Description

Opportunity Description

MEI Pharma (MEIP) offers one of the most asymmetrical risk / return profiles I ever came across. At current trading levels (stock at $1.54), its market cap ($57m) is below its cash balance ($58.9m as at 30-Sep-16), which, in conjunction to being debt-free, implies a negative Enterprise Value. The company has an asset base which I believe is potentially worth over $500m today, which the market seems to be disregarding even though recent announcements have substantially de-risked it. Whereas the full value of the asset base will only materialize in a few years, there are substantial near-term catalysts that should lift the stock over the next 12 months. MEIP offers over 10x potential return with very limited downside, given it trades below cash.

Granted, there is substantial risk in this investment (discussed further below), but at the current valuation you are getting very disproportionately paid for this risk. I believe the stock is heavily disregarded by the investor community as it’s been a fallen angel since one of their legacy tests failed to produce the desired results. It’s equity research coverage is minimal, and both factors combined create a unique buying opportunity.

Important to mention that, as of today, MEIP is a low liquidity stock – historically has traded around 370k shares daily on an LTM basis – and thus not suitable for all investors. That said, substantial volume spikes near announcements are quite visible. I believe the liquidity will increase substantially over time as the stock grows into a mid-cap, from its current microcap status.

Company / Business Description

MEIP is an oncology company, focused on the development of drugs for cancer treatment. The company was founded in 2000 and is HQ’ed in San Diego, US. It has a pipeline of 3 drugs in different stages of development: i) Pracinostat, ii) ME-344, and iii) ME-401. I will ignore any potential value from ME-344 and ME-401 for the rest of the article as they are earlier stage drugs and not really material to the main thesis.

Pracinostat is an orally available histone deacetylase (HDAC) inhibitor that is being developed for advanced hematologic diseases such as acute myeloid leukemia (AML), which stems from unsuccessful treatment of MDS (Myelodysplastic syndrome, aka pre-leukemia). AML, a far more severe condition than MDS, leaves untreated patients with just a few months of life expectancy. The American Cancer Society estimates about 20,830 new cases of AML per year in the US, with an average age of about 67 years. Treatment options for AML remain virtually unchanged for nearly 40 years. The typical treatment to AML is intensive chemotherapy which can be followed by a bone marrow transplant or softer chemotherapy for months. There are a number of reasons where this treatment won’t be possible, which could stem from the patient’s age (60+), weakened immune system, or as a side effect of other AML treatments.

In these cases, Azacitidine (marketed as Vidaza, owned by Celgene) is a possible alternative treatment for adults with AML who can't have a stem cell transplant. Azacitidine is a chemotherapy medication that's given by injection under the skin. It interferes with the growth of cancer cells and destroys them, and also helps bone marrow to produce normal blood cells. Azacitidine is the reference alternative treatment currently on the market with a median overall survival of 10.4months, and a 1-year survival rate of 46.5%. For a high-risk population, the figures are 6.4 months and 31%, respectively.

Pracinostat has been tested in more than 300 patients in multiple Phase I and Phase II clinical trials and found to be generally well tolerated with manageable side effects often associated with drugs of this class.

MEIP announced on August 1st, 2016 the results from Pracinostat Phase II trial. Quoting from their press release: “the U.S. Food and Drug Administration (FDA) has granted Breakthrough Therapy Designation for the investigational drug Pracinostat in combination with azacitidine for the treatment of patients with newly diagnosed acute myeloid leukemia (AML) who are ≥75 years of age or unfit for intensive chemotherapy. In addition, agreement has been reached with the FDA on the Company's proposed Phase III study design. The Breakthrough Therapy Designation is supported by data from a Phase II study of Pracinostat plus azacitidine in elderly patients with newly diagnosed AML, not candidates for induction chemotherapy, which showed a median overall survival of 19.1 months and a complete response (CR) rate of 42% (21 of 50 patients). These data compare favorably to a Phase III study of azacitidine (AZA-AML-0011), which showed a median overall survival of 10.4 months with azacitidine alone and a CR rate of 19.5% in a similar patient population. The combination of Pracinostat and azacitidine was generally well tolerated, with no unexpected toxicities.”

Also, “According to the FDA, Breakthrough Therapy Designation is intended to expedite the development and review of drugs for serious or life-threatening conditions. A Breakthrough Therapy Designation has all the benefits of the fast track program together with more intensive guidance on an efficient drug development program and an organizational commitment involving senior managers.”

Just a week later (August 8th), MEIP announced a deal with Helsinn Group for the development and commercialization of Pracinostat. Helsinn is a privately owned cancer supportive care pharmaceutical group with an extensive portfolio of marketed products and a broad development pipeline.

The terms of the agreement can be summarized were as follows:

1. MEIP will receive $20m in near term cash payments ($15m already received, $5m upon dosing the first patient of upcoming Phase 3 trial, expected 2017Q1)

2. MEIP will be eligible to receive up to $440 million in potential development, regulatory and sales-based milestone payments

3. MEIP will keep “tiered royalties” in “selected territories” (further disclosed on the management call that this starts “in the mid teens” in the US)

4. Helsinn will make a $5m equity investment in MEIP (later disclosed that it priced at $1.91/share)

Valuation Thoughts

The stock reacted positively to both announcements and went up to above $2.00 from $1.40 pre-announcements, but now is trading at around $1.50 again. I believe this valuation is nonsensical for a number of reasons:

1. Pracinostat Phase II results indicate patients are surviving ~2x longer than the incumbent drug on the market and has been granted Breakthrough Therapy Designation by the FDA

2. Pracinostat Phase III will be 100% funded by Helsinn (precise cost estimate never disclosed, but equity analysts put in the ~$40m range)

3. With the current cash balance, the company has substantial runway to develop the remainder of its drug pipeline and cover cash G&A for a number of years

4. The market is valuing at zero the $440m milestone payments from the Helsinn deal, part of which will be received even if the drug is not successfully commercialized

5. The market is valuing at zero any royalty revenue from the commercialization of Pracinostat

6. The market is valuing at zero the remaining drug pipeline, which has also shown promising (albeit earlier stage) results

Based on a very, very conservative SOTP approach, I believe the stock is worth at least $7.30/share today:

My key assumptions are as follows:

1. Cash balance: latest reported ($58.9m as of 30-Sep-2016, 17Q1)

2. Milestone Payments: not many details disclosed as of yet, but I assume very little is received during 2017, with the bulk of the $440m payments being received in 2018-20; I then discount these payments at 20% discount rate ($285m PV), and further haircut this by 50% to account for the risk that not all of the payments are received (i.e. Phase 3 goes wrong, enrolment takes much longer than expected, etc.)

3. US Royalty Stream: see below illustrative revenue calculation; I am PV’ing the royalty stream at 20% discount rate ($271m PV). I then apply a risk factor of 25% (75% haircut) to adjust for risk of achieving commercialization.

On an unrisked basis (excluding the haircuts), the stock is worth north of $16.70/share today (with cash flows still being discounted at a 20% unlevered discount rate). And this still doesn’t consider the international potential of Pracinostat, nor the remaining drug pipeline. If the drug is successfully commercialized (by 2020), the WACC of this business should go down materially, and I expect the stock to trade north of $30/share by then.

Pracinostat Royalty Stream – Illustrative Revenue Calculation

This is purely illustrative and only intends to give a sense of how much revenue could come from this product. The key assumptions are as follows:

1. Market: I only consider the US, which is the only market where the royalty level has been partially disclosed

2. Market size: 15,000 patients a year

3. I assume commerciality is achieved in 2020 and maintained for 10 years

4. Market share: I assume the product takes the majority of the market (capped at 80%, achieved in year 5 of commercialization) given its clear outperformance vs. the current incumbent (MEIP presentations refer to market research done with 87 leading practitioners, 92% of which mentioned they would switch to a new drug if overall survival was up to 30% superior to the current one, with only 8% stating they’d need to see a lager improvement; with Pracinostat results showing almost 100% improvement, it’s reasonable to expect it will dominate the market)

5. Pricing: $60k per full treatment cycle, in line with Vidaza (pre-generic times)

6. Royalty rate: as disclosed, conservatively capped at 20% (should go higher than that)

Based on all of the above, the royalty could potentially generate ~$150m per annum in steadystate (once target market share is achieved). I think this is conservative in terms of market share achieved and timing required to achieve it.

Expected Trading Levels

Over the coming 12-24 months the stock will trade as a function of the available cash balance plus some risked valuation of the milestone payments and royalty stream. If news flow and disclosures indicate Phase 3 will be very successful, the stock will eventually trade much higher than currently; if disclosure indicates otherwise, the stock will trade closer to its cash balance plus any expected near term milestone payments. I illustrate below the potential trading ranges depending on what risk factor the market attributes to each of the cash flow streams (all figures are PV’ed at 20% WACC). I think there is decent chance that the stock trades at a multiple of current levels even if the market does not ascribe any value to the royalty stream, as MEIP will approach the receipt of (part of) the $440m milestone payments.

Key Risks

1. “Single Asset Risk”: MEIP is effectively a single asset company today, with all risks inherent to a company as such; mitigants to this include i) the remaining pipeline, ii) the fact that a substantial part of the value attributable to Pracinostat is not entirely driven by commercialization (Milestone Payments for enrolment and Phase 3 trial progress)

2. Pracinostat Phase 3: historically, success rates for Phase 3 oncology trials have been in the ~35% area, but this figure doesn’t consider for the FDA involvement, which increases the likelihood substantially given such promising Phase 2 results; the main risk to the investment is that Phase 2 success can’t be replicated in Phase 3

3. Cash Burn: may be higher than estimated, leaving the company without runway to pursue its other pipeline drugs; however, the SG&A only cash burn is only roughly ~$5m p.a.

4. Helsinn credit risk: not fully clear as it’s a private company, but the data I was able to gather suggest they spend ~$150m+ in R&D yearly, and generate ~$75m+ of EBITDA, which suggests they should be able to comfortably accommodate the ~$40m required for Pracinostat’s Phase 3 trial and the interim milestone payments; in case of default, I can only assume MEIP would have struck a deal where all the drug rights revert to the company and all historical costs incurred by Helsinn are sunk; the problem then becomes finding another funder, but I don’t expect this to be a material hurdle given the drug’s perceived potential

Catalyst

1. Pracinostat Phase 3 enrolment program updates (during CY2017)

2. Further disclosure around Milestone Payments from Helsinn

3. Announcements regarding the remaining drug pipeline (several expected in late 2016 and during 2017), which could transform MEIP into a “2 horse company”

4. Roadshow, conferences and awards (management highly aligned with shareholders through the equity compensation programme)