Description

Unfortunately this stock has gotten away from me as I have worked on my write-up - to that I appologize. The stock has been on a run the last few days and now reflects a price $24.55.  All numbers below work off a $21 stock price as I have not had time to update the figures as I scramble to complete a write up before further momentum and appreciation.

Ligand Pharmaceuticals (LGND)

*Data is calculated using Q4 2012 financials and a share price of $21.00 USD of 03/01/13

Investment Thesis

Ligand Pharmaceuticals (LGND) is a unique pharmaceutical business standing at the cusp of a major inflection point.  Underfollowed and under analyzed, the company is on the verge of dramatic acceleration in earnings that will allow an investor at current prices to receive its 70-product pipeline for free.  We believe Ligand offers a compelling long-term GARP (Growth At A Reasonable Price) investment for the following reasons:

• Ligand is on the verge of a major acceleration in earnings as it receives the royalty revenues from two recent blockbuster drugs: GlaxoSmithKline’s Promacta, and Onyx Pharmaceuticals, Kyprolis.  

• Ligand currently has seven royalty products, with the potential for 6 more in 3 years.  2013 has several upcoming catalysts that could provide positive tailwinds to their future earnings.

• Ligand’s vast pipeline offers a shot-on-goal model with a lottery ticket for upside given its current valuation.   Currently, 56 of Ligand’s 70 potential products are R&D funded by Ligand’s partners.

• Ligand operates as a distressed buyer in the biotechnology space.  They have proven to be disciplined acquirers of partnered products and remnant pipelines of underfunded biotechnology companies having received bad news.

• Ligand currently has over $750MM in gross tax assets / NOLs.  Management forecasts that the company will not pay more than 2% in taxes for the next 6-8 years.  

• Ligand’s business model allows for gross margins north of 90%.  As earnings accelerate, investors will be drawn to the quality of earnings and the dramatic impact that each dollar of incremental revenue has on the bottom line

• Ligand’s story is just beginning to become noticed by Wall Street having gone from one analyst in 2011, to just six in 2012.  Examination of analyst research indicates that several of them have not taken the time to properly understand the story.

Ligand is a unique biotechnology company that is best described as a royalty fund with a hedge fund arm.  Ligand’s current model was begun in 2007 with a “shots-on-goal” business model aimed at 1) Driving R&D to the earliest inflection point for partnering 2) Acquiring assets efficiently to further build the portfolio[1]  In doing so, Ligand has created a high-margin, low incremental cost business that a diverse avenue of potential drug approvals.

Ligand was founded in 1987 and operated as a traditional pharmaceutical company until 2006 when Third Point took control and fired management.   Ligand’s two main businesses concerning oncology and the drug Avinza were divested for $500M, resulting in a 34% dividend in 2007 and a share repurchase plan.  Ligand’s current business model is the manifestation of 2006’s installed board and Ligand’s current CEO, John Higgins.  At that time Ligand had exactly 9 partnered programs. Today it has over 70.

Secular Tailwinds

We will preface this write-up with the disclosure that we are not biotechnology experts.  We are generalists who hunt for opportunistic investments within the construct of secular themes.  We have spent much of the last two years following the biotechnology / life sciences arena given our belief that the sector is on the verge of a major shift in technology that will install it as the next great driver of America’s economy.  For those desiring greater detail we offer a brief hand out that can be found here: LifeSciences2.0

In 2010 the FDA approved just 21 drug approvals, well below the average of the prior two decades.  We believe this time will mark a major inflection point where as universal medicine began its shift to personalized medicine.   Historically, the biotechnology universe has seen an 8% success rate.  To many biotech’s, fail to achieve FDA approval has meant destruction to their company.   We believe that as technology improves and genome and DNA analysis enters the biotechnology sequencing and trial populations, the success rate will rise.  Drugs will become more personalized and accordingly the types of people targeted for efficacy will becomes more precise.

So what does this mean to Ligand? First, with a pipeline of 70 potential drugs, we believe it is reasonable to see an increase in pipeline approval rates by the time all products make it through the process. Whereas the historical 8% success rate might estimate 6 future drugs, efficiencies in the drug trial process might raise Ligand’s prospects to 6-10 future approvals coming from the pipeline.  Second, as new drugs are approved and become more personalized, the world will change for the better. We believe that this newfound and broad ‘innovation’ in the sector will be rewarded with market premiums across the sector and to companies offering high-depth pipelines.

Blockbuster Approvals

2012 was a large year for Ligand following the approval of two large drugs from which it is entitled to a partnered royalty: Onyx’s Kyprolis and the expanded approval of GSK’s Promcata for Hepatitis C.

Promacta is an oral thrombopoietin-receptor agonist owned by GSK.  The drug has been show to effectively increase platelet counts in people suffering from abnormally low counts.  Promacta is a powerful drug in that it targets and helps terribly sick individuals.  It is currently the only TRO agonist to reach the market.  In November 2012 Promacta was approved for the treatment of thrombocytopenia in patients with chronic hepatitis C, expanding Promacta’s role.  GSK currently estimates there are 4.2MM prevalent patients in the US, with 3.5% representing an unmet medical need in Promacta.  At a 150,000 potential patients worldwide, a capture of 100,000 could represent a $2B opportunity to GSK

GSK is now turning Promacta’s attention to oncology where Promacta would be used in offsetting the adverse effects of thrombocytopenia resulting from chemotherapy.  Currently in phase II, an NDA approval could be seen by 2017 and would represent another massive opportunity for GSK and Ligand.

Promacta offers Ligand royalty protection through 2024 and pays significant royalty rates:

Kyprolis was developed by Onyx Pharmaceuticals, and approved by the FDA in July of 2012 to treat patients with multiple myeloma who have received at least two prior treatments.  A review of ONYX’s most recent their recent conference call lends testimony to the potential of Kyprolis and the significant weight being thrown behind it. Onyx estimates that there are between 10,000 and 15,0000 patients in the US eligible each year for Kyprolis.  Onyx is currently conducting 3 registration-enabling Phase III trials that would establish Kyprolis as an earlier option in lines of myeloma therapy.

Ligand is tied to Kyprolis through the use of its Capistol solubility agent.  It is currently the most significant driver of Capistol’s value as analyst estimates project Kyprolis becoming a blockbuster drug with over $3.5B in annual sales. A vial of Kyprolis contains roughly 60mg of active ingredient and over 3000m of Capistol, making Capistol a very critical element to Kyprolis’ formulation. From a revenue standpoint Kyprolis holds the potential to generate 2-3x the revenue of Promacta, but at a lower tiered royalty:

Recently, analysts have worried about Kyprolis’ role following Celgene’s approval of Pomalyst.  However, several white paper surveys now indicate that the two treatments will work in collaboration and benefit to each other, rather than against each other. To quote an Onyx confernce call, “Over 70% of participating physicans who’ve used Kyprolis, report finding they will continue to use it”

 This view has recently been reflected by a rise in ONYX stock price following a slide into Celgene’s approval

Other Drivers

In addition to Kyprolis and Promacta, Ligand’s future earnings will be driven by three primary revenue sources: sales of captisol, license and milestones, and near-term drug approvals.  

1) Capistol is a solubility agent provided improved absorption and bioavailability when formulated with molecules comprised of suboptimal biopharmaceutical properties. The technology was acquired through Ligand’s purchase of CyDex pharmaceuticals in 2011 and has protection through 2029.  By providing a delivery platform for stability and solubility, Capistol provides an excellent partnership platform for Ligand to actively market itself to compounds seeking solubility solutions.  An article by the American Pharmaceutical Review gives credit to the interest of solving solubility solutions in the industry and their dramatic increase over the past 10 years.

Material sales of Capistol currently account for Ligand’s COGS on the income statement.  Hovione provides outsourced manufacture of the product and utilization currently stands at 20% of capacity.  Capistol material sales are projected to produce 60% gross margins for the next few years.

2) License and milestone payments represent 100% gross margin revenues to Ligand and will contribute to offering a blended gross margin north of 90%.  Ligand’s guidance currently forcasts between $3 and $5MM per year in L&M based on their existing deals.  This has already proven to be a conservative measure following recent news regarding a global licensing agreement between Ligand and Spectrum pharmaceuticals for development and commercialization of Melphalan, formerly a stage II oncology drug being self-funded by Ligand. Under the terms of the agreement Ligand is eligible to receive a licensing fee, up to $50MM in future milestones, as well as future royalties.  Following the announcement Ligand raised its 2013 guidance and EPS estimates by 35%.

3) Ligand currently has 6 potential products that could reach approval over the next three years:

• An undisclosed drug with Merck
• An undisclosed drug with Hospira
• IV clopidogrel with The Medicines Company
• IV Cabamazepine with Lundbeck
• Aprela with Pfizer
• IV Delafloxacin with Rib-X

Income Statement

Ligand’s business is built around a royalty revenue model.  Accordingly, with zero cost of goods on royalties, Ligand offers a high margin business that can flow profits to the bottom line.  Current management predicts that moving forward Ligand will achieve 90% gross margins.  The 10% COGS is a function of Ligand’s sale of Capistol, and should decrease as a % of revenue as Ligand moves into the future. 

Another attractive component of Ligand’s income statement is its relatively fixed expenses. As described, Ligand is basically a royalty fund operated by hedge fund arm consisting of small and lean staff.  Ligand’s total employee count totals 22 individuals, primarily made up of the executive office, administration, and business development (analysts).  To quote CFO John Sharp, “We don’t need to increase expenses to grow our revenue.”  Current SG&A is estmated to come in at $16MM in 2013 and increase no more than 5% a year for the foreseeable future. When we questioned management about their current workload capacity, they said that they currently are accepting applications for two more business development analysts but saw little need in further hiring to meet their goals and scale.

Due to its high gross margins and low and relatively fixed expenses, Ligand offers an attractive acquisition target to a larger company or private equity. A purchase would provide an acquirer with near immediate synergies as Ligand’s royalties are absorbed to the bottom line.

R&D

Ligand’s partnered portfolio currently represents 56 fully-funded partnerd products, with 25 various partners including GSK, Pfizer, Baxter, Merck, Onyx, Bristol Myers, and the Medicines Company.  On an annualized basis Ligand estimates that total partner funded research and development tops $150 million per year.

Internally the company spends around $10MM a year on 15 internal R&D programs.  Conversations with management have led me to project this expense to be a relatively fixed expense where they commit to this level of internal R&D but don’t intend to dramatically go beyond it.  The spending is therefore allocated to the highest and best use opportunities available to the company.

Capital Allocation

Looking into the future, Ligand will be recipient of an estimated $125MM or roughly a third of its market capitalization in cash over the next four years.  Management has indicated that this cash will have 3 primary uses.  First, cash will be used to pay off the remaining debt on Ligand’s balance sheet. Second, cash will be used to build Ligand’s war chest.   A review of recent conference calls places stress on managements desire to only make disciplined, smart, fully-funded acquisitions.  Management describes themselves as distressed or prudent investors, and are comfortable waiting if nothing attractive comes to fruition.   Third, management intends to return excess cash to shareholders via a dividend or buyback, assuming a reasonable acquisition(s) cannot be found.

NOLS

According to Ligand’s Q4 2012 conference call, the company estimates to have approximately three quarters of $1 billion dollars in gross tax assets (versus a market capitalization of $419MM).   Accordingly they believe that their tax rate for the next 6 to 8 years will be less than 2%.  Theses assets are made up of a handful of $45MM of restricted NOLs, $435MM of unrestricted NOLs, $140MM state NOLs, $90MM of future capitalized R&D NOLs, and $37.5 MM in tax credits which can go one-to-one against the company’s tax payments. With extraordinarily high gross margins and relatively fixed expenses, this tax benefit will equate to large EPS gains and cash flow as Promacta and Kyprolis come into their sales cycle.

Valuation

By our estimates, which were roughly reinforced by management, a discounting of the projected sales and subsequent royalties of Promacta and Kyprolis out to their patent expiration currently offers a share price above today’s price.  In buying today’s shares one is in effect purchasing Ligand’s entire pipeline for free. Therefore an investment at his presents a shareholder with attractive growth prospects and an opportunity to receive a lottery ticket to future upside surprise.  Given Ligand’s lean cost structure, any incremental upside surprise could provide a dramatic boost to earnings.

While we significantly discount our ability to accurately predict future earnings, the target market and non-cyclical nature for Kyprolis and Promacta offer an above average look into Ligand’s future earnings power.  Using the conservative estimates provided by 16 analysts covering Onyx and GSK, we have broken out the future earnings ability of Ligand through 2017.  A complete projection of Ligand’s income statement may be found in the appendix,

We believe Ligand offers an attractive GARP (Growth At Reasonable Price) opportunity. The concluding estimates listed above are void of any future drug approvals, or significant milestones.   Accordingly, current valuations offer an attractive rate of return relative to both the market and the company’s potential for upside surprise.  Our model is currently at the low end of analyst estimates with some estimates recognizing 2015E earnings of $2.85 / share (forward 2015E of 7.4x earnings).  Given the strength of Ligand’s earnings (high margin, low expense) and the relatively early uniqueness (and now success) of its business model, we believe Ligand will trade at a premium to the market.  Comparables to other high margin (90%) biotechnology companies come in at roughly 20x earnings.  Therefore we have projected estimated valuations at 17.5x earnings.  

Analyst Coverage

Ligand is currently covered by 6 sell-side analysts and has no representation from a major Wall Street firm. This representation is dramatically up over the past year, with only one analyst covering Ligand in 2011.  While six analysts may seem like a large increase over 2011, review of sell-side research indicates that few have taken the time to fully understand the story. Current research is littered with errors including models completely void of Ligand’s favorable NOL tax structure.  In addition, we have yet to come across one piece of research that if focused on the pipeline in relation to Ligand’s current valuation. Not one piece discusses the prospect of acquiring the pipeline for free following a valuation discount of future revenues. We believe that Ligand’s story is still in its infancy and the company’s limited float (20MM shares) will provide institutional support as more analysts begin coverage of the company.

Major Holders

The Biotech Value Fund (BVF) is Ligand’s largest shareholder with 3.58 million shares representing 18% of Ligand’s float.  Recent filings review that BVF has been buying as recently as December 2012 following the approval of Kyprolis.   For tax reasons Ligand currently has a shareholder rights plan in place through 2016, but has grandfathered BVF for exemption.  Of other interest is David Knott of Knott Partners Management who holds a board seat and retains a beneficial interest of 1.45 million shares.

Conclusion

Given the insight into Ligand’s foreseeable future, we believe an investment is Ligand is warranted due its prospects for growth. While biotechnology will continue to be a challenging industry, Ligand’s high margin business will provide its shareholders with ample free cash flow as they wait for the potential benefit of Ligand’s massive pipeline.

Catalyst