Shares in Intercept Pharmaceuticals Inc (NASDAQ:ICPT) climbed as much as +31% on February 12th following a report from Reuters citing anonymous sources that the company is considering a sale after receiving interest from potential buyers. In the short term we see ICPT share confined below $130-$137 until the FDA Adcom on April 07th for OCA in PBC. Short term sentiment indicators suggest a pull back is likely or imminent with $118.25 -$120 as minor support, a close below these levels opens up downside to the 20-day moving average at $107.64 currently. Ideal long setup would be waiting for a test and confirmation of one of these support levels, then selling $80-$90 strike put spread (selling higher strike put, buying lower strike put to hedge).

The news source suggested Gilead Sciences, Inc. (NASDAQ:GILD) as a potential suitor. GILD has a demonstrable strategic interest in NASH, and would not surprise us if they were considering ICPT as a takeover target given their internal pipeline already includes 3 assets targeting each component of NASH (simtuzumab/fibrosis, GS-4997/inflammation, multiple FXR agonists/metabolic). Other potential bidders named were Shire (SHPG), Merck (MRK), Abbvie (ABBV), BMY, Pfizer (PFE), AstraZeneca (AZN) and Roche, given these companies have therapeutic overlap with liver/orphan diseases. We note that GILD ranks second only to JNJ in the sector on M&A capacity right now.

ICPT bears would cite the fact that GILD acquired Phenex’s FXR agonists in 2015 rendering ICPT’s lead FXR agonist, obeticholic acid (OCA) a redundant asset for GILD. We disagree, and think there is credence to the idea of GILD acquiring ICPT despite their recent acquisition of Phenex. GILD’s commercial strategy is keenly focused on having multiple assets per drug target to adequately manage their product lifecycle, and Phenex’s FXR agonists are years behind OCA in clinical development representing first-mover advantage for ICPT. GILD historically has demonstrated an ability to act forcefully when acquiring assets that are first and/or best in class (Sovaldi).

With no other biotech’s valuation has the market imposed such a clear “mandate” for M&A than what we have observed with GILD over the past 12-months. It is eerily similar to AAPL in 2013-2014 when both David Einhorn and Carl Icahn began their activism crusades to unleash shareholder value, and indirectly succeeded in doing so. GILD diverges from AAPL though because of their long and consistent track record of returning 50-60% of FCF to shareholders since 2010. Moreover, global investor surveys show that the buy-side wants M&A and not more repurchases.

As a result, we focused our analysis on GILD as a potential suitor for ICPT for several reasons. First, the market wants M&A desperately from GILD. Second, its one of the most cited potential acquirers with any cancer, liver, or inflammation asset. And finally, our own biases, we know GILD better than the others and choose to use it as a template to represent the others.

OCA is Approvable in NASH, but Market Penetration Will be Limited to 20-30%

We cannot deny that ICPT represents one of the few remaining late-stage blockbuster drugs, and while many think OCA will become “more de-risked for an acquirer” if approved in PBC this summer, we do not think a potential acquirer would attribute much additional valuation to NASH from a positive Adcom in PBC. While we believe OCA is an approvable drug in NASH, we are increasingly confident that its use will be restricted to a smaller segment of the market than consensus currently models, and note that our expectation for OCA pricing is dramatically lower than consensus expects and believe the PCSK9 drugs are the best proxy, not the HCV drug class and pricing will play a significant role in patient access.

With OCA having one failed and one positive Ph2 trial in NASH, we re-reviewed all of our own past research on OCA, reexamined the most of the literature published on NASH during the past 14-months in the journal Hepatology, including the FDA/AASLD workshop in NASH held in 2013, and reassessed the sell-side’s models and assumptions.

Finally, we rebuilt our DCF model based on a 2-year review of most publicly available KOL feedback on OCA, and conducted multiple M&A scenario analyses to assess the potential valuations of ICPT (in the current market environment). What we do not attempt to do here is speculate on the likelihood that GILD or another bidder will act anytime soon, but what is evident to everyone is GILD has the second largest “war chest” in Biotech and Pharma, second to only JNJ.

History Suggests Patience Is Indicated Though for Any Potential Bid

GILD disclosed on November 21st, 2011 that they were “reviewing the Pharmasset deal for a year, and they noted that they were comfortable with IP on both 7977 and 938 (which does not have an issued patent),” according to a Deutsche Bank report on the same date. In the immediate aftermath of the GILD/VRUS deal the discussion focused on whether or not it was cheap or expensive, which we all know now that GILD only paid 0.9x and 0.6x on 2014A/2015A WW HCV sales respectively. Additionally, the market chatter was focused on “who would be next” with “INHX and IDIX cited most frequently,” and we note both were later acquired at 1-M premiums of 76% and 379% or $2.5B and $3.85B respectively.

In our view, with ICPT’s growing cash burn that some analyst estimate will grow to $300-$400M per year, on the eve of OCA’s first potential approval, we believe bidders can exercise patience at a minimum until after approval or denial by the FDA in PBC. We also note that GILD’s patience to acquire major assets has been validated, and now can make offers with +60-70% premiums and only pay what these same assets were trading for just a few short months ago. Once again, it appears GILD remains the best capital allocator in the business, yet essentially trades at a hefty discount to any valuation metric one chooses (P/E, DCF, relative to S&P 500, peer group etc).

The Fundamental Question

Whether or not GILD (or other bidder) believe consensus estimates of peak and 2020E OCA sales. Our review of sell-side estimates from 2011-2013 found that GILD only paid 2.1x – 3.6x sell-side peak sales estimates during the 2011-2013 timeframe, and only ~4.7x 2014E sales that were forecast the month prior to Sovaldi’s approval. We also surmise GILD would derive their valuation of OCA based on their own expansive database of gastroenterologists and hepatologists compiled during the commercial launch of Harvoni and Sovaldi in HCV.

With this in mind, we believe no one is better equipped to properly value ICPT than GILD Specifically, the major levers to ICPT’s valuation will be driven by the actual diagnoses rates of F2-F4 patients who are under care of a specialist currently, the real world annual progression rates, and the true volume of new patients diagnosed with NASH, the capacity to treat those patients, and physician attitudes toward treating them.

The primary risk to OCA’s approval in NASH and hence, ICPT’s valuation stems from the uncertainty on whether or not the FDA will restrict OCA’s labeling to a more narrow population with low risk of cardiovascular events upon initial approval until full outcomes data are available in 2021.

  • Our research shows that OCA will undoubtedly be restricted to NASH patients who are at low risk of experiencing a cardiovascular event. Given the reality that both diabetics and obese patients comprises an estimated two-thirds of the total NASH population; any acquirers base case has to be peak market share of only 25-33% of the diagnosed population. These estimates are also confirmed by multiple physician surveys.
  • While NASH is a disease of the liver, the most common cause of death in patients with NAFLD, NAFL and NASH is cardiovascular disease. KOL’s have stated that NASH is best characterized as cardiometabolic syndrome that is manifest in the liver, rather than a liver disease with a cardiovascular impact. This fact is so pervasive, that many specialists treating liver diseases have even are calling for a name change of the disease to “metabolic induced liver injury (MILI)”.
  • We believe consensus has a misinformed view of OCA’s risk/benefit profile, and more importantly how a potential acquirer would view its probability of approval and its total addressable market. Indeed, the cardiovascular component of this disease cannot be ignored, which we believe the Street has largely done with their models while ICPT’s shares have fallen -80% since their peak at $497 despite endless bullishness from the sell-side. In our view, the sell-side’s risk-adjustments simply reflect the probability of approval, while failing to reflect the clinical, regulatory, and above all, the commercial risks in achieving peak sales estimates.
  • OCA’s sales ramp is likely to experience a very slow sales ramp to peak, until full outcomes data are available similar to the PCSK9 market. Increasing diagnosis rates will be difficult in a disease that for the foreseeable future requires a highly invasive liver biopsy for confirmation. Doctors indicated that of 6mn US NASH patients, 10%-20% are diagnosed and expect this to double with launch. Currently, NASH diagnosis is gated by the need for invasive liver biopsy, which will not change with OCA launch. For comparison, doctors estimate ~60K-120K patients are currently on Vitamin E in the US for NASH.
  • We contend that any potential acquirer would balk at the sell-side’s risk adjustments ranging from 60-75%, and foresee any acquirer only assigning 45-59% citing Hay and colleagues data published in Nature in 2014, which is the historic probability of success for Phase 3 cardiovascular drugs (n=121), and would also only pay 3.75-6x multiple on their risk-adjusted peak or 2020E sales estimates to acquire ICPT.

Bottom Line

Despite the negatives facing OCA in NASH, we believe it is approvable, but potential conditions restricting its use will erode some of its appeal from a risk/reward that an acquirer would be willing to accept.

However, these risks can adequately be accounted for in valuation. To reflect these realities potential bidders could use our more realistic 45% risk-adjustments based on the historic Phase 3 probability of success in cardiovascular indications. We then apply this to both our and sell-side OCA sales estimates to reflect the increased regulatory and commercial uncertainties. The results are show in the associated table

Finally, an acquirer could transfer a portion of this risk to ICPT shareholders through the use of contingent value rights (CVRs). On an adjusted sales basis there is strong concordance on the potential sales of OCA in NASH of more than $3.3B (mean of $4.4B) despite including the aforementioned risk factors. As a result, the primary divergence between estimates is driven by OCA’s pricing and probabilities of success, which we already made abundantly clear how we view the latter component (45% POS). On pricing, our six sample “consensus” ranges from $11K-$20K, and the mean price target adequately reflect this variable.

Hence, we constructed a CVR model isolating the probability of success in NASH. We surveyed 5 sell-side estimates that had a mean POS of 59%; we assumed that this would be the max bid for OCA in NASH, which diverges from our estimated asking price of $263 per share (75% POS) we believe that ICPT would demand. To close this gap we estimated a back-ended CVR worth $56 or $1.36B in equity value that would close a deal representing the difference between OCA’s NPV in NASH at 75% POS (ICPT’s Ask) and our consensus mean POS of 59%.

Our final takeover value of $240 per share in this scenario is based on applying our base case DCF price target of $184 as the cash component of the deal then adding the estimated value of the CVR of $56 per share. This represents a deal structure consisting of 77% in upfront cash and 23% in back-ended CVR’s isolating OCA’s probability of success in NASH as the major variable to valuation. Importantly, the cash component of the deal represents a +74% premium above ICPT’s 20-D moving average of $105.94 from February 12th. Compared to GILD’s historical M&A 1-M premium mean of 62%, the sector mean/median (2004-2015) of +65% and +50% respectively, and compares well to GILD’s historical maximum 1-M premium of +89%.