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Market Musings - December 16, 2018

[NOTE: This blog entry was drafted on December 16, 2018 but not published until February 18, 2019. Due to procrastination, we never acted on the long thesis, missing out on ~44% appreciation (to date).]

We continue our blog series: Market Musings, Volume 2, Edition 24, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Merrimack Pharmaceuticals--Break Up Play?".

Merrimack Pharmaceuticals (MACK) (SEC filings here), a cancer drug developer, has been a dreadful dog of a stock over the past few years, falling 97% from its April 2015 top, mainly due to drug trial and other commercial failures (note that MACK effected a 1-for-10 reverse split in August 2017):

The CEO was fired back in October 2016...

...following which most of the company's commercial assets were sold to Ipsen S.A. (IPSEY) for $1.04 billion, resulting in the company downsizing its employee base by 80% and its drug pipeline to just three molecules (MM-121, MM-141 and MM-310)...

...a new CEO was appointed in early 2017...

...following which $140 million of the Ipsen asset sale proceeds were returned to shareholders as a special dividend ($1.06/share)...

As a result of the foregoing, as of mid-2017 the company had a refocused pipeline, new leadership and the following balance sheet:

Normally, one would presume that the bleeding would slow significantly following these actions, but no, the stock has continued to plummet throughout 2018:

The most recent debacle occurred in late June, when the company announced yet another drug trial failure...

...thereby reducing its pipeline to just two drugs, MM-121 and MM-310, as follows:

  • MM-121 (seribantumab), a monoclonal antibody targeting the HER3 (ErbB3) receptor, is being tested in combination with standard-of-care treatment in two randomized Phase 2 studies: SHERLOC, in patients with non-small cell lung cancer, and SHERBOC in patients with metastatic breast cancer. Both studies are enrolling patients with high tumor expression of heregulin, the signal for the HER3 receptor. Top-line results from the SHERLOC study are expected in 2H 2018.

  • MM-310, an antibody-directed nanotherapeutic targeting the EphA2 receptor, is currently being tested in a Phase 1 study in solid tumors, with safety data and the maximum tolerated dose expected in 2H 2018.

Enter An Activist

Fortunately, one of the positive aspects of a 97% stock price decline is that following such a drawdown a company is much more susceptible to shareholder pressure via activist investors. Such is the case with MACK, as in early November a Form 13D was filed JFL Capital Management (SECs here), reporting ownership of 941,502 MACK shares (about 7.1% of the company's outstanding stock). Judging by its SEC filings, JFL Capital appears to be a small (and relatively new) hedge fund, founded by Dr. Joseph Lawler:

The 13D states that "[JFL Capital] have engaged, and intend to continue to engage, in communications with [MACK]’s management team and Board of Directors (the “Board”) regarding means to enhance stockholder value." Interestingly, shortly after this 13D filing, MACK's board and management suddenly "got religion" and decided to drastically reduce company spending, as well as pursue a strategic alternatives process,as they stated currently with announcing Q3 2018 financial results:

Is a Break-Up In Store for MACK?

We think that shareholder value could be maximized by breaking MACK up. The company's assets now reside in two distinct buckets, which could be separated: First, MM-310, the remaining pipeline asset which MACK intends to develop itself (note that the company also has several preclinical pipeline assets), and second, approximately $450 million in potential future milestone payments from Ipsen related to the ONIVYDE asset sale, as follows:

Both of the larger milestones (totaling $375 million) depend on the success of drug trials currently in Phase 2 at Ipsen (see here), so it will likely be several years before either come up for FDA approval. Nevertheless, this asset could be monetized immediately for MACK shareholders by spinning it off as a contingent value right, or CVR. CVRs are routinely used in pharma M&A transactions as a way to obtain value today for drugs that won't be approved for years (if ever).

With MACK's market capitalization now sitting at an anemic $54.4MM (based on 13.34MM shares outstanding, as of the most recent Form 10-Q filing on November 1, 2018) and an enterprise value of a minuscule $24.4MM ($54.4MM less $30MM of net cash as of 9/30/18), the company is clearly valued by the market at far less than the sum of its parts. Assuming just a 10% likelihood of obtaining the full Ipsen milestone payments yields $45MM in expected value, almost twice the current enterprise value. Moreover, the company stated just over a month ago in its Q3 earnings release that its current cash position (specifically excluding future milestone payments, but including further possible cost saving measures) could allow it to continue operations without additional equity dilution until "at least the second half of 2022". Thus we think that the milestone payments plus the option value of MI-310 should easily be worth at least $100MM, or $7.50/share (84% above the recent market price), with much higher possible upside should any of the milestones actually be hit (if all were fulfilled, MACK would receive almost $34/share in payments from Ipsen).

The Agency Problem

Of course, all of this should make eminent logical sense to the MACK shareholder, but not necessarily to an empire-building management team who don't actually have to pay for any of their stock on the open market (there have been zero insider purchases of MACK stock since Q1 of 2016). For the latter, shareholder dilution is usually a wholly acceptable price to pay to guarantee the large salaries and bonuses that come with running a big(ger) pharma company (and the dilution incurred can easily be offset--for insiders, not outside shareholders--through additional insider option and RSU grants at lower and lower prices). When in doubt, bigger is almost always better for these folks. Thus, it is vitally important to have an activist involved (as MACK currently enjoys) holding management's feet to the fire, thus preventing unnecessary destruction of shareholder value by faithless agents.

This is especially true given that most of the MACK directors have very little skin in the game (and thus little reason to block management overreach). Per the 2018 Proxy Statement, as of April 2018 the non-executive members of the board of directors owned just 441K shares of MACK stock outright (or 3.3% of the outstanding shares), the vast majority of which are owned by MACK "lifer director" (on the board since 2004, chairman since 2005) Gary Crocker:

While Crocker has a relatively impressive track record of insider purchases, the other five non-executive directors decidedly do not. The fact that the company spent nearly $1 million on directors' compensation in 2017 (or 1.8% of the current market cap) is not encouraging.

Potential Roadblocks to Realizing Intrinsic Value

1. Management / insiders - as discussed above;

2. Tax leakage - One important consideration with respect to separating assets is tax leakage that MACK might incur upon the receipt of future milestone payments. As of December 31, 2017, MACK had federal net operating loss carryforwards of $138.1 million, which begin to expire in 2034, and state net operating loss carryforwards of $223.4 million, which begin to expire in 2028 (see page 30 of the company's Q3 2018 10-Q filing). It would be vital to insure that these NOLs continue to be available to offset tax gains attributable to milestone payments if these were spun off to shareholders via a CVR.

3. Debt facility with Hercules Capital - In Q3 2018, MACK borrowed $15 million under a new debt facility, described in the Q3 2017 10-Q as follows:

On July 2, 2018, the Company entered into a Loan and Security Agreement (the “Loan Agreement”) by and among the Company, certain subsidiaries of the Company from time to time party thereto, the several banks and other financial institutions or entities from time to time parties thereto (collectively referred to as “Lender”) and Hercules Capital, Inc., in its capacity as administrative agent and collateral agent for itself and Lender (in such capacity, “Agent”) pursuant to which a term loan of up to an aggregate principal amount of $25.0 million is available to the Company. The Loan Agreement provides for an initial term loan advance of $15.0 million, which closed on July 2, 2018, and, at the Company’s option, two additional term loan advances of $5.0 million each upon the occurrence of certain funding conditions prior to December 31, 2018 and December 31, 2019, respectively.

A copy of the Hercules loan and security agreement can be found here. Section 7.8 of the loan agreement states that "[e]xcept for Permitted Transfers, Permitted Investments and Permitted Liens, [MACK] shall not, and shall not allow any Subsidiary to, voluntarily or involuntarily transfer, sell, lease, license, lend or in any other manner convey any equitable, beneficial or legal interest in any material portion of its assets (including cash)." Section 7.7 of the loan agreement also prevents the payment of dividends to shareholders. Thus, this facility would need to be paid off (or an appropriate waiver received) prior to any distribution to shareholders of the Ipsen milestone payment rights via a CVR or of the cash received pursuant thereto via a dividend.


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