John Rogers Explains Why He Has Owned Vical For 10 YearsVW Staff
John Rogers Ariel Investments Letter
Dear Fellow Shareholder: This was a disappointing quarter for Ariel Discovery Fund, as our return of +2.47% lagged the +7.59% return of the Russell 2000 Value Index and the +5.24% gain of the S&P 500 Index. Year-to-date, Ariel Discovery Fund has returned +19.67%, as compared to +23.07% for the Russell 2000 Value and +19.79% for the S&P 500 Index. We continue to trail the benchmark since inception due to a tough launch, but even with this tough quarter our two-year annual return of +27.18% is respectable compared to the Russell 2000 Value Index and the S&P 500 Index.
Top performers during the quarter were Furmanite Corporation (NYSE:FRM), which gained +47.98%; Emergent Biosolutions Inc (NYSE:EBS), up +32.11%; and Gulf Island Fabrication, Inc. (NASDAQ:GIFI), which returned +28.51%. On the downside were Vical Incorporated (NASDAQ:VICL), losing -60.38%; JAKKS Pacific, Inc. (NASDAQ:JAKK), down -40.71% before it was sold, and Pendrell Corporation (NASDAQ:PCO), which fell by -25.67% (although it remains up +52.67% year-to- date). Vical is discussed in detail below.
Year-to-date, our biggest contributors were Furmanite, which gained +84.36%; ARC Document Solutions Inc (NYSE:ARC), up +79.30%; and Market Leader Inc (NASDAQ:LEDR), which rose by +68.40% before we sold it prior to the close of its acquisition by Trulia Inc (NYSE:TRLA). Vical has been our biggest loser year-to-date, falling by -57.39%. JAKKS dropped by -46.00%, and Rentech, Inc. (NASDAQ:RTK) was down by -24.71%.
As noted above, for the one-year period ending September 30, 2013, Ariel Discovery Fund gained +17.31% versus a gain of +27.04% for the Russell 2000 Value Index. Meanwhile, the S&P 500 Index gained +19.34% over the one-year period. The results were driven by individual stock results. Our two biggest contributors to performance were large holdings
Market Leader Inc (NASDAQ:LEDR), up +64.63%, and Madison Square Garden Co. (MSG), which gained +50.34%. Top detractors for the past year were Vical Incorporated (VICL), down -71.36%, and Imation Corp. (NYSE:IMN), which lost -26.65%.
Vical Incorporated (VICL)
We typically use these letters to discuss our approach to deep value investing, to outline the case for our favorite stocks, or to comment on trends in the market which we believe will affect our portfolio holdings. This quarter, however, we will share the story of a stock we have held for more than a decade which, at first glance, appears to have “blown up.” We want to explain why we have owned it, how our valuation work continues to indicate a bargain within our long-term discipline, and how we will evaluate the company going forward. Most importantly, we want to demonstrate why we think the company is on solid footing and continues to provide a great long-term investment opportunity. On Monday, August 12 th , after announcing that the Phase III trial of its Allovectin compound, a metastatic melanoma therapy, had failed, Vical stock dropped by 57%. Specifically, it did not meet either the primary endpoint of objective response rate or the secondary goal of overall survival. This result obviously disappointed the company, shareholders, and, most of all, cancer patients. Many had hoped this immunotherapy compound would revolutionize treatment for those battling this terrible disease. Although we would have preferred a better outcome on Allovectin, our thesis for Vical was not a simple bet on its success. In our analysis, the company’s infectious disease platform – with multiple promising products – was worth well more than the $240 million enterprise value of Vical just prior to the announcement. We continue to believe that is the case. All along, we knew a Phase III failure for Allovectin would lead to a s h or t- term hit to the stock, but we believed in the long-term, Vical was an undervalued infectious disease company. To us, Allovectin represented a free option on a cancer treatment with enormous upside potential. This option proved to be of no value, but our view on the rest of the company has not changed.
Due to the impending binary event surrounding Allovectin, we limited our position size. Indeed, we frequently reduced our weighting in the stock over the years when it traded higher. Just prior to the Allovectin announcement we had a weighting of roughly 3.5%, reflecting our view of extreme long-term undervaluation combined with near-term uncertainty. By comparison, our larger positions tend to be in the range of 5.0% to 6.0%, when we find severe dislocations but greater clarity.
We first bought Vical shares in late 2002 in our Ariel Micro-Cap Value Product as part of a “basket” of eight micro-cap biotechnology stocks combined to equal one normal position. A sustained market decline had left the industry in shambles, and we were able to buy the small positions in emerging companies for roughly half their net cash. True, we had limited insight into any specific early-stage compound’s approval, but we were able to own cheap assets—cash—and invest in science (difficult to value, but potentially quite valuable). As the market recovered in 2003, the stocks moved sharply higher, and we sold all except for Vical. We held Vical and later built it into a normal-sized position in both our Ariel Micro-Cap Value Product and eventually Ariel Discovery Fund. We realized its shares were priced like a one-product, early-stage biotech company.
In reality, Vical’s DNA delivery technology platform allowed it to build a deep, well- advanced pipeline of compounds whose potential outcomes are related but not identical. In addition, management did an outstanding job over time of partnering with larger pharmaceutical companies, enabling Vical to conserve cash and minimize dilution.
Success with Allovectin would have led to significant upside, but its failure has no bearing on the likelihood of success for Vical’s infectious disease candidates:
ASP00113 (formerly TransVax) – This is a therapeutic vaccine for cytomegalovirus (CMV) in transplant patients. Vical has partnered with Astellas, granting an exclusive license in exchange for up to $130 million in payments and double-digit royalties. Astellas recently launched a Phase III for stem cell transplant, and is expected to begin a Phase II for solid organ transplant later this year.
CyM Vectin – CMV vaccine for prevention of congenital infection. This could potentially be an opportunity of more than $2 billion for adolescent females. Vical is exploring partnerships for development of this promising compound.
Vaxfectin Adjuvant – This mixture is designed to increase immune responses when added to a vaccine. It has value either in Vical programs or as a technology for license or sale.
Herpes Simplex Program – This early stage program uses a Vaxfectin-formulated vaccine against HSV-2. The company expects to initiate a Phase I/II trial in late 2013.
– Vical also has a pandemic influenza rapid response technology, collaborations with Sanofi and Anges in angiogenesis, and two approved animal vaccines.
Given its current price of $1.25/share, the company’s enterprise value is a meager $38 million. To value Vical, we look at the company as a collection of assets held in cash ($70 million), product candidates, approved animal vaccines, and intellectual property in the form of its DNA technology platform. The company has one Phase III candidate being fully funded by a major global firm plus a number of potentially valuable assets. Thus we believe the valuation is extraordinarily low; in our opinion the market’s reaction to the Allovectin failure was wildly overdone.
For each of the prospective compounds, we estimate the following: market potential, Vical’s likely share upon approval, and the probability of success. We then calculate the probability-weighted revenues for each candidate, apply an appropriate price/sales multiple, and discount these values back to the present. Each compound then has a probabilistic present value. To err on the side of conservatism, we do not add in any value for the animal vaccines or for the DNA technology platform itself – thereby assigning no value to any potential future discoveries. Finally, to be extremely conservative, we assume that all cash including any raised from equity offerings or from Astellas will be spent, and we assume a doubling of the share count.
potentially even the sale of the company. Such actions should eliminate the need to raise capital at dilutive prices and therefore preserve and potentially enhance the value we believe exists in Vical. The duration and size of our ownership will depend greatly on how we view these issues. The company has already made significant cost reductions in recent weeks, and we believe that Vijay Samant and the Board of Directors will be focused on proper capital allocation.
Again, we were truly disappointed in the Allovectin results and never enjoy reporting news that hurts your returns. That said, we believe there is a great deal of value in Vical stock, and if correct, we expect to be rewarded for our patience. We will continue to monitor the actions of management and the Board closely and as a major shareholder we will strongly encourage them to act in owners’ interests.
Portfolio Comings and Goings
There were several deletions during the quarter. We sold out of Orion Energy Systems, Inc. (NYSEMKT:OESX), Ballantyne Strong Inc (NYSEMKT:BTN) and Gaiam, Inc. (NASDAQ:GAIA) due to their small sizes, as we plan to focus on stocks with market capitalizations of at least $100 million going forward. We sold one of our original holdings, The Madison Square Garden Co (NASDAQ:MSG), as it had grown from under $2 billion in market capitalization in early 2011 to over $4.5 billion. We eliminated JAKKS Pacific after its declining business caused it to issue a dilutive convertible bond, leading us to believe our thesis had dissolved. We sold the last of our position in Market Leader shortly before its deal to be acquired by Trulia closed. Finally, we sold our position in Vical to realize a tax loss in early September, but have repurchased the stock as of this writing as the necessary 31 days have passed. We added three attractive new names during the quarter, as follows:
RealNetworks Inc (NASDAQ:RNWK) — Based in Seattle, RealNetworks is best known for its RealPlayer media player software. The company has struggled in recent years, but we were attracted by the return of founder Rob Glaser to a company trading barely above its net cash and below our estimate of liquidation value. Since our initial purchase, the company has introduced RealPlayer Cloud, which along with other new products makes us confident that Mr. Glaser is likely to lead a successful turnaround.
Superior Industries International Inc. (NYSE:SUP) — Los Angeles-based Superior is the leading wheel supplier to the North American auto industry. The company is solidly profitable, pays a dividend yielding over 4%, and has attractive long-term growth prospects if it is able to effectively increase its capacity. Yet the stock trades below book value, with no debt and significant excess cash.
Brooks Automation, Inc. (NASDAQ:BRKS) — Based outside of Boston, Brooks produces semiconductor manufacturing equipment, and has recently expanded into the life sciences area. The company has a leadership position in tool automation for semiconductor makers. The company has a pristine balance sheet with excess cash, solid leadership under CEO Steve Schwartz, and currently trades for roughly its book value. We appreciate the opportunity to serve you and welcome your questions or comments.
Investing in small-cap stocks is more risky and volatile than investing in large-cap stocks. This commentary candidly discusses a number of individual companies. These opinions are current as of the date of this commentary, but are subject to change. The information provided in this letter is not reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell a particular security.
Portfolio holdings are subject to change. The performance of any single portfolio holding is no indication of the performance of other portfolio holdings of Ariel Discovery Fund or of the performance of the Fund itself. Click here for the most recent holdings for the Ariel Discovery Fund .
The Russell 2000 ® Value Index measures the performance of the small-cap value segment of the U.S. equity universe. It includes those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. Russell ® is a trademark of Russell Investment Group, which is the source and owner of the Russell Indexes’ trademarks, service marks and copyrights. The S&P 500 ® Index is the most widely accepted barometer of the market. It includes 500 blue chip, large cap stocks, which together represent about 75% of the total U.S. equities market.
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Performance data quoted represents past performance. Past performance does not guarantee future results. All performance stated in this document assumes the reinvestment of dividends and capital gains and represents returns of the Investor Class shares. We caution shareholders that we can never predict or assure future returns on investments. The investment return and principal value of an investment with our Funds will fluctuate over time so that your shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Click the following link for the annual expense ratio and standardized performance data current to the most recent quarter and month end periods for Ariel Discovery Fund.