Yes, they're keen, and it's a great announcement - a bolt from...

Yes, they're keen, and it's a great announcement - a bolt from the blue! Doing some rough numbers and playing with the assumptions re probability of success in China, you can get a value of this Chinese deal at or above the current share price. Here's why:

1. Milestone payments and royalties should dwarf up-front payments

Some have complained about the size of the upfront payment. They're missing the point. The company doesn't need any more cash at present, so it is better to negotiate higher milestone payments and fatter royalties to maximise the long term value of the company. I think these longer-term payments will completely dwarf the up-front payments announced in this deal. Some of the milestone payments could conceivably come in the current financial year, depending on how they go negotiating with the Chinese FDA re trial structures and endpoints etc - some could even be tied to things like successful outcomes in the US Phase 3 trials (I'm just speculating the kinds of things people would typically look for).

Having said that, the US analysts on the call certainly didn't sniff at the up front payments, one saying "this deal is multiples of other deals" and all congratulating SI on the deal. Just wait for the milestone payments - they could be huge if you take into account the market opportunity in China.

The Prof has been doing these sorts of negotiations for years and has been determined not to accept deals which aren't highly beneficial to MSB. When you look at the US analyst valuation assumptions, they use 25% as the royalty rate for most indications - so when the announcement says double digit escalating royalties, let's think well above 10%, maybe approaching 20% (just to cut the numbers back a bit to be conservative).

To repeat - these longer-term numbers are applied to a population nearly 4x the size of the US, with a health system rapidly moving to embrace biologics and monoclonals (Keytruda etc) - and as the Prof noted in the call they expect that the market size would be about the size of the US and that reimbursement would be
at similar levels to Japan (and there is already some reimbursement going on in China at this level). However, I would note that over time the market size could grow dramatically if current Chinese economic growth rates continue and as the Chinese population grows older and wealthier and therefore it could become bigger than the US market by the end of the analysts' 10-year cash flow forecasting period.

Just look at how China is embracing other emerging technologies of the 21st century (solar panels, rare earths production etc) to see their plans for world leadership in the growth parts of the global economy.


2. None of this is in analysts forecasts of cash flows or target prices

I've gone back through the most recent US analyst valuations prior to the deal and as I've previously noted, the average 12-month price target amongst the larger US researchers is around $A5 (or 3x the current share price). That's BEFORE the China deal - there is nothing in their valuations for this China deal (or anything like it).

So, eventually, they will start to put this deal into their numbers - but there's more than enough upside with a $A5 average valuation, and analysts are notorious for not going too far from the herd or from the current share price. Don't get me wrong - they should upgrade for this deal - and by quite a lot - but they are already almost at an extreme of difference from the current price. That doesn't stop the price rising, and means that the analysts will probably keep upgrading their targets as the share price rises and so we could well have years of upgrades ahead.

The analysts have applied swingeing discounts to their models to pull their targets down to an average of $5. For example, one estimates cash flows up to 2030 of probability-adjusted, NPV discounted cash flows using only US, Europe and Japan sales and a probability of success of only 40% for heart failure and 35% for Rheumatoid Arthritis - the relatively aggressive discount rate of 15% is then applied to get the NPV. They value the ADRs at $US23 ($A6.20 per Australian share) after all this discounting, but don't include anything yet for this new China deal.

One-third of this valuation is the US heart failure market - so if China could just get to half of the US heart market value, that adds $US3.80 (or $A1.04 per Australian share) to their valuation, taking it to $A7.20. This is a rough guess to get an order of magnitude - the China deal may be on a lower royalty rate but also lower operating expenses than assumed for the US heart failure indication. And it could be much better than this if you play with the probability of success - let's say the Chinese are serious about pushing this through quickly - then a probability of success could lift this additional value of the China deal to $A2.60 per share - or more than the current share price!

Another way of looking at the potential ultimate impact of this deal, assuming 100% probability it succeeds is to use the royalty assumptions for the US market then halve it to take into account the lower reimbursement in China, and cut the royalty rate from 25% to 15%, and discount these cash flows at 10% and I get a $A700m valuation before taking into account the potential milestone payments which could once again take the NPV up to or above the current market cap of nearly $A800m - so it could justify the current market cap on its own, and everything else is riding for free!

I'm admittedly making lots of assumptions here and I confess I don't know the royalty rate - but I believe that there is upside to this NPV figure if there are big milestone payments early in the life of the cash flows and if we use a discount rate of 10% to reflect the quality of the Chinese partner and the fact that the partner will fund "all development, manufacturing and commercialization activities".

Another analyst values the ADRs at $US16 after using probability of success of 35% in RA, 40% in lower back pain and and 60% in the other main indications. They then apply a monster discount rate of 20% for their NPV calculation. They don't have anything in their valuation for the China deal. Again, there is huge upside potential in this valuation.

3. Bottom line - this deal is potentially huge and the share price hasn't yet reflected it

Analysts forecasts are already heavily discounted for probability of success and use very high discount rates to reduce their NPV and share price targets and they have not yet included any value for this China deal in their numbers, yet they still get price targets of $A5, or 3x the current share price (average of major US analyst forecasts). The China deal has the potential to justify the current share price (or more) on its own, depending on some rough assumptions. This will all become clearer in coming months, but it is clear it must add to current cash flow estimates and price targets - and that the pressure will be on analysts to lift these targets as clarity emerges.

MSB is at a stage of much greater maturity now than in June 2016 when the Teva pullout saw the share price plunge from $2 to $1. This deal partially replaces Teva and still allows MSB to partner the technology in the rest of the world ex-China. MSB has formed a strong base of price support over that period and its prospects including clinical trials, technology and production capabilities have improved dramatically since then. It is well funded for the next 18 months and milestone payments from the China deal could significantly increase cash flows.

Even if new buyers are still reluctant to buy due to the higher risk of MSB compared to the market, the shorts are under pressure to reduce their positions as there is no near-term prospect for a discounted capital raising, which is how they have previously successfully covered, and holding shorts is very expensive due to the very high cost of borrow and as the price rises.

Given all this it seems easy to justify a short-term rise at least back to the $2 level - after that, we may see a gradual move up to the average US analyst valuation of $5. After that, who knows, but as I have noted above, it isn't hard to see the analysts engage in rolling price target upgrades as trials confirm the technology, the FDA potentially grants accelerated approval, more partnering deals emerge, and probability of success increases for the riskier indications, all leading to a lower discount rate being applied to clearer and more certain cash flows.

This whole process has barely started and I view this stock as one of the best opportunities I have seen to get in on the ground floor in the leading company in a new globally significant technology in the high growth health care sector.