Selvita — Update 25 April 2016

Selvita’s partnership with Merck is gaining pace, with the most recent drug development agreement announced on 31 March. The two companies have signed a second deal, which involves an undisclosed protein target with potential therapeutic compounds initially developed by Selvita using its cancer metabolism platform. Financial details are same as in the previous deal with Merck, announced on 22 December 2015. According to that agreement, Selvita may receive up to €1.9m in payments during the first five years depending on undisclosed R&D milestones. Total payments may add up to €16.5m if the drug is successfully commercialized.

Going further back, the first partnership agreement with Merck was signed in October 2013 with the goal of collaborating on discovery and development of multiple new compounds. This two-year agreement has clearly been successful, with the two new drug development programmes now ongoing. To capture the potential value of the drug discovery collaboration with Merck, we included two projects in the valuation of our last report. The new drug development deals in December and March confirm our expectations that Selvita is able to deliver services and innovation to attract large pharma attention.

Furthermore in November 2015 a second drug discovery collaboration was agreed with Merck to identify first-in-class small molecules as lead candidate drugs for multiple oncology indications. This indicates that we could see more development deals in the near term. We summarise the collaboration and drug development agreements with Merck below.

Other drug discovery collaboration partnerships are also progressing according to plan. The collaboration on a kinase platform with H3 Biomedicine was renewed for an additional year to September 2016 to further validate two kinase targets. While the details about the potential projects remain undisclosed, the companies plan to initiate IND-enabling studies in 2016.

The cancer quiescence platform is run in collaboration with Felicitex Therapeutics (US) with the aim of developing DYRK kinases, which is a novel approach with expected efficacy against quiescent cancer cells that are not actively proliferating and thus less susceptible to classical chemotherapy drugs. These more resistant malignant cells may cause tumour relapse once the treatment ends. The partnership was established in November 2014 and two series of compounds were developed with a high likelihood of naming clinical candidates, as reported in the FY15 results.

SEL24 is Selvita’s most advanced oncology programme and is well on track to enter a Phase I study around mid-2016, which will be managed by US-based CRO Theradex. The study will run for nearly two years. While the company is able to finance the study itself, Selvita’s goal is to secure a partner for the SEL24 programme, and the company has previously indicated that it is in advanced partnering negotiations with several potential pharma and biotech companies.

The project is focused on developing a first-in-class compound with a potential dual mechanism of action to target two kinases, namely PIM (1, 2 and 3 isoforms) and FLT3 mutants, which have been shown to be important in the development of acute myeloid leukaemia (AML) and other haematological malignancies.

SEL120, Selvita’s second lead product, is a first-in-class selective cyclin-dependent kinase 8 (CDK8) inhibitor, which differs from other less selective or pan-CDK inhibitors in late stage development or on the market. The main issues with the first generation of CDK inhibitors were not only the lack of selectivity within the CDK family, but they also inhibited numerous other kinases leading to a variety of side effects in clinical trials, most often bone marrow suppression, anaemia and leukopenia.

SEL120 is uniquely differentiated selective CDK8 inhibitor shown to have a favourable safety/efficacy profile in non-GLP studies in two species and now the company is preparing for IND enabling studies. Although the main concepts of CDK inhibition were discovered more than two decades ago, selective CDK8 inhibition is a fresh approach. It recently gained attention after Merck & Co in-licensed a selective CDK8/CDK19 inhibitor from Harvard University in a deal with an upfront payment of $20m and tiered royalties, which is the largest licence fee for technology developed at the university. In our view, this clearly shows interest in selective CDK inhibitors is high. The agreement involves a natural compound, cortistatin A, and recently published articles show anti-leukaemic in vitro and in vivo efficacy, which adds to Selvita’s pre-clinical data.

Selvita plans further preclinical development of SEL120 in 2016 with the goal of entering Phase I in H217. So far, preclinical studies from the company (Exhibit 2) and from third parties point to potential efficacy in haematological malignancies, colorectal cancer or triple-negative breast cancer.

Selvita has demonstrated excellent growth, with 2015 being a second profitable year and total sales reaching PLN56.1m, up 35% year-on-year. Total sales growth corresponded to a CAGR of 51% since 2012 and we expect double-digit total revenue growth to continue (19% and 12% in 2016 and 2017 respectively). Exhibits 2 and 3 below demonstrate the revenue growth projections and change in revenue mix; notably, other operating revenues are immaterial. Strong organic sales growth in FY15 translated into increasing profitability with core operating profit of PLN6.8m up 29% and profit after tax of PLN7.7m up 31% year-on-year (adjusted for employee stock options programme expense and impact of deferred tax asset changes in 2015, Exhibit 5).

Selvita’s operations are divided into two business segments – Services and Innovation, while revenues from subsidies are allocated to each of these segments.

We note positive comparable growth in the backlog as well. Commercial backlog of PLN27.9m in Q116 (excluding grants and subsidies, per Selvita’s corporate presentation, March 2016) increased 57% year-on-year. For comparison, the commercial backlog in Q115 was PLN17.7m and 2015 sales to external customers (ie excluding subsidies) came in at PLN41.0m, which translates to 2.3x the backlog at the beginning of the year. Our 2016 commercial sales estimate is PLN51.1m, which is 1.8x the current backlog so represents a conservative estimate, which nevertheless implies double-digit growth expectations for sales to external customers.

As Exhibit 4 shows 2015 revenues and operating profit were in line with our expectations. We have included a milestone payment of €0.2m from Merck in Q116. Seeing the increase in backlog we have also adjusted our sales expectations upwards in FY16 and FY17, while revising the EBITDA margin slightly downwards in FY16 to reflect the expected expansion of research capacity and hiring of new personnel. However, we expect a partial recovery of EBITDA margin in FY17 to allow for economies of scale. We have also increased our bottom line estimates starting from 2017. Our organic growth expectations are supported by a rapid expansion of Selvita’s sales capability. In 2015 the company opened three international sales offices based in Cambridge, UK, San Bruno in San Francisco Bay, US and Boston, US. This will allow for sales activities to be based closer to customers. Selvita will also open a new research facility in Poznan, which will potentially expand its research capacity by 30-100 employees in addition to the existing c 300 at end of December 2015.

As of March 2016 the cash position was PLN32.4m with virtually no debt. Based on this and combined with cash generated from profitable research services business, we believe there is sufficient cash for the internal drug candidates SEL24 and SEL120 to complete Phase I and pre-Phase I studies respectively. For these programmes to progress further, we anticipate additional financing and/or a partnership deal is needed.

Applying a standard DCF model for the research services business and a risk-adjusted NPV model for the SEL24 and SEL120 programmes, our valuation of Selvita is now increased to PLN354m (€83m) vs PLN333m (€70m) previously, or PLN27.0/share vs PLN25.4/share. The change is driven by rolling our model forwards, raising our forecasts and adjusting for the net cash position of PLN28.8m at end of December 2015. Note that Selvita had cash of PLN32.4m at end of March 2016 (per the FY15 results announcement) and the company was virtually debt free at end FY15.

We have made some minor adjustments to our rNPV model to reflect our view that a partnership deal for SEL24 in 2016 is less likely (but not impossible). We have postponed our assumed partnership deal to 2017, which implies a delay in development timelines by one year after Phase I (we note that Selvita is on track with its R&D plan for Phase I trial to start in mid-2016). This however, had rather minor impact on the project’s rNPV, which now is PLN51m vs PLN54m previously. We have not changed our SEL120 assumptions or those related to collaboration projects (see our last outlook for more details).

For collaboration deals, we have already included two projects to capture the value of the partnership with Merck. As detailed in Exhibit 5, each project has similar characteristics with the total milestone value of €28m each and royalty rates up to 2%. This compares to a €16.5m total milestone value and no royalties in each of the two deals with Merck. Although the value of the announced deals is less than what we currently model, we maintain our assumptions as we take the two new development agreements as a positive confirmation of Selvita’s ability to deliver to large pharma standards. We see further potential for the partnership with Merck to expand especially given the fresh drug discovery collaboration signed in November.

Although we see our combined DCF and risk-adjusted NPV valuation at PLN354m, we note that due to the early stage of the lead R&D projects, success probabilities typically range from 5% to 7.5%. In other words, if all programmes (in Exhibit 6) achieve success, as per our model, the valuation will be PLN911m.