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I want to recommend Medarex Inc. (MEDX) — the stock has been hammered, biotechnology is out of favour, and yet venture capitalists continue to pour money into the cancer drug sector. That contradiction should present an opportunity.

Yet the risk-reward at Medarex is just too unfavorable. If the company receives approval of Ipilimumab for melanoma in early 2009, I see Medarex as fairly valued in the $8-$12 range (current price is $8.37). If they fail to win approval, the downside would probably be penny stock land.

Medarex’s Opportunity Now is Ipilimumab

Medarex is focusing attention on their drug Ipilimumab, a treatment for melanoma (skin cancer) that they are developing in partnership with Bristol-Myers Squibb. All three of Medarex’s ASCO abstracts this year (9010, 3018, and 9025) refer to Ipilimumab and its impact on patients with advanced melanoma.

I note that Medarex has a pipeline of six wholly owned monoclonal antibodies generated from their UltiMAb Antibody Platform, but the revenue generating potential for these drugs is unlikely to impact my five year time horizon.

Medarex expects to bring Ipilimumab to the FDA for approval in early 2009. Their trial results have been inconclusive, but the company believes that the FDA will look favorably on Ipilimumab because of “the body of evidence” and the fact that melanoma patients have few good options right now. Let’s quantify the possible impact of an Ipilimumab approval.

View the spreadsheet used for this analysis of Medarex.

The American Cancer Society estimates that 60,000 patients were diagnosed with melanoma in the US during 2007, while 8,000 people died. In terms of cases and deaths in the US, this puts melanoma at about the size of kidney cancer. This gives us an opportunity to size the potential revenues for Ipilimumab and Medarex.

If Ipilimumab sales match the combined global sales of kidney drugs Nexavar and Sutent (both approved in late 2005), then Ipilimumab could generate $1.2 billion in global sales by 2012.

Medarex keeps 45% of the revenues generated by Ipilimumab, while their partner Bristol-Myers Squibb keeps the rest. Accordingly, I calculate that Ipilimumab could generate $540 million in revenues for Medarex by 2012.

Using aggressive assumptions on margins and valuation, I get a 2012 target price for Medarex of $18. Discounting that back at 20% per year, I arrive at a net present value for Medarex of $7.80. The stock is trading at $8.37 this evening, so it is overvalued for me even assuming the approval and success of Ipilimumab.

The approval of Ipilimumab would take away a significant risk in Medarex’s story. At that point, the stock might be valued with a 10% internal rate of return, yielding a net present value of $11.70. This is how I get my $8-$12 fair value for Medarex on the upside.

Medarex’s High Burn Rate Increases Downside

There is considerable risk to this story, however. First of all, Ipilimumab may not be approved in early 2009. Medarex spends over $260 million per year on operating expenses (R&D and SG&A), so without significant topline revenues, their $590 million in cash and marketable securities will be gone by the end of 2010. Ipilimumab is really their only chance on the operating side to change that calculus.

With Ipilimumab approval, my model has Medarex skimming past a negative cash position during 2010-2011 and breaking even by 2012. There is another problem, however. Medarex will have to deal with a $150 million convertible loan coming due in May of 2011. The loan is convertible into Medarex shares at $13.72 per share (well above the current price), so Medarex will probably have to come up with $150 million in cash in 2011. Medarex will have to finance the rollover of that debt — they won’t have the cash on the balance sheet regardless of Ipilimumab’s approval status.

I hate seeing convertible loans like this outstanding, because they can be toxic to the common shareholder. Hedge funds like to buy convertible issues and then short against the convertible position, driving the stock to nothing. The hedge fund makes money off the short position while the common shareholder loses everthing.

I would avoid Medarex for now. If Ipilimumab is approved next year, we can revisit the stock. I expect Medarex will be under $12 even with the approval.