Gentium: Several Underappreciated Investment Positives

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 |  About: Gentium S.p.A. ADR (GENTY)
by: Nottingham Research

Gentium (GENT) shares have climbed 67% YTD, largely on the heels of the positive opinion for the company's drug defibrotide (defitelio), which received a positive opinion from the EU's Committee for Medicinal Products for Human Use in July. I continue to recommend accumulation of shares at GENT's current valuation, as the stock trades at a steep discount to its orphan peers (3.9x 2014 sales vs. an orphan drug median multiple of 10.8x), has a number of catalysts over the next 12 months, and has several lesser-discussed characteristics that would make GENT attractive to larger acquirers, particularly those with an existing specialty or oncology footprint. As GENT remains relatively underfollowed with only two brokers providing research on the company, these investment positives may not be fully appreciated by investors.

I continue to assert that GENT warrants a trading multiple that approaches the multiples of other early stage orphan biotech companies, such as Aegerion, NPS, and Raptor. If GENT could command an EV/sales multiple of 5x 2014 sales - still well below the multiple enjoyed by those three peers, GENT would trade at $29.50 (based on consensus 2014 sales estimates).

Selected Orphan Drug Comps as of 9/6/13

Source: Yahoo! Finance and company documents

Net Operating Losses Will Boost Cash Flows

I view GENT as an extremely attractive investment primarily on the basis of its key product, defibrotide. I have explained the key drivers of the GENT story in a prior article. GENT enjoys orphan drug protection in both the EU and USA, which will allow the company to own the market for hepatic veno occlusive disease (NASDAQ:VOD) for up to a decade following formal drug approval. What should make the cash flow generated from sales of the drug even more robust is the net operating losses the company has accumulated over the years. From the company's recent annual report:

As of December 31, 2012 and 2011, we had net operating loss (NOL) carryforwards of approximately €53.48 million and €51.32 million, respectively.

GENT will be applying these NOL's against its future taxable income in order to reduce taxes over the next several years. A potential acquirer would likely view GENT's NOL as an attractive asset.

Switzerland = Low Corporate Tax Rate

From the company's most recent annual report:

In August 2011, we formed a wholly-owned subsidiary, Gentium GmbH, organized under the laws of Switzerland, as headquarters for our commercial operations.

Why is this important? The corporate tax rate in Switzerland ranks among the lowest in the industrialized world, at 18%. This compares favorably to the USA at 40%, Italy at 31.4%, UK at 23%, and Canada at 26%. Note that favorable tax structures have helped to prompt many biotech and pharma deals in recent years. Actavis' acquisition of Warner Chilcott (domiciled in Ireland, which has a 12.5% corporate tax rate) is expected to lower ACT's tax rate to 17% from 37%. Perrigo acquired Elan (also Ireland-based) this year, and expects its tax rate to drop from 30% to the high teens within a year. In early 2012, Jazz acquired Azur and Jazz now benefits from a lower Irish tax rate. These tax synergies should allow all three companies to bolster their respective inorganic growth strategies.

The Swiss tax rate GENT enjoys should help its future free cash flow margins, should the company remain independent. And in the event of strategic interest in defibrotide by an acquirer, considerable tax advantages may also accrue to any suitor that might be domiciled in a country with a higher tax rate.

Strong Potential for Off-Label Sales Based on Existing Usage

While the CHMP issued its positive opinion for treatment of severe VOD, I would expect off label usage once the drug is approved, based upon demand GENT has seen in its existing named patient programs. For example, on GENT's 2Q conference call, management noted that 35% of pre-approval, named-patient usage during the quarter was for prophylaxis of VOD. On the company's 1H:12 conference call, management stated that "We have also seen increasing use of defibrotide in non-severe VOD patients…and there is a good reason for that…non-severe VOD can very rapidly turn a false alarm into a 4 bell alarm."

Additionally, during that same period, management noted increased use of defibrotide in non-stem-cell transplant patients suffering from leukemia: "Moreover, we have also seen increasing use of defibrotide in non stem-cell transplant patients -- patients who have only received chemotherapy and subsequently developed VOD…this is close to 8 to 9% of the total patients that have been treated."

I expect formal EU approval of the drug for treatment to have a halo effect on VOD prophylaxis usage and for other patient populations. This may begin to include other, lesser-known forms of VOD, such as pulmonary VOD, over time.

Peak Sales Could Exceed $500M

How high can defibrotide fly? I am not aware of an instance where GENT management has formally published or communicated peak sales estimates. So this is my own back-of-the-envelope calculus.

· Base case - severe VOD treatment: I conservatively assume that peak sales are comprised solely of defibrotide usage for treatment of severe VOD. I assume ~3K cases of severe VOD occur each year; this implies an addressable market opportunity of $159M at the current $53K USD price of the drug (€40K based on recent 2Q conference call - a price that is still well below prices commanded by other orphan drugs).

· Case 2 - all VOD treatment: Assuming that ~9K cases of VOD occur annually are ultimately treated with defibrotide, this implies potential peak sales of 9 x 53 = $477M.

· Case 3 - Prophylaxis of high risk patients: For peak sales of defibrotide with prophylaxis usage only, occurring on ~20K patients that are at high risk for VOD. 20K x 53K = $1.1B.

· Case 4 - GVHD: Assuming the company's indication is expanded to include acute graft vs. host disease (GVHD), which occurs in 40% of allogenic transplants (~13.2K GVHD cases per year), this alone would represent potential peak sales of $700M for GVHD (apart from what could be generated through VOD).

GENT Remains Undervalued; Substantial Upside if Acquisition Interest Were to Materialize

Trading at 3.9x consensus 2014 sales, I continue to believe GENT is extremely undervalued at its September 6 closing price of $18.99. Moreover, the stock carries no built-in M&A premium, judging by its steep valuation discount to its peer group. Many biotech acquisitions occur based upon a multiple of potential peak sales; for example, AMGN's recent acquisition of ONXX occurred at 16x 2013 revenue, but when considering that ONXX's cancer drug Kyprolis is expected to generate peak sales of $2B, the deal occurred at ~5x peak sales.

While it is not my contention that an acquirer will emerge near-term, given the uncertainty around GENT's approvability in the US (the company expects to file with the FDA prior to year end), it is still a useful exercise to run through a few takeout scenarios, given the attractive characteristics of the orphan drug market, in addition to the aforementioned company-specific positives.

Assuming that an acquirer paid only 3x my middle-of-the-road GENT peak sales estimate of $600M, this would imply an enterprise value of $1.8B vs. the company's current EV of $276M (equating to a share price of $116). Even assuming that an acquirer would only factor the bare-bones, base case scenario (treatment of severe VOD) and would be willing to pay 3x this estimate (I believe a higher multiple would ultimately be warranted), I calculate an EV of $477M, implying a share price of $31.8, 67% above the company's September 6 closing price of $18.99.

Disclosure: I am long GENT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.