Description

Overview QLT Inc. (QLTI) is an intriguing small-cap special situation story with 3 main facets: (1) it's currently trading near its net cash per share of $2.09; (2) a tender offer outstanding through January 15, 2009 may allow the company to repurchase 27-30% of its stock at a value-accretive price; and (3) is completing an asset divestiture program whose final sale should bring in over $2 per share. Three less important sources of value include: (1) an already marketed drug, Visudyne, undergoing combination therapy trials to revitalize its market share; (2) three drugs in early-stage clinical trials and (3) the potential (admittedly unlikely) for a win on appeal of a patent litigation case that could reverse a $100MM+ patent infringement judgment. I lack the expertise to evaluate the future potential of QLTI's drugs and the outcome of patent litigation, so I will use a simple valuation methodology: I value the cash and cash flow generative drugs and treat the investigative studies underway as worthless despite charging the company 3 years worth of costs to develop them. I still generate a rock-bottom conservative intrinsic value of $4.08 per share, 74% above the current price. QLT Inc. is a Canadian biotechnology company focused on developing drugs utilizing unique delivery technologies (manufacturing is contracted out and marketing is partnered). The stock trades in Toronto under QLT but the majority of volume is on NASDAQ under QLTI and the company reports in U.S. GAAP. QLTI currently has two commercialized products: Visudyne treats macular degeneration (the leading cause of blindness in adults over 55) and Eligard treats advanced prostate cancer. A combination of declining Visudyne sales, needing to post an appeal bond on the patent infringement judgment and making a $42mm acquisition left QLTI with $127MM of cash at year end 2007. Facing redemption of a $172.5MM puttable convertible note in September 2008, QLTI needed to raise $50MM and so it embarked on an asset divestiture program that is now largely complete. Despite having averted a cash crunch, received some positive clinical data and signaling its willingness to downsize, refocus and return excess cash to shareholders, QLTI's stock has continued to decline throughout 2008. Visudyne Visudyne treats the "wet" form of age-related macular degeneration (AMD), a degenerative disease of the retina that is the leading cause of blindness in people over 55. It was QLTI’s first commercialized drug, launched in 2000 with blockbuster potential. Visudyne is protected by several patents; the key patents expire in 2015. It is marketed by Novartis and operating profits are shared 50/50; after QLTI receives certain cost reimbursements from Novartis, QLTI's net profit share of Visudyne sales (effectively EBIT margin) works out to about 20%. Competing drugs Macugen and Lucentis have since taken significant market share; Lucentis especially has superior results to standalone Visudyne. However, in early clinical studies, combinations of Visudyne with either drug show better results than any monotherapy. QLTI believes that if Visudyne combo trials are successful and lead to a label change, revenues will increase from the current $150MM to $200-250MM annually (assumes combo therapy achieves 30-40% market share vs. its current 15% share in off-label combination usage). QLTI is conducting a phase II study (RADICAL) of Visudyne plus Lucentis. Top-line results are expected in 1H09. Interim RADICAL results were announced December 16th and were positive. Novartis is also conducting two studies on combo therapy with data expected in 2009. After plummeting for several years, sales of Visudyne finally stabilized in 2008 at a $150MM run-rate with QLTI's run-rate EBIT (at 20%) of $30MM. If combo therapy studies are successful and sales increase to the low end of QLTI's range ($200MM), the incremental annual EBIT would be $6.5MM. Eligard Eligard treats the symptoms of advanced prostate cancer by reducing production of testosterone, which shrinks or slows the growth of prostate cancer tumors. Eligard uses QLTI's proprietary Atrigel delivery technology to deliver sustained release generic Lupron for up to six months. Atrigel allows for the injection of a drug within a bio-degradeable polymer casing that degrades over time resulting in controlled release. QLTI receives a net royalty of 21% from Sanfoi-Aventis on Eligard sales; after costs of production, QLTI's effective EBIT margin on Eligard is about 15%. Eligard is the first six-month depot product in this mature market; it offers increased convenience & has been taking market share in a slow-growth market. Eligard is patent protected through 2018 and its sales are annualizing at $220MM. Current rapid growth of ~20% will peter out as the new 6-month depot finishes taking market share in Europe. QLTI's run-rate EBIT (at 15%) is $33MM. Punctal plugs In Oct 2007, QLTI acquired a punctal plug drug delivery technology from privately held ForSight Labs for $42 million. Punctal plugs can be inserted into the eye's tear ducts and are capable of providing sustained release of a drug into the eye. The first drug tested will be latanoprost, which treats glaucoma and ocular hypertension. QLTI believes the punctal plugs can provide 90 days of treatment. Latanoprost is the most prescribed drug for glaucoma with U.S. sales of $1.7 billion. Its major problem is that 50% of patients are non-compliant with their eyedrops within 6 months; punctal plugs could address this problem. In a small 90-day proof of concept study completed in May 2008 that enrolled five patients, two lost the plugs while the other 3 reported positive results (reduction of intraocular pressure). QLT initiated a phase II study of punctal plugs for glaucoma called "CORE". Its interim results were announced in Oct. 2008; showing acceptable efficacy, although 23 of 61 patients discontinued due to loss of efficacy of loss of punctal plugs. QLTI will initiate a higher dosage in another Phase II study. They are also working on improving available plug designs to improve tolerance and reduce plug loss rates. QLTI management is very positive on the technology and believes that if it is successful in glaucoma, the punctal plugs could be utilized for several other therapies Other matters QLTI has two other experimental drugs in proof-of-concept / phase I studies. Going forward, QLTI’s annualized operating costs (SG&A and R&D, but excluding COGS counted in EBIT above) will be about $40MM. Management has promised not to make acquisitions with its cash. CAPEX is minimal as manufacturing is largely outsourced. QLTI’s current financials are difficult to interpret for several reasons: (1) Eligard is classified as a discontinued operation and disclosure is scarce; (2) Visudyne royalties don’t cover overhead so QLTI reports quarterly operating losses; and (3) the asset sales distort quarterly results. Litigation QLTI was sued by the Massachusetts Eye and Ear Infirmary (MEEI) in federal court in 2000 for patent infringement on Visudyne. QLTI succeeded in getting the case thrown out in 2002, but MEEI appealed and won reinstatement in 2005. In November 2006, MEEI won the case. In July 2007 MEEI was awarded a 3% royalty on Visudyne sales, back royalties plus accrued interest and legal fees. The payment for back royalties and legal fees was $108MM. QLTI decided to appeal the judgment and was required to post an appeal bond equal to 110% of the judgment to do so ($118.8MM). The appeal bond, as well as royalties as they accrue and the interest on the judgment are all included in restricted cash on QLTI's balance sheet. I have excluded restricted cash from my valuation, assuming QLTI loses the appeal and the cash is paid out to MEEI. Oral arguments were heard in Sept. 2008 and a ruling is expected at any time in 1H09. Liquidity crunch / asset sales In January 2008, QLTI initiated a restructuring plan. Key points were major expense reductions (cut 45% of workforce) and four asset sales: (1) Eligard; (2) its recently approved acne drug Aczone; (3) the Atrigel drug delivery technology for uses outside Eligard; and (4) its Vancouver headquarters. In the first three quarters of 2008, QLTI sold its HQ for C$65.5MM of which C$12MM was a seller financing (a two-year 6.5% interest only second mortgage) and C$53.5MM was paid in cash, sold Aczone to Allergan for $150MM and licensed Atrigel to Reckitt Benckiser for $25MM. These asset sales allowed QLTI to redeem its $172.5MM of converts in September and left it with net cash of $156MM. QLTI is currently in active discussions to divest Eligard. QLTI has largely offset capital gains from the sales with its capital loss carryforwards. On the 3Q08 conference call, QLTI disclosed that QLT USA (the subsidiary holding Eligard) has a $70MM net operating loss that can be used to either shelter future operating income by an acquirer or shelter capital gains tax on the sale, depending on the form of the transaction. I assume that QLTI will either sell Eligard in a tax-free transaction or keep it rather than accept a low bid or permit substantial tax leakage. Tender offer QLTI announced a $50MM tender offer on 12/01/08 to return cash to shareholders. The stock had been trading at 52-week lows of $1.80 - $2.00 for the two prior weeks. It's a modified dutch auction to repurchase $50MM of stock at a price within a range of $2.20 and $2.50 per share. After receiving bids, QLTI will select the lowest price at which it can repurchase $50MM of stock and all tendering shareholders will receive that price (subject to pro-ration if necessary). So size will vary between 20MM and 22.7MM shares if the tender is fully subscribed. The tender offer commenced on December 4th and expires on January 15, 2009. It's uncertain the tender offer will be successful since the stock has recently rallied to $2.35 and only a total of 18.8MM shares have traded since the offer was announced. Anyone who tenders (besides any small-scale arbs who bought in recently) will take a loss so it's unclear how many shares will be tendered. So I value QLTI below both with and without a successful tender offer. Valuation My first step in valuing QLTI is updating the 9/30/08 cash balance of $155.9MM. QLTI's 4Q08 EBIT (from Eligard + Visudyne) at current run rates should be $12.7MM. 4Q overhead (SG&A & R&D) is estimated at $11MM. QLTI also expects to make a $16.5MM cash tax payment owed on the asset sales. These items will result in a 4Q cash burn of $14.8MM, leading to an estimated year-end cash balance of $141MM (also note QLTI doesn’t have any debt). I value Visudyne using a simple DCF through patent expiry in 2015 assuming no growth of current EBIT of $30MM, a 35% tax rate (even though cash flow from Visudyne is less than overhead and QLTI isn't paying taxes) and a 10% discount rate. My DCF value of Visudyne is $99.6MM. I value Eligard with a similar DCF but assume 5% annual EBIT growth from the current $33MM through patent expiry in 2018. My DCF value for Eligard is $175.7MM. The Vancouver two-year mortgage note is for US$9.9MM; discounting this back two years at 10% yields a present value of $8.2MM. Adding up the cash, Visudyne, Eligard and the mortgage yields $424.6MM. Next I assume QLTI spends current annualized overhead of $40MM for three years as it completes its current clinical trials, with no positive results. So I subtract $120MM cash burn from my asset value, leading to intrinsic value of $304.6MM. I realize this is a bit unorthodox, but three years will be enough time to complete current drug development projects and I simply don’t see QLTI spending $40MM every year into the future with no positive results. Based on 74.62MM shares out, the intrinsic value is $4.08 per share, 74% above the current price. This is my rock-bottom conservative valuation. If the tender offer is successful at the maximum price of $2.50, QLTI will spend $50MM to retire 20MM shares. The post-tender intrinsic value rises to $4.66, 98% above the current price. Adding in more speculative sources of value, the Visudyne combo therapy upside of $6.5MM annually boosts its DCF value by $27MM, and I value the punctal plugs platform at $50MM ($42MM purchase price plus some value appreciation from positive trials). These increase per-share intrinsic value to $5.11 pre-tender and $6.07 post-tender. Additional (though even more speculative) value could come from early stage pipeline drugs and QLTI's appeal being successful, which could return $120MM cash to the company.

Catalyst

Completion of accretive tender offer.
Tax-efficient sale of Eligard near intrinsic value of $175MM.
Additional cash return to shareholders.
Positive clinical trial results on Visudyne combination therapy and/or the punctal plugs.
Potential ruling in the company’s favor in the MEEI patent litigation.