Summary
Several years ago, we were shareholders of the biotechnology company Genzyme, which was purchased at a significant premium by Sanofi, the large French pharma company. The purchase price included a right, which still publicly trades under the ticker "GCVRZ." The right is to payments based on a potential FDA approval and subsequent sales of a drug used to fight Multiple Sclerosis. The drug, Lemtrada, is a safe and effective drug. Our expectation is that the right holders will receive a payout equal to approximately 50% of the market price by the end of the year based on the anticipated FDA approval. The remaining payments are based on sales of the drug once it is approved. Once the likelihood of these sales are re-rated, we expect the right to trade above $2 after a $1 payment for a total value of over a 50% upside in 2013.
Alemtuzumab
Alemtuzumab (Lemtrada) is a monoclonal antibody used to treat multiple sclerosis (MS) by killing T-cells - a type of lymphocyte involved in the MS immune response. It reduces MS relapses by about half. It can stop and in some cases reverse disability. See Figures 1-2 below for details. The most common side effect is abnormal thyroid function, but as one of the researchers noted, doctors can replace thyroid functions but cannot replace neurons.
GCVRZ
GCVRZ is the Contingent Value Right (CVR) issued to Genzyme shareholders upon a sale to Sanofi-Aventis (SNY) in 2011. The future payments of the CVR are tied to the future approval and sales of Lemtrada. Based on our analysis of the drug, we believe this investment has the potential to yield a 50% return in the coming months plus substantial future upside.
CVRs
Broadly speaking, a CVR is a contract that offers contingent future payments to the holder upon the attainment of specific, predetermined milestones. A CVR can be used in acquisitions, like SNY-GENZ, where the two management teams cannot come to an agreement over the future value of a particular product, in this case, Lemtrada. One appealing aspect of CVRs in comparison to common stock is that they separate the function of business operations from the function of asset reallocation. When the milestones are met, the companies with CVRs simply send you the money instead of dreaming up some new excuse for keeping it. Another appealing aspect is that they can often be bought at a discount to their expected values because they are outside of the mandate of many conventional money managers who sell them price-insensitively. The last CVR that we recommended, a Celgene (CELG) right ("CELGZ") has reached its first milestone and has appreciated with the success of its drug. The capital market utterly mispriced the security last year:
For what it is worth, GCVRZ is better. It is a far more promising CVR based on a far more promising drug.
Value Components
GCVRZ's value can be divided into two parts:
A $1 payment for drug approval of Lemtrada by the FDA, which we believe is highly likely andUp to $12 paid over time based on four sales milestones for the drug.Sales Milestones
As for the sales milestones of GCVRZ, the total potential payout per CVR is $13, with $12 based upon sales milestones. CVR owners will receive $1 for FDA approval, $2 if Lemtrada sales hit $400 million in certain geographies by certain dates, $3 for sales over $1.8 billion, $4 for $2.3 billion of sales and $3 for $2.8 billion of sales. If we are correct that the FDA decision will be soon and that it will result in the approval of Lemtrada, then the valuation issue will focus on the probabilities of hitting each sales milestone. Unsurprisingly, opinions differ on the various likelihoods.
MS Market
The MS treatment market is worth over $11 billion in annual revenue, growing to $14 billion by the end of next year. In the Genzyme acquisition negotiations, the respective management teams did a good job at bracketing the reasonable "bid" and "ask" side of the market in terms of the Lemtrada market opportunity. Genzyme's upside case of $3 billion in annual global sales would lead to $13 of cash flows from this security. We think this view is overly optimistic, but don't have to share their view unless the CVR trades above $6. Sanofi's downside case of $700 million in annual global sales would lead to $3 of cash flows. Even in this scenario, the current market price is fully justified. Splitting the difference between the two views would lead to $6 of cash flows. The parties appeared to have agreed to the security's structure based upon their respective views of the probabilities. After you get $1 for the likely approval, you would get another $2 for a reasonably likely downside sales scenario, another $3 for a base case, another $4 for a good outcome, and a final $3 if everything Genzyme's management believed comes to fruition.
Sales Milestones' Net Present Value
If and when the FDA clears the drug and we receive our first milestone payment of $1, the subsequent milestones will be worth a net present value of at least $2. It is possible that within a short interval of receiving a $1 payment, the residual security will trade up towards that value. After an FDA clearance, it is possible that the current capital at risk will result in cash flows of $12.
Why is this potential return available?
We do not believe that the current market price is primarily driven by a net present value analysis of the cash flows. Such analysis would likely result in a price somewhere between $2 and $3 approaching the FDA decision. The fact that the price is so much lower raises the possibility that the structure of this security creates an unusual dynamic in which the market price system fails. Since each remaining milestone is a dependent variable, the downside - even a remote possibility of that downside - associated with the failure of the first milestone makes the rest worthless. If the FDA does not approve the drug, the value could become $0. This creates a sizing problem for some investors such that this security is often sized based on one's maximum loss tolerance and not one's assessment of the probabilities.
The 3 Reasons to Expect Success
So, if this drug can secure FDA approval, the right will return 50% in the remaining months of 2013. What are the three reasons to think that this could happen? The probability of FDA approval is high and the timing is soon. Recent developments indicate that Sanofi management thinks so, too.
First, SNY pulled the drug in question from the market (it is currently in use to treat other illnesses marketed as "Campath") in order to prepare for the key FDA decision. This costs them real revenue and is not something that they would do without a high degree of confidence in approval for MS.Secondly, Sanofi conducted a Dutch auction in which they bought back about 30% of rights at a price of $1.75, a premium of 25% over the market price at the time. Such tender offers are confidence inspiring because Sanofi had good visibility into where they stood with the FDA at the time of the tender offer.Thirdly, in Europe, the Committee for Medicinal Products for Human Use (CHMP) made a recommendation in favor of licensing Lemtrada in June 2013. The final EMA decision on a license was secured this week. The EMA is closely coordinating their review with the FDA; it is reasonable to expect the FDA to reach the same conclusion as the EMA.I enjoyed the chance to congratulate the key research leaders earlier this week. Speaking on Monday, September 16, 2013, Prof. Alastair Compston said,
"This announcement marks the culmination of more than 20 years work, with many ups and downs in pursuing the idea that Campath-1H might help people with multiple sclerosis along the way.
We have learned much about the disease and, through the courage of patients who agreed to participate in this research, now have a highly effective and durable treatment for people with active MS if treated early in the course."
"or"
In Europe, Lemtrada is indicated for the treatment of adult MS patients with Relapsing-remitting MS with active disease defined by either clinical or, alternatively, imaging features. This is the first acceptance by regulators that sub-clinical MRI activity can be disease activity. Why is this important? It is important because it increases the size of the market of MS patients that can benefit from Lemtrada. According to Dr. Sheldon Robbins,
"Marketing authorization includes clinically active RRMS OR MRI findings of worsening disease. This is very important. Regulators have never accepted the finding of increasing white matter lesions on MRI as evidence of worsening disease. But in fact, a patient with MS can develop many new lesions without exhibiting clinically worsening disease. This is because the lesions are developing in areas of the brain that are not directly responsible for motor or sensory control. Think of it as a systematic destruction of your neurological reserve or brain back up system. Once that is gone, it is a slow progressive downhill course.
This is setting up nicely for GCVRZ owners. The clock does not start ticking until there is FDA approval. This allows Genzyme more time to prepare for a full roll out of the drug.
Regarding, NICE, the British Neurologist Association is a consultant organization, and regards alemtuzumab as a "step change".
I will be writing more, but the evolution is now morphing into revolution. The debate for neurologists and patients will be whether to stay on maintenance therapy or go on an induction therapy that leads to remission/cure of the disease.
Any medication that a patient takes on a daily or monthly basis is by definition a maintenance therapy. When you stop taking the medication, your disease comes roaring back.
Any medication that a patient takes once or twice and which results in a silencing or remission of the disease is called an induction therapy. Alemtuzumab is the only induction therapy that exists for MS patients.
Neurologists and patients will decide which way they want to go. Once everyone understands that the risks associated with alemtuzumab are very manageable, you will see an ever increasing number of patients migrate over to Alemtuzumab."
Dr. Robbins added,
"I am more bullish than ever. The British neurologists are really pushing this drug as a first line therapy.
Once the FDA issues an approval, we enter a new era in therapy (The revolution). While the market is fragmented and analysts will focus on Tecfidera, the debate amongst neurologists will focus on maintenance therapy vs induction therapy, The British neurologists are favoring induction therapy from what has been written in draft NICE documents. The American neurologists have been silent on the issue probably because we have not had the FDA approval yet. Induction therapy will eventually be the choice of most neurologists and patients."
Conclusion
In short, by purchasing GCVRZ before the FDA approval, one pays $2 for about $3 of expected value, which is likely to result in an imminent cash payment of $1.00, followed by a re-rating of the residual milestones to result in a market value of around $2 with an upside of $12. This is a potential 14x return well worth the risk.
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Disclosure: I am long GCVRZ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
Additional disclosure: Chris DeMuth Jr is a portfolio manager at Rangeley Capital, a partnership that invests with a margin of safety by buying securities at deep discounts to their intrinsic value and unlocking that value through corporate events. In order to maximize total returns for our partners, we reserve the right to make investment decisions regarding any security without further notification except where such notification is required by law.
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