share cafe 17/4

Family Values: Bell Potter Lifts Mesoblast's Target Price

There was one anomaly in Tony Abbott’s 700 strong Asian trade delegation. Along with the great and the good of our major corporations there was one CEO whose company has not yet traded a single product or service.

Mr. Abbott personally introduced this CEO to the Japanese PrIme Minister saying that Dr Silviu Itescu, headed up a company that was leading the world in stem cell research. This may not have been the most tactful of introductions as Shinzo Abe has aspirations for Japan to become the world leader in regenerative medicine. Still, the words were uttered and the greeting was cordial.

As one may suspect there is a back story here. As an ardent nationalist whose grandfather served in the Japanese war-time cabinet, Abe has made stem cell research a government priority following the co-award of the 2012 Nobel Prize to Dr Shinya Yamanaka. Just as his co-winner found that a piece of intestine could be inserted in an egg to clone, Yamanaka did the reverse. In a lab setting he took skin cells of mice and turned them back into stem cells.

This recognition of Japanese science (although done in California) led to a surge of interest in stem cells and some heady statements from Abe about stem cell research being a key plank in his “third arrow” of economic reform. One part of this was legislation passed five months ago to wave the standard large scale studies for stem cell regulatory approval. Trials with as few as 10 people would be sufficient provided the demonstrated safety and some effect. While this is still on a case by case basis, it would allow big savings and give a kick start to companies (like Mesoblast) to Japanese markets.

There is even a back story to the back story as just a week before these introductions there was uproar in Japan when a researcher at Japan’s leading regenerative medicine institute was outed for making several mistakes and falsifying data in experiments intended to support Dr Yamanaka’s work.

The claim was that by simply shocking the spleen cells of mice with acid they would reverse their developmental path to become progenitor stem cells again: the cells which contain all the information required to turn into any type of cell in the body: nerve cells, blood cells, bone, heart etc. As other researchers had been puzzled by these claims the revelation of mistakes accompanied by fraud created national embarrassment and made Dr Itescu’s appearance in Japan even more relevant and timely.

Here was the CEO of the only company in the world that is on the verge of marketing the first of a series of 12-15 different stem cell therapies which will not rejected as foreign organism, which has wide patent family cover and is being urgently sought by hospitals. The first product has approval status in a number of companies to minimise complications caused by bone marrow blood transfusions and while not as large as the target markets to follow, it may build confidence that Mesbolast’s business strategy lives up to the expectations built around the stock three years ago. It would also steal the thunder of the critics who believe the Mesoblast story is over-blown.

A big cap already by our standards

Certainly enthusiasm is more muted than it was. Bell Potter at one stage had a $14.50 PT on it but since peaking at $9 in 2011, Mesoblast has, in fits and starts, fallen 45% from its peak to the current $5.00 level or lower which equates to a $1.6 billion market cap. By Australian market standards this is a hefty amount for a company relying on shareholder funds and the possibility of success payments to fund its future. The success payments from its major shareholder Teva are admittedly huge at up to $1.7 billion, but in the equities world projections and potential are thin air until the events actually happen. It will also spend much or most of its $250m cash (Dec 31) on one or possibly two Phase 3 trials. As a Phase 3 trial may cost up to $100m, shareholders would be unnerved if one of the trials bombs out as Prana’s did recently.

Prana is not alone. Its 75% slump follows on from the steady decline of formerly strongly supported stocks like Acrux with its testosterone treatment and Starpharma with its portfolio of lego-like molecules. Bionomics remains upbeat after mid March release of its renal cancer trial results showed little efficacy even though some interesting new aspects came out.

If we want to call up grisly memories of markets recent and past there are dozens more - all promising high margins and good biomedical deeds, but either slumping with a bang or more often shrivelling slowly as board fees, unnecessarily fancy accommodation, conference attendance and prolonged R &D drained away shareholder funds.

This is sobering and not assisted by the current Nasdeq sell off of biotech and IT stocks trading in some cases >100 times earnings and more. Many are scratching their heads at the connection with the ASX where there are no Facebooks or Twitters, but more generally Mesoblast’s supporters caution about lumping all biotechs into the one basket.

For one thing Mesoblast and its 30 or more stem cell peers, largely American and Japanese, are not drug development companies in one critical, but often over-looked sense. They are not attempting to synthesise an existing natural compound or create a new compound from scratch either to suppress some function or stimulate it. The idea is much simpler: it is to greatly magnify the activity of cells that already exist in the body. These cells are pre-programmed to orchestrate the regeneration of kindred cells. The issue is that without a big surge of these cellular instruction kits human cells often do not renew and reform, as opposed to merely repair and patch.

Unlike newts, salamanders and starfish which regrow tails, legs and arms as often as they are chopped off, humans have a limited capacity to regenerate ligament, bone, nerve and most organ cells. The liver can partially regenerate and brain tissue, which we were once told was fixed for life, turns out to be more active and self-repairing than previously thought, but there are limits.

Our newtish past

For reasons unclear, mammalian capacity to self-heal is only residual: it is an echo of our far distant newtish past. The heart contains small numbers of stem cells, but does not regenerate whatever the treatment, rest or diet. Perhaps surprisingly the liver to some extent will regrow, but not so far kidneys unless current work at Monash and elsewhere reveals that this too is just a wrong assumption. The kidneys of many fish regrow entirely - even sharks. This must be one of the few upsides of being a white pointer these days.

Conversely there are many examples of finger tips regrowing and even rib bones borrowed for skull reconstruction regrow. (This is not hearsay. Many years ago my father’s finger was crushed to a pulp. As most of the skin survived the flesh and multiple bone fragments were repackaged by fine surgeons. Within two years a nail bud appeared, after decade what had been an immobile stump had a joint that flexed and perfectly formed finger nail and looked just like the other index finger). But typically scar tissue which lacks many of the normal skin or tissue cells takes precedence. It acts more quickly and usually blocks regeneration depending on the age and scale of the trauma.

Mesenchymal family groups

But science is catching up to observation. Research of the last 7-8 years has reconfirmed work done in the sixties which revealed that stem cells are not confined to embryos and bone marrow. Instead they are seeded in varying volume in every part of the body waiting in a suspended state to become activated by signals triggered by trauma. One group is not completely naïve being already differentiated into familial lines - bone, nerve, blood and fat and tissue.

The discovery that belly fat and dental pulp (the soft tissue inside teeth), are both “rich” in adult stem means that the risky and difficult extraction of bone marrow can be avoided as can the ethical issues of using embryo stem cells. (This explains why the Vatican honoured Professor Itescu last year for his scientific achievements).

Mesoblast’s portfolio of achievements in the field led by Itescu and colleagues include studies into the mechanisms that switch inert multi-potent stem cells into action, but the commercial achievement is more to do with the realisation by Itescu back in 2001 that research at Adelaide’s Hansen Institute offered a way around the difficulties of capturing stem cells. Along with insights from collaborative work with Harvard and Itescu’s research team at Columbia, he had both the theoretical and practical tools in the form of licence which would allow precise selection and culturing of mass volumes of stem cells from various sources. These partly, but evolved but not yet individualised mesenchymal cells could be injected directly to flood the damaged site and trigger “natural” repair of heart tissue, bones, spinal discs etc.

Manufacturing biologics

In this sense some may miss the obvious. Mesoblast is aiming to be a biologics manufacturing company with a platform technology for producing naturally occurring cells in high volume. Given that each new application is not a new type of drug, but simply another version of the same category of stem cell, the market may start to pick up on this reduction of risk. No doubt there are still many other forms of risk. Batches could become contaminated and under some circumstances there is a possibility that cells programmed to send repair signals reverts to a previous status where the only chemical signal short circuits and it ceaselessly clones itself as a cancer cell does.

After more than a decade of trials these risks are not particularly high as the bio-mechanisms are now fairly well understood. In Australia Vets have used stem cells for several years. Dogs formerly suffering from hip dysplasia, crushed hind legs and osteoarthritis are today happily running around Australian backyards.

Checkmate move

As mentioned above the first cash-flow is likely later this year following on from its acquisition of the stem cell division of the US based Osiris. This division had a pre-existing relationship with Japan’s JCR Pharmaceuticals and a suite of patents which extends MSB’s coverage of mesenchymal cells selection from 35 to 61. Bell Potter’s biotech analyst Tanushree Jain calls this “a checkmate move” propelling it to clear world leadership not only by extending the patent reach but by bringing its cell separating and cell culturing techniques to Osiris. It is also planning to lift its own “2D” culturing method to a more efficient “3D” version which can be applied to the Osiris cell lines.

The Osiris buy-out led Jain to lift her PT to $7.70 but with a likelihood that positive spinal disc results would add another $2.50 in it. This has occurred and the latest note from the large private client firm ups the target to $9.40. At each step analysts are likely to adjust their risk discounts as the implications for related therapies are factored in. Success with Crohn’s disease trials will have, for example, partially de-risk other inflammatory disease targets. Risk also runs the other way. Infuse, a spinal fusion product by Medtronics which stimulated bone growth, had very large sales in recent years in the US but after patients suffered complications, some very serious, demand has fallen significantly. Jain expects Mesoblast’s spinal fusion and disc repair to form a $2.5 billion annual market at peak. David Stanton, another well informed health sector analyst discussed this sub-market in detail in very thorough and clear 2011 report when with Nomura. He put the existing annual market at $7.5 billion with around 350,000 procedures a year costing an average $25,000 each.

Industry heavies join board

Jain also points out in this note that the latest additions to the board, a former Pharmaceuticals CEO of Roche and a former CFO of Novartis and Astra Zeneca bring not only their big pharma experience to the company but signal to the biotech community that two corporate biotech heavies are backing Mesoblast to occupy a central space in this sector. The former Roche executive also sits on the Board of Shire PLC, a Dublin based pharma with interests in regenerative medicine, inflammation and renal (kidney) therapies. He is also on the board of Chugai, a Japanese company with a similar profile.

Jain places emphasis on these new recruits. Traders don’t have a clue about corporate personnel and don’t care, but fund managers who make the big long term commitments can read every skerrick of research they like, but there is nothing like the comfort factor of seeing executives backing a stock with their reputation and experience. Rain’s best case is $19.50, but after risk adjustment per therapy this is scaled back by half. Worst case gross margin is 75% and best case 95%.

So clearly Mesoblast is a stock to take very seriously and one that should be judged by global standards, not necessarily ASX standards. It is not widely understood as regenerative medicine is still largely over the conceptual horizon, if drawing near.

It is tempting to suggest that it is so radical that some are unwilling to let go of their preconceptions especially when an Australian company is playing a key role. By all accounts this doesn’t make any difference in the US. At a recent Regenerative Medicine Conference in New York there were 30 separate presentations with the keynote speaker holding a chair at New York’s oldest University, Columbia: ie Professor Itescu.