Description

Summary
Ligand Pharmaceuticals is an event-driven special situation which has a good chance of increasing over 40% in the near term and could more than double (or triple) in the next year or two. The stock trades for $7 and my estimate of intrinsic value is between $10 and $20. This situation is very ripe for a 13D activist because the board is unstaggered, the majority of large shareholders hate management, an annual meeting is on the horizon and break-up/private market asset values are more than 2x the current stock price.

Company History
Ligand Pharmaceuticals has traded between $5 and $20 over the past 12 years and is trading well below its 1992 IPO price of $11. The stock hit a high of $24 in April 2004. Then the trouble started. The company missed earnings estimates in May 5, 2004. EPS came in at (0.18) versus analyst estimates of (0.06) and the stock fell from $21 to $18. Then the auditors left and the company missed its earnings guidance on August 3, 2004 resulting in the stock dropping from $13 to $8. Earlier this year Targretin, a drug in the R&D pipeline, did not meet its goals in Phase 3 trials and the stock fell from $8 to $5. Since then, the company said they were not going to file their 10k on time and that they would restate results for 2002 and 2003 as well as 2004.

Valuation
The company has 73.9 million shares outstanding plus $155 million of 6% converts due in 2007 that have a conversion price of $6.17. These bonds convert to 25.1 million shares resulting in a total of 99.1 million shares outstanding. The majority of options are out of the money with an avg exercise price around $11.

This is the classic case of a bad business masking a good business. Also, we have lots of hidden assets with a number of royalty arrangements, a costly R&D pipeline and NOLs. As a result, I use a sum of the parts approach to value the company.

1. Ligand owns Avinza, a branded, patent protected drug which generates $140 million in 04 sales (estimate of “sell through sales”) and $170 million in 2005 sales. Avinza is a once-a-day morphine pill used for chronic and cancer related pain and it has roughly a 5% market share in the sustained release opioid market. The drug gets positive feedback from physicians and competes with Oxycontin, Duragesic and Kadian and is a “best in class” drug. Sales reps we have talked to who compete with Avinza and have sold Avinza think the drug could generate $400-500 million in sales if it were managed by a more sophisticated and marketing-oriented pharma company. The contribution margin on Avinza is around 30-35% which is after paying 30% of sales to a co-promote partner (the co-promote partner is Organon, a division of Akzo Nobel). A strategic acquirer would likely already have a sales staff that could detail Avinza. There are numerous buyers of pain drugs including Cephalon, Endo and J&J. There is a chance Ligand gets out of the Organon co-promotion relationship because Organon is not meeting contractually agreed upon sales targets. Ex-Organon, Avinza has a much higher contribution margin (60% pretax) to an acquirer. Ex-Organon, Avinza generates $85 million of pretax income on 140 million of sales. Based on these assumptions, I think Avinza could be worth $450 million at the low end assuming they can’t get out of the Organon relationship and $1 billion at the high end.
2. Ligand owns two cancer products, Ontak and Targretin which generated $44 million in sales in 2003 and are on track to do $60-70 million in 2004 sales. There are numerous public and private companies looking to own cancer drugs and cancer related R&D. It is difficult to nail down an exact value on this asset but these drugs and the R&D associated with them could be worth 4-5x 2004 sales or $240 – 350 million.
3. Ligand owns a 3% sales royalty on 3 SERMs (selective estrogen receptor modulators – ie. women’s health care drugs). The 3 SERMs include Pfizer’s Oporia, an osteoporosis drug set to launch this year with analyst estimates of 2008-2010 annual sales ranging from $500 to $1 billion. Wyeth has 2 SERMs in phase 3 planned to launch in 2006 and 2007. I think there’s a chance we have $1.5-3 billion in sales in 4-5 years on which Ligand receives at 3% royalty. There are a handful of buyers for royalty streams including Royalty Pharma and Paul Capital, among others. Over the years, Ligand has sold a portion of the royalties to Royalty Pharma. I estimate that the SERMS are worth $200 at the low end to $400 million at the high end.
4. The company has more than ten royalty arrangements with Glaxo, Wyeth, Lilly and TAP on numerous drugs in IND, Phase I and Phase II status. Various partners are spending hundred of millions of dollars of R&D to make drugs from these molecules. Ligand receives a 10% royalty on the corporate partnered drugs if they ever come to market and, importantly, Ligand does not spend money to develop these drugs. The company has also spent over $600 million in the past 11 years on other R&D (some of which was for Targretin and Ontak). The company’s website has information about the partnerships and the R&D. Altogether I value the royalties and the other R&D at $50-250 million.
5. The company reported $110 million of cash at 12/31/04. To get a current number, you need to deduct the $33 million the company spent to buy down a royalty from Lilly and add $4.5 million of milestone payments received this year. The cash burn reported in Q3 2004 was $7 million per quarter. I assume the company burned $15 million for the first 6 months of the year, an assumption I think is conservative. I assume cash is around $65 million today, though I would not be surprised if it were $70 or $80.

Valuation Summary:
Avinza $450-1,000
Ontak/Targretin $240-300
SERM royalties $200-400
Other royalties/R&D $50-250
Net cash $65
Value $1005-2065
Value per share $10 to $20
Current price $7

Low end values for Avinza, Ontak & Targretin support the current stock price. For “free” we get a basket of high volatility call options. We have a call option on an R&D pipeline of indeterminate but substantial value, a call option on sales increases for Avinza, and call options on a pipeline of royalties which may start contributing to the P&L this year, and call options for a takeover as there is strategic value to the assets and the pipeline to various big and mid-sized pharmaceutical companies.

Inside ownership/stock sales
As of the last proxy statement, the CEO owns about 400,000 shares directly and has 676,000 options. Management & the board directly own 560,000 shares. There are 6.2 million options outstanding with an average strike price of $11.27. The lowest tranche of options is 1.8MM options exercisable from $1.82 to $9.25 with an average exercise price of $7.12.

The CEO has never sold shares and has a reputation of being honest but somewhat incompetent and tired. The Chief Scientist has a terrific reputation in the industry. Board members and the CFO have exercised options below $10 and repeatedly sold small amounts of stock between $18.50 and $21 from March to July 2004. The CEO, CFO and John Groom, a board member, exercised options at $9 and $5.50 in late 2004 and May 2005 and have yet to sell their shares.

Restatements
The company has not filed its 2004 10k with the SEC yet and is restating 2002-2004 financials to recognize revenues on a sell through basis rather than on a sell in basis. IMS data shows that Avinza has 5% market share and that prescriptions have been increasing about 15% in 2005 YTD over 2004. The IMS data shows Avinza “sell thru” sales of $96 million for the first 3 quarters of 2004 in comparison the company’s reported Avinza “sell in” sales of $74 million. I think the restatement may show an upward revision to 2004 sales figures. Moreover, I think the risk of fraud is very small given the IMS data and the fact that the company has never made a profit and management has never sold substantial amounts of stock.

Catalysts
Catalysts include a restatement of financials and the elimination of delisting risk, expected some time this summer. (Nasdaq has given the company until the July 29 before the stock is delisted.) I would guess that some people on the sell-side will upgrade the stock once the financials are reported, assuming they’re clean which I think is a high probability bet. Additional catalysts include a curtailment of R&D expenditures and a turn to profitability in late 2005. Another catalyst is the 2005 - 2006 launch of Oporia by Pfizer on which Ligand has a 3% royalty (currently ignored by most sell-side analysts). If all these events come to fruition, I think we will have a stock price between $10-15.

Activist Wanted
I am not a 13d filer but I know that over 50% of the shares are in the hands of shareholders who are disgusted. Call some of the shareholders and you'll get a sense of things -- everyone is hoping an activist shows up but they are all biotech investors, not value investors or activists. The board is not staggered and everyone is up for reelection in 2005. There are numerous potential buyers for the company (or parts of it) including J&J, Cephalon, Endo Pharmaceuticals, Pfizer, and others. Talk to some sell side analysts and the business development people at the aforementioned companies and you are likely to get an indication that this company is worth much more dead than alive. (The CEO will also tell you this, only much more defensively and in more palatable terms.) One sell side analyst said CEPH was rumored to be interested in the company at $15 a couple years ago. This was confirmed by someone we know close to CEPH. With an angry shareholder base, a tired management team, a low price relative to intrinsic value, and numerous strategic buyers who can justify paying two to three times the current price, this situation is very ripe for an activist. Neither management nor the board wants to be aggravated by a mud-slinging proxy fight especially because their record is indefensible. All an activist would have to do is file a 13D and growl and I think the activist would have so much support from shareholders that management would just sell the company. If the company is put up for sale I think we have a very good chance at getting the high end of our valuation target ($15-$20 per share).

Catalyst

Restatement of financials, elimination of delisting risk, sell-side upgrades, profitability in late 2005, launch of Oporia by Pfizer in 05-06, filing by 13D activist