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
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