MannKind Corporation: Back To The Fundamentals

 |  About: MannKind Corporation (MNKD)
by: George Rho


The collaboration agreement with Sanofi looks far more attractive upon further review.

MannKind should be able to shed the "story stock" label in relatively short order and become less susceptible to the scurrilous attacks that have been common in recent years.

These shares offer wide capital appreciation potential, with diminishing risk.

Developmental-stage biotechnology stocks are by their very nature story stocks, driven by news, hope, fear, hype, uncertainty, emotions, and expectations. Their individual stories will continue as long as there is some underlying fundamental basis for investor support. At the end of the day, however, the bottom line for all common equities is the bottom line of its issuer. Put another way, as with other story stocks like Tesla, Amazon, Netflix, and Twitter, developmental-stage biotechs eventually have to deliver earnings to justify their valuations, let alone fuel additional share-price advances. As it pertains to MannKind (NASDAQ: MNKD), despite a long and rocky road, as evidenced by a stock chart that resembles a rollercoaster track, the fundamentals underpinning its story have improved considerably over the last several years. One could enumerate the long list of steps taken forward, but suffice it to say that financing and the possibility of further dilution is no longer a source of anxiety; the Food & Drug Administration (FDA) has approved the commercialization of a product that targets one of the paramount health concerns of the global community, and the enterprise that's undoubtedly the best-suited for the task left at hand has agreed to further develop, market, and sell that product all around the world. Going forward, the emotional components that go into a story will gradually diminish in importance as driving forces for the stock and they'll be replaced by cold hard facts.

Following the August 11th announcement that MannKind and France-based Sanofi (NYSE:SNY) had reached a global collaboration agreement to market inhaled insulin Afrezza, there has been considerable handwringing about the terms of the deal and about the lack of specificity. Needless to say, since we expressed our views in a Seeking Alpha article last week, we were disappointed with the same issues. Having had more time to reflect, however, our disappointment has dissipated greatly and we fully appreciate why MannKind "enthusiastically" decided to go with Sanofi; during one of the company's conference calls last Monday, management noted that the vetting of all potential partners was a robust effort that reflected the massive (and growing) market for diabetes-related treatment options. With that said, in this article, we take a big-picture view of the collaboration agreement. As well, we try to incorporate the terms of the deal into an earnings model in an effort to provide some perspective on the current stock price. Given the many unknowns, which a Seeking Alpha colleague detailed last week, our numbers will clearly be subject to considerable adjustments in the future. There are a lot of things we do know, though, so a carefully and conservatively constructed model ought to give investors a better sense of whether MannKind stock is a buy, sell, or hold; the conservative component is geared towards providing a large cushion considering the myriad uncertainties.

The Diabetes-Care Market

There are approximately 382 million diabetics in the world, including 29 million in the United States. Of this total, only about 95 million receive any treatment and a mere 25 million achieve desired outcomes and live free of diabetes-related complications. The global market for diabetes care products totaled approximately $40 billion in 2012, with various insulin products accounting for almost half of that figure. Despite the large size, the insulin market is thoroughly dominated by three companies. As of a couple of years ago, Danish concern Novo Nordisk, which we've reviewed in a Seeking Alpha article, had a 44% market share, by insulin value, followed by Sanofi with 33% and U.S.-based Eli Lilly with 22%; the other suppliers had a total of just 1% of the market. In the United States, Novo and Sanofi had roughly equal market shares, with about 37% each. Lilly had a 26% share and the rest of the field was essentially inconsequential. The barriers to entry are substantial: strong brand loyalty, equating to limited switching between therapies; a large number of prescribers, which means that market players have to have significant commercial operations; and the need for high volume production, meaning significant capital requirements. At the same time, sales of diabetes care products are outpacing growth of other prescription medications, reflecting a world population that is getting increasing unhealthy, with the prevalence of people both living longer and being either overweight or obese growing rapidly in many countries. (Note: The numbers and percentages cited in this article derive from various sources, including Novo Nordisk, Sanofi, MannKind, FiercePharma, and the U.S. Centers for Disease Control and Prevention. Some of the data are stale, dating back two or three years. The sources and dates weren't specified throughout the article primarily to make it more readable and because the age of the data was largely inconsequential.)

A Closer Look at the Insulin Sector

In conjunction with the expanding population of diabetics, insulin consumption is rising around the world. Indeed, sales of insulin products have spearheaded the growth in the diabetes care products segment, growing at a roughly 13.5% pace over the past five years. Of the major economies, diabetics in Germany, the United States, and the United Kingdom are most likely to be treated with insulin, receiving on average 426, 349, and 293 units. By contrast, insulin usage in Japan is very low at 99, reflecting a population that's highly averse to needles. In China, the number is even lower at just about 14.

Looking more specifically at the domestic landscape, roughly 25% of Americans with diabetes are treated with insulin, with about 40% receiving just basal (or long acting), about 29% both basal and prandial (fast acting), 14% pre-mix only, and another roughly 14% getting only fast acting. In all, the U.S. insulin market is represented by about 34% prandial, 30% pre-mixed, and 36% or basal. On a company-specific level, Sanofi has the lion's share of the long-acting segment, with its flagship Lantus accounting for more than 60% of all basal insulin sales; worldwide sales were $7.6 billion in 2013. The short-acting segment is dominated by Novo Nordisk (Novolog; $3.0 billion) and Lilly (Humalog; $2.6 billion), however, with Sanofi sales of prandial insulin barely registering. That said, Sanofi has to contend with realities that could change the competitive balance over the next several years. For one, Lantus loses U.S. patent protection next year and will likely face a generic (or a bio-similar, to be more exact) rival by mid-2016; Lilly is looking to launch a challenger but a lawsuit will probably keep it at bay until 2016. Two, Novo is in the process of rolling out a long-acting rival to Lantus in countries around the world, and Tresiba is taking market share; an FDA request for additional data will keep Tresiba off the U.S. market until about 2018 or 2019. Sanofi has a successor to Lantus that has the potential to forestall the sales erosion in its invaluable basal insulin franchise but Toujeo (or U300) is still in clinical trials.

Revisiting the Sanofi Collaboration Agreement

MannKind shares sold off in the days following the deal's agreement. As we noted last week, the selloff probably reflected disappointment that the company wasn't simply being acquired; the upfront payment was far smaller than anticipated and the profit split seemed tilted heavily in Sanofi's favor. Bottom line, the conclusion stemming from the terms of the deal was that MannKind either got snookered or Afrezza's commercial prospects aren't as rosy as many had anticipated. Lack of familiarity with Sanofi among most American investors undoubtedly contributed to the unfavorable reaction, as probably did general ignorance of the dynamics of the insulin marketplace. The lack of deal specifics certainly didn't help investor sentiment either.

So, what exactly does MannKind get in return for the global marketing rights to Afrezza? Beyond the obvious $150 million upfront payment, which both obviates any cash worries for the foreseeable future and allows management to focus on new-drug prospects, we would suggest the biotech gets the following:

Ø The potential to receive a total $775 million in milestone payments, which will probably provide a steady infusion of cash over the next several years.

Ø Considering the $175 million loan facility being provided by Sanofi to cover the initial losses, a roughly $500 million commitment by the French concern to establish the Afrezza franchise, using the 65/35 profit/loss ratio.

Ø Sanofi's extensive commercial infrastructure, which will support a robust launch early next year; the U.S. sales force totaled 4,770 at the end of last year, and the global total was 33,510; Novo's entire workforce totals around 38,500, with about 4,000 based in the U.S.

Ø A substantial manufacturing infrastructure, including the production of insulin, which should allow the two companies to drive down production costs and boost profits.

Ø A long established relationship with the many physicians that write prescriptions for diabetes-case medicines.

Ø An experienced team to conduct the post-marketing studies required by the FDA.

Ø An experienced team to expand Afrezza's commercial potential through labeling enhancements.

Ø Expertise in getting products approved and launched in almost all of the countries in the world.

Ø A highly motivated partner considering both the threat to its basal insulin franchise and a virtually insignificant presence in the prandial insulin segment.

Ø The opportunity for substantial synergistic benefits, with respect to both COGS and SG&A expenses.

Clearly, the upfront terms weren't as lucrative as had been expected by most investors. Indeed, it's hard to imagine that other prospective partners didn't offer superior terms, especially when one considers the deals that other companies, such as Arena Pharmaceuticals and Orexigen, secured. Looking out longer term, however, it's virtually impossible to identify another potential partner that could've positioned MannKind better to prosper over the long haul; it may be instructive to note that Arena got attractive upfront terms from its relatively small Japanese marketing partner but a sales force that numbered only 200 at the outset (and only around 500 now) is having trouble generating much in the way of sales. MannKind's chief financial officer noted in one of the two conference calls conducted on August 11th that present-value calculations - undoubtedly using far better numbers than we'll be using below - that looked well into the future made the profit-sharing plan the clear arrangement of choice, and we're in neither the position nor the inclination to disagree, based on a more expansive review of the agreement and a closer look at the many possibilities that Sanofi brings to the venture.

Constructing an Earnings Model

In the article linked above, Psycho Analyst details a long list of unknowns that he concludes make a numerical assessment of the Sanofi deal impossible. While not disagreeing with his or her list, we certainly know more now than we did 10 days ago, and we were making predictions back then; just as an aside, not knowing whether a person being cited is male or female is just one of the many reasons for my aversion to the concept of anonymous authors - with all due respect to Psycho Analyst. Indeed, if analysts had to know ahead of time a new drug's intended price, a seller's marketing strategy, patient acceptance, etcetera, Wall Street would be devoid of biotechnology analysts, and the authors on Seeking Alpha would have a lot of competition.

While recognizing the limitations of projecting biotech earnings and stock prices, it should be noted that there is a lot relevant that is known. Moreover, we think there is value in making carefully generated, transparent projections, which allow interested readers to dissect and adjust accordingly. With that said, first we would note the following facts:

The top 10 diabetes-care drugs in 2013 were all blockbusters, generating a total of more than $28 billion in sales. At the top of the list was Lantus, with revenues of $7.6 billion, which was up 20% year over year and was more than the next two drugs combined. The number of diabetics is increasing at an alarming rate and the people with diabetes are living ever longer. Life expectancy was just 56 years in 1970 but had risen to 69 by 2010. It's expected to reach 82 years by 2050. As such, considering the average age at which diabetics initiate insulin treatment, the number of years during which the average patient will generate insulin-related revenues will continue to rise from the current 12 years. Moreover, Afrezza has substantial revenue potential in both China, where incomes are rising and insulin usage is extraordinarily low, and Japan, where an aversion to needles have limited demand for insulin injections. Significantly, too, in making our projections, we can also draw on the financial data reported by Novo Nordisk, which is the closest thing there is to a pure-play in the diabetes space, and by Sanofi, since Afrezza's destiny now lies in its experienced hands; Sanofi has disclosed its pricing plans for Afrezza, but it clearly has to be competitive with Novo's Novolog and Lilly's Humalog.

Lantus was introduced early last decade and became a blockbuster in just its third full year post launch. The best-selling basal insulin achieved the $4 billion mark in just the seventh year after commercialization was initiated. Remarkably also, the rollout of Lantus was executed by a relatively small and inexperienced team, which certainly won't be the case with Afrezza. Several other drugs on the top-10 list, including Merck's Januvia and Janumet and Novo's Victoza, achieved blockbuster status in quick order.

Sales - For our projection purposes, we think Afrezza, which will be targeted at diabetics who already use prandial insulin and those who are insulin naïve, will reach $4 billion in revenues by year four or five. This assumes launches in Europe by early 2016 and in Japan about a year later. We don't think the sales target is particularly aggressive considering the huge target market; the large number of diabetics who aren't achieving treatment target; the many surveys (conducted by Eli Lilly, Pfizer, MannKind, and Sanofi) that show a huge preference among diabetics for an inhaled version of insulin; intuition and anecdotal evidence; and the relatively small number of patients that would be needed to reach that figure. Just for some perspective, Novo has some 24.3 million patients using its diabetes care products.

COGS - Novo's gross margin in 2013 was 83.1%. Given the synergies afforded by putting Afrezza and Lantus under the same umbrella, we think the cost of manufacturing Afrezza could fall below 17%. For now, though, we'll use the same gross margin as Novo. The Novo cost structure is probably more appropriate here since the company produces mainly diabetes-related products whereas Sanofi's income statement reflects a very diversified product portfolio.

SG&A - In 2013, Sanofi's SG&A outlays represented 26.1% of revenues, while the comparable tally for Novo's was 32.2%. The incremental costs associated with marketing Afrezza aren't likely to be huge, so the SG&A ratio for the inhaled insulin venture could be considerably below that of corporate Sanofi. That said, pending further details on both the company's marketing strategy, which should include plans on whether a dedicated salesforce will be deployed, and the allocation of expenses between Afrezza and non-Afrezza-related activities, we will use 22.5%.

R&D - Investment in research and development activities hover in the neighborhood of 14% to 15% for both Sanofi and Novo. Since the heavy-lifting has already been done for Afrezza, however, embedding a 5% figure for the venture would probably be reasonable, at least until we're guided otherwise.

Operating profit - The operating expenses add up to 44.5% of sales, leaving an operating margin of 55.5%, or $2.22 billion. MannKind's 35% share would equal $777 million, which equates to a 19.4% royalty rate.

Valuing the Stock

Our calculations above ignore the first several years of the venture, precluding, quite frankly, the headache and task of making myriad specific guesses. The guesses would include the timing and magnitude of milestone payments, the timing of launches in various countries, and gradually changing expense items. For our valuation purposes, we're also going to ignore what should be a reasonably strong balance sheet, an R&D program that might include some new-drug prospects, perhaps being developed on the Technosphere delivery platform, and the entire income statement, as if Afrezza represented an entity that largely stood on its own, separate and distinct from MannKind. On this basis, ascribing a 20 P/E multiple would give us a market capitalization of $15.5 billion, or $34.53 a fully diluted share; the multiple is probably reasonable, if not low, since earnings would still be early in the rapid growth phase.

We'll leave it up to the reader to decide whether our projections are reasonable and to make whatever adjustment he or she wants to make. This most certainly would include whether to make the projection year 2018 or 2019, which would determine how far back to discount the price. We've also decided not to suggest an appropriate discount rate, while noting that the risk associated with MannKind has fallen dramatically since the beginning of the year, in light of the FDA approval of Afrezza, the bolstering of the balance sheet, the validation of Technosphere as a drug delivery platform, and the securing of a world-class marketing partner in Sanofi. All things considered, our projections suggests that our various assumptions could be way off the mark but MNKD shares could still be hugely profitable.

Disclosure: The author is long MNKD, SNY, NVO.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author is open to any disagreements and/or suggestions and would consider editing same into the article. All readers are encouraged to add his or her two cents.