Description

OABI – OmniAb Writeup – nobluff VIC 11.30.22

This pitch is a timely submission following a spinout – I do not believe the opportunity will exist for long to acquire shares near $3. At a $2.90 share price, I believe OmniAb presents 320% upside in my base case. 

OmniAb (OABI) is a recent spinout of Ligand Pharmaceuticals (LGND) that merged with a SPAC sponsored by Avista Capital Partners, an $8b healthcare-focused private equity firm. While I believe OmniAb is a compelling company with durable future cash flows, I am sharing my thesis now given the timely nature of the post-spin dynamics. This is a technical, biopharma company. I will provide a high-level overview but would encourage anyone interested to take a deeper look at the company’s materials and scientific papers related to the antibody-based therapeutics market.

Overview of OmniAb Business

In 2016,  Ligand saw an opportunity to expand into the antibody drug development industry. Ligand made six acquisitions from 2016-2020 that expanded OmniAb’s services and capabilities. The first acquisition was a company called OMT (Open Monoclonal Technologies) that developed the world’s first transgenic rat that could produce fully human antibodies. In the other acquisitions and internal R&D, OmniAb acquired or developed capabilities with chicken antibodies (exclusive to OmniAb), bispecific rats and chickens (exclusive), cow-derived antibodies (exclusive), and mice. Generally speaking, OmniAb takes these animals, injects them with a specific antigen designed to produce human antibodies within the animal, removes the antibodies produced, screens them, and greenlights them for evaluation by the pharma clients.

OmniAb charges pharmaceutical companies, from large pharma to smaller startups, fees to access the OmniAb platform, which grants them access to the repertoire of antibodies OmniAb’s technology produces. Once an antibody has been screened and selected for preclinical trials, OmniAb is embedded within the potential success of that therapeutic. If the drug progresses to the clinic, OmniAb receives milestone payments as the drugs enter Phase I, Phase II, Phase III, and hit regulatory approval for marketing. Some contracts also have milestones for patent filings and other events, but this varies. If a drug gets FDA, EMA, or another regulatory body’s approval for a respective geography, OmniAb receives royalties, except in a few cases, on the drug sales. Royalty rates most commonly range from 3%-5%. In summary, OmniAb earns revenue from access fees, milestone payments, and royalties. It also earns additional services revenue from performing end-to-end CRO-style work for some clients who want OmniAb to perform molecule development, screening, and testing.

The royalty streams are long-term arrangements in that they are for the longer of ten years following the first commercial sale or the longest-dated patent expiration including an OmniAb antibody. When pharma clients file patents along the life of clinical development, the OmniAb antibody is a named portion of the intellectual property that client is seeking to protect. This extends OmniAb’s rights to future payments. I expect most royalties to range from the minimum ten-year arrangement to twenty years on average.

OmniAb has the only rats and chickens available to the market. Mice are a more competitive segment, with companies like Regeneron, AbCellera, and others producing transgenic mice antibodies. OmniAb also does cow-derived and bispecific antibodies and is the only major player in those categories, as well.  OmniAb has patent protections on the exclusive parts of its business as well as the mice – but mice can be found at other providers. Therefore, a large part of OmniAb’s competitive advantage comes from its proprietary offerings outside of mice. For reasons I won’t detail in this pitch, there are pharmacological benefits of running drug trials using non-mice antibodies due to the genetic differences and evolutionary distances from humans that other animal mediums provide.

Industry Overview

Antibody-based therapeutics have been around 4+ decades, but the FDA and EMA have approved the lion’s share of drugs in the last decade as pharmaceutical companies have prioritized them. Just over 110 approved drugs exist in the antibody market across the US and EU.

The average approved antibody drug did $1.7b in annual sales in 2021, well above other drug class averages. The median figure was $1.3b. Given this, pharma companies see high ROIs on drug trial investments upon approval. To be fair, these prices will come down over time – not every drug will do $1b in sales. Most will do between $600mm and $900mm on our estimates, with outliers on the tails. However, it is worth noting that the cost of drug trials given the failure rates is so high that a drug must meet a minimum projected threshold of $300mm global annual sales to justify the investment in most cases.

Antibody drugs also have higher probabilities of success rates in the clinic, with a 12% average success rate vs 8% for small molecule modalities from the start of Phase I to marketing. This is largely due to the high specificity, low delivery dispersion, lesser side effects, and other factors versus small molecule drugs.

In 2021, antibody-based therapeutics sold $215b in global sales. By 2030, experts project this to grow to $356b. This is based on the increased number of new programs pharma companies are initiating and the probabilities of successful approval and marketing expected following the 10–14-year timeline from start to finish. Antibodies are the fastest-growing area of large molecule (biologics) drug development and should continue to grow well into the future as more successful programs yield results for both patients and pharma companies.

The SPAC Merger and Post-Spin Setup

Starting 18 months ago, Ligand began preparing to spinout OmniAb to allow OmniAb to pursue an independent growth track with a dedicated management team and a fresh balance sheet. Ligand was later approached by Avista Capital Partners who wanted to diligence OmniAb as a SPAC merger candidate. Avista has a long history in healthcare, and in biopharma specifically. The Ligand board saw an opportunity to infuse OmniAb with additional capital from Avista and gain a long-term equity owner alongside Ligand’s remaining ownership of OmniAb from Ligand shareholders. The deal valued OmniAb at $850mm pre-money at a $10 SPAC share price and netted the company with ~$96mm in fresh cash after netting out spinout related expenses.

Upon closure of the deal, Ligand owners retained 83.5% ownership, Avista gained 14.8%, and non-Avista SPAC owners owned 1.7%. This is on the basic share count of 98.5mm shares, excluding the earnout shares split between Ligand and Avista that would add another 16.3mm shares. The earnout shares vest 50% at $12.50 and 50% at $15.00. Given the shares are below $3.00, we have a great distance until the shares vest. There are also employee options (priced at $10 in most cases) and warrants (struck at $11.50) that would further dilute the share count by 33.3mm shares. Please note that the company is using the share count of 114.8mm, which includes the earnout shares but excludes the RSUs/PSUs/warrants.

With that groundwork laid, let’s look at what happened post-spin. Upon closure of the deal in mid-October, the stock traded down to about $7 from non-Avista SPAC shareholders selling on no volume. On November 1, the shares were distributed to Ligand shareholders. Within a few days, the shares traded down to $1.91 – a massive move. This could mean two things: either the Ligand shareholders who were not Ligand insiders thought OmniAb was not worth owning and were willing to exit at any price or these shareholders were constrained by investment mandates under which they could not own OmniAb due to its size, lack of profitability, industry focus, or another characteristic. While it is reasonable to assume some Ligand holders did not find OmniAb to be of sufficient quality or valuation, I believe the structural selling element is the main reason the shares trade where they do. John Higgins, the Ligand CEO and Chairman of OmniAb, said as much in the recent Ligand quarterly call. Most of the institutional holders of Ligand could not own the spin. Looking at the volume, about 35mm shares traded in the four trading days following the Ligand distribution. I estimate that 40mm-45mm of the shares in the Ligand distribution belonged, or belong, to forced sellers. Therefore, I believe the majority of these shares have traded, but there may still be 10mm-15mm needing to clear given some of the volume seen in those days would not be from the Ligand owners. Regardless of the accuracy of these estimates, I believe this dynamic placed a big weight on the share price and provides a near-term opportunity.

Further, sell side firms are in the process of picking up coverage. On 11/28/22, Stifel initiated with a $12 PT. SVB followed suit on 11/29/22 with a $6 PT. I expect other firms, likely the banks that supported OmniAb in the spin process, are soon to follow. With biotech stocks, most sell side price targets look outlandish – and most are. But there is a bit more predictability on this business’ future cash flows than other companies. I think OmniAb will garner more attention from investors with time, but while it’s in post-spin purgatory, I think this setup is interesting on a near-term (3-month) basis. Beyond that, I also believe the company has sufficient cash to reach longer-term targets and could mature into a multi-year stock to own.

Not Your Typical Biotech Bet

Many biotech pitches are binary with massive returns if you’re right and massive downside if you’re wrong. The nuance here is that OmniAb already has 3 approved drugs, 22 in the clinic, 12 in preclinical, and 245 in discovery. Using data provided by scientific papers and the company’s materials, you can apply a probability distribution on the success rates and the corresponding years it would take to reach approval on the existing pipeline. Unless the FDA, EMA, and other regulatory bodies force antibody drug development to cease, there is a near guarantee that OmniAb produces one to two more approved drugs within the next four years, with 20+ gaining approval in the 2030s. I understand that such long-dated figures are subject to scrutiny, but using basic math and historical precedent on drug approval rates it is a defensible model – and one less bullish than the company’s internal projections.

The stock market is a discounting machine. However, in tough times like we find ourselves today, investors are less likely to stretch their time horizons; but you do not have to rely on out years’ royalty cash flows to price out a reasonable valuation on this business. The medium-term milestone payments, access fees, and services (CRO-type) revenue will be enough to generate FCF before royalties come into play.

Therefore, I argue that this is not a binary outcome. I believe the bear case assumptions on this business would merit a share price nearly double where it trades today (assuming no terminal value on the business after 2040 and sanity checked by a conservative FCF multiple on 2024 estimates), and the base case would result in a HSD share price. The structural selling has presented the market with an opportunity to acquire shares at a steep discount to intrinsic value. And as I will explain a bit later, this business also has extremely high takeout value by a strategic acquirer, adding a margin of safety into the share price over time.

While I believe all of this is true, I admit that a small cap biotech that is a recent spinout is likely to have a volatile first few months of trading. Further, this stock is thinly traded with ~$2.5mm ADV. This places limitations on sizing the position, but I believe the upside merits the illiquidity risk.

Valuation and Price Target

OmniAb is a capital efficient business. Cash operational expenses are relatively low, and the ~$96mm in cash should provide sufficient runway to see this business through to cash flow maturity. The bulk of OmniAb’s future earnings will come from royalty payments on approved drugs. But this will take 4-5 years to begin working through the financials. In the medium term, OmniAb’s growth will stem from milestone payments, boosted by the steadier access fee and services revenue. OmniAb can still generate profits without royalties, but the opportunity is compelling largely on the basis of future royalty streams.

Using a DCF, while imperfect, is the best way to analyze a business with long-dated cash flows. In the current market environment, these types of businesses, particularly biotech ones, are out of favor. I do not expect this sentiment to shift on the industry at large, but I believe a self-funded, asset light player with large future expected royalty streams is a more reasonable bet than many other unprofitable businesses today.

It is hard to predict the next three years of a business, much less the next 20 years. However, given the existing pipeline of programs, the associated probabilities of drug success through the development timeline, and the company-checked payout levels on both milestones and royalties, I believe I have reasonable certainty to apply a DCF out to 2040. For reference, the company has provided a cash flow projections model out to 2045, against which I am much below their estimates. I am also more aggressive on operational expenses, tax rates, capital expenditures, and more – not unreasonably so but more aggressive than management’s current expectations.

At a $2.90 share price, the TEV of the business is $333mm (using the fully diluted share count). The market cap is $429mm, with net cash of $96mm. If you opt to use the basic share count that is at play before shares surpass $10, the TEV is $156mm. I will use the higher share count to be conservative.

The mechanics of the model are relatively simple. I take the existing pipeline of drugs and each one’s respective maturities in development, run a waterfall against the probabilities of success to be promoted to the next step in development, recognize milestones and royalties accordingly, and then run the revenues through the operating model, accounting for the growth in spending required to meet the scaled demands of the business. Using a 12% cost of capital to reflect the long-dated nature of the model as well as the assumed high costs to borrow for a company of this nature alongside a -5% terminal growth rate, I arrive at a share price of $9.29. This target is built off of a fully diluted share count of 148mm shares (too conservative given the options, earnout shares, and warrants would not vest until the shares were north of $10). However, I leave room for future dilution on stock-based compensation, acquisitions, etc.

I use a negative terminal growth rate here largely to be conservative in the event that OmniAb were to prove unable to maintain an annual pipeline of new drug program adds and to account for the expiration of patents that impact royalties.

The key point here, however, is that the present value of the cash flows from 2022-2040 is worth $940mm in my estimates, which would be assuming NO terminal value. If you used a fully diluted share count of 148mm, which would be steep, the value would be $5.74/share, nearly a double from here. If you apply a terminal value and use a fully diluted count, that gets you to the $9.29 share price. I expect the shares to close the valuation gap quickly, pulling forward the already high IRRs. This is partly due to the mechanics of the structural selling abating combined with broader market awareness of the business as more firms pick up coverage. Therefore, I believe this is both timely and attractive on a risk adjusted basis.

To further sanity check my model, I believe the shares trade at a FCF yield of 7.8% in 2024 and 10.2% in 2025. This should provide near-term support for the stock without relying on far out year cash flows. A business like this should trade at less than a 5% yield when compared to peers like AbCellera (ABCL). Using 2024E FCF at a 5% yield, you would earn a $6.42 share price using the 116mm shares outstanding that would be relevant at the time. (It would be higher using only the basic count that would be at play).

Regarding timing and potential IRRs, I believe it would take no more than three years to realize my PT of $9.29, resulting in a three-year IRR of 47%.

Risks to Thesis

The primary risks are:

• Patent Challenges: OmniAb’s rat offering has been challenged in European patent courts, but OmniAb won the case. This should further strengthen its position. This does not mean that future litigation will not arise, and other areas like the chicken may come under pressure. A loss of a patent case would allow for stronger competition, but it is still unlikely to upend OmniAb’s business given the technical complexity around developing thousands of specific types of antibodies using the animal methods. 
• Additional Cash Raises: The company has stated that they believe they have sufficient cash to propel the business into sustainable free cash flow territory. The burn rate on operational expenses is not expected to place the balance sheet at risk of needing to do a dilutive equity offering. Should this change, it would obviously impact the share price and returns expectations.
• Disruptive Technologies and Competition: Given the patent barriers and technical complexity, I do not foresee a competitor taking share from the rat-based, chicken-based, or other OmniAb exclusive mediums. However, in a space as fast-paced and dynamic as antibody biopharma, there is always a risk that a competitor with a newer technology could create trouble. To my knowledge, there are no viable threats to organically derived, transgenic antibody production.
• Negative Shifts in the Antibody Drug Market: Thus far, regulation has been positive for antibody-based therapeutics. If that sentiment were to shift in the US or Europe, it would impact pharma companies’ willingness to invest in this modality. I do not see this as a large risk given the history of successful drugs and the large opportunity set for antibody treatments, but it is worth noting.

Additional Considerations

OmniAb is likely to be acquired within the next 3 years.  This business would fit well into strategics like Charles River Labs, LabCorp/Covance, AbCellera, or Regeneron, but it would also be a compelling private equity asset. The business needs minimal to no incremental capital to reach its maturity. It has a robust pipeline of drugs in the clinic and many more working their way through discovery and preclinical. Given the royalty streams expected, this business stands to generate massive cash flows in a capex light and asset light business model. A smart acquirer would be able to diligence the pipeline of drugs, assess the probabilities of success and corresponding annual drug sales, and take this business private to enjoy the future cash flows and proprietary antibody offerings it has.

The CEO, however, has been engaged on this company since its origination within Ligand and wants to prove himself as public company manager. This is not a bad thing, but I do believe it means he and the board will reject bids that they feel are not fully representational of their high expectations, especially within the first couple of years post-spin. Further, there is a small (sub $50mm) tax indemnification that an acquirer may have to pay Ligand if a deal is struck within 24 months of the spin. However, the structure of the tax-free spinout has limitations on what is charged in taxes to an acquirer. Either way, I do not believe this would deter bids from being offered. I do though believe the CEO and board want at least two years to get the business running well as a public company before seeking an exit.

Insiders also own shares. Matt Foehr (CEO) owns 1.9mm shares. Ligand CEO and OmniAb Chairman, John Higgins, owns 3.9mm shares. Avista has board representation and owns 17.1mm shares. Insiders will earn a greater portion of the outstanding shares upon the vesting of earnout shares and options/warrants. Upon the structural selling following the spin on 11/02/22, Matt Foehr invested $280k in the open market acquiring shares at an average price of $2.76. On 11/28/22, the CFO invested $28k – while not huge, a positive signpost. Matt also owns nearly $12mm in Ligand shares, and I hope he sells LGND for OABI to further show investors his faith in the buying opportunity.

Disclaimer

I (we) own shares in OmniAb (OABI). Nothing noted here is financial advice, and any prospective investor in the company should perform their own due diligence and not rely on information presented here. Further, biotech/biopharma stocks are inherently risky and volatile, which could result in the total loss of principal.

Catalyst

The main catalyst is the near-term relief of the structural Ligand shareholders selling the spin. I expect this to abate within a month, and it may be cleared up before that.

Additionally, increased sell side coverage will highlight the business to investors who otherwise have not paid attention to the spin or decided the technical complexity of the business would be more easily discerned alongside a detailed initiation report.

Additionally, the company will periodically share updates on their partners’ drugs’ progress through the clinic. If my estimates are correct, at least one big pharma partner will announce drug progress in the next three months, naming OmniAb, which will allow OmniAb to share more detail on its successful platform.

Lastly, the strategic nature of this business is such that an attempted acquisition is likely to occur within the next 12-24 months depending on the progress of OmniAb’s drug pipeline.