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In Part 4, we use the discounted free cash flow valuation method to estimate the fair value of Pharmacyclics' (PCYC) stock. To derive the free cash flows, we utilize the projected revenues, R&D costs, and SG&A expenses described in Part 2 and Part 3. Based on our Baseline Scenario which assumes that ibrutinib will be approved for CLL and MCL and 50% probability of approval for the other B cell tumors, the fair value for PCYC is $92.3. The current stock price is thus fairly valued.

The following data and assumptions were used in the inputs for the valuation (see Table 1).

(click to enlarge)

Revenues: The sources of revenues from 2013 to 2015 are from series of milestone payments from the Johnson and Johnson (JNJ) partnership agreement (see Part 3), whereas the revenues in 2016 and 2017 are from the sales of ibrutinib. The total revenues from ibrutinib sales are estimated to be $500M (2016), $1.22B (2017), $2.24B (2018), and $3.7B (2019).

Expenses and Net profit margin: Current expenses on R&D and SG&A are about 50% of total revenues. We estimate that the tax rate will be in the 12%-15% range for the next 5 years. We estimate that the net profit margin will decrease from current 46% to 38% as the company expands its clinical trials, manufacturing capacity, and product marketing activities.

Capital expenditure and net borrowing: We also factor in capital expenditure and working capital to be 10% of the revenues and assume that it will increase to 12% when the company starts marketing its drug.

Discount rate: We applied a 20% discount rate for PCYC's valuation. As reference points, we usually assign 10%-12% discount rate for a mature pharmaceutical company like JNJ and Pfizer. Private equity firms usually use 25%-30% discount rates for private and small cap companies. Here we think 20% is appropriate for PCYC because there are still uncertainties regarding the approval status and commercialization of its products. On the other hand, the company's drug has demonstrated superb efficacy and has a high probability of receiving FDA approval.

Long-term growth rate: After year 5, we assume that PCYC's revenue growth rate will start to decline to a more normal range comparable to industry peers over six-year span. We used three different long-term growth rates, 8%, 10%, and 12% to derive the fair values.

We present three scenarios for the fair value assessment.

Baseline scenario: This assumes that ibrutinib is approved for CLL and MCL indications for both naïve and relapsed patients with 100% certainty. To be conservative, we estimate a 50% probability that ibrutinib will be approved for other B cell cancers (MM, FL, DLBCL). The fair value of the stock is $92.3 (at 10% long-term growth rate).

Optimistic scenario: This assumes that ibrutinib is approved for CLL and MCL indications for both naïve and relapsed patients with 100% certainty. In optimistic case, ibrutinib has a 67% probability that ibrutinib will be approved for other B cell cancers (MM, FL, DLBCL). The fair value of the stock is $97.3 (at 10% long-term growth rate).

Pessimistic scenario: This assumes that ibrutinib is approved for CLL and MCL indications for both naïve and relapsed patients with 90% certainty, but only a 34% probability to be approved for other B cell cancers (MM, FL, DLBCL). The fair value of the stock is $87.6 (at 10% long-term growth rate).

The fair values at various combinations of long-term growth rates and three scenarios are summarized in the following table.

Conclusion:

Based on our discounted free cash flow valuation, PCYC's current stock price ($90) is fairly priced according to the Baseline Scenario. This suggests that investors are pricing PCYC under the expectation that ibrutinib will be approved for CLL, MCL, and possibly one or two other B cell cancer indications. However, investors should still be mindful about potential risks.

First, the stock is currently priced near its fair value. The company's survival is solely dependent on the successful approval and launch of ibrutinib. Therefore, any setback in the clinical trials or delayed approval by the FDA could pose significant downside risk to the stock price. Other risks associated with the stock include the need for substantial additional financing, future equity issuances or a sale of a substantial number of shares of the common stock may cause the stock price to decline.

On the other extreme, a potential unexpected surprise is that the company may be acquired by its corporate partners. An intriguing question is whether PCYC might be acquired by JNJ. If so, when might the acquisition occur? Is it before or after the approval of ibrutinib by the FDA? Is it in the best interest of JNJ to acquire PCYC or does the current partnership structure work to JNJ's advantage?

Nonetheless, the interim data from any of these clinical trials may still move the stock price one way or the other, which may present potential trading opportunities for investors.

References:

http://ir.pharmacyclics.com/index.cfm

PCYC corporate presentation-Jan2013

PCYC financial results-Dec2012

PCYC 10K-2012-end-June30

Source: Pharmacyclics, Part 4: Financial Projection And Stock Valuation