The sector seems to be searching for a bottom and it is not clear whether this is simply part of that process or a pause before the next leg down. As I noted last week, I will not try to call the bottom but will be a buyer on the large moves down. Whether this ends up being only one buying opportunity or two or three is yet to be determined. Given the broader sector uncertainty, I will again focus this note on one company (and one that I used the selling to add to last week).
1. CNAT is one that continues to puzzle me to a certain extent. It is in the bucket of NASH plays but it seems grossly undervalued compared to the others. Is this simply on that the market is missing (and if so why) or is there more to this story than meets the eye and deserves caution? I have now met with the CEO, had a follow up conversation with their IR as well as follow up call with the CEO and am getting more comfortable with the story (hence I added to my position in the latest dip). Obviously there are always risks but why am I bullish on this company and why am I confident (moreso) that this is simply an undervalued company? Let me go through some background on emricisan and its potential.

2. One of my original worries was the history of emricisan. This compound was originally developed by Idun pharmaceuticals (ran by most of the same management team at CNAT) and the company was sold to PFE for $300M. The key of that sale was emricisan and so PFE continued the development and brought on a fair share of Idun management. PFE eventually dropped development and gave the rights to CNAT, which was formed by the old Idun management to develop emricisan. So why should we be excited by this compound when PFE dumped it? I talked to the company about this and PFE decided to stop development because some of the early studies showed a possible carcinogenic signal and the FDA wanted some additional studies to clear the drug of that signal. PFE decided that they did not want to fund those studies (emricisan was being developed at PFE for fibrosis indication) and discontinued development. This makes sense but now the question is why should we be interested in the company given this signal? The answer is that CNAT performed the requested studies and the drug came back clean. So despite the potential red flag of this being a compound dropped buy PFE, it seems that the decision was both rational from PFE and CNAT has used that decision to its advantage to gain access to an effective drug.

3. Given the history of the drug, there is a significant amount of clinical data that has defined both its efficacy and safety profile. This certainly decreases the risks associated with its development but its lead program is not in NASH but acute-on chronic liver failure (ACLF). ACLF is an unmet medical disease in which patients with chronic liver failure receive an acute insult that increases the risk of multiple organ failure and death. There are about 150,000 patients that suffer from this a year in the US and EU and Roth estimates that with a $25,000 price tag and peak penetrations of 35% that ACLF is a $1.3B opportunity. The company expects to get results from its phase 2B study in the second half of this year and potentially start registration trials for the US/EU in 2015. This is critical to understanding the undervalued nature of this company because this is a $1.3B opportunity (obviously risk discounted at this point) outside of NASH. In other words, you can buy CNAT at these values and take NASH as a free call option. Assuming positive data this year, I suspect the company jumps (or maybe we see a run up into this data).

4. So CNAT is essentially cheap given the ACLF potential (and you have POLT as a smaller indication) but there is also a rationale for its use in NASH. The company is going to conduct a quick phase II NASH trial to make sure that the PK/PD in these patients works as expected and it is generating the predicted efficacy. In addition, they are going to slow play this space given the lack of clarity in terms of proposed endpoints and phase III trial designs. As such, they are content to ensure they have the proper dosing for a phase III and let the first movers do the regulatory work and when all of that is settled they will be able to quickly move into a phase III. Given that we know emricisan has effects on liver biomarkers, it is highly likely that this phase II trial will be a “success” in that it will show clinical improvements in NASH patients. In many ways that topline will be important in moving the stock but the details are what will matter for the phase III trial design. In any case, these data are also expected by the end of 2014 and are yet another stock moving catalyst.

5. Long story short, CNAT appears undervalued given its potential in ACLF and then you have the potential game changing addition of NASH. Obviously there are risks but my inclination is to see the valuation gap as one that is based off of a lack of exposure and not some fundamental reason. So there are really two ways to make money in CNAT. First, is to play the increasing exposure play (like we did with IPHYF). When will this happen is not clear but it is likely to be 2014. Second, is a longer term play in that emricisan looks to be an effective drug with large commercial potential and even once the company get revalued higher this is a company that is potentially sitting on a blockbuster (but we are still certainly early).
I will call it a day here and I will be out of town tomorrow, so there will not be an update. Have a great start to your week.

Disclosure: Long CNAT and PFE March 22nd $33 calls.