I’ve noted on a few occasions that investing in shares of biotech companies is quite challenging for the average investor. In this case, as I suggested a few weeks ago, a biotech fund may be the best choice for some, since it reduces the risk of a specific holding plunging as cash dwindles or as a promising drug fails key testing criteria.

#-ad_banner-#Well, a pair of recent big gainers now tells me that a “swing for the fences” approach still has some merit for others. Here’s what’s going on…

Back in early in October, I recommended three oncology stocks as part of a three-pronged approach to biotech.

Shares of Celsion (Nasdaq: CLSN) are off 27% since then, while Medivation (Nasdaq: MDVN) has shot up a stunning 330% in the same period. Yet it’s the third pick, Threshold Pharma (Nasdaq: THLD), that has me the most intrigued. The stock is up 150% since I looked at it four months ago. And I think it’s only getting started.

 

Hypoxia — a word to know
Threshold Pharma has hit on a novel approach to fighting cancer tumors. The company’s scientists realized that tumors thrive in areas with little oxygen, known as hypoxic regions. Threshold ‘s TH-302, which is being tested on pancreatic cancer, among other tumors, works best in areas with little oxygen, yet has the ability to leave surrounding healthy tissue alone.

TH-302 has proven quite solid in clinical trials. But since the company is constantly in search of fresh cash, and hasn’t been able to line up a big strategic partner thus far, investors simply lost interest. By the middle of last week (Jan. 30), the company’s entire market value had fallen to just $65 million. This figure drops to $40 million when cash is excluded. Investors appeared to assume that the TH-302 platform was not worth all that much.

The White Knight arrives
Threshold’s management knew the company was sitting on valuable technology and was understandably in need of a confidence booster. Well, a White Knight finally arrived to change the company’s fortunes radically. On Thursday, Feb. 2, Germany ‘s Merck KGaA announced it wanted to join forces in hopes to profit from the potentially huge upside that TH-302 offers.

After a quick review of the contractual terms, investors may still be underestimating Threshold’s stock. Let’s take a look at the math…

After a sharp two-day spike, Threshold is now valued at roughly $150 million. That’s a fraction of what Threshold could make from the relationship with Merck KGaA. For starters, Merck has cut a check for $25 million as an upfront payment. Second, if upcoming clinical data remain promising (slated for release later this month), then Threshold will get another $20 million. Later this year, if other undisclosed milestones are achieved, Threshold gets another $35 million. If you’re keeping score, that is all worth more than Threshold was valued by investors just last week.

Prior to obtaining approval from the Food and Drug Administration (FDA), TH-302 will need to pass a few more testing hurdles. If TH-302 continues to appear effective — with minimal side effects, then Threshold will receive up to $280 million in additional milestone payments in 2013 and 2014.

If the drug finally gets approved, perhaps as soon as the fourth quarter of 2013 but more likely in 2014, then Merck KGaA would get global distribution rights to TH-302, while the two companies would share marketing rights in the United States. Threshold’s royalties from Merck could bring in another $245 million.

Add it all up, and we’re talking about $600 million that may end up in Threshold’s hands. The company’s market value, as noted, remains below $200 million. Said another way, Merck KGaA may shell out 10 times as much cash to Threshold as Threshold was worth just last week.

Risks to Consider: This is surely a “best-case scenario,” and Threshold still has much to prove with TH-302. The drug still has yet to enter Phase III clinical trials, which are the toughest hurdle yet.

Action to Take –> It’s usually unwise to buy into a stock AFTER it has had a big run.  But in the case of Threshold Pharma, shares were so undervalued to begin with that they still have significant potential, perhaps 100% or more from current levels.

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