This is a 3-part report to analyze Incyte (NASDAQ:INCY). In Part 1, we reviewed Incyte's business model, its key products, and risk factors associated with the company. In Part 2, we discussed INCY's partnership agreements with NVS and LLY and presented a 5-year projection for its total revenues. In Part 3, we focus on financial issues associated with Incyte. As it stands, the company is still not profitable. It has $1.7B of accumulated deficit and negative shareholder's equity (-$175M). The company also has $400M convertible notes due in October 2015, which is most likely to be converted to equity - we will discuss its potential impact on the company's total debt, financial leverage, and dilution of common shareholders' ownership. We estimate that Incyte will turn profitable in 2014, with earnings projection to be -$0.20 (2013), $0.57 (2014), $1.23 (2015), $1.54 (2016), and $1.85 (2017). Using the discounted cash flow model, the intrinsic value for INCY is about $25-$26 per share. The current stock price of $19-$20 is thus traded at about a 25% discount to its intrinsic value.

**Income Statement**

Let's first review INCY's financial statements (INCY 2012 10K). In 2012 (ending December 31), although reporting a net loss of $44.3M, it was the company's first time reporting significant product revenues ($136M) due to JAKAFI sales. Incyte also reported contract revenues of $157M from its corporate partners NVS and LLY. As mentioned in Part 2, Incyte generates revenues from the product revenues, royalty revenues, and contract revenues. We estimate that total revenues for INCY will be $358M (2013), $432B (2014), $665M (2015), $836M (2016), and $992M (2017).

As the company expands its clinical programs, we estimate that the company's combined R&D and SG&A expenses will be about 65%-70% of total revenues. This translates to an operating margin of 30-35%, which is in line with comparable companies. Assuming the tax rates are in the 10%-12% range, the net profit margins are ~25%. Therefore, the projected earnings per share (adjusted for depreciation and amortization) are -$0.20 (2013), $0.57 (2014), $1.23 (2015), $1.54 (2016), and $1.85 (2017).

**Balance Sheet**

Now, let's look at INCY's balance sheet. As of December 2012, the company has approximately $330M total assets, which include $228M cash and marketable securities. However, due to large total liabilities ($500M), shareholder equity is -$175M. Moreover, due to long-term losses, the accumulated deficit now stands as $1.7B. This is common for early stage bio-pharmaceutical companies before they turn profitable.

Another sticking point is the company's $400M senior convertible notes (4.75% coupon) due October 2015. If the stock price is above the conversion price of $8.78, which is the case based on current stock prices, it is highly likely that the debt will be converted to equity. If this indeed happens, the debt will be converted to an equivalent of 45.584 million shares and bring total common stock to 175,331,000 shares. This will lead to a 35% increase in common shares, a significant dilution of current shareholders' ownership.

On the positive side, the conversion of debt to equity will reduce total debt levels, increase total equity, and reduce financial leverage. For example, INCY's current total debt/total capitalization ratio is 264%. After the debt conversion, the ratio will reduce to 59%. So, overall, the company will improve its financial strength. The company's accumulated deficit, currently at -$1.7B, will gradually reduce to -$780M by 2017 due to the debt conversion and increased earnings. While we always wonder whether large accumulated deficits may prevent a company from being acquired, as the company turns profitable it will certainly become more attractive as a potential acquisition target.

**Stock Valuation**

Table 2 summarizes the projected data inputs used for stock valuation. INCY's cash flows from operations (NASDAQ:CFO) are estimated to be between $33M and $250M from 2014 to 2017. We also factor in capital expenditure to be 10% of the cash flow to operation. After subtracting capital expenditures from its CFO, Incyte's free cash flows increase from $30M (2014) to $224M (2017). The free cash flow numbers were used to derive INCY's intrinsic value.

We utilized the Discounted Free Cash Flow model to derive INCY's intrinsic equity value. Based on the free cash flow numbers from 2013 to 2017, a long-term growth rate of 5% and a 15% discount rate, the estimated per share stock value is ~$25.5.

The fair value is greatly impacted by long-term growth rates. For instance, a 4.5% growth rate would elevate the fair value to $24.5, whereas a 5.5% growth rate would bring down the fair value to $26.6.

We applied a 15% discount rate for INCY's valuation. As a reference point, we usually assign 10%-12% discount rate for a mature pharmaceutical company like JNJ and Pfizer and 15%-20% for small-cap companies. Again, the fair value is affected by the discount rates. A 14.5% discount rate will elevate the intrinsic value to $27.3, whereas a 15.5% will reduce the value to $23.8.

INCY is currently trading at $19-$20 as of 6/20/2013. This price represents a 25% discount to its intrinsic value and its all-time high of $26.3.

**Conclusion**

Incyte developed and commercialized the first JAK inhibitor approved for myelofibrosis. Its JAK inhibitor drug pipeline has a great potential to extend to indications in oncology, inflammation, and autoimmune disease areas. Incyte has secured a partnership with Novartis (NYSE:NVS) and Eli Lilly (NYSE:LLY) to co-develop its products. The partnerships generate royalty and contract revenues for the company before it generates its own product sales. We estimate that INCY will be profitable in 2014, primarily due to increasing JAKAFI sales in the U.S. and in EU.

Although INCY currently has ~$250M cash and marketable securities, it has alarmingly high levels of accumulated deficit (-$1.7B), and current shareholders' equity of -$175M. It will take years before the accumulated deficit turns into retained earnings. We anticipate that its $400M senior convertible notes will be converted into equity in 2015. If materialized, this will increase common share counts by 35% to 175.3M shares. While this is significant dilution of current shareholders' ownership, the conversion will increase shareholder's equity and reduce total debt level and financial leverage. So, overall, the company will improve its financial strength.

Based on the earnings projection and stock valuation, we derive an intrinsic value for INCY at $25.5. At current stock price of $19-$20, INCY is traded at about a 25% discount to its intrinsic value.

**References:**

INCY corporate presentation June2013

LLY INCY present 52 week results for RA June 2013

**Disclosure: **I am long INCY, NVS. 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.