Generating an earnings model for a developmental-stage biotechnology company is far closer to art than science, requiring all sorts of assumptions about a large array of variables. The variables include the time-line for clinical trials, data compilation, and the Food & Drug Administration's deliberation process; likely product price, which is seldom disclosed; market acceptance and penetration rate; profit margins; and the number of shares outstanding. Deriving price targets for these companies requires additional layers of guesswork, concerning both an appropriate discount rate for the earnings projected and a reasonable price/earnings multiple. While acknowledging this inherent complexity, it's incredibly difficult to make any sense of Wall Street's price targets for MannKind Corporation (NASDAQ: MNKD). Indeed, one would be hard-pressed to envision any of the many possible scenarios that could play out over the next 12 months that would have the small biotech's common shares trading anywhere near the consensus price target nominally established for next June. In this article, we evaluate the financial establishment's figures and then outline alternative possibilities. As with the article we penned in May entitled "Pricing A Highly Probable Takeover Of MannKind," our purpose is to provide an analysis that might be helpful in making buy, hold, and sell decisions, to supplement that provided by a small number of Wall Street analysts, who can have outsized influence on the stock price of small companies that have limited institutional research coverage. While last month's write-up focused on a possible buyout of the firm, this one looks at two other scenarios, one involving marketing partnership(s) and the other on the company launching its flagship inhaled insulin product Afreeza on its own.
Price Possibilities, Per Wall Street
According to data provided by Thompson First Call, seven analysts have published price targets for MannKind. They range from a low of $4.00 to a high of $11.00, with a mean and median of $6.57 and $6.00, respectively. The latest action by an establishment analyst dates back to last Friday (June 7, 2013) when Bank of America's Merrill Lynch unit lowered its rating from "buy" to "neutral" but raised its price target to $8.00 from $5.00. By contrast, we speculated last month that the company could be taken over within a year at a price around $27.50 a share. With that said, we would note that valuing MannKind would require the consideration of the following variables, in addition to the many cited above: 1) Will the company have secured a marketing partner by next June? 2) What would an agreement look like, in terms of up-front payments, royalty rate, manufacturing arrangement, etc.? 3) In the absence of an agreement, how would the company fund its product launch, that is, how many shares would be outstanding, and/or what would be its debt-servicing obligations? All in all, the many moving parts make it almost pointless to derive a single price point.
As to our contention in the opening paragraph concerning the improbability of the stock price being anywhere near the $6.57 consensus estimate, it's based on our fundamental view that MannKind could follow one of four general paths over the next 12 months. The first course has MannKind reporting very disappointing Phase 3 results in August and/or the Food & Drug Administration rejecting its application to commercialize Afreeza. This scenario would undoubtedly have the stock trading below $1 next June, well below the consensus. If the results are, in fact, poor, then the FDA decision and partnership/buyout possibilities that have long been the subject of speculation and anticipation become moot. On the flip side, the other three courses - buyout, partnership agreement, and going it alone - originate with Affinity 1 and Affinity 2 essentially confirming the efficacy and safety profile of Afreeza , as delivered through the Dreamboat device; the previous trials were conducted with the MedTone delivering the aerosolized insulin. Each of these scenarios, which are reviewed in some detail below, would most likely translate into a stock price that's well above the prevailing level, considering both the product's commercial potential and the dissipation of myriad uncertainties and risk.
Why the First Scenario is Highly Unlikely
Some 65% to 70% of drugs that enter Phase 3 trials achieve their primary endpoints and move to the next step of the regulatory approval process. The odds of success are even higher for products that have completed their respective clinical study, which is the case for Affinity 1 and should be true for Affinity 2 within a few days; some trials are terminated early due to adverse events or unfavorable preliminary data. MannKind isn't expected to announce the results until mid-August but Afreeza's exhaustive testing-to-date (almost 6,000 patients) and management's upbeat comments this late in the process strongly suggest that investors (and diabetics) won't be disappointed. As a reminder, in a recent conference call, Alfred Mann, the company's founder and chief executive indicated that Afreeza could be "major weapon" in the battle against the global diabetes pandemic and "could potentially even become the most significant medical product ever." It's also important to note that the two trials, which were designed in very close consultation with the FDA, set low bars for success. In Affinity 1, the primary endpoint is to show non-inferiority of the change in A1c levels in the Dreamboat/Afreeza group compared to the injected insulin analog group. The company also has to show bioequivalence between Dreamboat/Afreeza and MedTone/Afreeza. The FDA's instructions to include a MedTone/Afreeza arm in the study largely validate the science behind Afreeza and MedTone. Indeed, if MedTone/Afreeza didn't work, then the regulators would have been irresponsible in allowing a group of patients to be treated with that product. Moreover, the need to show bioequivalence would be rather absurd. In Affinity 2, the endpoint is to show superiority in the Dreamboat/Afreeza group compared with the Dreamboat/Placebo powder group, which previous studies show shouldn't prove too difficult.
What is MannKind Worth on a Stand-Alone Basis?
In our attempt last month to derive a possible takeover price for MannKind, we made a lot of assumptions that others might argue were too high, too low, or just plain wrong. Our effort here to price the company in the other scenarios will also require a lot of guesswork. That said, as with the previous attempt, we lay out the facts, in some detail, on which our assumptions are based, without, hopefully, repeating too much from the May article, which can be accessed by clicking here.
Lessons from Pfizer's Exubera Experience
On January 19, 1995, New York City-based pharmaceutical giant Pfizer, Inc. (PFE) entered into a licensing deal with a small company named Inhale Therapeutic Systems (now called Nektar Therapeutics) to develop an inhaled insulin product that later came to be known as Exubera. The number of diabetics was large (and growing) and the drug giant thought that Exubera would help address the problem of many patients avoiding treatment because they found insulin injections unpleasant and inconvenient. At that time, there were an estimated seven million Americans diagnosed with diabetes. In January 2006, Pfizer agreed to pay Sanofi-Aventis (SNY; since renamed Sanofi) $1.3 billion for its worldwide rights to help market Exubera. At that time, the three partners - Nektar Therapeutics, Pfizer, and Sanofi-Aventis - were awaiting clearance from the FDA to sell the inhaled insulin product. Pfizer launched the product in July of that year and projected revenues of $2 billion by 2010. On October 2007, given very poor sales, the company announced that it was shelving the novel product and taking a $2.8 billion charge to write off its nearly 13-year investment. Soon thereafter, both Novo Nordisk A/S (NVO) and Eli Lilly (LLY) terminated their respective programs to develop insulin inhalers. Exubera's problems were manifold and it was probably doomed to fail from the outset: Insurers found it expensive and were reluctant to pay for it; physicians found the product difficult to use and were concerned about its long-term safety; and perhaps most important, patients found the large device cumbersome and embarrassing to use, with some comparing it unfavorably to a bong that's used to smoke marijuana. All that said, it's important to note that the diabetes market has grown considerably larger since then and a major problem remains the avoidance of treatment by diabetics reluctant to inject themselves multiple times a day. As well, in addition to apparently being far more efficacious, Dreamboat/Afreeza is substantially smaller, easier to use, and is expected to be priced competitively with other insulin products.
A Huge and Growing Target Market
According to the International Diabetes Federation, the number of people with diabetes approximates 366 million. Changes in lifestyle and consumption habits have spread the disease to all corners of the world and the total number is expected to reach 550 million by 2030. There are an estimated 26 million diabetics in the United States, 32 million in Europe, and 91 million in China. Affluent Japan and Korea also have a relatively large proportion of its population suffering from the disease, with a combined total of 14 million people. The global market for diabetes care products is correspondingly large, aggregating approximately $40 billion in 2012. Various insulin products account for about 49% of the total, oral diabetes products 45%, and GLP-product 6%. The market has grown at a roughly 10% rate annually in recent years.
Novo Nordisk is the market leader, with a global market share of 26%, in dollar value. The Danish company is also the closest thing to a pure play in the diabetes therapeutic category, deriving some 78% of total sales from diabetes care products. In 2012, this equated to 60.9 billion Danish kroner, or 10.8 billion U.S. dollars. The other major players in the category are France-based Sanofi, which markets Lantus, the top-selling branded insulin product, with sales of $6.5 billion in 2012 (up 19.3% on a constant currency basis), and U.S.-based giants Merck (MRK) and Eli Lilly . Oral medications Januvia and Janumet contributed $4.1 billion and $1.7 billion, respectively, to Merck's top line last year, while injectable insulin Humalog added $2.4 billion to Lilly's sales, and Humulin another $1.2 billion. Significantly, the diabetes drugs are critical to Merck considering the rapidly eroding sales of other huge sellers, Singulair and Remicade, which now face generic competition. Sales of the former plunged from $5.5 billion in 2011 to $2.7 billion last year, while those of the latter slumped from $3.9 billion to $2.1 billion. Also noteworthy is Humulog's loss of market exclusivity last month.
The Buyout Scenario
The possibility of MannKind being acquired was discussed in great depth in Pricing A Highly Probable Takeover Of MannKind, so we'll address the comments by several readers of the article that Alfred Mann would not sell a company named after him and that a partnership is far more likely and desirable. Mr. Mann is 87 years old, has many potential heirs, including seven children, and a history of selling his companies. The company will need a large cash infusion shortly and most likely both a substantial sales infrastructure and a new leader. A marketing agreement with a big pharmaceutical, medical device, or biotech concern would certainly resolve the cash and sales force issues, but would undoubtedly also complicate a potential sale if that were ultimately desired. An assessment of Arena Pharmaceuticals (ARNA) would probably illustrate this problem well. The maker of a recently launched weight-loss drug has frequently been cited as an attractive takeover candidate, including by other contributors to Seeking Alpha, but it should be noted that company has a marketing and supply agreement with Japan-based Eisai Inc. that covers most of North and South America, including the critically important United States market. As noted in the company's filings with the Securities and Exchange Commission, Arena "will manufacture and sell BELVIQ to Eisai for marketing and distribution in the United States." An acquirer of Arena would essentially become Eisai's manufacturing arm. The only suitable suitor might be Eisai but, paraphrasing an old maxim, why buy the cow when you're already getting all the milk. A partnership agreement also leaves open the succession issue, while also muddying Mr. Mann's estate planning.
There are many difficulties and uncertainties inherent in pharmaceutical research and development and the introduction of new products. The failure rate is extraordinarily high and the process to bring a drug from the discovery phase to regulatory approval can take 12 to 15 years and cost more than $1 billion. Failure can occur at any point in the process, sometimes after a substantial investment has already been made. As such, the number of licensing deals between big pharma and small developmental stage companies has mushroomed over the years. The money involved, meantime, is invariably a function of a new-drug prospect's sales potential and its position in the development life cycle, with the more advanced (and less risky) obviously commanding a higher price.
The same corporations we mentioned as possible buyers of MannKind would clearly also represent suitable marketing partners. They include Novo Nordisk, Sanofi, Lilly, Merck, Pfizer , Johnson & Johnson (JNJ), and Medtronic (MDT). In view of the size of the market and the prevalence of diabetes in so many countries, it wouldn't surprise us if MannKind secured more than one partner, perhaps one to cover the Americas, another to target Europe, and a third to reach the Asian continent. Moreover, we wouldn't preclude the possibility of an Asian company entering the mix, given both the huge number of Asians with diabetes and China's growing financial clout.
Considering the onerous dynamics of developing a commercially viable new drug, the Exubera example, and the gigantic market opportunity, the upfront licensing fees to MannKind should easily total at least $2.5 billion. A marketing agreement would probably also include an arrangement that would have the company either receiving a royalty on all sales or, more likely, since it already has ample insulin supplies and a manufacturing facility, a supply agreement along the Eisai/Arena model. Marketing partner(s) would obviously facilitate a worldwide launch and accelerate a ramp-up in sales. Deferring to Mr. Mann, who understands diabetes and the diabetes market as well as almost anybody else in the world, given his long experience with MannKind and insulin pumps maker MiniMed, which he sold several years ago to Medtronic, we think $4 billion in annual sales seems well within reach. Loosely factoring in Pfizer's expectations, the uptake rate of other large-selling diabetes medications, and the market's growth rate, the level could be reached by 2018. By then, the total market value of diabetes products should approximate $55 billion, so $4 billion would represent a relatively modest 7.3% market share. Assuming the marketing partner(s) pays 35% of revenues, approximating Arena's economic arrangement with Eisai, a tax rate of 20%, and 400 million shares, this would translate into net income to MannKind of about $772 million and earnings per share of $1.93. Applying an 18 multiple would result in a stock price of $34.74, and $24.05 when discounted back to next June at a 10% rate. Throw in a strong balance sheet that could contain roughly $4 a share in cash, and the shares could be trading near the $28 mark, which is very close to the estimated price in a buyout. As a reminder: MannKind has enough insulin in inventory to generate about $10 billion in revenues; the inventory has already been expensed, so operating margins will be unusually wide in the early years; it also has $2.1 billion in cumulative losses, which will shelter some earnings from taxes. These two items provide ample cushion to our projections. In terms of valuing the shares, it should be noted that uncertainties about trial results and FDA deliberations will no longer be inhibitors by next summer. Wall Street's revenue and earnings models will also be more meaningful by then.
Going It Alone
The "going it alone" path is probably the least likely scenario as it complicates the path forward and would undoubtedly slow Afreeza's market penetration. If this were necessary, however, MannKind would probably have to raise an estimated $500 million to meet both forthcoming obligations and build a sales force. For our projection purposes, we assume the sale of 50 million additional shares and add another year before sales reach $4 billion (to 2019). Going down the income statement, we assume an operating margin of 34.2% in 2019, which is the average for Novo Nordisk's past three years, and a tax rate of 20%. The result is total income of $1.1 billion, meaning a net profit margin of 27.1%, also in line with Novo Nordisk. Factoring in a diluted stock base of 450 million shares, a price/earnings multiple of 18, and a discount rate of 10%, we arrive at an estimated price target of $27.42 for next June. The cheap cost of goods sold and the shelter earnings noted above apply here, too.
The Bottom Line
MannKind stockholders are understandably nervous given both the stock's huge price run-up since the beginning of 2013 and the rapidly approaching announcement of potentially make-or-break results of two clinical trials. As such, rumors, speculation, and the pronouncements of the few analysts that follow the company can have undue influence on the stock price. All in all, we think the investors who were lucky enough to get their shares in the early stages of the run-up should count their blessings and not worry too much about it being "overbought" or getting "overheated." Our assessment of the four possible scenarios suggest that MNKD stock still offers considerable upside potential and is far less risky than two CRL (complete response letters) would imply. That said, we would also remind investors about the dangers of excessively overweighting a single position, irrespective of how attractive it might appear.