Genzyme Contingent Value Right: A Great Bet On The Most Efficacious MS Drug

| About: Sanofi (SNY)

For the past few months, I have been reading or at least scanning all Seeking Alpha Pro articles. Many authors claim a stock is cheap based on valuations of competitors or based on future growth expectations. I ignore these suggestions since I am looking for deep value investments rather than just relatively cheap stocks. The suggestions that are valuable to me are often arbitrage plays. Over the years I have experienced that carefully selected arbitrage plays offer stellar returns. I will first give two examples before continuing with the best Seeking Alpha Pro investment tip I have found so far.

Provida (NYSE:PVD)

On Aug. 14 an article about Provida was published. The Chilean pension fund is a merger arbitrage play. The company has been bought by Metlife (NYSE:MET). A merger arbitrage play can be classified as the opposite of a lottery ticket. I suppose that less than 2% of the signed deals fall through. So, a merger arbitrage play gives a small but relatively certain gain. But, when a deal falls through, investors usually suffer a huge short-term loss. Instinctively, many of us like placing the always lousy lottery-type bets, and therefore the opposite bet is usually undervalued.

The spread between the offer from Metlife and the stock price was about 8% when I first bought it. The deal was expected to close within six months. The article appeared awhile after I bought it -- just after the deal was approved by the Chilean authorities. Why was this stock so safe from an investment point of view? It was an extremely safe bet because Provida's low forward PE, its solid balance sheet, and the high dividend yield were providing downside protection. Furthermore, merger arbitrage investors can minimize their risks by carefully analyzing the interests of each party in the deal. In the case of Provida, the deal was extremely safe since all parties benefited roughly equally.

It is still possible to invest in Provida for about 10% less than the offer from Metlife. I think the company will continue to pay huge dividends. However, the stock will probably be delisted, and it is not certain whether the interests of the minority shareholders will be respected. Therefore, I don't recommend buying this ADR anymore.


Another SA Pro article analyzed Perma-Fix. This is a monopolist processing nuclear waste. It is not only a monopolist -- it has a very limited customer base as well. Its main client is the U.S. Department of Energy (DOE). The company had attracted my attention for its extremely low P/B ratio at the time. Unfortunately, the company had an urgent revenue and cash problem and it received few new orders.

The article pointed out that the DOE couldn't take the risk of Perma-Fix going bankrupt. Furthermore, the author expected new orders from the DOE as a result of some recent favorable management changes within the DOE. So, in this case, the market is probably mispricing the risk that Perma-Fix needs additional financing or will even go bankrupt. As with merger arbitrage plays, analyzing the interests of the various stakeholders led to the points of the article. And apparently the analysis has convinced many investors: The stock has gone up 50%.

It is probably still early enough to profit from Perma-Fix. As far as I can remember, the article did not even mention the fact that Perma-Fix has an exclusive license on technology to produce the medical isotope Molybdenum-99. During their last conference call, Perma-Fix confirmed again that they are in the final stage of commercial development. To be precise, see the response on the second and the third questions from Craig Egenthall (spelling taken from the SA transcript). If Perma-Fix succeeds in producing large quantities of Molybdenum-99 at a competitive price, the stock could be a 10-bagger.

Genzyme Contingent Value Right

I have given the examples above to make it easier to understand why I find the next example an even greater opportunity. It is a complicated story, but it has basically the same elements as the examples above:

  1. Misunderstanding of downside risks relative to the probability of profit.
  2. Analysis of the interests of the various stakeholders and their influence on the downside risks and probability of profit.

About a month ago, Chris DeMuth Jr. published an article analyzing the Genzyme Contingent Value Right (NASDAQ:GCVRZ). His investment fund tries to profit from corporate events that are misunderstood by the market (see here). His article got an overwhelming response; many people commented and provided additional information. A radiologist with the nickname Rootbeer made a large number of good comments. He and Chris appreciated my suggestion that I summarize all new information from the comments here.

GCVRZ is basically a right to receive payments when certain milestones are met in connection with the approval and the annual sales of Lemtrada, a new drug for multiple sclerosis (MS). The generic name for Lemtrada is alemtuzumab. Such rights are usually the consequence of a merger. In this case, Sanofi (NYSE:SNY) bought Genzyme in 2011. Apparently the two parties couldn't agree on the value of alemtuzumab. So, Sanofi agreed to issue contingent value rights (CVR) to Genzyme stock holders in addition to paying the purchase price. The CVR reduces the downside risk for Sanofi if the drug is not approved and/or does not achieve certain annual sales targets (milestones). On the other hand, the owner of the CVR is entitled to large returns if the drug is approved and then meets the annual sales before expiration of the CVR in the year 2020.

So the payments on the CVR are made by Sanofi upon achieving the milestones. The five milestones are described here and in more detail here. In total payment on the rights may be up to $13 until the rights expire on Dec. 31, 2020. In this article I will focus on the first three milestones:

  1. The first milestone pays out $1 if the FDA approves alemtuzumab on or before March 31, 2014.
  2. The second milestone pays out $2 if the worldwide sales of Lemtrada exceed $400 million in the four successive quarters within six quarters after its launch in each country.
  3. The third milestone pays out $3 if in any four consecutive quarters worldwide sales exceed $1.8 billion. There is an extra payment of $1 if the drug is approved after March, 31, 2014, when and if the sales reach $1.8 billion for a total possible payment of $4.

Minimum Value of GCVRZ

So what is the value of these rights? Before going into details, remember that the milestones are the result of a negotiation. In these negotiations, Genzyme management has tried to maximize shareholder value. That alone signals that it is more likely than not, that the first two milestones will be met. Moreover Genzyme had a small advantage while negotiating: It had better information on the prospects for alemtuzumab.

Given that alemtuzumab has been approved already in the EU, it is even more likely that the first two milestones will be met. Let's assume that the first milestone will be met before the end of this year. Let's also discount the value of the second milestone with a rate of 10%. Then we arrive at a real value of the CVR of at least $2.80. So, at a price of $2 the margin of safety is at least 40%. The reason for this undervaluation is the risk of ending up with a value of $0. This risk causes fund managers to limit the size of their investment in the CVR. For example, David Abrams has almost $60 million invested in this CVR as of June 30. This is only 3.4% of the total value of his investment fund.

Will the FDA Approve Alemtuzumab?

What is our base rate, the probability that the FDA approves a new drug anyway? According to this article the percentage of new drugs that have been approved has gone up from 5%-10% to 40%-60% over the last 30 years. Apparently Sanofi management thinks the chances that alemtuzumab will be approved are even higher, since it bought back about 30% of the rights in a tender offer for $1.75. We could ignore this and judge the buyback as speculation. Indeed, we should not stop the analysis here since if the FDA does not approve alemtuzumab the CVR will become worthless.

So, it is worth learning a bit more about alemtuzumab. I have assembled a number of useful sources: this video, this lancet abstract, this lancet abstract, this blog, this article comparing MS drugs, this abstract comparing MS drugs, the GCVRZ forum, and this article. See here for a negative opinion. In summary, alemtuzumab seems to be thoroughly tested and very efficacious. It is the most efficacious MS drug so far developed. It is one of the very few MS drugs that have been tested against an injectable therapy (which was considered first line therapy) instead of against a placebo. While this fact may be lost on investors, it is an extremely important fact that will not be ignored by experts in the field of MS.

However, it has some potentially serious but, manageable side effects. This is both different and comparable to another efficacious MS medicine: Tysabri with generic name natalizumab. This medication can cause PML, a potentially fatal disease progressing faster than MS. Alemtuzumab is at least as effective as natalizumab. It has serious side effects, but these are less serious than those for natalizumab and can be adequately treated. Since alemtuzumab has been used for about 12 years for leukemia at much higher doses than will be used in the MS population, the occurrence of new unexpected side effects is unlikely. And, relatively speaking, in comparing the safety profile of alemtuzumab to the already approved PML inducing medication, Tysabri, it is unlikely that the FDA would reject alemtuzumab on the basis of nonlethal complications.

Suppose furthermore, that alemtuzumab won't be approved at all. In that case, many patients from the U.S. will seek treatment in European hospitals. This is relatively easy since the therapy involves just a couple of weeks of hospitalization while the therapeutic effect can possibly last for more than a decade. Therefore, not approving alemtuzumab is a no-go for the FDA. There is the possibility that the FDA approves alemtuzumab after March 31, 2014. Further investigation of the side effects could result in such a delay. In that case, the first milestone will not be paid out. The second milestone is still likely to be met, which gives us a present value of at least $1.8. But if the third milestone is met, then the $1 for the late FDA approval will be paid out on top of the $3 for the sales milestone of $1.8 billion.

We can consider the approval process a black box but, in reality, there are real people convening and deciding whether alemtuzumab should be approved. One of these people is Dr. Russell Katz, the head of the FDA division of neurology products. On March 27, 2013, he commented on the approval of Tecfidera, an oral maintenance therapy: "No drug provides a cure for multiple sclerosis, so it is important to have a variety of treatment options available for patients." I see this comment as another indication that the side effects of alemtuzumab will not block its FDA approval.

Value of the Sales Milestones

The market for MS treatment is large. Chris DeMuth Jr. claims that the MS treatment market is worth $11 billion. Just Copaxone, an injectable medicine from TEVA (NYSE:TEVA), had annual sales of $4 billion per year. Certain analysts expect the MS drug market to grow slowly to $18 billion in 2019 (see here). This growth will be due to new medications such as alemtuzumab and due to the increasing incidence of MS. It is important to realize that many patients relapse on their current therapy. There is a new paradigm in MS treatment. This is called "zero tolerance." This zero tolerance for disease activity will compel neurologists to seek more effective therapy in order to prevent further relapses. So, while patients may choose a less efficacious medication such as Copaxone or one of the new oral agents, relapses will eventually lead to the choice of the more efficacious monoclonal antibodies. Of the two monoclonal antibodies, that will be available, alemtuzumab will be chosen more often than Tysabri since it does not cause PML.

The European Union has approved alemtuzumab for first line therapy. This view has not been accepted by the worldwide community of MS specialists yet. If alemtuzumab is eventually used for first line therapy in treatment naive patients in addition to the use as a second-line therapy in patients with highly resistant disease, then all milestones might be met and, in total, $13 will be paid. In 2010, Genzyme published a press release on alemtuzumab. In this press release they projected peak sales of between $3 billion and $3.5 billion. They projected that the adoption rate would go up from initially 5% to at most 20%, five years after launch. According to these estimates, all sales milestones will be achieved. It is not uncommon for sales people to be optimistic. In one of the comments on Chris' article, Rootbeer, the radiologist, made two conservative sales forecasts based on Tysabri sales figures.

In the first analysis he assumes that no other neurologist than those who participated in the trials will utilize alemtuzumab as first line therapy. With a price of $80,000 for an induction, 5,000 patients are needed for the first sales milestone. During the trials the patients were treated on 142 locations in 14 countries. That means that just 0.7 patient per week per location will be sufficient to meet the first sales milestone.

It seems to me that this projection is conservative. First, because the first sales milestone is easier to achieve due to the effect of inventory building. Second, because other neurologists might prescribe alemtuzumab as well. Third, because a price of $80,000 per treatment is too low. $80,000 is roughly the current U.S. price per year of the competing natalizumab/Tysabri treatment. However natalizumab is a maintenance therapy while alemtuzumab is an induction therapy. Patients need only two treatments with alemtuzumab: Five daily infusions in the first month and then three daily infusions at the start of the second year. This and the smaller risks justify a higher price. Though I find a price below $100,000 unlikely the future price per treatment is one of the risks with this investment.

The second analysis is based on the number of patients (20,000) that took natalizumab/Tysabri in the first six quarters after its relaunch in 2006. Tysabri was withdrawn from the market due to a high reported incidence of PML and then relaunched after a risk management strategy was developed. By comparing the relaunch of Tysabri to the new launch of Lemtrada/alemtuzumab, Rootbeer was attempting to convey the notion that his estimate was truly conservative. So we can project 13,000 patients taking alemtuzumab in the first year after launch.

One would expect that alemtuzumab will be prescribed instead of natalizumab for new patients. With a price of $100,000 for the first treatment and $50,000 for the second treatment I expect $1.3 billion sales in the first year and $1.9 billion sales in the second year. With these projections the first two sales milestones will be met. In such a scenario, the CVR will pay out at least $6. After discounting the cash flows using a rate of 10% the present value is about $5.25. Finally, note that my sales projection is still below the Genzyme sales forecast.

Competing MS Drugs

I invite readers to comment on MS drugs in development that are just as efficacious as alemtuzumab. Of course, other MS medicines will be developed and will replace alemtuzumab eventually. Therefore, any sales after 2018 are speculative. Moreover, after Sept. 19, 2017, the patent for alemtuzumab expires. Alemtuzumab, however is still protected under "data exclusivity" laws for 12 years following approval in the U.S. and Europe. Protection, therefore, lasts until 2025, well beyond the expiration of the CVR.


GCVRZ is an extremely compelling bet. Mr. Market is clearly overestimating the probability of the downside scenario and underestimating the sales potential of alemtuzumab.

Disclosure: I am long GCVRZ and PESI. 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.