Incyte: Life After Debt (Part I)

Last week, Incyte (INCY) sold over $130M worth of stock and $400M worth of convertible debt in an effort to solve its balance sheet issues. Thanks to the stronger cash position, the company can finally be evaluated based on its promising pipeline rather than its capital structure. More importantly, it will be able to complete a series of business development deals and focus on becoming a commercial stage company.

As I explained in a previous article, the company presented investors with a dilemma. Fundamentally, it had a potential blockbuster with a high likelihood of reaching the market in 2011, whereas financially, it was heading for insolvency, with ~$150M in cash and more than $400M in debt (due 2011) as of the end of Q2. To make things more complicated, Incyte was trying to get a lucrative deal for its lead drug candidate, INCB18424 (424), but the company’s shaky financial position diminished its negotiation leverage. The debt overhang also put pressure on the stock, which prevented Incyte from raising the necessary funds without substantially diluting its shareholders. Consequently, Incyte had to compromise on the terms of the offering or those of the licensing deals.

Bitter-sweet pill

Based on last week’s offering, Incyte chose to dilute its shareholders over lowering the price tag of its pipeline. It sold $400M worth of new convertible notes, stating the proceeds will be used to recycle the original debt in the same amount. The new bonds carry a 4.75% annual interest and a conversion price of $8.78 per share. This compares unfavorably to the terms of the original bonds, which carried an interest rate of 3.5% and a conversion price of $11.22 per share.

The new bond holders made an excellent deal. With the strengthened balance sheet, Incyte could secure better deals for 424 in oncology as well as several other programs, which will instantly translate into a higher share price. In the long run, what seems like the inevitable approval of 424 in myelofibrosis (expected in 2011) could push shares much higher than the conversion price for the bonds, which are due in 2015.

Therefore, it seems that the company exchanged the debt overhang with a dilution overhang. Assuming Incyte’s share price exceeds the conversion price, the current shareholders are looking at an addition of approximately 45M shares, not including the recently issued 20.7M stocks in the secondary offering. As of June 2009, Incyte had ~98M shares outstanding, so the combined offering could increase that number by approximately two thirds. Looking on the bright side, by this time next year, Incyte will probably become a rich, debt free company.

Based on the stock’s behavior, investors were willing to swallow the bitter pill in return for financial stability and a better negotiating position. Although the merits of doing the offering prior to the licensing deals are debatable, this sequence makes sense given 424’s substantial and immediate commercial potential. For example, assuming 424 reaches sales of $180M in hematological indications in the US, Incyte’s ability to retain as much US rights as it can, could translate into a difference of tens of millions of profit every year. This, in turn, could add hundreds of millions of dollars to the company’s market cap, using standard industry multiples.

A shift towards business development

After solving the debt issue, Incyte is shifting its focus to business development. In the coming 12 months, the company is expected to announce several out-licensing deals which could support the stock during 2010, prior to data release from 424’s pivotal trial in myelofibrosis. The deals will enable Incyte to be involved in multiple late stage programs without the need to finance most of them. They will also serve as a validation for the quality of assets Incyte has been developing and brought to a stage of clinical proof of concept. Overall, the imminent deals should position Incyte as a mature, versatile and low risk biotech play.

If everything goes according to plans, Incyte will license all of its clinical stage programs. Assuming all deals are carried out, they could add as much as $180M to Incyte’s balance sheet and offload development costs. The company hopes to out-license its JAK program (in two separate deals), its diabetes drug, INCB13739, and its sheddase inhibitor for oncology.

INCB18424 for oncology

Incyte intends to split its JAK program between oncology (including hematologic disorders) and inflammatory diseases. 424 is currently in two phase III studies in myelofibrosis (MF), a blood disorder for which there is no approved treatment. Because MF is a relatively small indication, Incyte intends to market the drug in the US and sign an ex-US deal with a large pharmaceutical company. Depending on the exact deal structure, this deal could include an upfront payment of $70M-$90M.

Exclusion of the US market is something pharmaceutical companies find difficult to accept, however, Incyte might succeed where others have failed thanks to 424’s high chances of approval, the highly unmet need in MF and the likely label expansion into additional indications. These indications include two additional blood disorders that are believed to be driven by JAK, the enzyme 424 inhibits. According to the company, encouraging results from a phase II study in these indications will be presented in December at the ASH 2009 meeting, but a licensing deal could be signed prior to that.

Inflammation programs

The size and competitive landscape that characterize inflammatory diseases such as rheumatoid arthritis (RA) or Crohn’s disease require very long and expensive clinical programs. For example, the two pivotal trials in MF are expected to cost the potential partner less than $40M, while in order to get 424 approved for RA, a $300M development program is warranted. Consequently, Incyte will strive to sign a global partnership for 424 or its other Jak inhibitor, INCB28050, for these indications.

To date, Incyte published positive results for 424 in RA and psoriasis. The RA study included 50 patients and demonstrated excellent dose dependent efficacy. The RA market is currently dominated by biologics that have to be injected to patients several times a year. 424 is an oral drug, which could be an important differentiator going forward.

Anti-inflammatory drugs that can be taken orally have become a hot area in the pharmaceutical industry, led by Pfizer (PFE) and its JAK inhibitor, CP- 690550. In terms of efficacy, 424’s results were comparable to those of CP- 690550, however, the latter has data from larger and longer studies, making it the most promising RA drug in development.

Incyte is enrolling patients in a 3-month study for 050 in RA, which is expected to generate top line results next year. If positive, this trial could serve as the basis for a global licensing deal. Nevertheless, Incyte will have trouble getting anything beyond a double digit royalty rate and an upfront payment of ~$40M without a larger study.

Last month, Incyte published positive results from a phase II trial in psoriasis. When applied topically, 424 demonstrated superior activity compared to placebo and an excellent safety profile. Although the trial did not compare 424 to standard of care drugs, it seems quite effective in reducing disease symptoms without the safety issues that are associated with the mainstay treatment for psoriasis, steroid ointments. As a result, 424 could be given for longer duration, as opposed to steroids that are limited in treatment duration. This might enable Incyte to position 424 as an equally effective but safer topical treatment for mild to moderate psoriasis, an indication with a prevalence of 5 million in the US alone.

Portfolio updates

Since its inception one year ago, the biotech portfolio, co managed by Ran Nussbaum and myself, generated a return of 51.6%, better than other healthcare and biotech oriented ETFs.

Last week, following the acquisition of Curagen by Celldex (CLDX), our two positions in Curagen were converted into a single position in Celldex we intend to keep for now. We are selling Crucell (CRXL) with the intention of buying more Incyte and Immunogen (IMGN) in the coming weeks.

The biotech portfolio as of Oct 11th, 2009