Description

Summary

Ocera Therapeutics (“OCRX”) is an interesting event-driven situation where one can create a cheap option to make 1.3-4.0x one’s money on the contingent value right (“CVR”) in the next 12-24 months if OCRX’s acquirer Mallinckrodt (“MNK”) goes ahead with the phase III trials of OCRX’s lead program OCR-002. Based on existing data from the Phase II trial, I think that at least going into the Phase III is highly likely despite the poorly received Phase II results because it’s pretty clear from the detailed data that higher dosage strongly correlates with higher efficacy.

For a cash consideration of $1.52, MNK is buying OCRX on the cheap for $29mn excluding net cash balances, in the process wiping out all out-of-the-money warrants except for the 2015 warrants granted to management who stand to make $6.3mn if the sales milestones are met. On top of the cash consideration, MNK would only need to pay $25mn (equivalent to $0.93 per share) to existing shareholders via the CVR shareholders are getting for a drug that has the potential to become the first line therapeutic in acute care settings, which is a $1.1-1.4bn market in the US alone. Given the Phase II data is not nearly as terrible as widely perceived and there is potential to improve efficacy by increasing dosage levels, I think it is very likely that MNK will go ahead with the Phase III trials and thus, the CVR represents a pretty interesting option around current share price levels.

Situation Overview

OCRX announced on November 2, 2017, that they will be acquired by MNK for a consideration of (i) $1.52 per share and (ii) one CVR that will pay up to $2.58 per share subject to hitting certain development and sales milestones. If one buys one OCRX share today, one will receive $1.52 upon acquisition and the CVR, which will pay out (i) $10mn equivalent to $0.37 per share upon enrolment of the first patient in a Phase III trial of the intravenous formulation, (ii) 15mn equivalent to $0.56 per share upon enrolment of the first patient in a Phase III trial of an oral formulation, and (iii) $50mn equivalent to $1.65 per share upon reaching cumulative product sales of $500mn, which has to occur before December 31, 2029. I don’t attribute much value to the sales milestone because it is unclear whether OCR-002 will receive FDA approval at all.

Below, I’ve outlined the “unlevered” as well as “levered” returns in the form of money multiples, for various purchase prices of OCRX shares to show that even if one only received the first milestone payment, one can make a 1.05-1.08x if one considers the entire acquisition price, or 1.61x-1.36x if one only considers the implied price on is paying for the CVR. The difference between the “unlevered” and “levered” returns is that for the levered returns, I’m only considering the “stub” price at which one is creating the CVR at assuming that the acquisition will go ahead as is and one receives $1.52 in cash for its stock. Just as a reminder that if one buys the shares at $1.77 and for whatever reason, not a single milestone is met, the MoM on a levered basis is 0.00x, i.e. a percentage loss of 100%.

Drug Development Overview

OCR-002 is an ammonia scavenger to treat hepatic encephalopathy (“HE”), essentially mental confusion or worse that’s likely to be caused by alleviated ammonia levels in the bloodstream. Acute or chronic liver disease can cause alleviated ammonia levels that can temporarily and permanently cause personality changes and eventually lead to death. Ammonia scavengers like OCR-002 are supposed to bind or clear ammonia from the bloodstream.

OCR-002 has just completed its Phase II study with positive results in most areas other than its primary efficacy endpoint, time to improvement of HE symptoms versus a placebo (difference of 17 hours, p=0.129), or the secondary endpoint of median time-to-response in HE symptoms (difference of 15 hours, p=0.361) whilst meeting other endpoints of reduction of plasma ammonia levels (p=0.017), and time to achieve normal ammonia levels (p=0.028). Failing the primary and some of the secondary endpoints is certainly disappointing, but when looking at the detailed results, this can be attributed to (i) poor study design and (ii) low dosages used. With regards to the former, the removal of 30 patients that had normal or missing baseline ammonia would’ve allowed OCRX meet its primary endpoint.

Patients receiving the highest doses of 20g / day had more clinical responders (70% at n=27 vs. 55% placebo, overall was 64% for p=0.149), and 63% (n=27) achieving CR at 3 hours with 55%, 48%, and 45% achieving CR within 3 hours for the 15g, 10g, and placebo respectively, which would suggest that one is likely to be able to see significantly improved efficacy from generally higher dosages.

Based on alternative measures, e.g. median change in ammonia from baseline, it’s quite clear that increasing dosage correlates with higher efficacy.

It’s not possible to deduct statistical significance due to small sample sizing from the above, so the dosage study that MNK intends to undertake before initiating Phase III trials is sensible and necessary. For what it’s worth, based on safety data, there appears to be plenty of room to increase dosage without reaching intolerable toxicity levels, or even just doing statistically worse than the placebo.

Key Risks

Three key risks relate to (i) closing of the acquisition, (ii) hitting the milestones, (iii) credit risk of MNK. Pharma acquisitions usually fail because of failure to reach an amenable agreement to management as opposed to failure toc lear regulatory / anti-trust hurdles, so in this instance; furthermore there is no financing risk for MNK for an acquisition of this size. Whilst the last and biggest milestone is a bit hard to underwrite, I think there is very limited risk to the first if not the second milestone, which will be sufficient to give current investors an attractive return. Gastroenterological drugs normally have a 55.9% approval rate from Phase III to approval (as per BioMedTracker), so one does have some chance of a big gift in a few years’ time. Last but not least, one has to bear in mind that MNK has been a highly acquisitive company and generally quite highly levered, so one has to be mindful of its longer term credit profile.

Catalyst

Completion of acquisition by MNK, completion of Phase II dosage study, initiation of Phase III studies