Value investors normally shy away from pharmaceutical companies. These companies tend to gobble up lots of cash to produce drugs whose approval odds are worse than a coin toss. But where there is less crowd, there is more opportunity. A strategy that my favorite investor, Seth Klarman, follows is to buy into companies which already have substantial long term royalty incomes protected by their patents but are burning cash because of management spending it on expensive R&D efforts.
One such company is ENZON Pharma (ENZN), which has been completely revitalized by the activist shareholder. Here is a case study of this company as it stands today.
- It has $440 M in cash
- NOL carryforwards of 90M and 72M for federal and state taxes respectively
- Many famous value investors on the stock owner list including Klarman, Icahn, Highbridge Capital and Iridian Investment. Iridian Investment's CEO is on board.
- Core expertise has been in engineering improved versions of injectable therapeutics through the chemical attachment of PEG. Currently, there are six marketed biologic products that utilize their proprietary PEG platform, two of which they had marketed through their specialty pharmaceutical business, Adagen and Oncaspar, and three for which they continue to receive royalties, PEGINTRON, Macugen and CIMZIA.
- The CFO`s performance bonus is tied to "Complete the evaluation and potential sale of PEGINTRON royalties" for 2010
- The CEO resigned in Feb 2010 and was replaced by the CTO
- In January 2010 they sold off their specialty pharmaceutical business.This reduced their research and development, specialty and contracted services expenses by $24M per year.
- Currently, their main R&D effort is linked to developing compounds using PEG-SN38 technology for cancer treatment and LNA technology.
- PEG-SN38 is in Phase 2 of the clinical trial for its efficacy against colorrectal cancer and breast cancer.
- Corporate research and development expense was $45.6 million, $43.5 million and $44.0 million for the years ended December 31, 2009, 2008, and 2007, respectively.
- The royalty income is from 3 drugs PEGINTRON (Merck), CIMZIA (UCB Pharma) and Macugen (OSI Pharma).
- In August 2007, they sold 25 percent of the future royalties from the sales of PEGINTRON for $92.5 million in gross proceeds.
- It seems PEGINTRON is their cash cow, and selling it will bring lots of money. From their 10k "Our current sources of liquidity are our cash reserves, interest earned on such cash reserves and royalties — primarily those related to sales of PEGINTRON. In January 2010, we received approximately $300 million net proceeds from the sale of specialty. Once our board of directors has determined the funding needs for the continuing operation of our business, some portion of the value derived from the sale of specialty may be returned to our stockholders.."
- Royalty revenue for past 3 years have been 54M,59M and 67M.
So how do we value this business as of Q2 2010 ?
- Cash + marketable securities (US bonds) = 440M + 70M = 510
- Royalty business = 3*92.5M based on valuation that Merck paid = 277.5
- R&D expense for future will be in range of 43per annum
- G&A = 24M per year. 1Q G&A was outlier because of stock options and salary cost of employees of the sold speciality business.
- Debt = $134M 4% notes convertible to common stock at 9.55 per share before June 2013
- Company repurchased $12.4M of common stock at price of $10.41 per share in first half of 2010
Hence, buying ENZN at its current price of $10.4 is an asset play with a free call option on their drug discovery.
In many other, similar situations, I would not expect a pharmaceutical company to curb research and development spending; management typically stands to benefit substantially from the success of R&D spending, but bears none of the cost of failure. Enzon's Board and management, however, are not typical. They were installed after a proxy fight launched precisely because prior management was misallocating capital to research and development. Prior management ran into the arms of Carl Icahn to defend themselves in the proxy fight--prior management is now gone and Icahn has four people on the Board; Iridian has one. Chairman Alex Denner was previously a portfolio manager at Viking. So you have a Board that considers capital allocation as you do. Enzon authorized a $50 million share repurchase in December 2009 (8.4% of the then outstanding stock) and repurchased over $20 million of its convertible notes at a discount in 2009.
Disclosure: No positions yet