MSB Trading - 2019, page-1148

Vinn. I could not agree more...you inspired me to lift up the skirt on my thoughts about valuation.

Let’s face it, understanding how to value Mesoblast is quite a struggle. As a largely pre revenue company it may seem just too complicated to bother with for many investors .That would be a big mistake. A typical timeframe for a new drug from the submission of the Investigational New Drug in the US to market entry, post regulatory approval , is around eight years.

Reasons to be cheerful : PART 1

In a research paper written by Raphael Rottgen, he makes the point that loss making biotechs form the majority of companies listed in the biotech index. He notes that one prominent study estimated that the total cost of developing a successful drug exceeds $2.5bn. Other studies show costs to total around $1.4bn. The difference being that the former number includes an estimate of the opportunity cost of capital invested while the former represents out of pocket expenses only.

https://www.toptal.com/finance/valuation/biotech-valuation

“If you’re interested in or have experience in the biotech space, it should come as no surprise that biotech companies with little to no revenue can still be worth billions. Consider the most prominent 2017 biotech M&A deal when Gilead bought Kite Pharma for almost $12 billion. At the time of the deal, Kite was still loss-making, with over $600 million in accumulated deficit, but significantly, it also had a pipeline of CAR-T cell therapies, which treat cancer. Kite wasn’t necessarily an anomaly. Almost 80% of the constituent companies of the Nasdaq Biotech Index (NBI) companies have no earnings; over 150 companies representing over $250 billion in market capitalization. And, the average VC investment in biotech has more than doubled over the past decade, from $4.6 billion in 2005 to $12.9 billion in 2015. As institutional equity investors, it’s clear that this cannot be simply explained by the exuberance of investors. Rather, it’s meant to demonstrate that pipeline often justifies the value of a company.”

This must sound all too familiar to Mesoblast shareholders ! When you consider that there are only 524.1 m ordinary fully diluted shares in issue, placing a market capitalisation at A$1.46, of A$765.19m equivalent to US$525m . Mesoblast has two products already which have passed phase 3 clinical trials and we are now waiting on two late stage phase 3 clinical trials for the two real blockbusters of CHF and CLBP. How can such a low current market capitalisation be possible ? By the way, it is noteworthy that Shawn Tomasello, who served as the Chief Commercial Officer of Kite Pharma Inc and played a pivotal role in its acquisition (source Bloomberg), has been a non executive director of Mesoblast since July 11th 2018.

So what do the analysts say about Mesoblast, when it comes to risk adjusted discounted NPV valuations? I have decided to review Bell Potters February 2019 Report ,which is freely available on the internet .

https://www.bellpotter.com.au/ca25/Research/GetFile.aspx?id=F9678493-18EF-48CA-BD0C-CF4C9C2DBC6F

Before looking at this sum of the parts valuation I have captured below, people should read the whole report to allow a fair representation. In particular, I would draw attention to Page 5 :

Upside risk to our valuation

Paragraph 2

“•At this stage we only model MSC-100-IV for Steroid refractory acute GvHD in children for both US and EU. We do not include any value for the MSC-100-IV for the expanded indication into high risk adults (those with gut and liver involvement). It is MSB’s intention to pursue a trial in this high risk adult GvHD population in the future to expand the label for MSC-100-IV. We also do not include any value at this stage for potential off-label usage in adults following the approval of the product for children. We also expect the FDA would require commitment from MSB to run a trial in the adults’ population given the potential for off label use as a condition for marketing approval in the paediatric indication. Once MSB initiates clinical trials in the high risk adult population, it would be a source of considerable upside to our valuation, given the adult opportunity is expected to be 3x times that of the paediatric opportunity. “

Hang on a second, in my view, approval in the adult market would be considered by most physicians to be a “slam dunk” if this is approved for the far more sensitive paediatric market. Ask yourself this ….WHY DID INCYTE NOT ATTEMPT TO SEEK APPROVAL FOR CHILDREN UNDER 12 ?

I believe Bell Potters approach is being overprudent After all lets consider the timelines for Remestemcel-L being able to address the market for adult, chronic and acute. Lets assume , Mesoblast are successful with a BLA application for Remestemcel-L (which I anticipate will occur in probably around March 2020…after full submission of all 5 modules in October 2019). Supported by huge volumes of clinical data from three years of use with adults in Japan, I would expect Mesoblast to quickly agree with the FDA to initiate a confirmatory trials first for adult aGVHD and later for acute and chronic conditions. These confirmatory trials would be typically of six months duration and require no more than 70-90 patients costing between $25m-$35m which I believe could easily be funded by a securitised facility from the likes of Royalty Pharma, Clarus or Oxford Finance LLC not to mention Novaquest. It is perfectly feasible that Mesoblast could legally market to these patient populations by the 1H of 2021.

Of course the reason why Bell Potters number are far too conservative in my opinion is that physicians will have the opportunity to administer the treatment “off label” for these markets as soon as the BLA application for paediatric aGVHD comes through. People should remember that hospitalisation costs can range from $0.5m to $1m for a Grade C &D patients ! Whether or not ,the confirmatory trials are undertaken is missing the point. Once approved for paediatric use many physicians would be highly likely to prescribe off label for adult gut and liver conditions , not to mention the large numbers of skin patients who have adverse reactions to Jakafi because of the need to digest orally rather than through IV or where immuno suppressive therapy poses risks to the patient.

If the above is true, revenue from non paediatric use of Remestemcel-L might begin to impact the bottom line significantly as soon as the 2Q /3Q of calendar 2020.

Jakafi Side Effects…. According to phase 3 clinical trial data , Remestemcel-L already has far superior efficacy in gut and liver aGVHD conditions . I do not see that changing even with itacitinib approval. If you don’t believe me, why not take the view of Incyte’s Barry Flannelly, who is hoping that hopefully some of the more nasty side effects can be brought under control !

http://www.bloodjournal.org/content/bloodjournal/122/23/local/advertising.pdf?sso-checked=true

https://seekingalpha.com/article/4258062-incyte-corporation-incy-ceo-herve-hoppenot-q1-2019-results-earnings-call-transcript?page=14

Barry Flannelly EVP Manager USA NASDAQ (INCY)

“Well, we think we have an advantage because we're able to launch, we will be able to launch ruxolitinib Jakafi in GVHD. So we're understanding that market very well right now. So, we've gotten to know the BMT treaters, we've gotten to understand exactly what drugs they're currently using. But then itacitinib, when it gets approved, it really does, in fact, should have a better profile, at least in terms of cytopenias. So we really think that we could continue to develop rux or people will use rux in that setting, but ultimately, itacitinib should be the drug of choice in steroid refractory and acute GVHD.”

Jakafi is very useful to Mesoblast because it establishes pricing for Remestemcel-L. As Jakafi was first approved for Myelofibrosis, its pricing formula (see below) can already be referenced on the assumption of similar dosing.

Of course, with superior efficacy ,negligible side effects and shorter hospitalisation periods, I believe Mesoblast will be successful at a pricing point of about $300,000-350,000 per complete treatment.

According to Morgan Stanley, in coverage of Incyte dated August 1st 2018 , 70% of the adult aGVHD market can be reached by targeting the top 50 allogenic stem cell transplant centres . As there is considerable geographical overlap with the same paediatric facilities for aGVHD I think Mesoblast would only need to recruit another few sales staff to penetrate this additional market. I have heard unconfirmed reports that a major broker in the US now believes that aGVHD is a $1bn a year market in the US alone. In a recent Incyte conference call, the chronic and acute aGVHD market in the US, was profiled as having patient annual patient populations of 3500 for each condition ! Assuming Mesoblast was able to treat 400 paediatric patients (the target market estimated by Oppenheimer in their recent note) and 800 adult patients off label) in 2022 (or more with approval) I believe that would represent sales of approx $360m. Based on 6.5 times multiple of sales for 2022 that would justify a market capitalisation of US $2.34bn ...just for this part of the business.

Furthermore, I believe that Mesoblast will be able to bring COS down below 10% within a few years if they gain approval to use Rexlemstrocel-L rather than Remestemcel-L . This change also would probably mean no royalty payments due to Osiris and improve efficacy considerably. Either way just remember that Bell Potter have only put a value of $148m on non Japanese aGVHD sales in their report. Should I bother mentioning that European approval would likely follow with -9 months of US regulatory approval !

https://www.ahip.org/wp-content/uploads/2016/04/HighPriceDrugsReport.pdf. Page 16

So coming back to valuation. I can only agree with Bell Potters assessment of SR Acute GvHD (Japan). Remestemcel-L already has dominant market share and it is unlikely that JCR royalties to Mesoblast will peak much above $7m in the next few years based on average net royalties of 25% after deductibles. They do however apply a very aggressive cost of capital of 21% which is unnecessary, considering the income stream already has an established market share with no competition in sight…but these are small differences in valuation. Why you might ask is the royalty income so small ? The answer partly lies in the lack of heterogeneity of the Japanese population which has allowed a high percentage of tissue matching resulting in a higher percentage of autologous compared to allogenic therapies. However, the valuation attributed to total sales of aGVHD leaves a lot to be desired, especially when you consider the US. Market is 12 times bigger, being a function of 1) size of population 2) susceptibility to the aGVHD grades C & D in the US 3) pricing traditional being three times greater in the US than in other major industrialised nations ( I have already alluded to this in a recent post)

https://www.ncbi.nlm.nih.gov/pmc/articles/PMC3972059/

Asian patients had a significantly lower incidence of acute GVHD (Japanese patients: 40.0% grades II-IV and 15.3% grades III-IV; non-Japanese Asian patients: 42.1% grades II-IV and 15.7% grades III-IV) compared to Caucasian patients (56.5% grades II-IV and 22.6% grades III-IV) (p< 0.001). The hazard ratio (HR) of acute GVHD for Caucasian patients was significantly higher than for Japanese patients. Unexpectedly, the HR of leukemia relapse in Caucasian patients with early disease status was also significantly higher than that in Japanese patients. These results provide a platform for future investigation into the genetic factors for unrelated donor HCT and clinical implications of diverse ethnic background.Table 4 - MSB- Probability-Weighted Sum-of parts Valuation Summary

Please forgive such a long and verbose post. I just wanted to reassure readers that I do not just pluck numbers out of thin air or ramp stocks. I genuinely believe that analysts are applying one valuation for Incyte and completely ignoring the upside on Mesoblast. That does not surprise me bearing in mind that there appear to be different biotech analysts following both stocks.

When I have more time I will show there are several other reasons why the current market cap is a joke in my opinion. Obviously, I must caveat these comments by saying this is a binary outcome stock. There still remains material risks, such as the issue of funding and reliance on positive regulatory outcomes. If the BLA application for aGVHD is not successful…..if the LVAD pre BLA application FDA meeting being held “mid year” is not successful ( I think it was moved a few weeks into July because of FDA applications backing up after the shutdown), if the Phase 3 CHF trial result is Inconclusive , if the CLBP is unsuccessful or the Company runs out of funds, the share price could materially underperform…. However, in my opinion the above information shows that the share price could well be five times its current level just on prospects for aGVHD within a year !

I own a reasonable position in Mesoblast which I trade on occasions . I have never shorted this stock. Whilst I have attempted to be thorough and truthful I sometimes get it wrong. Please do not rely on any information, opinion or representation contained therein, when making an investment decision.

Please do your own research and best of luck to all. Other Perspective