Yesterday Mallinckrodt officially launched the tender offer for Ocera Therapeutics with a deadline on the 8th of December while the merger should be concluded shortly after. Concurrently with the tender offer document Ocera also filed a “solicitation/recommendation statement” that has some interesting information that can be used to value the CVR. The document contains some tables with managements estimates of the probabilities of passing the various hurdles that need to be taken to commercialize OCR-002, and what kind of revenue it expect to generate. Management’s estimates of the probabilities are as follows:
The two most important milestones for the CVRs are those related to successfully starting Phase 3 trials. As you might remember from my previous post, I estimated a 80% probability for an intravenously version of the drug entering Phase 3 trials and a 20% probability for the oral version. It’s nice to see that as a total pharma nitwit I managed to guesstimate something in the right direction. Ocera management is going with 75% and 35.7% respectively. This would value the first two milestones at $0.43/share, pretty close to the number I was getting.
There is a big difference between my estimate of the probability of commercial success versus Ocera’s, but since my estimate was a super low 1%, that’s not really a surprise. They estimate a 34.6% probability of getting FDA approval combined with a 60% probability of commercial succes which implies a 20.8% probability of hitting the last CVR with just the intravenously version. How this probability increases with adding the oral version to the mix is a bit unclear. Presumably all outcomes here are highly correlated with each other, and adding the oral version to the mix will not meaningfully increase the probability of hitting the last milestone. Hitting it stand alone has a 16.5% times 80% probability of success which is a 13.2% probability, and presumably most of the outcomes overlap with those in the 20.8% pie of hitting commercial succes with the intravenously version. If we simply go for the 20.8% probability the third milestone is worth $0.34/share, although this number does need to be discounted significantly. Payment will not only be very far away in the future, a Mallinckrodt receivable might also carry a significant amount of credit risk
The tables with projected revenues also give some hints with regards to the timing of the various milestones. With the intravenously version possibly hitting the market in 2022 and the oral version possibly hitting the market in 2023 I guess we should expect the milestones related to entering Phase 3 trials to payout relatively soon. That good, not just because of the time value of money, but also so we don’t have to worry too much about credit risk since most of Mallinckrodt $5.9 billion in debt is due between 2022 and 2025.
Clear is that we don’t have to expect a quick payment on the last milestone. Using these projections cumulatieve revenue would hit the $500 million somewhere in 2027 while the oral formulation only hits it in 2030. And we shouldn’t forget the reason why this deal is partly financed using a CVR: presumably Mallinckrodt didn’t agree with all those projections and they certainly could be too optimistic. On the other hand a CVR can also simply be a way to share risk and borrow money. Given the highly leveraged nature of Mallinckrodt not spending too much hard cash on a deal must be attractive to them.
Author is long Ocera Therapeutics
Noticed this as well, and it definitely helps, but as the outcome is close to your (and my) previous conclusion, it does not change that much for me.
I agree with you that these estimations could be overly optimistic as management wants to get the deal done, and wants to encourage shareholders to vote for it. That being said – This gives at least some of anchor point to haircut their estimations for the Biotech newbies (obv, valuation still very sensitive to the percentage haircut).
I approached this one the other way around, and looked at the break-even point. Taking a 10% opportunity cost of capital, you have to believe that there is a 60% (at 0% cost of capital it lies at 50%) chance the first milestone will be hit (and nothing more, which obviously is underestimating the true value due to the correlation in the achieving success on the other milestones).
So without any knowledge of biotech I expect this to beat the bank, but for me it is not good enough (and more importantly I do not know enough) to load up beyond my ‘temporary liquidity that I dont need in the next month anyway’. Hope to be wrong though 🙂
I’m certainly not buying a huge position either. Allocated maybe 3.5% of my portfolio to this deal, and after the initial payment of $1.58/share just ~0.25% will remain. It’s not a big bet. But that’s how I play most merger arb deals. Individually they are (usually) all small, but make enough bets like this and at the end of the year it starts adding up.
Thanks H — ever the interesting idea. Could you explain your rationale for position sizing here? Either there’s a massive edge here, or none at all.
For instance, at current 1.70 price, the market’s essentially offering just below even money odds for a punt at the IV milestone alone, which is like a lot of edge if we believe there’s a 75-80% chance.
Whereas if we bring deal risk into the picture, and assume a failed merger sends OCRX back to the 1.20 area for the loss of 50 cents (generous), then the odds on offer are more like 3-for-10 (practically zero edge).
Obviously these are just high level considerations ignoring the other milestones, discount rates, hold period etc (hard enough knowing what will happen not to speak of when it will happen). Thoughts?
Why is the situation so polarized in your opinion that their is either a massive edge, or none at all? I think it’s in between those extremes. I don’t think deal risk is a big deal, but there is of course a tiny bit there. But the fact that the milestones will probably take a couple of years to pay out means that they payout needs to be discounted a decent amount.
Secondly, to get a meaningful exposure to only the CVR you need a pretty huge position in OCRX. I don’t have the cash laying around for that.
Well, my opinion has nothing to do with the facts of the case: on one hand, if an investor ignores merger deal risk, then there’s a massive edge, no? (75-80% probability estimate vs EVEN odds is incredible, even if one either haircuts the probability estimates or heavily discounts future payouts, both equivalent actions). On the other hand, if we acknowledge deal risk, then there’s no edge whatsoever given the downside in OCRX’s price.
So, obviously, in a long series of small bets like these, it’s perfectly fair to wonder whether there’s an edge. While I’m long the merger at slightly better odds than current (before the idea was widely circulated), I view it more as an experimental study than anything.
Regarding sizing, okay, so a decent % of bankroll but it didn’t warrant your selling other positions to load up? Got it.
Alpha–so should holderstender their shares or just wait for the merger to close. Also, does the CVR have language regarding a change in control , bankruptcy, sale of the asset etc. thanks.
Why would you want to wait? You get the same amount of money, but it might take a lot longer…
And you can find the full text of the CVR agreement here: https://www.sec.gov/Archives/edgar/data/1274644/000119312517330223/d487980dex21.htm
Thanks for the writeup. If the price continues to increase, how do you think about the EV of the CVR vs. the certainty of the delta above $1.52?
At some point of course it will be a though question that needs to be answered, but don’t think a price that is a few cents higher makes things materially different.
As stated in the solicitation statement: “The probability of commercial success is applied directly to relevant revenues and expenses that are projected to occur in commercialization.” So, for example, the 25 million in IV Formulation (POS Adjusted) actually means $25 million / 0.6 = $42 million in the scenario of Commercial Success. So, before the POS adjustment, I see that cumulative revenue exceeds 500 million at the end of 2025 for IV and at the end of 2029 for Oral.
Thanks for the correction. That should make the revenue milestone a bit more valuable 🙂