2023-11-10 14:46:49 ET
Summary
- Alkermes plans to spin out its oncology research division into a standalone entity, creating a potential value-unlocking transaction.
- The spin-off will allow Alkermes to focus on its neuroscience assets and cut $180 million of R&D spending, leading to an overall undervaluation of around 20% for the standalone company.
- On the other hand, the standalone oncology business Mural Oncology will likely face heavy selling pressure right after the distribution.
We believe that Alkermes (ALKS) looks interesting ahead of a potential value-unlocking transaction. The company is indeed set to spin out its oncology research division, which is currently a money-losing machine, into a standalone entity. We think this is a great setup for a spread trade by buying Alkermes and shorting the spin-off to benefit from significant differences in their valuations.
The company is pursuing this strategy to concentrate its efforts on its already available commercial products while offloading some heavy R&D spending from its income statement. We think there is an overall undervaluation of around 20% for a standalone Alkermes going forward.
The setup: R&D-heavy oncology vs core neurosciences
Alkermes has long been a mixed reality of an oncology business developing drugs for ovarian cancer and melanoma, and a neuroscience business focused on schizophrenia and bipolar disorder. By the end of this month, this will come to an end, with Alkermes spinning out its oncology business into a separate entity with its own balance sheet and employees.
We believe this will benefit Alkermes in two main ways: (1) more focus on developing neuroscience assets and driving sales growth of approved drugs, and (2) significant cost reduction with no topline losses stand to significantly boost the bottom line.
Let's have a closer look at the current corporate structure and revenue/costs mix.
This is where product revenue came from over the past years. LYBALVI was only approved and introduced into the market in late 2021, but the company is investing big in it. The other two drugs have long been Alkermes' flagship products, and they also have been steadily growing.
The oncology business contributed zero to the topline as all the drugs are currently on trial waiting for approval. They are being tested for ovarian cancer and mucosal melanoma, two very tough diseases that have been historically hard to cure.
But the soon-to-be spin-off contributed a lot to Alkermes' cost structure instead.
This is the contribution from each segment to the overall R&D spending. It is staggering to see that the oncology business has been responsible for some $170-180 million of spending per year. This directly impacted the bottom line as there are no revenues from this segment yet to offset these expenses.
We believe that the upcoming spin-off will directly benefit EPS and FCF as these items are cut from the current structure. This means a higher present value of all immediate cash flows while taking only a smaller hit on longer-term revenue growth as we exclude the oncology assets under development.
With the current rates and valuations environment this decision makes perfect sense as the SOTP valuation is clearly benefiting the revenue-generating business while assigning zero or negative value to the oncology.
A big shakeup in the neuroscience portfolio is coming as patents expire
While this is good news, we also need to look at some concerns around the business. The neuroscience segment is indeed facing some potential structural issues over the next years due to patent cliffs. Between 2027 and 2030, which seems like a long time but from a DCF perspective is very little, the company will lose rights on virtually every drug they are currently selling. This means not only facing competition from similar generics but also from identical generics developed using their own expired patents.
We find that this is particularly important for two main reasons: (1) to properly model a steep decline in topline after each patent cliff, and (2) to assume increased spending either in the form of M&A or proprietary development to sustain the portfolio. Of course, the company will need to replace these assets, and some spending for acquisitions will likely be needed, as development will take years.
Their current neuroscience pipeline is very limited. The only treatment that could see approval is a pediatric version of already approved LYBALVI. This means very little TAM expansion from proprietary assets, and the need to shop around for newly approved drugs.
Valuation and Positioning: long Alkermes short MURA
The company r ecently filed Form 10 that describes the spin-off, and the transaction is set to occur on November 15. Shareholders of the parent (RemainCo) are set to receive 1 share of the newly formed Mural Oncology (MURA) for every 10 shares owned by Alkermes. The record date was November 6 for being eligible for the distribution, so now it makes sense to trade only after the closing date.
We think the setup is clearly set for a spread positioning of long Alkermes (RemainCo) and short Mural (SpinCo). The reasoning is the following: (1) Alkermes is set to benefit from valuation re-rate as costs are being substantially cut, (2) MURA will need substantial amounts of cash to develop their assets, and (3) there will be substantial selling post-distribution from certain passive funds.
Let's first look at the re-rate thesis for the parent company. We believe that the current valuation discount against peers of Alkermes is precisely driven by holding these money-losing oncology assets. Once they are off the books, the market will start to assign higher EV/EBITDA and P/E multiples.
By focusing on FWD multiples, we expect EV/EBITDA to fly north of the 10-11 range instead of the current 9.5. Similar movements for the P/E multiple. We expect FY 2023 EBITDA of $424 million post transaction (after cutting $175 million of oncology expenses). Assuming a multiple of 11, and subtracting post-transaction net cash ($270 million are going to SpinCo), the fair value per share is $28. An upside potential of around 20%.
On the other hand, Mural Oncology will face two main issues: (1) the market is very pessimistic around pre-revenue biotech valuations, and (2) index funds that own 20% of the current Alkermes will likely sell down a big portion of the newly issued company as its size and index inclusion is very different. These are not fundamentals-driven investors, and they are actually forced to sell no matter the price they get.
As the ratio is 1-to-10 shares, this means that the company will be valued somewhere around the $400 million range (10% of the current market cap), and with $270 million of net cash, the EV post-transaction will likely be around $130 million. We think that the market will likely push for close to zero EVs right after the distribution. This is implied by various players in ovarian cancer and solid tumor development that trade at a discount or close to net cash. The potential downside is thus between 20% and 30% by the end of November.
Conclusion
Alkermes is rightly pursuing a spin-off of its oncology business which has long been weighing on its R&D spending and lowered value for shareholders. This will boost net income by some $170-180 million, and will likely cause a re-rate of RemainCo's valuation. At the same time, we think Mural Oncology will see forced selling and depressed multiples driving down the stock price. We think that investors could benefit from this transaction by shorting SpinCo Mural Oncology and buying Alkermes.
For further details see:
Alkermes plc: A Spread Trade On The Spin-Off To Capture Valuations Re-Rate