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NBIX: A Risk/Reward Case Study

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By ponch73
June 23, 2006

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NBIX: A Risk/Reward Case Study

To preface this post, I must admit that one of my pet peeves with this board is the low signal-to-noise ratio from a fundamental due diligence standpoint (although there have been some great due diligence posts from the likes of tman77, BMW, captainccs, Bakuvdanet, invertirmenor and TwinDeltaTandem, just to name a few).

We seem to be in no shortage of posts suggesting that stock XXX looks like it's near it's 15/20/30-year low CAGR with the requisite link to one of Mike's charts. There also appears to be (at least to me) a blind faith with regard to blue chip companies that seems to imply that we don't need to do due diligence on the Microsoft's, GE's and Coca Cola's of the world. That kind of thinking makes me shake my head disapprovingly. The BMW Method is not merely about stock charts. It also is about thoughtful due diligence.

In my humble opinion, we could stand to have a few more posts offering a sensible discussion about the actual business(es) underlying stock XXX. Shouldn't we know that Microsoft has consistently failed to generate sufficient return on its investments in the Internet realm, that GE's CEO Jeff Immelt is trading near-term cash compensation in exchange for deferred stock or that much of Coke's earnings growth under former CEO Roberto Goizueta was driven by financial engineering of its relationships with its bottlers? I consider preparation to be the antidote to panic and greed.

With the increased free time I now have at hand, I will try to do my part toward advancing the due diligence effort on this board. Hopefully, this post will represent an auspicious start to a more meaningful discourse on the fundamentals of the companies we are evaluating as potential investments.

DISCLAIMERS:

1. This writeup is for information purposes only. It in no way represents a recommendation to buy.
2. Buying NBIX based on this post without doing your own homework would be foolhardy and irresponsible.
3. There is no incontrovertible evidence that I'm a capable investor. If anything, I have been too early on this name. Furthermore, I have no experience whatsoever investing in biotech stocks.
4. Don't overlook my ulterior motives or self-interested agenda. My wife and I own 675 shares of NBIX at a cost basis of $14.97 (purchased 100 shares on 5/30 at $20.56 and 575 shares on 6/20 at $13.98). Currently, we are down over 7% on our NBIX investment (hopefully, the wife will forgive me).
5. NBIX does not really qualify as a BMW stock. It does not have even close to a 30-year track record as a public company. It has also never achieved profitability from a net income or free cash flow standpoint.

NEUROCRINE BIOSCIENCES (NBIX, $538 mil)

FUNDAMENTAL THESIS

The stock is significantly oversold based on near-term fears over the financial prospects of its flagship Indiplon insomnia drug. At the current price of roughly $14, the risk/reward profile is disproportionately tilted in investors' favor. The downside risk to roughly $13 (based on my estimate of the company's intrinsic value) is significantly dwarfed by upside to roughly $50 (based on a back-of-the-envelope analysis described in the valuation section).

Downside: $(1)
Upside: $36
Required Probability of Upside Case for Break-Even: ~1%

BACKGROUND

Neurocrine (NBIX hereafter) is a San Diego-based biotech company focused on discovering prescription drugs to treat neurological and endocrinological disorders (and therein lies the name of the company, Neurocrine). The company was founded in 1992. NBIX went public in the summer of 1996.

BUSINESS

As a biotech, NBIX's valuation is driven by the probability-weighted cash flow generating potential of its pipeline of drugs under development rather than by the company's current or recent streams of revenues, income and cash flows (which are largely non-indicative of the go-forward prospects of the business). As a result, in this analysis, I will not focus on the income or cash flow statement. Entering 2006, NBIX management expected to achieve break-even profitability in 2006 (although that guidance will likely change in coming weeks).

NBIX's has 9 drugs in its pipeline, 7 of which are in clinical development. They are listed below. Please recall that drugs must go through 3 phases of clinical trials before they can be presented to the FDA for approval. The vast majority of drugs in NBIX's pipeline are in Phase II.

1. Indiplon (insomnia, Phase III completed, FDA status to be discussed in following section)
2. GnRH Antagonist (endometriosis, Phase II, estimated 2005 worldwide market of $2.0 bil)
3. Altered Peptide Ligand (multiple sclerosis, Phase II, estimated worldwide market of $4.9 bil)
4. Altered Peptide Ligand (type I diabetes, Phase II, estimated U.S. market of $10 bil)
5. CRF R2 Peptide Agonist � Urocortin 2 (cardiovascular/endocrine, Phase II)
6. CRF R1 Antagonist (anxiety and depression, Phase I, estimated U.S. market of $13 bil)
7. GnRH Antagonist (benign prostatic hyperplasia, Phase I)
8. Adenosine 2A Receptor Antagonists (parkinson's disease, pre-clinical trials)
9. H1 Antagonist (insomnia, pre-clinical trials)

NBIX is partnered with Pfizer in the development and commercialization of Indiplon and partnered with Glaxo SmithKline in the development and commercialization of the CRF R1 Antagonist.

NBIX has given Pfizer exclusive worldwide rights to sell and distribute Indiplon. In exchange, Pfizer has made upfront and milestone-related payments to NBIX, reimbursed Indiplon-related research and development costs and, starting in 2005, subsidized a 200-person NBIX sales force to jointly sell Indiplon and Pfizer's Zoloft to psychiatrists. Pfizer must pay NBIX a royalty on any Indiplon sale (the royalty rate on domestic sales is 30% and is believed to be somewhat lower � 20%? -- on international sales). NBIX must pay DOV Pharmaceutical a 2.5% royalty on any worldwide Indiplon sale (thus, NBIX's net royalty rate is 27.5% domestically). To date, NBIX has recognized roughly $325 mil in revenues from Pfizer in the form of license fees, milestone payments, sponsored development and sales force allowances. Pfizer may terminate the agreement with NBIX upon 180 days written notice, upon which all product rights revert to NBIX.

NBIX is collaborating with Glaxo SmithKline to develop and commercialize CRF Antagonists. To date, NBIX has recognized roughly $46 mil in revenues from Glaxo SmithKline in the form of license fees, milestone payments, sponsored development and reimbursement of development costs. Glaxo may terminate the agreement with NBIX upon 90 days written notice, upon which all product rights revert to NBIX.

THE INSOMNIA MARKET

85 million adult Americans suffer from insomnia, of which 22 mil suffer chronic insomnia. Elderly patients constitute an estimated 18% of the target market for insomnia drugs.

During the 1980's, a class of drugs called benzodiazepines that non-selectively targeted the receptor for the GABA brain chemical were used as sedatives to treat insomnia. Unfortunately, "benzos" had undesirable side effects, namely negative interactions with alcohol, the development of a tolerance in patients, rebound insomnia, worsening insomnia when the drugs were discontinued as well as impairment of coordination and memory due to the drugs' long half life.

During the late 1980's, a class of drugs called non-benzo's was developed to target a specific side on the GABA-A receptor of the brain. The selective binding by the drugs on the GABA-A receptor led to a reduced incidence of side effects of these drugs.

In 2005, the estimated U.S. market for non-benzo insomnia drugs was $2.7 bil. Ambien, a drug owned by Sanofi-Aventis, dominates the market with $1.8 bil in worldwide sales. Lunesta, a drug owned by Sepracor, generated $329 mil in worldwide sales. Sonata, a drug owned by King Pharmaceuticals, has been a market laggard and generated only $118 mil in sales. Ambien, by way of reference is expected to face generic competition next year as it comes off patent. Lunesta has patent protection through 2012.

While the non-benzo's represent an improvement over the first generation of insomnia drugs, they are not flawless. Ambien, in particular, has been associated with side effects including night-time sleepwalking, sleep binge-eating and next-day grogginess. You may recall a recent incident involving Rhode Island congressman Patrick Kennedy, who blamed a night-time car crash near the U.S. Capitol on his use of Ambien as a sleep aid.

INDIPLON

Indiplon is a non-benzo, GABA-A receptor agonist which acts using the same mechanism as the most popular insomnia drugs like Ambien and Lunesta. However, preclinical studies suggest that Indiplon has fewer negative side effects than the alternative drugs because it is metabolized and eliminated from the body more quickly. NBIX believes that Indiplon reaches sufficiently high concentrations in the bloodstream to induce sedation within 15 minutes of ingestion. As a result of its shorter half-life, Indiplon appears to significantly reduce the risk of next-day residual sedation effects relative to the competition. To date, clinical data on Indiplon has been amassed in 74 clinical trials involving 8,000 adult and elderly subjects and over 350,000 patient exposures. In addition, Indiplon appears to have higher efficacy than alternative drugs, suggesting that its sedative effects may be more compelling than Ambien or Lunesta.

NBIX hopes to market two versions of Indiplon to the general public: (1) a short-acting, immediate-release capsule formulation available in a 5 mg or 10 mg doseage designed for patients who have trouble falling asleep or who wake up in the middle of the night and can't fall back asleep and (2) a longer-acting, extended-release tablet formulation available in a 15 mg dosage designed for patients who want to maintain sleep throughout the night. The market for the second version of Indiplon � the 15 mg extended release tablet � is much larger than the first version and is expected to be much more likely to compete effectively with the insomnia drugs currently on the market.

RECENT EVENTS

As a quick perusal of the stock chart would attest, things have not gone swimmingly for NBIX in the last month and a half. In mid-May, the FDA defied the widely-expected consensus that both the immediate-release capsule and extended-release tablet formulations would be approved. Instead, the FDA issued an approvable letter (which will likely lead to a formal approval in subsequent months) for the less lucrative 5 and 10 mg immediate release capsule doseage and a non-approvable letter for the marquee 15 mg extended release tablet doseage.

In the fear and disappointment that ensued, essentially the entire NBIX shareholder base turned over as twice the company's shares outstanding traded over a 2-day period. Compounding the negative sentiment on the stock was a report that the CFO was forced to sell NBIX shares to cover a margin call with his broker. NBIX lost 80% of its pre-May 16th market value as a chorus of Wall Street sell-side analysts reversed themselves and downgraded the shares. Large, momentum-style institutional top shareholders like Fidelity and Janus invariably were also selling into/fueling the panic.

The emerging negative consensus centered around a few key points: (1) the 15 mg Indiplon tablet was dead forever, (2) the 5/10 mg capsule doseage was not competitive in the market relative to a generic version of Ambien, and could, at best, generate $100 mil in sales, (3a) Pfizer would walk away from the NBIX partnership due to its appetite for a large, blockbuster drug to fill its maturing product pipeline, leaving NBIX to pay for huge sales force and development costs on its own, (3b) Pfizer would buy a competitor like Sepracor for $7-8 bil and (4) NBIX's management team was inept, potentially corrupt and very much out of their league in dealing with the FDA.

In the intervening weeks, the basis for the FDA's non-approval letter for the 15 mg doseage remains sketchy. Early indications from NBIX were that the FDA did not have time to review all of the relevant clinical data, including a driving study that was submitted in early 2006. The FDA may also have viewed with skepticism NBIX's use of crossover studies (a practice that I believe involves using patients from one clinical trial in another trial). Finally, the FDA may have been overwhelmed with the length of the NBIX clinical data submission (an estimated 300,000 pages) and may have felt self-imposed political pressure with regard to an insomnia drug in the aftermath of the Patrick Kennedy fiasco.

NBIX management did itself no favors with the release of a cryptically-written press release last week indicating that additional clinical data may be necessary to substantiate the 15 mg Indiplon formulation (something that the Street interpreted as auguring additional clinical trials). Also puzzling were revelations that the vast majority of clinical data substantiating the extended release tablet centered around patient interactions with a higher doseage (20 mg) than the one for which NBIX sought FDA approval.

The one potential saving grace for NBIX in all of this controversy comes back to the fundamentals. In the thousands of patients in Indiplon clinical trials, there is no evidence of any safety concern. In addition, all the evidence suggests that Indiplon is more efficacious and presents fewer side effects for insomnia sufferers. That appears to be its competitive advantage and perhaps the advantage that leads to the eventual approval of the 15 mg doseage.

VALUATION

Current NBIX MARKET CAP: $538 mil

NBIX has a market cap of $516 mil based on today's closing price of $13.81 times 37.355 mil diluted shares outstanding. The diluted share count, however, includes 5.319 mil shares underlying options that are well out of the money (reflecting weighted average strike prices of $28.95 to $58.30). The company also has an additional 6.921 mil shares available for future issuance. Taking both of these into account yields a worst-case market cap of $538 mil (worst-case because the 5.319 mil option shares aren't exercised due to the stock price still being too low and because the company further diluted shareholders by issuing 6.9 mil new shares).

DOWNSIDE CASE

Tangible Book Value: $414 mil
Value of NOL/Tax Credit Carryforwards: $85 mil
Value of 5/10 mg Indiplon Revenue Stream: $33 mil
Assumed Value of NBIX Pipeline: $0 mil
Assumed Value of 15 mg Indiplon Revenue Stream: $0 mil
Estimated NBIX Intrinsic Value: $532 mil = $13.66 per share

NBIX has a tangible book value of $384 mil today plus an additional expected $30 mil milestone payment for approval of the 5/10 mg doseage of Indiplon. This brings the effective tangible book value up to $414 mil. Please note that of the $414 in estimated tangible value, an estimated $242 mil will be in the form of net cash (cash, equivalents, restricted cash and estimated additional PFE milestone payment less debt).

It should be noted that this tangible book value figure doesn't give NBIX any credit for appreciation of its San Diego corporate facilities since 2004 (the year when the facilities representing 200,000 square feet were constructed). From my understanding, the San Diego commercial real estate market remains healthy despite the residential real estate downturn. In addition, NBIX facilities are located on El Camino Real, suggesting reasonable transportation access to the facilities. Net of depreciation, NBIX valued its facilities at the end of 2005 at $99 mil ($25 mil for land, $57 mil for buildings, $3 mil for furniture and fixtures and $41 mil for equipment).

The 10-K tells us that NBIX has $371 mil in federal net operating loss (NOL) carry-forwards (which begin to expire in 2010) and and $249 mil in California NOL carry-forwards (which begin to expire in 2006). In addition, NBIX has federal R&D tax credit carry-forwards of $20 mil (which begin to expire in 2007) and California R&D tax credit carry-forwards of $11 mi (which last indefinitely). L

These carry-forwards have some value because they will allow NBIX to shield future income from taxation. Calculating the net present value on these figures is tricky because the NOL's and tax credits only have value to NBIX if they are able to generate positive net income in the future. The NOL's and tax credits would have significantly higher value to an acquirer (like a large pharma company) that could employ the tax benefits today. In the 10-K, NBIX values its NOL's and tax credit carry-forwards at the end of 2005 at $171 mil. For the sake of conservatism, I suggest cutting that number in half to $85 mil.

In a downside scenario, NBIX will only be able to market and sell the 5 and 10 mg dosage of Indiplon. In this event, it would be highly likely that Pfizer would sever the relationship between the two companies and 100% of the economics from Indiplon revert to NBIX. Building on the figures often estimated by the sell-side, we derive an estimate as follows:

$100 mil Worldwide Annual Sales of 5/10 mg Indiplon
(2.5) mil DOV Pharmaceuticals Royalty
$97.5 mil Net NBIX Indiplon Revenues
(32) mil Selling Costs (estimated at $8 mil per quarter)
(30) mil G&A Costs (assumes down from $42 mil in 2005)
(30) mil R&D Costs (down from $106 mil in 2005)
$5.5 mil Pre-Tax Profit
40% Tax Rate
$3.3 mil After-Tax Profit

Capitalizing the $3.3 mil at a 10x multiple (assumes no growth in perpetuity) yields $33 mil in Indiplon 5/10 mg related value.

The one caveat to the downside case is that it assumes that, in a worst-case scenario, NBIX management is smart enough to dramatically scale back its operating cost expenditures (something that not all managements have been willing to do when times are tough). Were NBIX to continue to burn cash at a $30 mil type of annual run rate without having anything to show for it (in the form of new, approvable drugs), my estimate of tangible book value would be significantly overstated (due to the decaying of the cash balances). In addition, in a world where NBIX only generates $5.5 mil in pre-tax profits annually, its NOL and tax credit carryforwards would likely be worth much less than $85 mil.

UPSIDE CASE
$4,200 mil Worldwide Annual Sales of 5/10/15 mg Indiplon ($2,800 U.S. + $1,400 International)
50% Market Share
$2,100 mil Indiplon 5/10/15 mg Revenues

$525 mil Net Royalty Revenues to NBIX (assumed at 25%)
$(150) mil Operating Expenses
$375 mil Pre-Tax Income
40% Tax Rate
$225 mil After-Tax Profit

Capitalizing the $225 mil at a 10x multiple (assumes no growth in perpetuity) yields a $2.25 bil market cap (or roughly $58 per share). Discounting this back at 11% for 18 months (the assumed delay in approval for Indiplon 15 mg in a best-case scenario) yields a $49-50 stock price.

DOWNSIDE: $13-14
UPSIDE: $49-50
CURRENT STOCK PRICE: 14

Best,

Ponch73


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