Investors in Celsion Corporation (NASDAQ:CLSN) are eagerly awaiting the announcement of Phase 3 results from the company's HEAT trial of Thermodox + Radio Frequency Ablation (RFA) in treating liver cancer. Arguments for the trial's success and failure have been made in several articles published across the internet. Most buy side investors we have spoken to feel that the trial is likely to fail in meeting it's primary efficacy endpoints. Nevertheless, it is interesting that the company has not taken advantage of the recent run-up in share price from under $2 in June to just over $9 last week, to raise capital despite having a $75 million Shelf Offering on file. Management is either really confident in the outcome of the HEAT trial, or they are simply being reckless by not raising capital when the financing window is open.
Fair Value Model
Ahead of binary events, one must always determine whether or not the current share price justifies the risk of holding through the event. For firms such as CLSN, where there really is only one viable drug candidate, a fairly simple model can be used to determine fair value.
To begin, we assume that, upon trial failure, the stock will be worth net cash on hand. Based on CLSN's Q3 10-Q, the company had approximately 50 cents per share of net cash ($22.7 million cash minus $5.09 million debt divided by 35.01 million shares). Note, CLSN recently received $5 million from their chinese pharmaceutical partner; however, since the company utilizes approximately $5 million cash per quarter, this payment does not change the cash position calculations materially from those based on Q3 numbers.
Next we make an estimate of the fair value of the stock upon trial success. Without getting into detailed analysis, let us assume that fair value for CLSN if Thermodox + RFA works is $1B market cap. This value assumes that CLSN could see Thermodox all the way through approval, but for a ballpark estimate, it is reasonable to say that a successful liver cancer therapy should be worth at least $1B in market cap or $28.56 per share.
Using these two extreme values (50 cents and $28.56), one can calculate a probability weighted fair value for CLSN stock ahead of the binary event. The general formula for the model is:
Fair Value = Price_success x Prob._success + Price_failure x (1 - Prob._success)
For example at Red Acre we believe that, optimistically, the HEAT trial has a 20% chance of success. Therefore fair value would be calculated as the sum of the probability weighted extreme values i.e.:
Fair Value = 20% X $28.56 + 80% X $0.50 = $6.11.
Working From These Numbers
Our simple model for fair value helps determine whether the risk of being long the stock is justified by the probability weighted outcomes of the binary event. To work from our model, one can adjust either the extreme values (our estimate of $28.56 on positive news is likely overly optimistic in the short term), or the probabilities of success and failure.
One useful way to work with these numbers is to calculate the implied probability of success given a certain price level of the stock. For Example, CLSN closed at $8.18 on January 25th. Using our extreme values of $0.50 and $28.56, the $8.18 price implies a 27.4% probability of trial success.
Another useful analysis to perform is to look at what the price should be on a successful outcome if the current price reflects an equal probability of success or failure. At $8.18, if the market is considering the HEAT trial as having a 50/50 chance of success or failure, the implied price of CLSN upon a successful outcome is $15.86.
Conclusion
It is interesting to note that during the bear raid on January 16th, CLSN stock traded as low as $6.17 - close to our own estimate of fair value at $6.11. In other words, those who managed to buy shares at the lows of the bear raid got a good deal because their shares were purchased at a fair valuation based on our assessment of the risks.
This simple model helps determine situations where a stock has reached unrealistic valuations ahead of a binary event. Different investors will have different numbers for both the price levels on success and failure and for the probabilities of the trial succeeding or failing. The model is flexible enough to accommodate a wide range of scenarios with a minimum of inputs. While more complex models based on discounted future cash flows etc. could be produced, at Red Acre we prefer simple models that let us identify stocks where the correct trade is abundantly clear.
In the case of Celsion, the current price of $8.11 does not favor a long position given our estimate of the probability of losing most of the principle invested in the trade; however, it is clear that an at-the-money call strategy would allow one to capture potential upside while minimizing capital invested. CLSN option premiums remain very high and we do not recommend this trade except for entertainment purposes. Treat it like a lotto ticket and enjoy the ride regardless of the outcome of the trial results.
