MACK - Merrimack Still Has Significant Arbitrage Potential

Summary

• In December 2022, MACK got positive clinical results for its Phase III clinical trial of Onivyde in first line pancreatic cancer.
• A $225m milestone from Ipsen will be triggered on approval, which corresponds to about $16.75 per basic share.
• After adjusting for NOLs, tax interest, and net cash, the valuation is $13.97 a share, or a 25% premium to current prices.
• We see this as an arbitrage opportunity with very low risk. We remain long MACK.

Merrimack Pharmaceuticals ( MACK ) is an operation that is little more than a holding company for certain rights to the drug Onivyde. This cancer drug was acquired by Ipsen in 2017, and the deal carried a series of milestone payments associated with future milestones. MACK management has stated that these milestones will be delivered to investors as special dividends. The current value of MACK is entirely tied up in the value of these payments as follows :

• $225.0 million upon approval by the FDA of ONIVYDE for the first-line treatment of metastatic adenocarcinoma of the pancreas, subject to certain conditions;
• $150.0 million upon approval by the FDA of ONIVYDE for the treatment of small cell lung cancer after failure of first-line chemotherapy; and
• $75.0 million upon approval by the FDA of ONIVYDE for an additional indication unrelated to those described above.

We reported in a previous Seeking Alpha article that we were long MACK. We entered the position before the results from the Phase III clinical trial of Onivyde for first line pancreatic cancer, and those results were positive, causing the stock to gap up over 200%. We are very happy with these results and we hope that the article also generated returns for our readers.

However, we believe that there remains value in MACK prior to delivery of the milestone. After accounting for tax factors, we believe that there is approximately $13.19 in residual value from the catalyst that will be delivered to shareholders as a dividend. This presents an arbitrage opportunity with some very low risk upside.

This trade should be complete with the approval decision of Onivyde for first line pancreatic cancer, approximately one year after Ipsen submits the application. We are currently expecting a submission sometime in H1 2023, for a H1 2024 FDA decision.

Background

We already covered much of the background in our previous article, but shortly Onivyde is a liposomal reformulation of the well established chemotherapy drug irinotecan. Prior to the most recent approval, the product was approved for pancreatic cancer in the second line, and the goal was to expand the market to first line therapy. We were long the data readout because of readthroughs from earlier studies in the second line, as well as a history of the use of irinotecan for this indication.

The product was studied in this setting in the n=770 patient Phase III NAPOLI-III study. It was tested as a combination therapy against gemcitabine + Abraxane. Ipsen stated in the results announcement :

Onivyde ^® (irinotecan liposome injection) plus 5 fluorouracil/leucovorin and oxaliplatin (NALIRIFOX regimen) met its primary endpoint demonstrating clinically meaningful and statistically significant improvement in overall survival compared to nab-paclitaxel plus gemcitabine in 770 previously untreated patients with metastatic pancreatic ductal adenocarcinoma (mPDAC) and key secondary efficacy outcome of progression-free survival ((PFS)) also showed significant improvement over the comparator arm. The safety profile of Onivyde in the NAPOLI 3 trial was consistent with those observed in the previous phase I/II mPDAC study.

However, the $225 million milestone associated with this result is tied to approval, not this results announcement. Ipsen will still need to submit an sNDA for the indication to the FDA and it will then need to be approved. We spoke to Ipsen regarding the plan here, and although they wouldn't provide concrete timelines for the sNDA submission, they did say that it was in process and they planned to file as soon as possible. If we conservatively assume that this is completed in H123, we can expect a response from the FDA approximately a year later in H124, which is when we expect the milestone payment to be delivered.

Calculating the tax liability

Note: before getting into the details, it needs to be made clear that the following calculations are estimations. For instance, we cannot predict the precise tax liabilities associated with the company without knowing the details of some internal financial events. We can however, provide what we believe is a close estimation.

On a basic share basis, the $225 million milestone is worth $16.78, however if we include options (1.6 million + 13.4 basic shares outstanding), the value per share is $14.96.

The company will be able to offset the vast majority of taxes owed on this milestone using its NOLs. The company reported in its March 2022 10-K that it had "federal and state income tax purposes of $209.5 million and $294.8 million, respectively," leaving a measly $15.5 million subject to federal taxes. We assume that the company will pay the nominal 21% corporate tax rate, although in practice the company may have means to reduce this that we cannot anticipate. This translates into a $3.3m liability.

However, the company has more substantial tax interest obligations. Tax interest cannot be offset using NOLs. The company is responsible for paying the compounded tax interest from the period when the product was sold in 2017 to when the milestone is delivered. For the reader that might not be familiar with tax interest, the IRS provides some hand guidance , as well as a historical schedule of rates. Using the nominal 21% tax liability on the milestone and these rates, we calculate a tax interest liability of $24.8 million.

Subtracting these costs from the $225 million payment, we arrive at $197 million in earnings, or $13.10 per share. This is an 17% premium to the current stock price ($11.20).

Other considerations

In addition to the milestone payment, the company also has a cash balance of $13.1 million. This increases our valuation to $13.97 a share or a 25% premium. Based on conversations with the company, one reason that they are retaining so much capital is to ensure that they could finance any legal issues that might arise if needed. We are not concerned that Ipsen would fail to follow through on this contract (more below), but this is rather a stop gap to make sure that the company cannot be taken advantage of. Also, the company will undoubtedly spend some of this cash, but historically, its cash burn has been very low ($0.2 million operational cash burn in 2021).

A final consideration when valuing the company is that there are additional milestone payments that could be delivered in the future. In mid-2022, the company announced the results of its Phase III clinical trial of Onivyde in small cell lung cancer (SCLC). The trial failed to hit its primary endpoints of superiority over topotecan, but we previously raised the potential of this product being approved on a non-inferiority basis in our earlier note. Because the precise data from the study was not released, it is difficult to evaluate the potential for approval here. Approval for non-inferiority is non-trivial. During our communications with the company, they left this option open, declining to state if the company would continue to pursue this indication. We see this as an option on some surprise upside, but don't include it in our valuation.

There is also the $75 million dollar payment associated with a third, undisclosed indication. Given the late stage of the product, we don't expect any additional lines of study to be announced for the product.

Risks

This current trade is very unlike our earlier MACK trade that we proposed. Although we were highly confident in the potential for Onivyde to produce positive clinical results, there was still a high degree of inherent risk, as there is with all clinical development. The current trade by comparison is very low risk, and it merely requires the parties involved to execute on their contractual obligations, something that everyone involved has indicated that they have every intention of doing.

The biggest risk is that for some reason Ipsen decides not to seek approval for the drug. We see this possibility as negligible because of the simple fact that the drug has a large revenue potential in the first line setting. Ipsen has stated that it expects this to double the addressable market for the drug. Moreover, our confidence is further bolstered by the fact that Ipsen stated directly both in the press release and to us in conversation that they have every intent of seeking approval and paying the milestone, because it was worth the cost. Moreover, Merrimack has informed us that there are the typical provisions in their agreements that Ipsen will take reasonable efforts to commercialize the product.

Another risk is that Ipsen seeks approval but that it is rejected by the FDA. We also see this risk as negligible for a number of reasons:

1. The drug is already approved for pancreatic cancer
2. The active molecule has been used in this setting for decades.
3. Clinical results were unequivocally positive
4. The sNDA submission requires less data than an initial NDA
5. GMP has been established for the drug since its initial approval
6. Ipsen is a well run pharmaceutical company with a huge degree of experience with the FDA and multiple previous approvals

We believe that it would truly require an edge case surprise for there to be any deviation from the current pathway towards approval. This profile and our valuation implies a very low risk potential return of 25% in 2023, and we'll take that.

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