MGTA - Magenta Therapeutics: An Interesting Liquidation Play But Beware Of The Risk-Reward

2023-07-31 01:50:08 ET

Summary

• Magenta Therapeutics is exploring a potential merger due to failed developments of its former products.
• The deal has to be approved by shareholders in a vote, which may not approve the transaction and force the company to liquidate its assets, allowing investors to capture an arbitrage.
• The current risk/reward ratio is not appealing, and an entry level below $0.75 per share would make the arbitrage opportunity more reasonable.

The idea of this opportunity is not coming directly from us, but since there is no coverage of this interesting setup here in SA we wanted to share our opinion on Magenta Therapeutics ( MGTA ). We noticed a blog article from Clark Street Value that highlighted the liquidation play around MGTA which is the result of a series of events that took place in 2023.

We believe that this is an interesting setup, but investors should be aware of the apparent disconnect between risk and reward that is the result of the recent share price increase. We will provide a range of prices at which MGTA shares might be attractive, using our own assumptions and considerations.

An overview: what happened and why is liquidation an option

The company was exploring assets in trials for the treatment of relapsed/refractory acute myeloid leukemia and myelodysplastic syndrome ((MDS)). However, in January 2023 they voluntarily stopped the phase 1 and 2 trials because some adverse reactions took place, and there was also a Suspected Unexpected Serious Adverse Reaction (SUSAR). This tanked the stock as the market immediately assigned virtually zero value to their assets, and only considered the net cash position of MGTA.

At this point, the company decided to issue a release in February that stated that they were "exploring strategic alternatives" and that these options were meant to "maximize shareholders' value". The market positively interpreted this as a chance for liquidation as the company was trading deeply below net cash in February (around 60%). However, MGTA decided to go for a merge instead of liquidating, and in May 2023 they announced a deal with Dianthus Therapeutics , an all-stock deal. This caused the shares to drop around 20% as the merger would actually cause tremendous dilution for existing MGTA shareholders while benefiting more the owners of privately-owned Dianthus.

The deal of course requires shareholder approval, and this is exactly where the opportunity gets shaped. In the meeting that will be called, there is a majority needed to pass the resolutions to allow MGTA and Dianthus to merge, and if there is no 50%+1 that vote FOR, the company will be likely forced to liquidate.

The assets: cash and net liquidation value

After an initial overview of why the opportunity is in place, let's see what shareholders would get if this actually gets liquidated. Management was actually so kind to include a liquidation analysis in the merger agreement (page 161) they presented for Dianthus.

It states the following:

Key assumptions underlying the Liquidation Analysis included (i) that the entire distribution of Magenta's net cash would be made in either May 2023 or June 2023, (ii) that Magenta would have approximately $65.2 million and $63.9 million of net cash as of May 2023 and June 2023, respectively.

Of course, this analysis represented a possible transaction in May or June, and so we have to adjust this figure for a more likely date, which could be September or October in our opinion. This is because they will likely vote on the merger by the end of Q3, and this means having a clear understanding if there is liquidation by September 30, 2023. At that point, it should not take long and the cash burn would be very much limited.

This is what our own liquidation analysis suggests. We wanted to remain as conservative as possible. We used the monthly cash burn rate of $1.3 million which is taken from Magenta's own analysis, computed as the difference between cash position between May and June 2023. We then subtract roughly $5.5 million of cash liabilities and get to around 92 cents per share. However, given the cash burn we expect that if liquidation were to close in November rather than October, the final value for shareholders would drop to 90 cents. This is a small difference, but if computed for an uncertain amount of months caused by possible delays it may create some issues.

We also consider that MGTA shareholders will receive a Contingent Value Right ((CVR)) at the closing of the transaction. Per the merger agreement:

Magenta stockholders will be issued contingent value rights representing the right to receive certain payments from proceeds received by the combined company, if any, related to pre-transaction legacy assets.

This is however of little value because the pre-transaction legacy assets represent the drugs of which Magenta stopped the development because of safety concerns. We believe that this CVR is simply a formality to sweeten the deal and increase the likelihood of approval at the general meeting.

The risks and the reward: assessing the downside and risks

It is clear now why some sort of discount exists, even though it closed a bit in the last weeks: the matter will be decided by a vote. And right now we only know a few things that we can use to assess the downside: which percentage of the share capital supports the vote, and what would be the pro-forma financials of the combined entity.

As per disclosure in the merger agreement (page 4) , around 6.9% support the merger. This is clearly a very limited support base and it means that the funds that control significant stakes did not disclose support for the deal.

This is a list of the most important holders of MGTA's shares. Tang Capital did not support the company, and neither did Lion Point, as they own more than 6.9%. This is definitely encouraging and improves the chances of a liquidation.

However we are also interested in understanding the downside of a possible merger going through, and what this would mean for current shareholders. To assess this risk we employ a peculiar technique: take the pro-forma net cash, apply the historical discount that MGTA traded at with respect to cash, adjust for MGTA shareholders' pro-forma ownership, and get an end valuation post-transaction for the current shareholders.

This is our own analysis. Using the data from the merger agreement for the pro-forma figures, and making one main assumption: a valuation that trades at 45% discount to cash. This is because historically speaking, MGTA traded well below the $100-140 million that, on average, it had in its bank account. Considering that Dianthus is a similar asset at a similar stage, that would thus require similar dilution for its development, we conclude that this is a reasonable assumption.

To cut to the chase: is this an opportunity to take?

We provided three main points to look at:

1. The upside case is a liquidation that sets the value per share at around 90-92 cents per share to remain quite conservative.

2. The downside case is the merger going through and a stock that trades at a significant discount at around 40 cents.

3. There is a vote in the middle, which makes this an almost binary situation as we do not know the intention of many funds (not publicly disclosed).

We think that the current share price needs to be monitored for an entry-level because right now, at $0.80, the risk/reward ratio is simply not appealing. As we are not sure about the intentions of many key holders of MGTA shares (some hedge funds), we cannot have clear visibility on the vote's outcome. This justifies treating the setup as a binary-like opportunity, and thus the chances of this getting liquidated, or merging are about the same - even though it can be argued that only 7% of the share capital openly supporting the deal is a positive sign if favor of higher liquidation chances.

Thus we think that any level below $0.75 per share would be far more attractive and make the arbitrage opportunity more reasonable in terms of annualized returns. This is always compared to a downside risk at around 40 cents (roughly a 50% drop from here).

Conclusions

Magenta Therapeutics is a failed biotech company that intends to use its remaining cash to merge with another biotech, instead of liquidating. The deal needs however shareholder approval and the current outcome of such a vote is uncertain, even though it looks more likely to fail than to succeed. We identified a range of fair values based on such an outcome, with the stock being worth around $0.92 per share in case of a liquidation, but subject to a downside risk to $0.39 per share in the case the deal goes through. Thus we recommend waiting for a more reasonable entry-level below $0.75 to make the arbitrage opportunity worth your while (and your risk).

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