Earlier this month Ocera Therapeutics (NASDAQ:OCRX) announced that it would be acquired by Mallinckrodt (NYSE:MNK) for $1.52/share in cash plus a CVR that could be worth up to $2.58/share. In general I like mergers with CVRs because I think market participants are often conservative with valuing them. I especially like gettings CVRs for free, but unfortunately that is not the case here since the stock is trading at $1.70/share.
The CVR has three milestones on which it will payout:
- $0.34/share if the first patient is enrolled in a Phase 3 trial for an intravenous formulation of OCR-002 (before 2029).
- $0.52/share if the first patient is enrolled in a Phase 3 trial for an oral formulation of OCR-002 (also before 2029)
- $1.72/share if cumulatieve sales of OCR-002 worldwide exceed $500 million before 2029
So to make this merger arbitrage a succes you basically need to hit the first CVR milestone. With a share price of $1.70 you are effectively paying $0.18 for the CVR, and if it returns $0.34/share at some point in the next couple of years it should generate a nice internal rate of return. The merger will be structured as a tender offer that is scheduled to be launched no later than November 16, 2017 and should be concluded before the end of the year. So with most of the cash being returned soon the only thing that really matters is how much are we paying for the CVR, and how much it’s expected to payout.
I know basically nothing about medicine, so take that in mind reading this post, but when reading the press release it’s clear that OCR-002 is not a sure thing to make it to a Phase 3 trial. It was unable to meet statistical significance in its primary endpoint in its Phase 2 trial, but it appears to be that this was caused by using a too low dosage of the drugs. That’s something that’s easy to correct, and Mallinckrodt is paying $42 million for Ocera Therapeutics so they must have a decent amount of confidence that they will not only be able to progress to Phase 3, but also get the product to the market. And I guess if you can make OCR-002 work intravenously there is also a decent probability of making it work orally.
I wouldn’t ascribe to much value to the sales milestone though. It not only requires OCR-002 to become a big success, you also have the problem that for a sales milestone your interests aren’t very well aligned with the company. If they are close to the deadline and close to hitting that $500 million milestone they will have a big incentive to stay below that number in order to avoid the $75 million milestone payment. You don’t have this problem with the two milestones connected to starting Phase 3 trials. Their whole purchase of Ocera Therapeutics will be a waste of money if they cannot start those trials.
To be honest I’m a bit surprised that there is no milestone related to successfully concluding a Phase 3 trial, but I guess that’s a good thing for investors here. Just starting Phase 3 trials is a milestone that is a lot easier to reach than successfully finishing them.
Attaching numbers to the various probabilities is a huge guess, but in my mind something like the following doesn’t sounds unreasonable. Maybe there is a 80% probability of starting a Phase 3 trial, maybe a 20% probability of also doing it for an oral formulation and maybe just a 1% probability of hitting the $500 million sales milestone. This would value the CVR at $0.39/share compared to a market price of $0.18/share, so as long that is roughly in the right direction it would be a good bet. I think it is.
Author is long OCRX