An analysis on Seth Klarman’s new purchase: Targacept (TRGT)
Current Price: $7.79
Market Cap Approximately $260 Million
Enterprise Value Approximately Negative $7 Million
Given the massive decline recently in shares of Targacept, as it was revealed on November 8th, 2011 that the first of four trials for TC-5214 “did not meet its primary endpoint of change on the Montgomery-Asberg Depression Rating Scale (MADRS) after eight weeks of treatment with TC-5214 as compared to placebo,” now appears to be an attractive entry point with significant upside potential and minimal downside risk. Below I will discuss my thesis in further detail.
From the most recent 10k:
“We are a biopharmaceutical company engaged in the design, discovery and development of novel NNR Therapeutics™ for the treatment of diseases and disorders of the nervous system. Our NNR Therapeutics selectively target neuronal nicotinic receptors, which we refer to as NNRs. NNRs are found on nerve cells throughout the nervous system and serve as key regulators of nervous system activity.
We trace our scientific lineage to a research program initiated by R.J. Reynolds Tobacco Company in 1982 to study the activity and effects of nicotine, a compound that interacts non-selectively with all nicotinic receptors. Based on years of focused research in the NNR area, we believe that compounds that interact selectively with specific NNR subtypes have the potential to achieve positive medical effects by modulating their activity. We have built an extensive patent estate covering the structure or therapeutic use of small molecules designed to regulate nervous system activity by selectively affecting specific NNR subtypes.
We have multiple clinical-stage product candidates and preclinical programs in areas in which we believe there are significant medical need and commercial potential, as well as proprietary drug discovery technologies. We have entered into two significant collaborations with the global pharmaceutical company AstraZeneca to provide expertise and resources to assist in the global development and potential commercialization of many of our product candidates. One is a collaboration and license agreement focused on TC-5214 as a treatment for major depressive disorder, and we refer to that agreement in this annual report as our “TC-5214 agreement with AstraZeneca.” The other is a collaborative research and license agreement focused in cognitive disorders, and we refer to that agreement in this annual report as our “cognitive disorders agreement with AstraZeneca.” Our most advanced product candidates are described briefly below.”
Product Development Pipeline as of 12/31/10
1) Product Candidate -TC 5214
a) Planned Target Indication – Major Depressive Disorder (adjunct therapy, “switch” monotherapy)
b) Status of Development – Phase 3 clinical trials as an adjunct therapy and Phase 2b clinical trials as a “switch” monotherapy
c) Commercial Rights – AstraZeneca
2) Product Candidate – TC5619
a) Planned Target Indication – Cognitive dysfunction in schizophrenia, ADHD and Alzheimer’s
b) Status of Development -Phase 2 clinical trial in cognitive dysfunction in schizophrenia; Phase 2 clinical trial in ADHD in adults; Potential Phase 2 clinical trials in Alzheimers
c) Commercial Rights – Subject to AstraZeneca’s right to license
3) Product Candidate – AZD3480
a) Planned Target Indication – ADHD and Alzheimer’s
b) Status of Development – Phase 2 clinical trials in adults with ADHD completed; considering trial for Alzheimer’s
c) Commercial Rights – AstraZeneca
4) Product Candidate – AZD1446
a) Planned Target Indication – Alzheimer’s
b) Status of Development – Three of four early stage clinical trials completed, which are expected to inform an AstraZeneca advancement decision
c) Commercial Rights – AstraZeneca
5) Product Candidate – TC6987
a) Planned Target Indication – Inflammation disorders
b) Status of Development – Separate Phase 2 clinical trials in asthma and type 2 diabetes
c) Commercial Rights – Targacept
6) Product Candidate – TC6499
a) Planned Target Indication – Gastrointestinal disorders
b) Status of Development – Exploratory Phase 2a clinical trials in subjects with constipation-predominant irritable bowel syndrome completed; Targacept considering possible future development plans
c) Commercial Rights – Targacept
The information above is dated December 31, 2010. Below I provide an update on each product as of the latest 10Q dated 9/30/11:
TC-5214 – Targacept is eligible to receive:
1) Additional payments up to $540 million if specified development, regulatory, and first commercial sale milestone events are achieved
2) Cumulative payments of an additional $500 million, over and above the first $540 million, if specified sales related to milestone events are achieved
3) Stepped double-digit royalties on net sales of TC-5214 worldwide
Related to TC-5214, Targacept is required to pay:
4) At least 10%, and possibly greater in certain circumstances, of each milestone payment to the University of South Florida Research Foundation (USFRF). The payment would be net of a deduction taken from Targacept’s projected share of initial development program costs. It is hard to say with certainty the precise amount Targacept would be required to pay, but since they are responsible for 20% of initial development costs, I will assume USFRF receives 8% of each milestone payment. This is consistent with the firm’s payment to USFRF after AstraZeneca’s payment of $200 million in December 2009.
5) Royalties on any product sales to USFRF and Yale University. The royalty rate is estimated to be in the low to mid single digits. For valuation purposes, I will assume 4% of each payment made to Targacept will be passed along to USFRF and Yale.
TC-5214 is currently Targacept’s most promising product. Targacept and AstraZeneca have jointly designed a program for the global development of TC-5214. If approved, TC-5214 would be used for patients who do not respond adequately to initial antidepressant treatment. While Targacept is responsible for 20% of the costs of the initial program, AstraZeneca is responsible for not only 80% of the costs of the initial program but also 100% of development costs to obtain regulatory approval.
Targacept and AstraZeneca are currently in the middle of conducting four RENAISSANCE Phase 3 studies investigating the efficacy and tolerability of TC-5214 as an adjunct therapy to an antidepressant in patients with major depressive disorder (MDD) who do not respond adequately to initial antidepressant treatment, as well as an additional safety study. As mentioned above, the first of four studies caused a huge decline in the share price as the study “did not meet its primary endpoint.” However, as I will discuss below, this does not mean TC-5214 is a failed drug. There is still a reasonable chance it moves beyond phase 3.
AZD3480 – Targacept is eligible to receive:
1) Additional payments up to $145 million if development, regulatory, and first commercial sale milestones are achieved ONLY for Alzheimer’s disease.
2) Additional payments up to $3.7 million related to clinical trials for Alzheimer’s disease contingent on providing respective roles and responsibilities and associated financial terms for such a study
3) Other payments if development, regulatory, first commercial sale, and first detail milestone events for AZD3480 are achieved for any other target indication under the agreement
4) Stepped double-digit royalties on any sales if regulatory approval is achieved
Targacept is required to pay:
A low single digit percentage of each payment, provided Targacept receives payments from AstraZeneca, to the University of Kentucky Research Foundation (UKRF).
Although revenue related to ADHD is possible in the future, in the latest 10Q dated 9/30/11, Targacept states:
“Based on discussions with AstraZeneca, we do not currently expect AstraZeneca will conduct further development of AZ3480 in ADHD based on concerns about the adequacy of the therapeutic margin for the ADHD patient population.”
Thus a potential revenue stream for Alzheimers, in which a phase 2b study was just initiated, is more likely.
AZD1446 – Targacept is eligible to receive:
1) Additional payments up to $73 million if development, regulatory, first commercial sale, and first detail milestone events are achieved.
2) Royalty payments on sales if regulatory approval is achieved.
In late April 2011, Targacept was notified that AstraZeneca had determined not to exercise its license option. In light of this decision, I will not incorporate any potential revenue from TC-5619 into my valuation model.
On a promising note, on December 5th, Targacept announced the initiation of two phase 2 studies for TC-5619 as a potential treatment for Schizophrenia and as a possible treatment for ADHD. Based on comments made at the Deutsche Bank and Oppenheimer conferences, the CEO believes the firm’s research in this area has significant promise.
The remaining two products being developed by Targacept exclusively are in developmental stages of testing, thus it does not seem possible to project any future revenues, nor does the company give any guidance of any near-to-intermediate term revenue stream. Here is further information on the two products from the 10Q dated 3/31/11:
TC-6987 is a novel small molecule that modulates the activity of the 7 NNR and is in development as a treatment for inflammatory disorders. We are conducting two ongoing Phase 2 clinical studies that are planned to help guide the selection of indications for which TC-6987 is best suited for later-stage development. One of the studies is in asthma and the other is in Type 2 diabetes.
TC-6499 is a novel small molecule that modulates the activity of the 4ß2 and 3ß4 NNRs. The 3ß4 NNR is located in the gastrointestinal tract, and we believe TC-6499 may have potential as a treatment for one or more gastrointestinal disorders. We have completed an exploratory four-week study of TC-6499 in 24 subjects with constipation-predominant irritable bowel syndrome and are currently considering possible future development plans.
Next I will discuss why Targacept represents a low risk investment at current levels.
If the firm’s balance sheet is examined, as of the latest 10Q, we see the following:
Cash and equivalents $130,541 Short-term Marketable Securities 82,939 Long-term Marketable Securities 57,380 Other Current Assets 3,334 P & E 5,409 Intangible Assets 136
Total Assets 279,739
Accounts Payable 1,423 Accrued Expenses 16,115 Current portion of Long-Term Debt 1,594 Deferred Revenue- Current 74,449 Long-Term Debt 2,195 Deferred Revenue (net of current portion) 1,951
Total Liabilites 97,727
The vast majority of assets are highly liquid and safe with almost no interest rate risk. Cash represents approximately 46% of assets, and marketable securities over 50%. The marketable securities consist of treasury, agency, and corporate securities, as well as certificates of deposit. All are “level 1” assets. The weighted average maturity of all marketable securities was approximately one year as of 9/30/11, and the longest maturity was only 3 years, according to the most recent 10Q.
As you can also see, the majority of liabilities are deferred revenue, mainly as a result of AstraZeneca’s $200 million upfront payment related to the development of TC-5214, which the company is recognizing over the appropriate time period, approximately 33 months according to the latest 10Q.
Thus the current liquidation value can be computed as follows:
Cash 130,541 (in thousands) All Marketable Securities 140,319 Liabilities minus Deferred Revenue 21,327
Current Liquidation Value 249,533 Diluted Shares Outstanding 33,377.874 Liquidation Value per Share 7.48 (slightly higher if less liquid tangible assets are added)
In its third quarter earnings press release, Targacept stated the following:
Updated Financial Guidance
Targacept now expects its cash, cash equivalents and investments balance to be at least $240 million at December 31, 2011. Targacept continues to expect its cash resources to be sufficient to meet its operating requirements at least through the end of 2014. This guidance does not include amounts that Targacept could receive if any milestone events are achieved under its collaboration agreements with AstraZeneca. Targacept is not making any adjustment to its previously announced guidance for expected net operating revenues or expected operating expenses for the year ended December 31, 2011.
From this guidance, I assume annual total expenses of $80 million through 2014.
Although horrible scenarios can be envisioned with any firm, in my worst case scenario, Targacept receives no revenues the first half of 2012 as the TC-5214 trials do not succeed, and burns through $40 million of the remaining $240 million in cash. I do not assume any further dilution from options not included in diluted shares outstanding if this scenario occurs because the share price is unlikely to appreciate substantially if this happens.
Under this circumstance, Cash and equivalents would be$200 million ending June 1, 2012, and Tangible Liabilities would be approximately $20 million, assuming accounts payable and accrued expenses do not increase materially. I assume tangible liabilities decrease slightly because Targacept is in the process of paying off two loans it took from an available credit facility, which are on target to be paid off by 2015. I assume payment on these two loans is part of their $80 million expense budget.
In this case Taracept would have a liquidation value of $5.39 per share. At this point, management would have to rethink capital allocation decisions and perhaps become more conservative in burning through cash. If the share price were to decline to $5.39 from today’s price of $7.73, it would represent a decline of 30%. However, this assumes no value is given to Targacept’s entire pipeline, which is highly unlikely given the fact that one major breakthrough, or even advancement during any product’s clinical trial, could provide several dollars more per share in revenue.
Another positive is the significant holding of shares by long-term investors. According to the latest proxy statement, dated April 21, 2011, Directors and Executive Officers owned approximately 20% of outstanding shares with nearly 16% of the 20% held by M. James Barrett. Mr. Barrett has been a board member since 2002. Within the last five years Mr. Barrett has served on the board of three publicly traded pharma/biotech companies that have been acquired, thus it is safe to say Mr. Barrett is not only a long-term investor, but also has a proven track record in realizing value for shareholders. The three companies include:
Iomai Corporation (acquired by Intercell AG) MedImmune, LLC (acquired by AstraZeneca) Pharmion Corporation (acquired by Celgene Corporation)
Mr. Barrett is also a general partner at New Enterprise Associates. According to the proxy statement, entities affiliated with this firm own nearly 16% of Targacept. In addition, according to a recently filed 13G, Baupost Group, a firm with a proven track record of long-term value investing, revealed a 17% stake in Targacept.
With nearly 50% held by long-term and influential investors, speculation by short-term traders could become rather difficult, which may help provide a floor in the current stock price.
Potential revenue streams:
According to the latest 10Q, Targacept and AstraZeneca are also conducting a Phase 2b trial of TC-5214 as a “switch” monotherapy in patients with MDD who do not respond adequately to initial antidepressant treatment. However, I will focus on Targacept and AstraZeneca’s development of TC-5214 as an adjunct or add-on to antidepressant therapy for patients with MDD through the Renaissance Phase 3 trials mentioned above.
Below is a link to the company press release discussing the first trial which “did not meet its primary endpoint:”
According to Daniel Chancellor at Datamonitor:
“Given the high placebo response seen in clinical trials of antidepressants, it was not a great surprise that one of the Renaissance studies to fail to meet its primary endpoint. Forest is experiencing the same problems in its development of levomilnacipran, which has a tried-and-tested mechanism. The first of its Phase III studies failed to demonstrate a significant difference between levomilnacipran and placebo in January 2011, although the company was able to present the drug in a much more positive light in July 2011 after all levomilnacipran doses proved efficacious in its second Phase III study.”
Recently Targacept presented at the 2011 Deutsche Bank BioFEST Conference, and mentioned how Pristiq failed several trials before it was approved. Pristiq is currently a $500 million plus drug from Pfizer (originally developed by Wyeth) which treats Depression. Targacept mentioned that the goal was for satisfactory results in 2 of 4 trials, as past results show it is very tough for a Depression drug to pass every trial.
According to data from the Biotechnology Industry Organization (BIO), approximately 44% of drugs in phase 3 trials are FDA approved. Excluding oncology drugs, the success rate is over 50%. In addition, excluding oncology drugs, drugs in phase 3 trials have a 60% chance of moving past phase 3. Investors are currently pricing the stock as if the drug has no chance of passing and as if all four trials have already failed.
Not only must we take into account the potential revenue stream for each drug, but also when the cash flows will be received. According to innovation.org, once a drug starts clinical trials in stage 1, it takes an average of 6-7 years to move on to FDA approval if successful. Given that TC-5214 trial results are expected by the first half of 2012, in my upside scenario, I will assume a portion of the $540 million is received by the end of 2012. After a drug has moved onto the FDA it takes 6 months to 2 years for approval, thus I will assume the $540 million is distributed in equal increments in each of the next three years. I will also assume 8% of each development milestone payment is distributed to USFRF.
It is difficult to say when sales milestones will be reached and we do not know how much of the additional $500 million (on top of the $540 million above)Targacept will receive, nor do we know when. Datamonitor estimates TC-5214 could be see sales of $1.1 billion annually. This is certainly possible, as sales from antidepressants were approximately $20 billion in the United States in 2010 according to statista.com. I will assume sales reach $500 million by the end of 2015. Since Targacept is eligible to receive double digit royalty payments, plus potentially an additional $500 million based on sales targets, I will assume they receive $100 million per year in 2015 and 2016; $50 million for reaching sales milestones and $50 million as a royalty payment. As stated above I will assume they pay 8% of the first $50 million to USFRF and 4% of the next $50 million to USFRF and Yale.
2) AZD3480 – (For Alzheimers only)
Because AZD3480 is still in phase 2 part b, I will not project payments from the $145 million of potential revenue if the drug is approved. According to BIO, there is a 33% chance a drug moves from phase 2 to phase 3 and a 15% chance of approval. Based on the timeline provided by innovation.org, the drug could move to phase 3 in 2-3 years and could be approved in 4-5. In 2010 the global Alzheimers drug market generated $8 plus billion in revenues, according to AM Mindpower Solutions, thus if approved, it is easy to see AZD3480 generating $500 million in sales by 2015-16. .
3) Since AZD1446 is only under consideration for phase 2 clinical development, I will not project any future revenues. According to the BIO study, phase 1 drugs have a 63% chance of moving to phase 2, but only a 9% chance of approval. Based on a reasonable timeline using information from innovation.org, it is possible Targacept will generate additional revenues from AZD1446 within the next few years.
Below is data illustrating potential upside:
In addition to my revenue projections for TC-5214 above, I also assume the following:
Deferred revenue between $18-19 million is realized during Q4 ’11. The majority of deferred revenue is recognized in 2012. Most relates to the recent $200 payment from AstraZeneca re: TC-5214 as discussed above. This is expected as it is listed as a current liability on the balance sheet The remaining deferred revenue is recognized in 2013
A normal tax rate of 38%, 35% for federal tax and 3% for state tax after exhausting all tax loss carryforwards and R & D credits. I assume similar carryforwards and R & D credits as mentioned in the 10K ended December 31, 2010, as they should not change much because Targacept is likely to have a small loss this year Assume all tax loss carry forwards are used in 2012
Diluted Shares Outstanding increase slightly due to anti-dilutive stock options which are currently out-of-the-money but may be in-the-money if shares appreciate, as well as options which were excluded in the EPS calculation last quarter, due to the firm’s quarterly loss. If the firm had a gain, many may have been included in common shares outstanding. As of the latest 10k exercisable options had a weighted average cost of $9-10, and as of the latest 10q there were approximately still 923,000 anti-dilutive stock options, as well as 3.8 million total shares subject to outstanding stock options, excluded from EPS calculations. I will assume 2 million more shares are added to diluted shares outstanding in my model below.
Depreciation and Cap Ex average $1.5 million per year
Cash + Marketable Securities – Debt, excluding new revenues generated, stays constant near $240 million
Interest on Investments is 1% of the starting annual cash/ms balances on January 1, 2012 and grows 15% per year because of increasing cash balances generated from new revenues
In the most recent press release, Targacept stated they would have approximately $240 million and marketable securities at year end and they had enough money to operate for at least 3 years. Given their guidance, I will assume total costs (R & D, G & A, and other) will equal $80 million per year the next three years. I assume total costs drop to $60 million in years 4 and 5 as the development costs associated with TC-5214 subside.
|TC-5214 Potential Revenues|
|M Payments to USFRF||14.4||14.4||14.4||4||4|
|RP to Yale and USFRF||2||2|
|Net Revenue to Targacept||165.6||165.6||165.6||94||94|
|Projected Income Statement|
|Recognition of DR||55.911||1.951||0||0||0|
|New Revenue Generated||165.60||165.60||165.60||94.00||94.00|
|Federal Tax Rate||35%||35%||35%||35%||35%|
|Tax Loss Carryfoward||40||0||0||0||0|
|Net Profit Attributable to FT||103.91||90.31||88.77||37.65||38.20|
|Tax at Regular Rate||36.37||31.61||31.07||13.18||13.37|
|R & D Credits Federal Tax||9.56||0||0||0||0|
|Federal Tax Due||26.81||31.61||31.07||13.18||13.37|
|State Tax Loss Carryforward||77||0.00||0.00||0.00||0.00|
|Net Profit Attributable to ST||66.91||90.31||88.77||37.65||38.20|
|State Tax Rate||3%||3%||3%||3%||3%|
|State Tax at Regular Rate||2.01||2.71||2.66||1.13||1.15|
|R & D Credits State Tax||1.02||0||0||0||0|
|State Tax Due||0.99||2.71||2.66||1.13||1.15|
|Total Tax Due||27.80||34.32||33.73||14.31||14.52|
|D & A||1.5||1.5||1.5||1.5||1.5|
|Adjustment for DR||55.911||1.951||0||0||0|
|Free Cash Flow to Owners||60.20||54.04||55.04||23.34||23.68|
|Discounted Free Cash Flow||54.7||44.7||41.4||15.9||14.7|
|Sum of Discounted Free Cash Flows||171.4|
|Potential Equity Value||411.4|
|Diluted Shares Outstanding||33.378|
|Potential Additional Shares||2.0|
|Total Potential Shares||35.378|
|Fair Value Per Share||11.63|
In summary, I believe Targacept presents 50% or more upside with minimal downside because of the quality of the firm’s balance sheet, the potential revenue from TC-5214, the further development of the remainder of their product pipeline, and the high percentage of shares held by committed long-term investors.
Buy Target: $8.00 Represents the amount per share of the firm’s current net cash
Conservative Sell Target: $12.00 Based only on potential short-intermediate-term revenues from TC-5214 plus the firm’s net cash balance
Please note: If milestone and royalty payments for TC-5214 are projected at the same pace started in 2015-16 until 2019-2020 when patents for TC-5214 are set to expire, the fair value increases above $13.00. Based on information contained in an 8k released in 2009 and the 2010 10k, if TC-5214 is approved, Targacept would receive royalty payments on TC-5214 at least until patents expire, possibly longer, which depending on location, ranges mostly from 2019-2020, assuming there is not an extension of patent expiration.
Source: http://www.gurufocus.com/news/156095/analysis-of-targacept-seth-klarmans-new-purchase (Matt Blecker)