MSB Capital Raise Makes Good Sense With A RoE Well Above Cost of...

MSB Capital Raise Makes Good Sense With A RoE Well Above Cost of Capital

This had to be a done deal, with the probability that Aussie and US instos were contacted over the weekend. I’ve heard it was 2-3x oversubscribed. While I'm usually prepared for the worst in relation to capital raisings, and they have usually been an opportunity for shorts to take advantage and the price usually falls to the placement price, there are reasons that may not happen this time.

There's no way Bell Potter would take on the risk of a $A100m underwriting in a small-cap volatile stock without having most of it pre-sold. It looks to have been very tight, and friends have told me they were cutback by 2/3 on larger bids, and I know at least one major new potential investor who got none. So, I think it unlikely that shorters could've used this as an opportunity to cover cheaply, or get much stock at all.

The theoretical discount is only 1c (from $3.44 to $3.43) so there's no dilution (for other than nitpickers) and there's a potential big upgrade in the long-term value of the company from investing this capital in growth projects at rates of return well above MSB's 15% Weighted Average Cost of Capital - so it is value creating, not diluting.

This is all about the Covid-19 opportunity – beginning to address the massive expansion in manufacturing which will be required and probably taking the opportunity to invest in the move into serum-free and eventually 3D manufacturing. I have previously said that I believe this opportunity will require support of governments, big pharma and would potentially make Mesoblast worth multiples of current share price valuations.

The numbers are eye-opening, mind-boggling and gob-smacking.

People have mentioned Barda - but if Barda advances money for building stockpiles, my understanding is that you can only charge cost plus a margin (of maybe 20%), rather than the 60-80% margin that MSB could make by manufacturing the cells itself.

At present, gross margins are around 60%, but with full 3-D serum-free production in the future the GM could approach 80%. If the Covid10-ARDS treatment costs $US75,000 the cells may be produced for $US30,000 (2D, bovine serum) now and $US15,000 (3D, serum free) in the future. These figures could be way out - I'm just backing out previously mentioned gross margins. I get $US75,000 to treat Covid19-ARDS as one-quarter of the estimated $US300,000 cost of aGvHD, since ARDS requires one-quarter of the number of treatments.

I had previously said, before Covid19-ARDS was a possibility, that MSB had more than enough equity funding. I also said I believed the only reason to do another equity raising was if a major new opportunity came along where the Return on Equity (RoE) was way above the Weighted Average Cost of Capital (WACC). I said that if that were the case, then the market would support an equity raising as it would increase the value of the company (and would obviously increase the value per share).

That value adding opportunity appears to be presenting itself – although I wasn’t expecting it to be a new blockbuster product indication, as I thought a new product would be years in testing and approvals. I didn’t have anything in mind – I was just trying to say that equity wasn’t required in the near term, although you couldn’t rule it out if there was a major value accretive opportunity e.g. an acquisition.

A gross margin of 60%, rising to 80% with technology upgrades on manufacturing these cells will drive an RoE of multiples of the WACC of around 15%. The RoE ultimately depends on whether MSB licence the product sales or do a 50/50 jv with a pharma, or get government institutions like Barda to fund the manufacturing.

Do you own numbers, they are staggering – but if this new equity is used to fund manufacturing upgrades and new production and is able to be turned over say 3x per year in building and selling inventory, it blows away the cost of this capital.




Covid19-ARDS Numbers Are Huge – 100,000 pa at least, assuming a vaccine comes

As I have previously noted, without a vaccine, MSB has no hope of supplying the whole Covid19-ARDS market unless they have a major pharma partner. So far over 80,000 Americans have died - if the death rate is 80% that means over 100,000 would've needed treatment - and the bulk of those deaths have occurred in just 2 months (up to March 11th there were only a total of 38 deaths in the US).

Note that the death rate didn’t rise above 3 dozen til mid-March, which was two-thirds of the way through the normal seasonal ‘flu season – ie it started late in the season and would’ve been much higher if it was a full season and if the economy wasn’t shut down with social isolation in place.

It isn't hard to see 1 million patients per year needing treatment for Covid-ARDS in the absence of a vaccine, and as penetration rates move up to much higher levels of the population if the US is reopened for business.

Let's assume a vaccine is developed that is 80% effective, you will still have over 100,000 people each year requiring ICU treatment for Covid19-ARDS (let alone the other existing ARDS sufferers from multiple other sources, including the seasonal 'flu).

These numbers assume that the US gains a vaccine, re-opens the economy and decides to live with a death rate of 100,000 pa as a steady state.

Mesoblast can't currently supply anywhere near these numbers, even with a vaccine.


MSB’s current preparation was for a GvHD market of 200 pa in the near term

Look at Ryoncil for paediatric aGvHD. I have previously estimated a market size of $US120m pa. At a cost of treatment of $US300,000 that would treat 400 very sick kids, and we are all expecting it to take a year or so to build up to 50% market share – or 200 kids. That’s what MSB’s current manufacturing expansion was looking to cater for. A market of 200 over the next year or so.

The aGvHD opportunity was then expected to have label extensions into adult aGvHD and chronic GvHD in the US and EU. The total market opportunity was expected to be $US700m. I think that’s conservative – but I note that opportunity could treat 2,000 to 3,000 people pa (reimbursements and sales price in EU likely to be lower in the US). That eventual market size is some years away and is 10x-15x the levels MSB was building up to in the near term. US analysts were saying that Ryoncil in GvHD alone justified valuations of the MSB shares in the $A2 to $A3 range.

Covid19-ARDS is a market of 100,000 pa even with a vaccine (maybe 1m pa without a vaccine). Covid19-ARDS uses one-quarter of the number of cells of aGvHD – so it’s the equivalent of treating 25,000 GvHD people pa in a steady state scenario where a vaccine is available that is 80% effective.

THAT IS MORE THAN 100X BIGGER THAN WHAT MSB WAS GEARING UP TO PRODUCE. WITHOUT A VACCINE IT IS 1,000X BIGGER.

MSB was lucky that it was already producing cells as inventory in preparation for the aGvHD launch if the FDA approval comes through by late September. They can use some of these cells for the Covid19-ARDS trial of 300 people. Those 300 people in the trial will use up the equivalent of 75 of the 200 aGvHD patients that analysts anticipate in the first year (if we get to 50% paediatric market share).

Note that some of the competing treatments for Covid19-ARDS are using 10m cells per kg versus 2m of MSB’s much higher quality cells in the Mount Sinai led trial. That is why MSB is so far in front and can treat up to 300 patients in the ARDS trial – they already had cells ready to go, and others are using up to 5x more cells per patient.

So, hips more manufacturing is needed just to rebuild this expected demand and before you start to think about building inventory in anticipation of approval of a label extension of Ryoncil for Covid19-ARDS.


This brings forward what would have happened

MSB always planned to eventually upgrade the manufacturing (both techniques and volume) as demand for their products built up and as approvals were granted. This was always a few years away, with paediatric aGvHD requiring a modest manufacturing capacity in the near term. Capital was adequate for these pre-existing plans.

This new potential Covid19-ARDS requirement for massive new manufacturing is a golden opportunity for MSB to open new manufacturing capabilities and take advantage of upgrading to serum-free production. FDA would be unlikely to baulk at serum-free as a major change to manufacturing – but going from 2D to 3D might be a bigger ask, and MSB could probably emulate CSL and go through a process to change over time.

I believe the cell lines take 3-4 months to manufacture from initial donations and building of master cell banks then replication.

I suspect there will be a real push for the AdCom to hold its hearing in July and approve Ryoncil early. Even starting now, there won’t be time to build any significant supplies for the next Northern winter, starting in November, so a second wave could still be devastating in the US.


Lack of foresight by Australian governments

Everyone has become very tribal and hates to hear anything against the political party they support. Try to put that aside when reading this section and think of the good of the state, the nation and of the health of our vulnerable people. We have Liberal and Labor state governments and this criticism applies to all of them – but particularly the big ones.

The Australian winter is a big risk for a second wave, and it is highly unlikely we would be able to access the volume of cells required to avoid a high death rate (especially if the economy is reopened).

We can have an Australian company which could massively alleviate this death rate, and which has been lobbying government her for months to get funding to build manufacturing in Australia, which would then give us some biosecurity. If plants are built in the US, I highly doubt Pres Trump will allow these life-saving cells to be exported – there won’t be nearly enough to save American lives.

If cost is an issue, I would be flabbergasted – let’s say treatment in Australia cost $A50,000 per ARDS patient (ie lower than America because our ICU costs etc are lower – total guess on my part). We have had nearly 100 deaths in Australia so far – ie around 120 people would’ve needed to be treated assuming an 80% death rate. So that’s a cost of $A6m for the cells, and a saving of more than that on all the building of ICU beds, buying of ventilators and less time in ICU as people are discharged much earlier and much healthier. ICUs could probably treat 3x the number of patients based on faster turnarounds. Let alone the cost of hundreds of billions in shutting the economy. Plus, 80% of those people may have been saved, and others could have lived much better lives without VILI and other debilitating long-term effects of Covid-19 ARDS (and other major organ failure, vascular and micro-clotting problems).

The economy could’ve been reopened much earlier if we could treat the worst cases of Covid19-ARDS and save their lives. The 80% of people who exhibit no symptoms or very mild symptoms could go back to work. The other 20% have symptoms of a bad ‘flu and around 5% may need ICU. Those most at risk, with comorbidities could be in stricter isolation for their own good – and if they contracted ARDS it could be treated with the Mesoblast cells.

But we won’t have the cells available in Australia if there’s a big second wave.

The Federal Government could’ve funded manufacturing. The State Governments could’ve funded it (it’s a fraction of the losses from lower stamp duty). The bank executives could’ve chipped in $6m to keep the economy open and stop their bonuses being cut. Bank shareholders would’ve happily made a contribution to stop their dividends being cut. What a massive failure of leadership this has been. The governments have been trying to treat a health crisis by alleviating the economic symptoms – putting a huge economic load on our future. The best they have done is to stop immigration and enforce some social distancing measures – that’s not a health treatment, and once it stops, we run the risk of the whole thing starting up again – it’s not a long term solution, it’s just an attempt to flatten the curve until a vaccine arrives – it’s like cutting the death rate on the roads by stopping people driving. A vaccine may never arrive.

MSB can’t afford $A50m to build manufacturing in Australia and it doesn’t make economic sense for them to do it. If the Federal Govt has some plan to do a deal with the US or Singaporean governments to get access to MSB cells, I’d like to hear it. I suppose we may even see the day when the Aussie government is dependent on China for cells if Tasly builds a plant there – let’s see how that goes in the current frosty environment.

My view is that such an investment should be a Federal initiative, so that all states can have access to cells in the event of a second wave. If the cells turn out not to be required for ARDS in Australia, they could be part of the global solution to Covid19-ARDS, or they could be exported for GvHD etc. There’s going to be more than enough demand and we will have established a whole new high-tech growth industry locally. If the Feds won’t do it, NSW or Victorian Governments should do it – they could then open their economies early, keep the death rate down, have new industry and have biosecurity. IT’S A NO BRAINER ISN’T IT?

MSB don’t need a plant in Australia to be successful, but I think it’s a major missed opportunity if we don’t do it


Bottom Line

Well, my rant’s over. The bottom line is that Covid19-ARDS is a massive new opportunity for MSB. They will need huge new partnership deals and investment in manufacturing to capitalise on it.

Most of this $100m which is being raised would’ve been spent over time anyway in upgrading manufacturing processes and in producing cells for future treatments. So even if Covid19-ARDS is not approved, it is just bringing spending forward.

I believe MSB must be very confident that Covid19-ARDS will be approved – probably as a label extension to Ryoncil’s aGvHD approval. If the ARDS trial is stopped early, I think it is quite possible an AdCom will be convened to approve Ryoncil early – quite possibly in July. There have been priority review drugs approved in as little as 3 months in the past year. Approval (or not) is due by September in any event. By early July we should have 30-day survival data on the first 90 ARDS patients (30% of the 300 in the trial) which is the primary target of the trial. This assumes it takes a month to recruit the first 90 patients – it could be quicker. The trial will be stopped early if there is overwhelming efficacy and those results could then be used to support a label extension for Ryoncil into Covid19-ARDS. This piggybacks off MSB’s years of trials and 2 years of data analysis and lodgement with the FDA (the phase 3 aGvHD trial completed around September 2018).

Do your own numbers on this opportunity – I have outlined the upside from Covid19-ARDS in the last few notes. Suffice to say that IFF it is approved it is a company changer for MSB. That is shown by a $A100m capital raising which was 3x oversubscribed. I know major Australian investors who applied for stock and got NONE. Others were cut back by 2/3 – these are friends of mine and this may not reflect the average levels of cutbacks, but they were for big bids into the book. I also know a small bid who was only cut back by 1/3 – so it varies depending on who you are and the size of your bid.

This capital raising is only 5.8% of the current issued capital and the dilution is only 1c. It was $3.44 before this issue with 538m shares on issue. The issue is $100m for 31.25m shares. So the total company after the issue should be worth $A1.95bn with 569m shares, or a theoretical ex price of $A3.43. So, the issue is not dilutive, and in fact when the capital is invested at a much higher Return on Equity than MSB’s Weighted Average Cost of Capital, the overall valuation of the company should rise – that’s why instos have snapped up this issue.

The raising is not enough to satisfy the instos who need to buy for ASX200 index inclusion in June and MESO appears to satisfy the requirements to go into the US Nasdaq Biotech Index in December, which should generate even more buying.

Notwithstanding the fact that there will undoubtedly be a few “flippers” over the next few days, and some shorters will probably make a desperate attempt to hold the price down (thinking that it will make the capital raising appear a mistake) which may keep the share price capped for a few days, I hope everyone can see why MSB did this raising and why it is beneficial to shareholders.

Remember, if the share price was worth $3.44 before this raising, it is worth $3.43 after the raising, BEFORE you consider the considerable valuation rise from investing in new growth projects at an RoE well above the cost of capital.

If the share price rises on this news, it will be a massive vote of confidence in MSB’s future by the new shareholders.

Currently US analysts have a 12-month price target for MSB Australian shares at the equivalent of over $A5.
US analysts keep their valuations low (if $A5 on average is low!) by using probabilities of only 25% to 30% that the major blockbuster product candidates and they include nothing for Covid19-ARDS (except Bell Potter who include a small valuation for Covid19-ARDS in their $5.80 target).
If the probability of success for Chronic Lower Back Pain and Heart Failure treatments are increased to 100% then this $A5 valuation would increase to $A10 to $A20.
If Covid19-ARDS were included in valuations, we could see multiples of that (see my earlier notes) - as I said, the numbers are gob-smacking.

One US analyst increased his valuation by 30% last week just by increasing the 2022 revenue multiple from 7x to 8x and slightly reducing the discount rate. Imagine how much his valuation would rise if MSB were selling a treatment for Covid19-ARDS by 2022 - put that on an 8x revenue multiple!!! I'm not prepared to write it here as the numbers are ridiculously big - do it for yourselves - I don't want to get moderated.

That's why US analysts are increasing their price targets and valuations as the share price increases. They have plenty of fat built into their valuations by applying discounts to their market estimates. They don't want to look stupid by having price targets way above the current share price. So as the price rises, and the probability of success rises as trial results are read out, they are likely to keep increasing price targets and the share price may never catch up.

Please do your own research - I have also covered some of the possibilities for Covid19-ARDS in previous notes. I don't want people to think this is advice. It isn't. It just looks at potential and why MSB may be doing this capital raising and why big instos are apparently so keen to get stock. This may not be reflected in short term price moves after MSB relists this morning - but that may just present an opportunity for the many instos who missed out on this relatively small capital raising.