Things are looking up for this biotech

Back in November I told you: I'm taking a punt on this biotech tearaway.

The story was about an unmitigated disaster. This was about a stock that had once traded at £11 and was now changing hands at 20p.

And as I wrote in that piece, at 20p it looked like a worthwhile gamble to me. I reckoned it was primed for a takeover.

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Well, news out on Friday has put a rocket under the shares. They're up some 30%. But if you took a punt when I flagged this up in November, chances are you're going to do even better.

I'll show you what I mean.

Even better than a takeover?

The stock in question is biotech group, Vernalis (LSE:VER) and it has just announced a placing and open offer for new shares. Shareholders have been asked to subscribe for new shares in the business and pony up a load of new cash.

You'll often hear about these cash calls and they're nearly always disastrous news. It's usually because the business is in trouble and needs to find some funds... quick-smart. The only way to convince shareholders to cough up is to offer the new shares at a much lower price than the market price.

As the terms are announced, the share price lurches down towards the new' price.

But a cash call needn't always be a kick in the teeth for shareholders. Crazy as it seems, Vernalis is selling its new shares at a premium to the share price before the announcement. And that makes this deal very profitable for existing shareholders.

Vernalis is raising funds to push through a very exciting deal in the States. It's looking at introducing some new whizz-bang cough medicines that have a patented time release system, slowly releasing the active drugs into the body.

Before the announcement, Vernalis was worth some £20m. And now they want to raise £68.5m. That's more than three times the market cap! How on earth can they expect shareholders to stump up that sort of cash?

The answer is they've already found buyers for the new batch of shares. Even if current shareholders don't want to take up the chance to buy new shares, there are plenty of others that will. In City parlance, the issue has been fully 'underwritten'. Better still, the issue was oversubscribed.

What does that tell us? Well, to me it says that the shares have been way undervalued for too long. If the City bods are willing to cough up (excuse the pun) more than the market price for the shares then there's clearly value here.

And since the announcement on Friday, the shares are up from 19.5p to around 25.75p an increase of more than 30%.

But as I said, for existing shareholders, this could be worth even more. Here's why...

The offer price for each new share is 20p. Shareholders will be allowed to subscribe for 2.9375 new shares for every one they currently hold.

So let's say you started off with 10,000 shares. If you take up the offer, then you'll end up with 39,375 shares.

That means if you buy the new shares, you'll not just have made almost 6p (that is the boost since Friday's announcement) on 10,000 shares, you'll have made it on nearly 40,000 shares.

Of course, in order to realise that profit you're going to have to stump up some more cash to buy the new shares.

A shocking outcome for the shorts

This is going to hurt short-sellers big time. They are likely to be called-against'; that is if they thought they were short one Vernalis share, suddenly they're going to find themselves short four and the price has gone 30% in the wrong direction!

This is a great example of why you should be very careful when it comes to shorting.

This stock looked like a great short. Look at the chart I showed you a couple of months ago. You'd have thought the stock was on a one-way path to oblivion:

But Vernalis is no HMV, or Woolies. I pointed that out at the time. Sure it's not a stock for widows and orphans; but if it can get its act together (and this deal is a defining one) then there could be fantastic upside here.

This is a classic example of why we shouldn't begrudge the shorters their trade. In this case it allowed us the chance to pick up stock on the cheap.

We're already up 30% since my tip. As things stand, and if you take up the rights, then you've got the opportunity to seal in that profit on nearly three times as many shares! Of course, the price may go down (or up) in the future... but if you own Vernalis shares, my recommendation is to take up the offer of new shares if you can.

As CEOIan Garland, says, the transaction is fundamental to making Vernalis a "diversified and self-sustaining" pharmaceutical company. "What we've found in one deal is up to six products with a very large commercial opportunity, with a fast path to market and technology protection."

Vernalis has now got funds to help see much of its existing drug pipeline through regulatory hurdles (see my initial article for more details). And on top of that, it's got a new, potentially self-sustaining business in the USA for cough medicines.

As you can see, new share issues needn't always be bad news.

A couple of weeks back I said that I've been digging into a stock. As it happens, it too recently did a cash call at a premium to the stock price.

However in the case of this one, the stock is still trading lower than the issue price. I think that's an opportunity.

I'll give you the outcome of my research very soon.

In the meantime, if you are not already in Vernalis, I'm not recommending you buy in now. Wait for my next ideas instead.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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