Description

Eli Lilly and Company, a $300+ billion pharma, is acquiring  Akouos, Inc  a genetic medicine company developing treatments of inner ear conditions. Eli Lilly is paying $487 million. AKUS has around $160 million in net cash. There is a contingent value right included that could lead to an increase of Lilly's bill to $610 million. I don't think the company would mind because the extra payout is contingent on milestones indicating a tangible increase in the value of these assets. The assets are not that relevant to the purchases, which does $10 billion in EBITDA, has $2.7 billion on its balance sheets vs. $14.7 billion in long-term debt. 

AKUS seems to have settled at $13.15, which is $0.65 above the cash tender offer. 

The absolute bear case here is that the deal breaks, which would be quite disastrous. But I don't foresee regulatory problems and the deal is a cash tender that should wrap up before yearend. The deal isn't material to the acquirer, which decreases the chances of a break significantly further. The deal is derisked (to the acquirer) through the contingent value right portion of the purchase price. The acquirer also gets a break fee of ~$17 million if the deal is terminated. 

IF the deal breaks, I expect to be down around ~$6 per share(I think the odds of this happening are below 5%). 

IF the deal succeeds, this effectively means $12.50 per share is returned but $0.65 is still at stake. 

Provided the deal successfully closes I am guestimating the probabilities like this:

Bear case for the CVR: -$0.65 (5% probability)  

Conservative expected value for the CVR: $0.95 (milestone 1) + $0.30 (milestone 3) + $0.10 (milestone 2)  = $1.45  (70% probability) 

Bull case CVR: something between $2 and $3 (25% probability) 

If I'm estimating the probabilities right the expected value of this bet is $1.15 at a $13.15 share price. That's a 8.75% return on the capital initially staked. However, I expect most of the capital should be returned within six months. The return is much higher on capital that will have to remain at stake over a longer period of time. 

The terms of the CVR

Milestones are as follows:

(I) $1.00 in cash, upon the fifth (5th) participant being administered with AK-OTOF in a Phase 1 or Phase 1/2 trial on or prior to Dec. 31, 2024

(II) $1.00 in cash, upon the fifth (5th) participant being administered with an Akouos gene therapy product for a second monogenic form of sensorineural hearing loss (excluding AK-OTOF and AK-antiVEGF) on or prior to Dec. 31, 2026;

and (III) $1.00 in cash, upon (A) the first (1st) participant being administered with an Akouos gene therapy product (excluding AK-antiVEGF) for a monogenic form of sensorineural hearing loss in a Phase 3 trial, or (B) receipt of FDA approval in the U.S. for such Akouos product, whichever occurs first, on or prior to Dec. 31, 2026, or its value will be reduced by approximately 4.2 cents per month until Dec. 1, 2028 (at which point the CVR will expire).

First Milestone appears very achievable

Interesting about this CVR is that the first milestone should be easily achieved and pays out $1. This $1 immediately recoups the premium to the deal price and quite a bit more. This trial has been greenlighted by the FDA. It is currently in "preparation" (according to the latest company presentation). From the wording of the press release, I gather at least two children should be enlisted that are 7 years old and/or 7 years old or older. 

Based on interactions with FDA during the 30-day IND review period, the Company expects the first two participants will be as young as seven years of age, and that subsequent participants will be as young as two years of age at the time of administration.

The Company plans to provide an update on clinical trial initiation activities for AK-OTOF later this year

AK-OTOF has an orphan drug designation and a rare pediatric disease designation. I understand the therapy likely has the best chance of working if administered earlier rather than later in life. 

Given both the early onset of serious manifestations, as well as the need for timely intervention due to anatomical considerations and developmental considerations, eligible participants for the clinical trial will be pediatric. Based on interactions with FDA during the 30-day IND review period, the Company expects the first two participants will be as young as seven years of age, and that subsequent participants will be as young as two years of age at the time of administration.

The Company plans to provide an update on clinical trial initiation activities for AK-OTOF later this year.

At an earlier date, the company had hopes of being able to enroll one-year-olds. It seems the FDA didn't agree to that ultimately. There's also a way to read this as if 2-year-old participants are ready to be enrolled because of the word "will". They didn't say something like "could be". They also refer to "participants" instead of "potential participants," although that may not mean anything. 

If it were a problem to sign up as many as five children in this trial before 2024, I think it is weird to use the word "will" unless you had one waiting in the wings. 

I'm inclined to believe either four children are waiting to get started or 2 children waiting to get started, and many more are expected. 

Either way, it should be easy enough to meet the hurdle rate of administering the therapy to five kids. The company has also communicated it would have an update on this trial in preparation before the end of the year. This could mean the start of the trial and raises the possibility the first $1 milestone could be wrapped up before the end of the year. 

This raises the question of why include this milestone. It indicates Lily must have some doubts. 

Another good thing is that the therapy needs to be administered to five kids before December 2024, but an FDA trial or the U.S aren't specifically called for. 

The third milestone seems speculative 

Then there is the third milestone that pays out $1 if AK-OTOF gets administered in a phase 3 trial before December 1, 2028 (expiry date for the whole CVR). From this $1 we need to subtract $0.042 per month past January 31st 2026. Its value declines linear past 2026. 

My guess, based on this white paper on trial success data, there is a 30% chance of hitting this milestone. Keep in mind that I'm not accounting for time value of money in my expected value calculations. Lily should manage 2028 imho but I could be wrong. 

Second milestone seems most speculative

The second milestone seems most speculative to me. I think the company has two pathways to hit this autosomal dominant hearing loss therapy and a GJB2 gene therapy. Currently, these programs are in a discovery and target selection phase. I don't have good data on how likely it is anything gets into at least one person enrolled in phase 1. My guestimate this is worth $0.10. As the companies have bothered to negotiate over it, there may be some insight on the sellers' part that leads them to believe this is worth a bit more. However, that's quite speculative on my part. 

The statistics I'm relying on to get to the above probabilities incl. I think my assessments are likely a bit conservative.

Catalyst

Tender offer wrapping up before end of 2022

(5th) participant being administered with AK-OTOF in a Phase 1 or Phase 1/2 trial

(5th) participant being administered with an Akouos gene therapy product for a second monogenic form of sensorineural hearing loss (excluding AK-OTOF and AK-antiVEGF)

Participant being administered with an Akouos gene therapy product (excluding AK-antiVEGF) for a monogenic form of sensorineural hearing loss in a Phase 3 trial