With Seth Klarman's consistent absolute returns year in and year out hovering near 20% for decades, even with large cash positions, I often find it instructive to look through his hedge fund Baupost Group for some investing ideas. One company Baupost has been investing in for years, and in large quantities recently, is Idenix Pharmaceuticals (IDIX). Baupost owns 18.48% of the company. At first, I questioned why a deep value investor with one of the greatest amounts of risk aversion would be investing in a company that has zero cash flow, funds itself through stock issuance and potentially might not make a successful product to justify any valuation. However, the more I read about Idenix, the more I understood the risk/reward potential and that the margin of safety is large considering the non-tangible assets the company possesses.
I will first describe what the situation is with Hepatitis C, its current treatment limitations and the opportunity that nuceloside/tide analogs and other direct acting treatments have in the treatment of HCV. I'll then take a closer look at Idenix's management, pipeline and underappreciated intellectual property, followed by a valuation of the company through take-out values of similar companies in 2011 and 2012 and a valuation as a going concern. This analysis shall show how the current negative perception of pharmaceutical companies focused on HCV next-generation treatment is well overdone and only temporary. A low end estimation of a buyout value would be a multi-bagger at 14.65 times the current price, which means a 10% chance of a buyout would equal 146% over the next year. A conservative estimate of the company on a stand-alone-basis, if a pan-genotypic drug is developed, could be worth similarly by 2017 leading to a 140% CAGR with many catalysts.
HCV Overview
There are six different strands, or genotypes, of Hepatitis C that can be found in different populations throughout the world. The current treatment is highly ineffective and there are huge market opportunities for a drug that has higher effectiveness, lower substantial side effects, high barriers of resistance and can be used to treat a wider portion of the HCV-infected population.
Current HCV Treatment Limitations
Conventional treatment of HCV, an injection of a combination of pegylated interferon plus ribavirin, is quite unsuccessful in suppressing the HCV virus for extended periods of time, also called SVR or sustained virologic response. The rates of success for genotype 1, which accounts for 80% of HCV patients in the US and Europe, is extraordinarily low at less than 50%. To make the low success and inconvenience of administering PEG treatment even worse, conventional treatment leads to numerous substantial side effects such as fatigue, bone marrow suppression, anemia and neuropsychiatric effects.
In 2011 Victrelis and Incivek were approved for addition to the conventional treatment of genotype 1 and did increase SVR rates for patients who can tolerate the triple combination of the therapy. These two treatments are also not without side-effects. Side-effects even with these new drugs continue to be severe causing allergic reactions, fatigue and blood problems that could sometimes even be life-threatening.
Why Nucleoside/tide Analogs and Other Direct Acting Treatments Are Better
Conventional treatment with PEG is limited because they don't directly target the virus. Companies in development of next generation HCV therapies are focused on the development of protease inhibitors, polymerase inhibitors and NS5a inhibitors which inhibit the enzymatic activity of protease (NS3), polymerase (NS5a) and NS5a stopping the replication of the virus. Nucleoside/tide analog polymerase inhibitors show the most promise by blocking the synthesis of HCV RNA and stopping the replication of the virus.
Idenix Pharmaceuticals' goal is "…to develop all oral combinations of direct-acting antiviral, or DAA, drug candidates that will eliminate the need for interferon and/or ribavirin as currently used in the treatment for HCV."
Why Are Idenix Shares Depressed?
The market has recently been ungrateful to HCV's most promising treatment, nucleotide/side inhibitors, after numerous FDA holds and the death and hospitalization of test subjects in Bristol-Myers Squibb's (BMY) nucleotide inhibitor research. Idenix's lead nucleotide inhibitor IDX184, although blocked a few times by the FDA previously, was blocked in connection with Bristol-Myers Squibb's death and abandoned by Idenix's management because the drugs were from the same 2'- methyl guanosine nucleotide inhibitor family. More recently on Thursday evening, Vertex Pharmaceuticals (VRTX) reported that the FDA issued a partial hold on its nucleotide inhibitor VX-135 due to high liver toxicity in some patients. The current market view is that these nucleotide/side inhibitors are too toxic for the FDA to approve.
The market's current negativity towards nucleotide/side inhibitors has only been a recent affair. In 2011 and 2012, large pharmaceutical companies were on a buying spree picking up many of the smaller drug development companies with a nucleotide/side inhibitor in their pipeline. These large pharmaceuticals bought these small companies for a very large premium and for good reason - the development of an all-oral, direct acting, non-interferon HCV treatment will be a blockbuster treatment.
Pipeline and Intellectual Property
Now that Idenix has suspended its lead nucleotide inhibitor, all is lost, right? I think that is too quick of a conclusion. Idenix has a pipeline, research department and intellectual property that is, I believe, well above the companies that were acquired in 2011 and 2012.
Idenix's IDX-719 NS5a Inhibitor is the drug that is currently furthest along in IDIX's pipeline, currently in phase two studies with Janssen's non-nucleoside inhibitor TMC647055 and eventually simeprevir. IDX719 is special because it is the first NS5a by itself to show pan-genotypic activity while competitors NS5a's are focused towards genotype 1.
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A detailed comparison between IDX179 and BMS-790052 further shows the pan-genotypic effectiveness of IDX179 compared to other competitors' NS5a drugs. Below, the y-axis indicates the suppression of HCV replication and the x-axis indicates the different genotypes. The main goal of HCV treatment is to suppress virus replication, so lower replication values are better. We see that IDX719 shows significantly greater suppression of HCV replication across all genotypes when compared to BMS-790052.
Source: Idenix Presentation
NS5a inhibitors will play a part in next generation HCV treatment as a combination with nucleotide/side inhibitors with their low-potential for drug-drug interactions; however, the main focus goes back to nucleotide/side inhibitors with their unmatched high barriers to resistance and potency. Before I get into Idenix's new nucleotide, I think it would be helpful to talk about some chemistry. ATP (adenosine triphosphate) is necessary in the transport of genotoxic substances in the liver, however; the HCV virus uses ATP to replicate thereby lowering ATP. In pre-clinical work, one is able to determine the potency of a nucleotide/side through ATP (adenosine triphosphate) levels that are found in the liver, and Idenix's uridine nucleotide candidate shows great promise when compared to Gilead's GS-7977 in mice and monkeys. Below we see that liver triphosphate levels of Idenix's uridine nuc candidate in monkeys and mice are 25.36 times and 51 times greater than GS-7977, respectively.
Source: Idenix Presentation
Potency this high would allow Idenix to keep dosage rates low and Ron Renaud, CEO of Idenix, believes that the new uridine nucleotide inhibitor could be a once daily dose under 100mg and potentially under 50mg. This dosage can be compared with Vertex Pharmaceuticals' VX-135 which showed elevated liver toxicity with dosages at 400 and 200mg. Idenix also has two other non-2'methyl guanosine nucleotide/side inhibitors that are in pre-clinical stages which combined with the uridine nucleotide, provide numerous catalysts to share price.
Hidden Value
The biggest asset that I feel the market overlooks is Idenix's vast intellectual property that has been gathered in the search for the most promising nucleotide. Researchers at Idenix have had to synthesize thousands of nucleotides and figure out the best for treatment of HCV. That data that hasn't produced beneficial HCV treatment data, however, isn't useless. There are a number of other non-HCV ailments that could potentially benefit from nucleotide/side inhibitors. Previously Idenix wasn't able to look further into the development of nucleotide/sides for non-HCV treatments because of the Novartis (NVS) agreement that allowed Novartis access to all of Idenix's pipeline. After successfully renegotiating, Idenix is free from Novartis to pursue all avenues in drug development and keep their drugs. The Novartis agreement could have also been a deterrent in another company not acquiring Idenix in 2012. The CEO stated that since the renegotiation, third parties have been extremely interested in screening Idenix's library. I feel that large third party interest could mean that Idenix could sell some of its development library, make them that much more of an interest to be bought out or used in the development of drugs in the future. I won't say that I have the expertise to value or have the amount of information to attempt to value the intellectual property, but we can look at recent buyouts to come up with a value for Idenix.
Take-Out Value
There have been three buyouts of similar companies since 2011 that we will compare to Idenix. As shown below, Pharmasset was purchased by Gilead for $11 billion, Anadys was purchased by Roche for $230 million and Inhibitex was purchased by Bristol-Myers Squib for $2.5 billion.
Source: Various 10Ks Before buy-outs, IDIX most recent Q
I feel there are only a few ways of looking at the data, the amount of money spent on R&D and multiple paid on shareholders' equity. We see that Idenix is most similar to Pharmasset in regards to both of those metrics. To be conservative in my estimations, I took all of the multiples that were paid to shareholders' equity and averaged them, 43 is what I got. So, 43x shareholders equity of $219 million gives a value of $9.5 billion. To get an even more conservative estimation, I took the $9.5 billion and discounted it by 20% to account for potential hotness in the M&A activity at the time. So, I would estimate that in the case of buyout, the low-end valuation of Idenix would be roughly $7.5 billion, the mid valuation at $9.5 billion and the upper valuation above $11 billion. The current market cap of Idenix is $479 million, so my most conservative estimate of $7.5 billion would be 14.65x higher than today's price or shares would be worth $52 instead of $3.58. Even though I don't think that a buyout is highly probable in the next year or so, a 10% chance of a buyout at 14.65x our current price would still equal 146% upside.
Valuation In the Event of Business-as-is
Since I believe there is a greater chance that Idenix does not get bought out in the next year, I feel it is also necessary to conservatively estimate the value of the company running on a stand-alone basis. According toRenub Research, the Hepatitis C market is expected to grow more than 3 times by 2018. With the current market around $20 billion that would mean that the market would swell to $60 billion by 2018. It is pretty safe to say that other drug developers will be first to market their nucleotide/side inhibitor, however, Idenix is positioned to be one step ahead, as described above, with its next-generation all-oral pan-genotypic HCV treatment. A pan-genotypic drug would mean that Idenix could sell the same drug to more people worldwide, where half the world is not genotype 1. If by 2017 Idenix has only 15% of the HCV market with $9 billion in revenues and $1.5 billion in EBIT growing at 15% for 5 years followed by stable growth at 2% and these other inputs:
Source: My Rough Calculations
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Source: My Rough Calculations
Source: My Rough Calculations
The above input approximations are based on Amgen in 2003 when they had $8 billion and a few drugs on the market, though my inputs are more conservative. These conservative approximations would lead to a valuation of $48 without taking into context the effect of Net Operating losses that Idenix has been generating which would be slightly offset by stock options and dilution to shareholders, which would be hard to approximate. A $48 value is slightly lower than my take-out value and a time frame of 3 years would mean this company on a stand-alone basis could generate a Compounded Annual Growth Rate of north of 140%.
Source: My Rough Calculations
Cash Position = Downside Protection
Idenix has a strong balance sheet of $205 million and zero debt. With that amount of money, it would be able to last through the middle of next year, complete IDX719, and get its uridine and other nucleotide inhibitors further down the pipeline. The company could issue more stock and with its potential upside, I think shareholders would be willing to take some dilution to keep the company running as they have done in the past. At a market cap of nearly $480 million, Idenix is trading for 2.34x cash, so I see very limited downside, especially when Seth Klarman and his large cash hoard is on the same side.
Management
First, management has their interests aligned with shareholders because they have stock options with exercise prices 200% higher than today's price. Also, I think it is very interesting to point out that the CEO Ron Renaud Jr. has an interesting background that might be conducive to shareholder friendliness. Ron spent two years from 2004 to 2006 as a senior analyst in the biopharama sector at JPMorgan Securities and was in the investor relations division in Amgen.
Risks
There are a number of risks but mainly the risk of the FDA putting holds on any of Idenix's pipeline will send the stock lower. Also, any hold instated on similar Idenix drugs developed by other companies could lead to share price declines. Stock dilution also is a risk. Until the successful development of a drug, this stock will be extremely volatile.
Conclusion
As Seth Klarman once said, "many of the forces that cause securities prices to depart from underlying value are temporary." He, as well as I, believe the temporary negativity surrounding Idenix Pharmaceuticals will pass, launching shares to the underlying value of the business. Any drug that moves forward in Idenix pipeline would send shares higher, and the potential for a multi-bagger makes this a company with good risk/reward characteristics.
Additional disclosure: This article is meant for instructional purposes and not meant as a recommendation to buy or sell. The only kind of intelligent investing is through your own due diligence.
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