A Special Situation Case Study - Paratek Pharmaceuticals, Inc. (NASDAQ:PRTK)
Introduction - Part
Let's apply the selection requirements contained in our introductory article on special situation investing to a real world example of a company possessing the unique characteristics of a special situation that may be used as a partial market hedge. It should be remembered that what we are looking for are corporate events (aka. catalysts) that will either reveal or unlock value, resulting in an increase in share price irrespective of whether the broader market rises or falls. For this purpose, we propose Paratek Pharmaceuticals, Inc. ("Paratek" or "PRTK") because it is timely, is outside the realm of the typical special situation investments so commonly covered (e.g. merger arbitrage, corporate spinoffs, bankruptcies, etc.) and is unlikely to be well-known to most Readers. [i] Even so, given the breadth and extent of the analysis that has already been presented on this particular company, we are unlikely to provide any new insight into or understanding of the company itself, and such is not our intention here. In this article we merely seek to use Paratek to illustrate (in real time) [ii] the benefits of including special situations within a broader portfolio as one means of hedging systematic/market risk and achieving absolute portfolio returns.
Therefore, in efforts not to recreate the wheel (and even that in an inferior manner) we will refer the Reader to the following Seeking Alpha articles here [iii], here [iv], here [v]; and if you have Seeking Alpha Pro access, these articles here [vi], and here [vii]. [Please be sure to review the very informative and instructive comments provided by Mr. Jim Roumell at the bottom of each article. We found them quite helpful in framing and understanding the opportunity.]
Discovering an Opportunity
How did we discover PRTK? Well, the truth is, we didn't. Although we always seek to follow the great investors' investing principles, sometimes we literally follow them into stocks, by piggy-backing on their investments. This blatant and shameless means of investment plagiarism isn't (always) intentional, but when we happen across a situation that looks attractive, only to find out that one or more great investors are already there, and have already laid down much of the investment groundwork for us, we tend to pay particular attention. As Warren Buffett often repeated of his Control situations "Everything else being equal, I would much rather let others do the work." [viii] Of course, we are being cheeky because we always have to do our own work. Sometimes, that work is just made easier when a pathway for our efforts has already been paved for us. [In addition, we are more than happy for the great investors to piggy-back off our hard work and analysis and the fact that none have yet taken us up on our offer does not discourage us at all. [ix]]
For reasons we won't go into here (but which involve our research into potential spinoff investments converging, quite surprisingly, with the due diligence we were conducting into a possible birthday present for one or our significant others who is a native speaker of a foreign language), we found ourselves visiting the website of Roumell Asset Management (RAM) found here [x] where we reviewed Jim Roumell's 4th Quarter 2014 Report, found here[xi], in which Paratek was highlighted as one of RAM's Top Three Purchases for that particular quarter. [xii] If the Reader wishes to discover how Jim Roumell discovered Paratek, and gain further appreciation of the benefits sharing good company in an investment can bring, the above links contain the story. We found it reassuring to know, that if the worst case scenario were to materialize, as minority shareholders we may benefit from effectual institutions.
Several items struck us as important when we began reviewing Mr. Roumell's publicly available analysis into PRTK:
First, any time one can follow Jim Roumell and Seth Klarman into an investment thesis, and can do so potentially at a similar or even lower average cost [xiii], and can further do so years after the fact when the investment thesis has become even more compelling (given the subsequent time lapse to maturity), and has been incrementally and significantly de-risked from the levels where even the investors we seek to emulate entered; well, that strikes us as a compelling potential opportunity, and is certainly one worth analyzing.
Second, like Seth Klarman, Jim Roumell has the reputation of a deep-value, balance-sheet focused investment analyst, and a cautious portfolio manager that most often invests in (relatively) safe, Benjamin Graham cigar butt-type stocks; so it (initially) surprised us to find him advocating shares in a late-stage, bio-pharmaceutical company. This alone was worth a look.
Third, we read (and watched) everything we could that Mr. Roumell and others had posted on the company, and we commenced independently confirming as much of what was published about the business, its competitors, the industry, and the FDA approval process as we could find readily available. In every instance where confirmation was possible, Mr. Roumell's analysis checked out, from market demand, to average probabilities of successful Phase 3 trials for various indications, to the average probabilities of successfully navigating the FDA approval process, to comparables yielded by the take-outs of recent competitors' antibiotics, to the transparency and competence of management.
In short, we really liked what we saw in the story, namely: the assets, management, the investment thesis, and the risk/reward profile. So let's take a look.
Brief Summary Investment Thesis
Despite the above direction to visit the other Seeking Alpha articles, some Readers are bound to have continued reading, so we will include a short summary of the company here.
Paratek Pharmaceuticals, Inc. is in late-stage development for a broad-spectrum, bacterial-resistant, effective, well-tolerated, thus-far-safe, antibiotic drug (Omadacycline), available in both IV-to-oral, and oral-only forms. [These are the characteristics for a commercially successful blockbuster antibiotic; meaning these are indicative of commercially successful blockbuster antibiotics currently on the market. Please refer to Slide #s 25, 43, 45, and 47 of the "Paratek Corporate Presentation 1-9-17", available here, for example.] At last report the company had over $100M of net cash, an enterprise value of $250M, and a market capitalization of roughly $350M with shares trading up to nearly $16. We will not review the company's history here, but it is worth noting that $400M+ has already been invested in the drugs' development, so the present time is actually a better opportunity to initiate an investment than has generally existed previously.
[Catalysts - Please refer to Slide #s 39 of the Paratek Corporate Presentation 1-9-17, available here.]
Catalyst(s) - Phase 3 Trials Underway: Six Months to Completion
If one of the two Phase 3 registration trials currently underway - in this case, Oral-only for a skin indication (ABSSSI) - is successful, and is paired with the already successful Phase 3 trial (IV-to-Oral, ABSSSI); the drug could be worth as much as $700M-$800M[xiv], more or less.
If the second of the Phase 3 registration trials (CABP) currently underway is successful, and is paired with the previously successful Phase 3 trial (IV-to-Oral, ABSSSI); the drug could quickly be worth perhaps $1B (at the low end) to as much as $1.5B (at perhaps the mid-point)[xv].
The results of the CABP registration trial are anticipated in Q2 2017, and the results of the Oral-only, ABSSSI trial are anticipated in mid-2017 (perhaps as early as Q2 2017); so our time frame for this portion of the special situation is approximately six months.
Catalyst - New Drug Application (NDA) Submission: Approximately Twelve Months from Here
If/when another successful Phase 3 trial is in hand; Paratek can begin drafting the NDA, which should take 6-8 months, as it can involve the submission of over 2 million pages of data. At least one of these trials must be successful in order for Paratek to submit a new drug application (NDA) with the FDA. The existing ABSSSI IV-to-Oral top-line results, on its own, are not sufficient for drug approval. Under the agreement with the FDA, two successful Phase 3 trials are required. [xvi] This may be comprised of two successful ABSSSI trials (IV-to-Oral and Oral-only) or the existing ABSSSI study (IV-to-Oral) and a successful CABP trial. The various possible combinations will impact the value considerably.
Catalyst - Prospects for Additional Capital Raise/Monetization: Six-to-Twelve Months Out
Paratek has enough cash on-hand to complete the Phase 3 trials it is undertaking (each of which requires approximately $30M) and to bring it through mid-2017, but not enough for commercialization. It is important to note, that at this stage (i.e. drafting the NDA post-successful Phase 3 registration trials), Paratek will require additional capital for development and commercialization. The good news is, that if/when this stage arrives (and we believe this to be probable, as discussed in our subsequent article), the share price should be much higher, and the opportunities for monetization should be both broader and more numerous. We would not be opposed to an additional capital raise at such a stage, if the share issue price is high enough, but we may prefer that Management first look at monetizing its secondary asset, the non-U.S. rights to Sarecycline, its acne drug in development with Allergan PLC (NYSE:AGN) via either a sell or licensing arrangement. In addition, there are bound to be opportunities at this stage to either license the non-U.S. development and marketing rights to Omadacycline, or to be outright acquired; though the value assigned at such a stage would likely fall short of the value that may be obtained subsequent to drug approval.
Catalyst - FDA Approval: Eighteen-to-Twenty-Four Months Out
If an NDA is submitted to the FDA by the first half of 2018, and if Omadacycline receives FDA approval in the second half of 2018, the company is likely to be worth anywhere between $1B and $2B (that is an estimate), and we believe the value could settle in at the top-half of this range if both the Phase 3 CABP trial and the ABSSSI Oral-only trial is successful. The time frame for this is believed to be 18-24 months, given the FDA fast-track status which results in a six-to-eight month response time from the filing of the NDA.
Potential Catalysts - Speculative Prospects
If the company is acquired, or announces strategic partnerships or licensing arrangements with a larger pharmaceutical company, the time frames for the maturity of our special situation investment may be pulled forward, and although such a possibility may meet Benjamin Graham's broad definition of a special situation, it does not meet his narrow definition, so we will set that eventuality aside for the time being. Suffice it to say, we very often substantially underestimate the potential returns on special situation investments, but when these pleasant surprises occur, we take them in stride.
Lastly, and this is the most important part, if any or all of the above fail to occur (e.g. a second Phase 3 trial isn't successful, the NDA is rejected by the FDA, or serious adverse events (e.g. safety concerns or restrictive labeling restrictions, etc.) were to arise, the company's share value would decline drastically. Although we believe there is far more than $15 of value existing currently, there is always a risk of a serious adverse event, no matter how small. The extent the shares would drop in such an event, would be dependent on both the company's cash position at that point in time, the value of its non-U.S. rights to Sarecycline, and the extent of any negative results and what they entail. We are not discussing probabilities in this section, but we believe a negative outcome would most likely result from the emergence of safety concerns (as Omadacycline's efficacy has a wide margin for error, and Management is both experienced, transparent, and demonstrating care in managing risks and value), and that the chances of such an event are fairly remote (knock on wood). All that said, we must always acknowledge that remote is still possible, and the downside risks always deserve our utmost attention and scrutiny.
Pausing to Take Stock
So what did we learn from the above? We learned that numerous catalysts exist, and we believe we may be able to make a very good return on our investment, but there is a risk we may end up losing the majority of our investment if the special situation fails to work out in one of the ways we believe it will. Therefore, we must now attempt to quantify our potential, risk-adjusted ROI using the probabilities assigned to each outcome in order to determine whether the risk/reward ratio warrants further research and analysis (and reading, for that matter). So how do we do that? There is no shortage of ways to go about this exercise. We simply wish to measure this opportunity against all available alternatives, including holding cash.
Reverting back to Benjamin Graham:
"By contrast, the investor's concept of the margin of safety - as developed earlier in this chapter - rests upon simple and definite arithmetical reasoning from statistical data. We believe, also, that it is well supported by practical investment experience." [xvii]
"A third business principle: 'Do not enter upon an operation - that is, manufacturing or trading in an item - unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. In particular, keep away from ventures in which you have little to gain and much to lose.' For the enterprising investor this means that his operations for profit should be based not on optimism but on arithmetic." [xviii]
"The whole field of 'special situations' would come under our definition of investment operations, because the purchase is always predicated on a thoroughgoing analysis that promises a larger realization than the price paid. Again there are risk factors in each individual case, but these are allowed for in the calculations and absorbed in the overall results of a diversified operation." [xix]
Example of Estimating Risk-Adjusted Returns in a Special Situation using Graham's Special Situation Formula
In our calculations and analysis, we will repeat, and then build upon an earlier quote from Graham and Dodd's Security Analysis:
"In the broader sense, a special situation is one in which a particular development is counted upon to yield a satisfactory profit in the security even though the general market does not advance. In the narrow sense, you do not have a real "special situation" unless the particular development is already under way.
"There is a logical and important reason for favoring this narrower definition of a special situation. By doing so we are able to conceive of these commitments in terms of an expected annual return on the investment…
"If we are willing to make the necessary assumptions, the attractiveness of any given special situation can be expressed as an individual annual return in per cent with allowance for the risk factor." [xx]
|Here is the general formula:|
|Let||G be the expected gain in points in the event of success;|
|L be the expected loss in points in the event of failure;|
|C be the expected chance of success, expressed as a percentage;|
|Y be the expected time of holding, in years;|
|P be the current price of the security.|
|Indicated annual return||=||G*||C||-||L*||(||100%||-||C||)|
[Note in arriving at the stated assumptions used in our calculations below, we will leverage off of probabilities and logic that will be further outlined in our next article.]
Assumptions - Scenario 1:
[Note, the assumptions and probabilities estimated below are for illustrative purposes only, are for our specific time-horizon, and are not probabilities of success outside our time horizon or outside this illustration.]
It has been proposed that it is probable (odds of >90%) that the Phase 3, once daily, oral-only study in acute bacterial skin, and skin-structure infection (ABSSI) skin indication will read out successfully in mid-2017; given a combination of the already favorable results obtained for the Phase 3, IV-to-oral study; given the average statistics for drug development; given what we know about Omadacycline and Management; and given all other available factors. For illustrative purposes only, we will use this 90%. With just these indications (ABSSSI Oral-only and ABSSSI Oval/IV), the share price may be expected to increase to as much as $30 [xxi] as the inherent value of the business becomes more widely recognized by the Market. In the statistically unlikely (but still possible) event that Omadacycline follows Tetraphase's, or Cempra's, lead in the next 6 months, after exhausting some of the cash currently on the balance sheet, we may still expect PRTK to trade for perhaps as much as $4/share (without consideration of Sarecycline), so for purposes of this example only, our loss would be $11/share from current levels during this timeframe.
[One can experiment with the various assumptions used in the formula to arrive at different estimated returns on investment. Obviously, extending the timeline out to 12 months will have a significant impact on the expected returns.]
Here we have run a calculation for an outcome of our special situation investment in Paratek, the magnitude of which we believe to be reasonably possible within our time frame. In this example, we have assumed there is at least a 90% probability of a $30 per share result, though there is a reasonable possibility that our time frame may have to be extended up to another six months (or 12 months in total) in order for the market to reflect it. The expected successful read-out of the Phase 3 Oral-only ABSSSI trial is simply the catalyst to driving this fact home to the market, in no uncertain terms, and to perhaps initiate monetization discussions with Big Pharma.
Assumptions - Scenario 2:
[Note, the assumptions and probabilities estimated below are for illustrative purposes only, are for our specific time-horizon, and are not probabilities of success outside our time horizon or outside this illustration.]
Now, let us look at the formula assuming a successful CAPB read-out, paired with the successful IV-to-Oral ABSSSI indication, which we will assume may yield a stock price of as much as $47/share, to which we will assign a probability of 70% (for illustrative purposes only) and a time frame of six months. Other inputs remain constant.
Here we have assumed there is at least a 70% probability of a $45 per share result, though there is a reasonable possibility that our time frame may have to be extended up to another six months (or 12 months in total) to achieve it. The reasonably possible (we believe 70% likelihood) successful read-out of the Phase 3 CABP trial, in conjunction with one or more successful ABSSSI trials would be an extremely powerful catalyst to unlock the full value of Omadacyline (pre-FDA approval). Such an event would allow for Management to begin monetizing non-U.S. rights to Omadacycline with Big Pharma at favorable valuations and would allow for additional capital raises at preferential terms. We believe there may be opportunity to exit the special situation at a valuation of as much as $45-$60 per share, in conjunction with the successful completion of the Phase 3 CABP trial.
Ultimately, this tool is not useful in gauging risk on its own, or in determining the overall investment merits, but it may be useful in estimating a probability-weighted, risk adjusted, rate of return for the special situation. Given the disparity in expected outcomes, all we really derive from the above exercise is that the estimated annual return on investment for a special situation investment in Paratek Pharmaceuticals, Inc. is significant, and can be compared to the risk-adjusted yields of other alternative value investments and hedge investments.
[Note in order to calculate our risk-adjusted, estimated rate of return on the FDA approval of one or more indications, we would need to expand our time frame to 24 months, and run another iteration showing the product of the successful Phase 3 probabilities with the probabilities of successful submission of an NDA and with subsequent FDA approval for Omadacycline. If we enter the special situation with this longer time frame, or choose to remain in the special situation after the earlier time frame plays out, this exercise may prove useful at that time.]
In this article, we have briefly introduced the Reader to Paratek Pharmaceuticals for consideration of a special situation investment and have run some probability-weighted, risk-adjusted calculations to arrive at expected annualized returns on investment in order to determine the approximate yield from a special situation investment in Paratek Pharmaceuticals, and we identified the conclusion of the Phase 3 trials as catalysts (i.e. corporate events) to unlock significant value.
In our next article, we will continue our case study by further dissecting the special situation investment thesis for Paratek Pharmaceuticals, and expand our analysis using time-tested, value-investing principles.
[i] Traditional, died-in-the-wool value investors may cry foul just at the suggestion of investing in an early-stage, bio-pharmaceutical stock with no sales. We understand, and we had the same initial reaction. We incidentally purchased several Magic Formula biopharmaceuticals nearly a decade ago, and quite fortunately made very acceptable returns, and believed it unlikely that we would ever again make such an investment. However, we believe Paratek is worthy of a special situation case study, as value can be found wherever significant disparity between price and value may be identified.
[ii] Reputational risks often accompany discussing existing investment holdings. This leads to the temptation to write about securities which we do not own, or in other words, not our best investment ideas. In our view, this practice short-changes not only the Reader, but the Author as well, because many of our most compelling investment ideas are never shared. As David Einhorn stated in Fooling Some of the People All of the Time: A Long Short Story, "Some of our peers disclose little because they worry people will gossip over their inevitable errors… My view is that actually losing money is much worse than the mere embarrassment of others' seeing we were wrong." Copyright © 2008 by David Einhorn, published by John Wiley & Sons, Inc., Hoboken, New Jersey, p 16.
[viii] See for example the BPL 1963 Letter, p. 7.
[ix] Benjamin Graham wrote "A fourth business rule is more positive: 'Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it - even though others may hesitate or differ.' (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.) Similarly, in the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand. From The Intelligent Investor, Fourth Revised Edition, Copyright © 1973 by Harper & Row, Publishers, Inc. pp. 286.
[xii] We will take the opportunity to publicly thank Jim for his excellent, and always detailed fundamental research.
[xiii] Disclosure: we made our first purchases immediately following the most recent capital raise at around $13 per share, and they were (surprisingly) even more recently available as low as about $10 per share.
[xiv] This estimate is based on the recent "take-outs" (i.e. acquisitions) of Trius and Durata. Trius: Cubist Acquired Trius in 2013 for $704M + CVR up to $100M. Trius was in clinical trials with tedizolid phosphate (TR-701), an antibiotic with indications for ABSSSI (in adults), which received FDA approval in June 2014 (and EC Approval in March 2015), and was later given the name Sivextro. Merck & Co., Inc. (NYSE:MRK) acquired Cubist for $8.3B in January 2015, which added $1.3B to Merck's 2015 revenues. $1.127B of Cubists sales in 2015 were derived from Cubicin, which provides insight into the level of sales for Sivextro in its only-partial, initial year of commercialization. Merck assigned $1B of the Cubist purchase price to Sivextro as an intangible asset. Merck subsequently began marketing Sivextro in Q2 2015. Sivextro is in Phase 3 development for the treatment of hospital-acquired bacterial pneumonia. Sivextro has U.S. patents expiring in 2028, (with pending patent term restoration) and 6-month pediatric exclusivity. Durata: Actavis, now Allergan plc , acquired the shares of Durata on November 17, 2014, which had a market value of $724.5M on that date ($639.7M cash, plus the assumption of $67M of debt plus $16.6M of non-equity settled awards) plus CVR equal to up to $5/sh, valued at $49M. Actavis/Allergan then began promoting Durata's antibiotic Dalvance. In 2015, Allergan, which did a reverse merger into Actavis, recorded an additional $6.4M contingent consideration (CVR) due to the Dalvance approval. Single Dose Milestone Payment = $1/CVR. EU Milestone Payment = $1/CVR. Net Revenue Milestone Payment = $3/CVR based on a Net Revenue Threshold of $600M (cumulative revenue) between January 1, 2016 and December 31, 2017. Long story short, each antibiotic was assigned a value of approximately $700M - $800M based on the take-outs, which included CVRs.
[xv] As described by Jim Roumell and Evan Loh, in this interview available at the link here, http://roumellasset.com/investor_day_2015.htm and confirmed independently, the initial news of the first successful Phase 3 trials by competitors Cempra Pharmaceuticals, Inc. (NASDAQ:CEMP) and Tetraphase Pharmaceuticals, Inc. (NASDAQ:TTPH) resulted in temporary market capitalizations of roughly $1.5B per company. Cempra is developing the antibiotic Solithromycin, while Tetraphase is developing the antibiotic Eravacycline. The reader will note the precipitous fall in the shares of these two competitors (roughly a 90%-95% decline for TTPH and a similar and far more recent decline for CEMP). For the former, the sell-off stemmed from a September 8, 2015 press release stating that Eravacycline did not meet its primary endpoint (i.e. objective) in its IV-to-Oral, Phase 3 trial for its UTI indication. Tetraphase's previous success (its initial IV-only, UTI Phase 3 trial for Eravacycline which was successful) had resulted in the initial run-up in the shares. Relative to Cempra, safety concerns ("not properly characterized in the NDA) were raised by an Advisory Committee which led to a CRL from the FDA denying the NDA in its present form, and advocating an additional 9,000 person, safety-only trial.
[xvi] In the fall of 2013, the FDA agreed to the design of our omadacycline Phase 3 studies for ABSSSI and CABP through the Special Protocol Assessment, or SPA, process. In addition, the FDA confirmed that positive data from the individual studies for ABSSSI and CABP would be sufficient to support approval of omadacycline for each indication and for both oral and IV formulations in the United States. In addition to Qualified Infectious Disease Product designation, on November 4, 2015, the FDA granted omadacycline Fast Track Designation for the development of omadacycline in ABSSSI, CABP, and complicated Urinary Tract Infections, or cUTI. Fast track designation facilitates the development, and expedites the review of drugs which treat serious or life-threatening conditions and fills an unmet medical need. In February 2016, we reached agreement with the FDA on the terms of the pediatric program associated with the Pediatric Research and Equity Act. The FDA has granted Paratek a waiver from conducting studies with omadacycline in children less than eight years old and a deferral in conducting studies in children eight years and older until safety and efficacy is established in adults. In May 2016, the FDA agreed to the design of the Phase 3 oral-only ABSSSI study and that it is consistent with the current ABSSSI guidance. PRTK Form 10-Q, June 30, 2016, MD&A, p. 20.
[xvii] The Intelligent Investor, Fourth Revised Edition, Copyright © 1973 by Harper & Row, Publishers, Inc. pp. 283.
[xviii] Ibid. p. 286.
[xix] Ibid. p. 285.
[xx] See specifically, Note 48 (p. 631 of the text), pp 729-730 in the classic 1951 edition, in which is included the reprint of SPECIAL SITUATIONS, an Article from the Analysts Journal, Fourth Quarter, 1946 (with Sequels Added). The Graham formula portrayed is also found on p. 730.
[xxi] We are assigning no value to either Sarecycline; the oral-to-IV community acquired bacterial pneumonia (CAPB) indication currently in Phase III clinical trials with results expected in Q2 2017, and probability of successful read-out estimated at 70%+; or to urinary tract infections (UTI) indications.
Disclosure: I am/we are long PRTK.
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.