By Ivan Deryugin
Just over a week has passed since our last report on Pharmacyclics (PCYC), in which we argued that the stock has solid upside potential based on a quality product pipeline, anchored by Ibrutinib, and a strong financial position. Since then, the stock has rallied well over 20%, driven by meaningful improvements in the fundamental Pharmacyclics story, improvements that are likely to lead to further upside from here and also serve as incremental increases to the likelihood of a takeover of the company. Even in the short-term, action from the sell-side is likely to move the stock higher as analysts adjust their price targets to accommodate Ibrutinib's breakthrough therapy designation, a first in oncology and one that accelerates the drug candidates pathway to the market considerably.
Breakthrough Therapy Designation: An Oncology First
On February 12, Pharmacyclics announced that Ibrutinib, its BTK inhibitor and lead product candidate, became the first oncology drug to earn breakthrough therapy designation from the FDA. This allows Pharmacyclics to pursue an accelerated pathway to FDA approval, and the company has indicated that it expects to file its NDA for Ibrutinib in CLL (chronic lymphocytic leukemia) in 2013, a full year earlier than Wall Street had been expecting. In addition, Pharmacyclics announced that alongside breakthrough therapy designation in CLL, the company had received breakthrough therapy designation in Waldenstrom's macroglobulinemia (also known as WM), an indication for which Pharmacyclics has not reported any data in the past. However, it's likely that the clinical data underlying this decision is solid given the high standards set forth by the FDA for breakthrough therapy designation.
This is a material achievement for Pharmacyclics, and strengthens the bullish thesis, as it brings approval and sales forward by a year. Most analysts covering Pharmacyclics utilize a discount rate of 12-15% (Piper Jaffray uses a 12.5% discount rate) when constructing a discounted cash flow valuation of the company. All else being equal, if sales are to occur a year earlier, models must be adjusted accordingly and discount rates in tandem. There are still analysts that have not changed their models to incorporate this new information, so we'll likely begin to see price targets rise as sell-siders adjust. These changes will spur additional momentum in the stock in the near-term.
Breakthrough therapy designation is a meaningful step in the pathway to regulatory approval, and it justifies Pharmacyclics' rally. Furthermore, it should be noted that this breakthrough designation will have spillover effects to other parts of the bullish thesis for Pharmacyclics, namely the likelihood of a takeover by Johnson & Johnson (NYSE:JNJ).
Takeover Prospects: Accelerating Payouts and Accelerating Decisions
When Pharmacyclics first struck its deal with Johnson & Johnson (specifically Janssen, the company's biotechnology division) in late 2011 shares plunged as investors worried not only that this deal precluded a takeover of Pharmacyclics, but that it was heavily loaded on the back-end. Of the $975 million deal, only $150 million was delivered upfront to Pharmacyclics. Another $250 million was to be paid for various Phase III milestones; the bulk of the deal's value was wrapped up in $575 million in payments related to regulatory filings and approvals for Ibrutinib. With breakthrough therapy designation, Pharmacyclics will be filing for (and potentially receiving) approval of Ibrutinib a year earlier, thereby accelerating hundreds of millions in payouts from Johnson & Johnson. In my view, this will cause Johnson & Johnson's executives to begin, at a minimum, debating whether or not they should make these payouts, or simply take full control of Ibrutinib. As mentioned in our last report on Pharmacyclics, this deal does not favor Johnson & Johnson. It's shouldering 60% of Ibrutinib's development costs for only 50% of its profits. And in addition, Johnson & Johnson is required to reimburse Pharmacyclics for any Ibrutinib development expenses exceeding $50 million per year. Pharmacyclics received $18.13 million in reimbursements in the last quarter, and these reimbursements are likely to continue. Johnson & Johnson's management will likely begin an internal review to see if these costs are worth bearing for only 50% of total Ibrutinib profits. And there's plenty of precedent for such a move.
Just last month, Allergan (AGN) took control of MAP Pharmaceuticals (MAPP) ahead of the April 15th PDUFA date for Levadex, the migraine drug that the two are developing, in part to avoid paying out $77 million in milestone payments. Allergan spent $958 million (the total price of acquiring all of MAP) to save $77 million in milestone payments and gain full control of Levadex. In addition, Allergan will be offsetting some of the payout for MAP by absorbing the more than $100 million in net cash & investments that are sitting on MAP's balance sheet.
Similarly, a takeover of Pharmacyclics will save Johnson & Johnson $575 million in milestone payments, and can be partially offset with the $317 million in net cash and investments held by Pharmacyclics. And Johnson & Johnson certainly has the capability to execute a takeover of Pharmacyclics based on its 3Q12 balance sheet, which shows that Johnson & Johnson holds $19.8 billion in cash & investments, or $2.92 billion net of debt. However, just $5.4 billion of the company's debt is due by the end of 3Q13, and its long-term debt matures at a smooth rate; only in 2017 and 2019 do the company's debt repayments equal or exceed $1 billion. A potential complication is the fact that almost all of the company's cash is said to be held offshore. However, given that Johnson & Johnson spent $17.8 billion on dividends and buybacks in the first 9 months of 2012 alone, I believe that the company will be able to find ways to utilize its offshore cash in the event that it decides to take control of Pharmacyclics, which currently has a market capitalization of just over $6 billion. Even when factoring in the potential premium needed to sway Pharmacyclics' board of directors, a takeover could potentially be completed for $10 billion or less (the price tag falls to almost $9 billion with the savings from not making regulatory milestone payments and Pharmacyclics' present cash & investments are taken into account). While I believe that Pharmacyclics offers compelling stand-alone prospects, and that a decision to invest in the company should be made on a stand-alone basis, there's precedent for a takeover of the company.
Pharmacyclics' recent rally was driven by more than just positive news regarding Ibrutinib. It was also driven by negative news from a competing oncology compound. On February 15, news broke that AbbVie (ABBV) had suspended development of ABT-199, the company's BCL-2 inhibitor for a variety of hematological indications, including CLL and Non-Hodgkin's lymphoma (NHL). The company has confirmed that 2 patients died in late-stage studies, ahead of Phase III testing. And while it's likely that trials of ABT-199 will resume later in 2013, once the company alters the dosing of ABT-199, this delay is an incremental positive for Pharmacyclics and Ibrutinib.
Pharmacyclics faces three other competitors in its various hematological indications: Celgene (CELG), Infinity Pharmaceuticals (INFI), and Gilead Sciences (GILD). Celgene's Revlimid is expected to receive FDA approval for the treatment of MCL (Revlimid has priority review status and a PDUFA date of June 5). In addition to Revlimid, Celgene is developing its own BTK inhibitor: AVL-292, which is in Phase I trials for the treatment of lymphoma. Consensus expectations are that Celgene will report new data for AVL-292 at ASCO, but that it's unlikely to blunt the potential of Ibrutinib, which is much farther along in the clinical trial process and has strong patent protection. Infinity Pharmaceuticals' IPI-145 is PI3K inhibitor currently in Phase I trials for a variety of hematologic malignancies, and Infinity expects to have meaningful advancements in the development of IPI-145 in 2013, with 5 planned cohort expansions, the establishment of Phase II dosing, and the initiation of 2 other clinical trials. However, while 2013 could be a key year for IPI-145, the drug is ultimately expected to compete not with Ibrutinib, but with GS-1101, Gilead's PI3K inhibitor currently in Phase III trials for the treatment of CLL, and in Phase II trials for the treatment of indolent non-Hodgkin's lymphoma (iNHL). Gilead has stated that accelerated approval filings for GS-1101 in indolent iNHL are a possibility, but are not likely to be a material threat to Pharmacyclics given that Ibrutinib's first targeted indications are likely to be CLL and MCL.
With shares of Pharmacyclics consolidating on February 19 after a meaningful run, further upside remains. The developments that have transpired in the past week are material and serve to further strengthen Pharmacyclics' competitive position. The company's financial condition remains strong, and the acceleration of hundreds of millions of milestone payouts may very well lead to discussions at Johnson & Johnson about whether or not to take control of the company. As Ibrutinib moves closer to its regulatory filings, the interest surrounding Pharmacyclics is likely to grow. ASCO 2013 is less than 4 months away, and many analysts, such as Stifel Nicolaus, have yet to incorporate breakthrough therapy designation into their price targets and models. That, combined with increasing interest in the physician community, is likely to lead to an even more intense focus on Pharmacyclics' potential: such focus is warranted.
Disclosure: I am long PCYC.
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