NVS - Surface Oncology And Coherus BioSciences: Does A Buyout Equal A Good Deal?

2023-08-15 20:58:15 ET

Summary

• Surface Oncology has agreed to be acquired by Coherus BioSciences in a deal valued at $65 million.
• The deal will result in a share dilution of 12.5% for CHRS, leading to a 12% reduction in its stock price since the merger announcement.
• SURF shareholders may not benefit significantly from the deal, as the value is already baked in, and there are potential short-term losses due to CHRS stock price.

Sometimes knowing what you don’t know is as critical as what you do. Biotech is a good example. I can talk electronics all day long, but biotech is another black magic, where I need to google half the buzzwords and everything looks shiny and bright. I remember the first golden age of biotech in the 1990s, dozens of biotech going public (Cephalon, Gilead, Human Genome Sciences, Isis being some notable) to change the world, and I decided to take a chance. I guess I picked the wrong ones though (they all looked so shiny), because when the dust settled some years later. I had a couple winners, more tax losses; cancer was still the #2 killer and big pharma had picked up a lot of dead stuff at pennies on a dollar. So, it was a lesson, and for 20 years I limited my biotech to mutual funds, where at least I had a hungry portfolio manager and a cohort of experts making decisions. That worked out well in some years, less well in others.

And then (maybe too much time at home due to the Covid plague), I decide it is time for more biotech investment. Long story short, I settled on 3 players in 2020, one was Surface Oncology ( SURF ). SURF was still nice and shiny, just a year or 2 out of IPO. It was about $5, down from a $15 IPO, and was sitting on $100M in cash, so the value quants were happy, It had a nice (3x) upturn after the Covid Financial Tsunami, so the tech chart quants were happy, it even had announced partnerships with the big boys, Novartis ( NVS ) and GSK ( GSK ) that were moving into Phase 2 studies. Didn’t really understand the antibody tech but looked like THE ONE. The next couple of years passed. There are some highlights, the stock peaking in 2021 with a $30M payment from GSK, but from there the general downward trend to under 70 cents in the spring, no bad news, but no good news, every quarter is another loss, and now that cash is sitting at $50M. And then, in June, Coherus BioSciences ( CHRS ) announces an agreement to acquire SURF in a deal valued at $65M. This brings the share price back to about $1, cold comfort, but it is what it is. So, the obvious next question is stay or sell. Does CHRS bring new value into a hard equation? Do SURF investors get the hail Mary of salvation they deserve?

Ignoring for the moment the key question of the value of the SURF antibody intellectual property, here is my look at the hard metrics on this deal.

CHRS will issue $40M plus (whatever cash) of new stock at 5.28 per shares to acquire SURF shares. CHRS and SURF estimate this cash will be $20 to 25M at closing. Assuming this is accurate, this is collar between 11.36M to 12.31M shares being issued. With SURF having 60.7M shares outstanding, this converts to a 4.9 to 5.3:1 ratio. 100 shares of SURF would exchange to between 18.8 to 20.4 CHRS shares.

So, 100 SURF shares, currently valued at ~$100 becomes ~$99.2 to $107.71 at $5.28/sh. Not bad, however it gets wonkier. The conversion rate is fixed at $5.28/sh. The current (8/15/2023) price of CHRS is $4.52 per share. In that case the value of those 100 SURF shares becomes $84.85 to $92.20.

CHRS has 94M outstanding share. If it issues an average of 11.8 M new share to acquire SURF, this amounts to a 12.5% share dilution. Does the market incorporate this dilution in its 16% reduction in CHRS price since the merger announcement? Perhaps, but it would be premature, and I have doubt that the market is that efficient, and if not, can we anticipate a further decline in price after closing. Time will tell.

Currently, SURF has after-debt cash position of about $46M. CHRS is stating they expect to receive $20-25M. So over $20M will be spent in next few months. Given this is a 35-person company, probably 25 by the time of the acquisition closing, while it seems like a lot of money is getting spend by a small number of management; the legal costs, shut down costs, termination fees, severance and parachutes do tend to add up quickly. Unfortunately, and barring oversight, both CHRS and SURF management have incentives to make this cash position a lower vs higher number.

If CHRS is getting $20M in net cash, after issuing $60M in stock at a 16% premium that has already depreciated to $51.5M (at $.4.52/sh), this whole deal is costing them basically $32M. Nice deal for them, maybe… SURF appears to have zero in 2023 revenue, and even with a deduced expense of a depleted SURF staff, they are looking at continued loss from SURF operations (in addition to their own intrinsic losses, $0.38 per share in last quarter).

There is a small ray of light in this basically cloudy situation, contingent value rights for 70% of milestone and royalty-based value of existing programs with Novartis ( NVS ) and GlaxoSmithKline ((GSK)). These are fundamentally very hard to quantify. The existing programs are in Phase 2 trials, there is little data at present to determine if the programs will be successful enough to justify phase 3. Even if so, we are talking about years to these being commercial medicines, while the rights the rights have a finite duration (10 years, I believe).

If they are successful programs, NVS and GSK will probably have clauses in agreements to acquire all rights for a single fixed price. It is worth noting that NVS and GSK would typically have been given right of first refusal on M&A, but passed on acquiring SURF, even at recent pricing. As they are managing the current trials, this does not bode well.

My takeaway is this is bad deal for SURF shareholders, especially those who are holding a capital loss (most of us, I think). Any value is already baked in, there is potential of short-term losses due to CHRD stock price, and SURF is dead money until the deal closes. The only real upside is the contingent rights, which, lacking Phase 2 success, are questionable in value and can probably be acquired separately on the open market. Unfortunately, given the lack of progress for the company in 2023, the continued losses expected, management throwing in the towel on the existing IP product; it may be the only deal in town.

I have held a position in SURF since 2020. I have a small tranche left, but over 75% of my position is sold. The remainder will probably get closed out this month. CHRS is interesting (I respect them for cutting a deal where heads I win, tails you lose) and I think their bio-similar business could be a good one, but I see lower lows for it as this deal completes. If and when those contingent value rights are sold at some point, I might gamble a bit on them. I am admittedly gun shy of losing money to small companies these days, especially when I don’t understand the tech involved, although there are some small caps that are making me lick my lips a bit.

As always, caveat emptor. I make no recommendations. I speak only for myself in sharing analysis done for my own personal use. All the above is based on my interpretations of information that I reviewed from public sources. I may have gotten it wrong, errors may have crept in. In talking about the future, you are almost always likely to get the best parts wrong. That's what makes it interesting.

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