PDL BioPharma — Update 12 May 2016

On the Q116 earnings conference call, PDL announced that sales of Glumetza were declining much more quickly than expected in response to the launch of the first generic formulation of the drug. Glumetza is a significant component of the company's so-called Depomed royalties and was originally licensed by Santarus from Depomed, but the drug is currently marketed by Valeant Pharmaceuticals. The adjustment to new sales models reported this past quarter resulted in a $48m write-down on the value of the Depomed assets (to $143.9m from $191.9m). The company cited a steeper than predicted decline in volume, as well as increased payer rebates as the reason for the discrepancy. Despite these adjustments, the company stated that the majority of the $17m in royalty revenue for the quarter was due to Glumetza, indicating that further declines in cash royalty streams may be expected before the market reaches equilibrium. We have also calculated that the write-down resulted in approximately $13m in tax benefits for the quarter, which largely offsets our predicted loss of sales for the quarter.

Q116 also marked the last major instalment of the Queen et al patent payments amounting to $121m. The royalty deal covering the technology used to generate humanized antibodies produced royalty streams from some of the most prominent antibody-based therapeutics ever produced (Avastin, Herceptin, Lucentis, Xolair, Tysabri, etc). The majority of the royalty stream was on products sold before the end of 2015. However, the agreement surrounding royalties on Tysabri (Biogen) is on drugs manufactured before the end of 2014, and therefore there may be some residual Queen et al revenue in the coming quarters as the stock of the drug is drawn down. Previous royalties from Tysabri were in the range of $13-15m per quarter, which we can see as the maximum potential revenue if there is more than one quarter’s worth of stock, although at this time we have very little insight into how much, if any, future revenue to expect.

In March 2016, Lilly changed the endpoints for its ongoing EXPEDITION 3 Phase III clinical trial for the Alzheimer’s drug Solanezumab. The trial was originally designed to measure both cognitive function (ADAS-Cog 14 metric) and a functional assessment of the ability of patients to perform daily tasks (ADCS-ADL). However, in March 2016 the company announced that it would remove the functional assessment as an endpoint for the trial. Lilly cited recent research that cognitive decline typically precedes functional impairment, although the two effects are correlated.1 This adjustment to the trial protocol is one of a number of improvements Lilly has made to the trial over previous studies. The previous Phase III EXPEDITION 2 study achieved statistically significant improvements in ADAS-Cog 14 scores in patients with mild Alzheimer’s disease and the EXPEDITION 3 study was structured to focus on this mild disease subgroup. Additionally, patients in the EXPEDITION 3 trial will be confirmed to have Amyloid β deposits, unlike in earlier trials. We believe that the latest adjustment in the trial is reasonable, and we remain optimistic about results expected in late 2016. PDL would be entitled to 2% of sales if the drug receives approval.

In May 2016, Ariad entered into an agreement to transfer its European operations to Incyte Corporation. The deal includes the transfer of Ariad’s European office of 125 employees and the European marketing rights for Iclusig to Incyte in exchange for $140m in upfront payments and tiered royalties between 32-50% on net sales. Ariad will also be eligible for $135m in development milestones if Iclusig is approved for additional indications, and Incyte will provide $7m in development cost sharing for each of 2016 and 2017. In response to this, Ariad and PDL amended their royalty agreement to adjust the amount of additional funding available to Ariad. The original agreement entitled Ariad to $50m in funding in Q316 (in addition to $50m delivered in July 2015), with the option to draw an additional $100m any time between January and July 2016. The new agreement reduces the amount of cash payable under the option to $40m, but extends the period in which Ariad has to take the option to July 2017.

PDL reported revenue of $103m for the quarter ending 31 March 2016 compared to our estimates of $144m. The discrepancy is because of a non-cash $48m write-down associated with the valuation of the Depomed royalty assets due to declining sales of Glumetza. We currently predict earnings for the year of $62m compared to previous estimates of $97m. Cash royalty revenue for the quarter was $17m, compared to our estimates of $21m, due to declines in Glumetza royalties. The company reported $9m in interest revenue for the quarter, which is below our estimates of $10m because PDL reached an agreement with DirectFlow medical not to accrue interest until September 2016 after DirectFlow has completed a financing.

Revenue for the Queen et al patents was slightly lower than our predictions ($121m vs $123m), although this difference may be reduced in future quarters with inventory drawdowns of Tysabri. We have adjusted revenue expectations from debt agreements in 2016 (to $38m from $41m), based largely on the ongoing impairment of DirectFlow debt and the interest forbearance agreement through September 2016.

Operational spending for the quarter was largely in line with our expectations ($9.8m vs $9.5m) and we have not adjusted our expectations for the year ($39m). Earnings for the quarter were $56m and we expect earnings of $58m for the year.

The company ended Q116 with net cash of $59.8m. The Glumetza write-down had an estimated tax benefit of $13m, which substantially offsets cash flow losses due to lower sales. We currently predict a net cash flow of $88m for 2016 compared to previous estimates of $94m. Effects on cash flows beyond 2016 are minimal and we still expect that PDL will be able to meet all its financial obligations (Exhibit 1).

We are raising our valuation slightly to $1,036m ($6.28 per basic share) from $1,033m ($6.29 per basic share). The reduction in value of the Depomed assets was offset by the realization of the previously discounted Queen et al payment, which was further enhanced by the tax benefit of the write-down. In response to sales of Glumetza, we have reduced our valuation of the Depomed royalties by $13.6m. This reduction is less than the $48m write-down taken by the company because our estimates for 2016 sales were substantially more conservative than the company’s. The remaining portion of the value of this asset attributable to Glumetza is approximately $10m. We have reduced the valuation of the DirectFlow notes by $2m to reflect the interest forbearance until September 2016. We also currently model the Queen et al royalties as fully realized. Our other valuations remain unchanged. We expect to update our valuations with developing news regarding the Wellstat litigation and the relaunch of Auvi-Q by Kaleo.