse as we head into the election and investors continue to jockey for position in anticipation of a victory for Hillary Clinton (an event that Wall Street collectively feels will be bad for healthcare stocks).

Of course, as discussed in previous issues, while there is no doubt that a downtrend is currently underway for the sector, history suggests that once the outcome of the election is known (and the stocks have found some support), there will be plenty of money to be made by investors willing to step in and pick up the names of quality companies that have been marked down to bargain basement prices… and you are encouraged to keep some powder dry for the sole purpose of adding to your positions in the biotech sector once the dust settles.

Shifting gears from biotech to semiconductors, I am pleased to report that the chip stocks are continuing to demonstrate some of the best relative strength out there (with the possible exception of the “pot stocks” that are hitting new all-time highs in anticipation of the election results in a number of states that are voting on the legality of cannabis use within their state – more on this circumstance below!), and you are therefore encouraged to be as patient as possible when it comes to taking profits in some of our recommended stocks that have notched solid gains so far this year (Cirrus Logic, NVIDIA, and NXP, in particular).

And, speaking of NXP, as many of you have noticed, the rumors that were circulating when last month’s issue went to press have proven to be true, as it was recently announced that Qualcomm (QCOM – $68.40) has, in fact, made a tender offer to buy NXP for $110 per share.  For now, the stock is trading at roughly a 9% discount to the tender offer (which is typical for a deal that is “probably fairly priced”), though the discount will likely shrink as word begins to spread about how successful the tender offer is likely to be.  As it stands, rather than buy more or lock in profits, I encourage you to simply be patient and sit tight with your position for another couple of weeks while we wait to see if there are any new developments between now and when the November issue goes to press.

Along with the chip stocks, if you are anxious to do some buying ahead of the election (and the November issue), you are encouraged to also take a look at Apple, Disney, and the SPDR Gold Trust ETF (and, of course, MannKind – but only after reading the commentary below).

MannKind

Though my original plan had been to keep it as brief as possible when discussing MannKind in this month’s Issue-Inter Commentary, I can tell from the emails I am receiving that enough of you are wondering the same things that it probably makes sense to spend some extra time on the topic, even if much of what I write will simply be speculation on my part.

So, first off, the three main thoughts I wanted to share with you as the stock continues slide ahead of the company’s next earnings call (tentatively set for November 9th) are:

• Despite the incessant chatter in the world of social media about the company’s “imminent bankruptcy filing,” I have to say that when I (and others who have shared their experiences with me) talk to Matt Pfeffer (the company’s CEO), he doesn’t seem to be as concerned about the issue as those of us on this side of the curtain might be (of course, that doesn’t necessarily mean he’s not bluffing… or in denial),

• I continue to believe very strongly that the company is sitting on a product (Afrezza), a technology platform (Technosphere and associated patents), and a bundle of tax credits/loss carry forwards that are collectively worth significantly more than $250M… and so, even if the company does end up needing to carry out a “fire sale,” there is still far more upside potential than downside risk in the stock from current prices, and

• Though “down is down” regardless of volume, I do believe it is worth noting that the stock has come down on extremely light volume… and this suggests to me that much of what we are seeing is patient institutions and/or market makers simply pulling their bids and soaking up cheap stock from despondent retail investors “who just can’t take it anymore” (and this, in turn, has helped exaggerate what I believe is already one of the largest mis-pricings of a company’s assets that I have seen in my 28 years of doing this – see second bullet point above – and though it sometimes lasts longer than seems possible, this sort of market inefficiency never lasts forever).

Having said that, I know many of you are justifiably concerned that even though it doesn’t seem like things could get any worse, “there’s a chance you could lose all your money”… and, while I do not think this is a likely outcome, I want to reiterate yet again that you should not own more of the stock than can afford to lose (and sleep with comfortably at night) – and so, if you are still above that level, the best thing you can do for yourself is sell down to it sooner rather than later!

Yes, it may mean taking a loss on whatever portion of your position you choose to sell, but I sincerely mean it when I suggest that you go with “whatever your gut tells you” after pondering the question “will I be able to live with it if this stock goes to $0 (or close to it)… or will I be kicking myself for not keeping the $0.45 per share that was still available at the end of October?” (and, please do ask yourself the question several times during the day before making a final decision “just to be sure” – though I am guessing that it will not take too many times before you’ll know where you’re actually at when it comes to what you really think of your position).

Also, please keep in mind that along with the silver-lining of having a tax write-off that you can use against some of the gains you may also be choosing to take in many of our other recommended stocks that are acting well this year (assuming you do decide to sell some or all of your position), you will also be raising at least a small pool of capital that you can earmark to go back into MannKind if/when it seems safer to do so (and assuming that the story doesn’t end abruptly with a buyout of some sort, of course).

Moving on to the next question I’ve been getting a lot, yes – I do think the upcoming earnings call is likely to mark the start of yet another chapter in the company’s wild history.  Matt Pfeffer (the CEO) will either be able to explain how he plans to get us across the finish line (or at least keep the lights on for a reasonable stretch of time), or he won’t… and if the path forward is either too vague or seemingly inadequate, I do believe it will cause the stock to trade down sharply (and most likely force the fire sale mentioned above).

On the other hand, however, given that the stock has traded down to current levels on an assumption that he will run out of fuel before he can get the plane back to the runway, if he does have a reasonable plan to raise capital after all, it ought to change the tone of the conversation significantly… and, with virtually nobody (except me, for better or worse!) still recommending the stock (and, one would assume, only the strongest of holders still in the stock), history suggests there could be a very quick and very sharp move in the stock back towards more reasonable valuation levels as analysts and investors alike start returning to the stock (or getting involved for the first time), only to discover that there really isn’t any stock available for purchase below $1… or $2… or even $5… depending how large a buyer they happen to be.

Of course, it also seems logical to assume that in addition to the investors on the long side who might become more interested in the story if the bankruptcy card is taken off the table, the folks behind at least a handful of the roughly 100M shares that are currently sold short might decide to start covering their position as well in order to move on to “easier pickings” (or to limit their losses if the stock does get back above a buck or two in a very short period of time).

As I’ve said before, honest-to-goodness short squeezes are more rare than people like to believe they are, but when they happen, they can be spectacular to watch… and, as I have also said before, I don’t think I have ever encountered a situation where the market cap of a company has gotten this far out of synch with the true value of its products and patents.  Of course, my claim is based on an assumption that Afrezza really does have the potential to become the prandial insulin of choice on a global basis if given enough time, but if I am right, I think it is fair to say that the stage may be set quite nicely for a short squeeze to develop here after all.

“But doesn’t MannKind’s debt load make them an unattractive candidate if they have to sell the company?” is another question I’ve been asked a few times in recent months, and while there may also be some lesser accounting benefits to assuming debt, the more important thing to keep in mind is that while MannKind’s debt seems “large” relative to MannKind’s current resources, it is actually just spit in the ocean for almost any company that might be interested in acquiring MannKind (the exception to this would be if MannKind ended up being acquired by another smaller company (possibly a device company, for example) in hopes of forming some sort of synergistic relationship that would help accelerate the adoption rate of Afrezza)… and so I hope that you don’t get too distracted by this “warning” that the folks writing negative articles about MannKind like to share on a regular basis (in addition, I think it is important to keep in mind that the bulk of MannKind’s debt isn’t due until 2018 or later – the $70M owed to Sanofi isn’t even due until 2024, for example – so there would be plenty of time for an acquirer to develop a plan to deal with it before it was actually due).

“So… what would ‘a reasonable plan’ look like, Nate – what do we need to be listening for in the conference call?”  In a nutshell, if one starts with the assumption that Afrezza is, in fact, superior (and perhaps by a sizable margin) to what’s currently available, then it really does just boil down “it’s only a matter of time” before success is achieved… and, in the case of MannKind at this stage of the game, “time” is measured in “cash.”

Consequently, what I need to hear to keep me excited about the story is an explanation of what they plan to be doing to raise awareness, a reasonable estimate of what “clear progress” (for the benefit of not only investors, but potential suitors as well!) would look like (along with an estimate of how long it might take to get there if they are able to successfully execute on their plan), and, most importantly, a clear explanation (ideally in the form of a simultaneously announced deal) of where the money will come from to get us across that goal line.

However, just to manage your expectations, I want to remind you that due to the constraints put on management teams everywhere by their legal counsel, we may get answers that are not as definitive as we would like (especially when it comes to things like trying to explicitly identify and assign prescription targets for different points in time, for example)… so the best any of us can (and should!) do is apply the old “sniff test” to see whether what they have to say makes sense or not.

What are some of the possible sources of capital to keep the lights on?

At the “easy” end of the spectrum… and I put it in quotes because the only time it is ever easy for investment bankers to raise money for a company is when a stock is already in demand on Wall Street (which usually means it is either hitting new all-time highs and/or there is a bull market going on for the sector that it belongs to – and, clearly, this is not the situation MannKind finds itself in at the moment!)… the company could simply figure out how much it really thinks it will cost to turn the corner, and then sell as many shares (via stock and/or some sort of convertible debt) as needed at whatever price the market would bear to get the deal done, and, in doing so, take “fear of bankruptcy” off the table for good (knock on wood).

Yes, the dilution would almost certainly be “significant” if the deal was done at current prices but, at the end of the day, if it gets us across the finish line, it won’t matter whether there are 500M, 600M, or 700M shares outstanding since the size of the prize is quite large, indeed… the trick, of course, would be in making sure that “enough” was raised to ensure that the exercise would never need to be repeated again.

Along with a straight up offering to the public, the company could instead raise capital by selling a sizable stake (i.e. 10% or more) to a single investor in a private placement.  And, while there may be a single, very large institutional investor out there willing to participate in such an offering, a more likely buyer of stock in this manner would be another drug company that might be interested in eventually owning MannKind and/or one that, as part of the transaction, would also end up partnering with MannKind to sell one (or more) of its products.

Besides raising money via one of the two paths mentioned above, one of the more intriguing ideas that has been making the rounds of social media following the leak last month of what is supposedly a Receptor Life Sciences “About Us”-type document is that MannKind and Receptor Life Sciences might do a “reverse merger” (a reverse merger is a transaction in which a private company acquires/merges with an already public company in order to become a publicly traded company itself without going through the very lengthy and complex process usually associated with “going public”).

No, we still do not officially know anything about RLS other than 1) it is, in fact, working on “cannabis products,” 2) it has signed an agreement with MannKind to develop products using the Technosphere platform, and 3) RLS’ chief scientist happens to be the same woman that was MannKind’s chief scientist until sometime late last year… and, at least in my book, those are three points that provide a nice framework around which to start wondering “what if ___?”

Again, without knowing for sure who is behind RLS and what their intentions may be, anecdotal evidence suggests that the group behind it probably does have “deep pockets” that may or may not end up providing upfront cash as part of a transaction… but even if they don’t put money in right out of the gate, a much more intriguing piece of the puzzle is the fact that while MannKind’s stock has been the dumps lately (along with rest of the biotech sector, I might add, even if not to the same degree as MannKind), cannabis stocks have been on fire lately – and, as mentioned above, when is the best and easiest time for companies to ask investment banks to raise money for them?  Why, during bull markets, of course!

Please note that I am in no way predicting that a reverse merger is in the works (nor should you invest based solely on this hope, mind you!), but given the relationships that already exists between the two companies… along with where each company finds itself sitting at this point in the market cycle for its respective industry… I think it is certainly a scenario worth pondering for at least a minute or two.

Along with the above possibilities when it comes to putting cash in the coffers, I want to also remind of you that there are some smaller dollar amounts that will come in from the sale of Afrezza (as well as via “the insulin put” that requires Sanofi to buy insulin from MannKind), along with a potential milestone payment from RLS in the fourth quarter, and though these almost certainly won’t be “enough” to keep the lights on, I want to reiterate yet again that while I cannot guarantee it will happen, I find it hard to believe that Sanofi won’t also end up making a settlement payment of some sort to the company before all is said and done, even if it is as “small” as simply forgiving the 2024 debt (which would, in turn, give MannKind the ability to raise money via the sale of the real estate complex that is currently pledged to Sanofi as collateral for the loan).

Having said all that, I want to thank you once again for your patience through what has become one of the most grueling and unpleasant situations I have been forced to endure since I started Nate’s Notes way back in 1995.  No, we are not out of the woods by any stretch, but given the circumstances, I do think we will know by the end of the next earnings call whether it is time to lick our (very deep, in some cases) wounds and move on… or if our patience and discipline will finally be vindicated.

Given that the conference call will be taking place just two days before I will start writing the November issue – along with the fact that I have no idea what the company will say (nor how the market will react to what is said) – I am not sure what sort of action (if any) will be required on my end; however, rest assured that if the price action in the stock warrants an “immediate” explanation, I will do my best to get something out to you prior to the actual publication of the November issue.

As always… stay tuned!

	current	one eyebrow	two eyebrows
DJIA	18,161	16,750	16,250
Nasdaq	5,190	4,500	4,200
S&P500	2,126	1,950	1,800
BTK	2,964	3,200	2,700
SOX	819	630	580

*As long as all five indices are trading above their “one eyebrow” levels, it is a sign that the current uptrend is still intact; however, if the indices start to dip below those levels, it will cause me to raise an eyebrow and wonder if the trend my be coming to an end… and if both eyebrows go up, it will mean that things are deteriorating in a hurry (if you see eyebrow levels being broken, start looking for a “Special Alert” from me in your email box).