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Spectrum Pharmaceuticals: When Being "Long" Backfires!

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Yesterday, I published an article titled, “When Being Short Backfires!” So it's only appropriate to look at the other side of the trade. Strangely enough, this comes as one of my favorite companies of the last five years released guidance that simply left me speechless, providing the perfect example of when being long and optimistic backfires!

Staying Long & Optimistic Despite Obvious Problems

In my book, Taking Charge With Value Investing (McGraw-Hill, 2013) I discuss the importance of knowing your own limitations and the personality defects that could cost you money. We all have certain investing tendencies, whether it be buying a stock on large pops, panicking and selling too soon, falling victim to the opinions of every analyst and blogger, or whether it be holding on to a lost cause stock because you don’t want to admit when you are wrong. Personally, I hate to admit when I am wrong. It’s the worst feeling in the world. I have created wealth as a retail investor, and mostly during a flat market. Therefore, overconfidence is a big problem of mine, and when it came to Spectrum Pharmaceuticals (NASDAQ: SPPI), I admittedly ignored all of the looming problems that were so evident to the open eye.

Asking the Wrong Questions When You’re Long

As recently as yesterday, I listed all the positives for the company moving forward. I stated, “This is a company that has seen multiple years of growth, has three FDA approved products, 10 drugs in its pipeline, a P/E ratio of 8, yet still has a short ratio of 33.30,” therefore implying it to be undervalued. However, the question should have been, “Why is there a short ratio of 33.30?” With this one particular stock I failed to follow my own rule, which is to first be skeptical and then form an outlook.

Longs Notice Problems, When it’s Too Late

This is a company where sales of its best-selling drug Fusilev were obviously under pressure from generics, and despite the company’s denials, it was just as clear that discounting was being used as a tactic to maintain sales stability. Furthermore, it is always wise to follow the smart money in any investment, and that is of those who know more than you.

According to Thomson Financial, there were 14 insider transactions in the last six months, with 13 being insiders dumping their shares. These insiders sold 767,743 shares and most were from the company’s CEO Rajesh Shrotriya. For the last several months, investors such as myself have defended his actions with excuses such as “it was a preplanned sale” and “he’s 68 years old and probably near retirement,” but the truth is, when a CEO dumps shares to this degree, in a stock that looks to be clearly undervalued, there is probably a bigger problem in the works.

When the Rumored Problems Come to Surface

So what was it that created an afterhour loss of 40%? Obviously, it was regarding sales guidance for Fusilev. However, it wasn’t just weak guidance; it was guidance that could not have been mistaken. There was no way that the company did not see this coming. For example, the company saw sales of $44.6 million and $204 million for Fusilev in Q4 and for 2012. Now, the company is expecting sales of just $10 million-$15 million in Q1 and $80 million-$90 million for 2013. Personally, this is the largest and most significant change in direction that I have ever seen in the 15 years that I have been a retail investor, and covering my own investments and the space.

What makes this pill even tougher to swallow is that just a few weeks ago management was saying that there would be sales growth in 2013. Therefore, how could the tide change so fast? How did they not see this coming? In my opinion, there are no reasonable answers to these questions, but rest assure, the SEC, analysts, and countless attorneys will find out. At first glance there looks to be various signs of fraud, misrepresentation, and misleading guidance on behalf of the company. Therefore, although it hurts to admit when you’re wrong, sometimes it’s better to admit the obvious, and live to fight another day.

With a 40% Loss Why Shouldn’t I Buy?

There will be many who look at the performance and the guidance issued by Spectrum and believe that it presents opportunity, and it’s very possible that these people could be right. However, at this point, it’s not an issue of valuation, but rather trust, and trust in management. Once a company loses the trust of investors it is quite difficult to regain. There's no overnight solution.

Consider the fact that Spectrum now expects total revenue of $160 million-$180 million for 2013; therefore with a 40% loss it’s trading with a future price/sales of about $2.60. In my opinion, this is too expensive for a company that just slashed full-year sales for its best-selling drug by 60%, and much of this guidance is based on the company’s guidance that sales of Folotyn and Zevalin will rise in 2013. However, can we trust the company with this guidance? My answer is no, not until proven otherwise.

Conclusion

Already, I have received emails and tweets with people comparing this situation to that of Questcor Pharmaceuticals (NASDAQ: QCOR). Questcor saw a decline from $51 to $20 following bearish research, a regulatory investigation into business practices, and insurance restrictions that will affect sales by less than 10%. Spectrum’s is far worse because it was sudden, after months of denial from management. Questcor is still growing by 100% year-over-year and faces far less questions than Spectrum.

I will conclude by saying that this is not an overreaction to news on my part. Instead, this is the result of a fundamental shift where the shorts were proven to be right and the longs were wrong. Sometimes a stock can have all the makings of being undervalued, but you are just flat wrong. It’s times such as this that being long a speculative stock backfires horribly, and works out beautifully for shorts. 


Brian Nichols is long QCOR. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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