MEI Pharma is an idea brought to my attention by a fellow value investor. Thanks a lot!
I believe that the essence of value investing lies in the uncovering of highly positively skewed bets. Such bets feature the favourable combination of very little risk for permanent impairment of capital and high reward. Value investors focus primarily on the mitigation of downside risks when evaluating whether or not a security is investible. Doing that they seek comfort in robust cash-flows or tangible asset bases that serve as solid lower bound to share prices. Only when it can be assured with reasonable certainty that the downside is minimal an investment awakens interest.
Pre revenue cancer therapy developer MEI Pharma exactly ticks this box. Immediate downside is very limited given the equity is trading at net cash, while the upside is a nice 7.5x.
Company & Pipeline
MEI Pharma is a San Diego based oncology company that develops new therapies for the treatment of cancer. It has three drug candidates under development. The thesis centres entirely around a single drug, Pracinostat, that has successfully cleared phase II trials recently. Pracinostat is a drug used to treat Acute Myeloid Leukemia (AML) and myelodysplastic (MDS) syndrome (MDS). MDS is a disease of the bone marrow affecting the production of healthy blood cells. MDS prevalently occurs with patients over age 60. If untreated MDS can evoke AML, a disease that causes uncontrolled multiplying of a dysfunctional pre-stage of blood cells (Leukemia).
Phase II study results indicate that Pracinostat in combination Azacitidine is a best in class treatment for AML. Of the people treated in phase II with the drug combination complete remission rates (CRR) were twice as high as the next best alternative on the market. CRR is the percentage of people where all detectable tumours have disappeared.
Source: MEI Pharma IR
Other drugs that the company works on are cancer medications still in early stage testing. While first results show some potential I will disregard them in the valuation.
Licensing, development and commercialisation agreement with Swiss-Based Helsinn
This year in August MEI Pharma secured a licensing deal with Helsinn Group. Under the deal Helsinn fully funds development and commercialisation of Pracinostat for the treatment of AML and other haematological diseases (diseases which affect the blood).
Helsinn has agreed to make several milestone and some upfront payments which can amount to USD 464 mn. USD 15mn of these have already been awarded to MEI Pharma with another USD 5 mn being due upon the dosing of the first patient in the upcoming phase III study or no later than March 2017. Helsinn has also made a USD 5mn equity investment in MEI Pharma. While information is scarce on how the USD 444 mn in milestone payments are awarded, MEI should be granted most of it in case phase II results can be replicated in phase III trials. The average duration of a phase III study is 40 months or roughly 3.3 years in oncology. So latest at the end of 2019 we will know whether or not phase III will be a success and how much of the outstanding USD 444 mn in milestone payments will eventually be received. Every now and the updates on the progress of the study should provide hints on the likelihood of a positive phase III outcome. In case Phase III clears, market introduction of Pracinostat should come approximately in 2020.
In addition to the mentioned milestone payments MEI Pharma is granted a licence to collect royalty payments on the sales of Pracinostat given the drug reaches commercialisation. The company will collect tiered royalties starting at 15% of net sales. Since Pracinostat will be the best in class treatment if it is granted FDA approval we can estimate that it will capture close to 100% of the U.S. market. The National Cancer Institute sadly estimates 20.000 new AML cases in 2016. Being very conservative I estimate that 15.000 of these will be treated with Pracinostat annually . A 2004 reasearch paper estimated the average cost for remission reduction treatments to be USD 46.000. If anything treatment costs have gone up over the years. Nevertheless to be conservative I estimate Pracinostat treatment cost at USD 46.000 per patient. This will translate into an annual revenue stream of USD 690 mn for Helsinn, of which at least 15% go to MEI Pharma. Royalty streams should thus come in at minimum USD 100 mn. per annum.
I estimate that today shares of MEI Pharma should be worth at least USD 5.61 per share or 3.1 x today´s price of USD 1.80 if we adjust for the probability of a successful Pracinostat commercialisation of 35%. In the success case the equity is worth USD 13.50 per share or 7.5x today´s price. I assume a cost of equity of 15% to discount net licence payments as well as future royalty streams.
Given the promising phase II results fixing the probability that Pracinostat makes it to market at 35% is likely a lowbal estimate. I also estimate royalty payments to decline from USD 100 mn to only USD 2,6 mn during the 10 years after launch of Pracinostat due to competitive pressures. Further, licencing fees that MEI Pharma has to pay to S*Bio of around USD 75 mn in case Pracinostat can reach commercialisation are factored in and reduce the valuation. Also I assume a 15% dilution due to option exercise and the awarding of RSUs to management (see model below).
Currently MEI Pharma holds a cash position of approximately USD 60 mn. vs a market cap of USD 65 mn) this means that USD 444 mn of probable licensing revenues and hundreds of millions of probable royalty streams are reflected in the valuation at zero. You heard right! Of course the other two drugs in the development pipeline come free as well. Essentially buying MEI Pharma at these prices compares to being awarded a free call option.
The price is also the sole reason why I am touching a pre-revenue pharma company in the beginning. Through a valuation near net cash I am not required to know anything about how likely it is that Pracinostat or one of the other two drugs in the pipeline makes it to market, or at which annual run-rate royalties will come in, or how the drugs work in detail. It is enough to be aware that there is a chance for a successful commercialisation, and this chance must be worth something. And today it can be acquired for free.
Since the company grosses no revenue, all its cash costs shorten the estimated time of survival for MEI Pharma. However, with around USD 60 mn in net cash the company will easily make it past phase III for Pracinostat. If phase III fails the shareholder is likely left with some millions of cash and two promising early stage cancer therapy drugs.
At a current price of USD 1.80 a share an investor can buy into a company trading near net cash, while getting the optionality to over USD 400 million of licensing payments and royalty streams of over USD 100 mn annually, as well as a promising drug development pipeline for free. I call this investment a highly positively skewed bet!
I am long MEI Pharma (MEIP)