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Under-the-Radar Biotech Could Score Traders 43%-Plus Profits

David Sterman

When it comes to investing in biotech stocks, it's wise to focus on companies that own drugs with a fairly large market opportunity. The bigger the potential revenue streams, the greater the market value. And one of the hottest stocks in biotech fulfills that maxim: Ironwood Pharmaceuticals (NASDAQ:IRWD) has seen strong initial demand for its Linzess drug that treats chronic constipation (CC) and was approved by the Food & Drug Administration (FDA) in August 2012, with sales beginning in December 2012.

Analysts now think this drug may generate more than $100 million in sales this year, and perhaps twice as much in 2014. Ironwood, which owns 40% of this drug, has surely caught investors' attention, adding more than $600 million in market value in just the past three months. The total market value now stands at an impressive $2 billion.

IRWD Stock Chart

Now investors are shifting their sights to another company that may become a major player in the treatment of CC. Synergy Pharmaceuticals (NASDAQ:SGYP) has generated solid clinical data for its own drug, Plecanatide. Not only does Synergy retain 100% ownership of this drug, but its $400 million market value is a fraction of that of Ironwood. And thanks to several upcoming events, this stock could prove to be a timely trade.

Apples to Apples?

Of course, such a valuation disconnect can partially be explained by the fact that Synergy's Plecanatide is still in the clinical testing phase, whereas Ironwood's Linzess has already received FDA approval.

Synergy has completed a pair of Phase II trials, but the completion of Phase III trials, and the potential FDA approval, could be several years away. Still, both of these drugs act in a similar fashion, and approval of Linzess bodes well for the eventual approval of Plecanatide.

Synergy recently merged with Callisto Pharmaceuticals, and it's not yet clear how much cash the combined entity carries. As of September 2012, Synergy had around $30 million in net cash, which likely won't last into 2014. 

The prospect of capital-raising explains another reason why the market value is relatively low compared with Ironwood. Synergy has not yet discussed whether it will seek to raise fresh cash through the sale of stock, or if it will bring in a licensing partner that makes upfront cash payments. Any new partnership agreements could provide an immediate pop for the stock.

This chart for Threshold Pharmaceuticals (NASDAQ:THLD) shows what can happen when such a relationship is announced.

THLD Stock Chart

Synergy Should be Able to Break Into the Market

Thus far in clinical testing, Synergy's Plecanatide has proven to be quite effective, and equally important, doesn't cause diarrhea as many other constipation treatments tend to do. In fact, that's one of the key downsides of Ironwood's Linzess. It hasn't stopped doctors from prescribing it, but Synergy's drug, if and when it gets approved, might find much greater favor with patients.

There are a number of factors that can trigger constipation, and sufferers often fall into the broader category of Irritable Bowel Syndrome (IBS), which plays a role in Ulcerative Colitis, Crohn's Disease and other infirmities. Broadly speaking, both Ironwood and Synergy are targeting a market opportunity worth around $2 billion.

Will Ironwood's head start in the market allow it to develop permanent market share leadership? Probably not. Synergy's marketing partner will be able to boast of similar efficacy for Plecanatide yet with fewer side effects, which will likely lead both companies to share this market on somewhat equal footing -- if Plecanatide gets approved.

Let's assume for a moment that Synergy goes it alone and raises $100 million though the sale of 20 million shares. That would push the market value into the $500 million to $600 million range, which is still a hefty discount to Ironwood. And it's also a fraction of the total IBS market opportunity.

The Banking/M&A Catalyst

Investment bankers have surely noted Synergy's progress in clinical trials, along with the recent trading success for rival Ironwood. As a result, don't be surprised to see investment banks start to assign an analyst (and a lofty price target) to this stock. The company's clear need for financing in coming quarters makes this a perfect company for the bankers to shop to clients, or to potential strategic partners.

Management knows that it's unwise to wait several more quarters to address the balance sheet to the point where cash is almost completely gone, which is why you should expect action on this front in the near term. Indeed many investors are on the sidelines until they see how the financing issue plays out and can assess the potential dilution. Once that issue is behind the company, these sidelined investors are likely to hop on board as well.

The Industry Event Catalyst

As a second catalyst, Synergy will deliver updated clinical trial results at the Digestive Disease Week conference being held May 18-21, in Orlando, Fla. Biotech stocks often trade up in advance of such presentations, so shares could strengthen throughout April in anticipation.

Risks to consider: As with any biotech stock, weaker data in the all-important Phase III clinical testing phase, along with any dilution associated with capital raises, are the biggest risks here.

Although it's not 100% certain that Synergy will successfully bring Plecanatide to market, the clinical trials have thus far proven the drug to be both safe and effective. Moreover, Synergy has a solid pipeline of IBS-focused drugs in the earlier stages of the clinical testing process that will also hold appeal to potential marketing/licensing partners. These next few weeks and months could deliver the catalysts that send this company's market value moving toward that of rival Ironwood.

Recommended Trade Setup:

-- Buy SGYP at $7 or less
-- Set stop-loss at $5
-- Set price target at $10 for a potential 43% gain in six months

If shares rally well in advance of eventual approval for Plecanatide, then investors would be wise to book profits, as ultimate approval for the drug isn't assured.

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