Imclone Systems IMCL S
November 16, 2006 - 4:21pm EST by
repetek827
2006 2007
Price: 33.40 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 3,079 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT
Borrow Cost: NA

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Description

Introduction: We are recommending Imclone Systems (IMCL) for short sale with an ultimate target below $10. IMCL is a single product biopharmaceutical company. That single product is an EGFR antibody called Erbitux.  The conventional bear case on Imclone centers around the idea that new competition from Amgen (AMGN) will meaningfully eat into Erbitux sales and profitability. We believe the bear case is much stronger than commonly thought. Due to the loss of a key patent in a recent litigation, IMCL appears guilty of breaching its representations and warranties to its exclusive US marketing partner Bristol Myers Squibb (BMY). It was directly due to this breach that AMGN had the ability to get a license to the lost patent and compete with Erbitux. We believe that BMY has the leverage, ability and motivation to either successfully sue for billions ($4 billion estimated) in damages or dramatically renegotiate the economic terms of its original agreement with Imclone. (Imclone currently receives a 39% royalty on all sales of Erbitux, milestone fees and manufacturing fees.) Any material change to these terms would have a dramatic effect upon IMCL’s earnings power and share price. We believe our thesis is supported by statements provided by BMY in its September 2006 10Q and recent statements by Carl Icahn. Not a single sell-side analyst is of the belief that this issue is significant. Finally, Yeda, the licensing arm of the Weizmann Institite, has recently followed up on their court win against IMCL (they were awarded sole ownership of the 866 patent) by filing counter claims that could be worth $1 billion.  
 
The Company: IMCL is a biopharmaceutical company that derives all its revenue from a single product; Erbitux. In the mid-1990s IMCL acquired exclusive rights to the predecessor patent applications and intellectual property of what later became Erbitux from Aventis. IMCL took over the patent application and became the exclusive licensee. The only patent that resulted from the Aventis license is the 866’ patent. Analysts estimate the royalty paid to Aventis to be 3.5%
 
IMCL has two primary marketing partners both of whom enjoy exclusivity in their respective territories. For the US and Japan it is BMY and for Europe and most of the rest of the world it is Merck KGA.  While 60% of worldwide sales of Erbitux take place in the US and the remainder outside, approximately 90% of royalty income comes from the US since the royalty rate paid by BMY is 39% vs. 9% from Merck KGA. Thus, it is fair to say that approximately 90% of Imclone’s  intrinsic value stems from its continued successful partnership with BMY. BMY also owns 14.4 million shares of IMCL, representing 16% of the outstanding shares.
 
Erbitux is currently approved for end stage colorectal cancer and is also in late stage trials for head and neck cancer pancreatic and lung cancer.  The company’s stock hit a 52-week-high of $43 in July 2006 on speculation that the company would be sold. The stock declined to $28 when it was disclosed that the company intended to remain independent but has recovered to the $33 range most recently as investors are excited about Carl Icahn having taken control of the board of Directors as well as upcoming clinical trials.
 
Conventional Short Thesis: The conventional bear case argues that not only has IMCL lost its monopoly to Amgen’s drug (Vectibix) but also that Vectibix is a better drug. Vectibix necessitates a less frequent dosage than Erbitux, has a better safety profile and is 20% cheaper. For these reasons the conventional bear case assumes that revenue growth from Erbitux is limited from current levels as competition will grab at least 50% of the market and that pricing will come down as the number of indications increase.  In addition, it is argued, current earnings are overstated by the amount of non-recurring payments received from partner Bristol Myers Squibb. Such payments have been traditionally amortized into earnings. As a part of the agreement with Bristol Myers Squibb, Imclone was paid $900 million based on achieving certain regulatory milestones. Because these payments are non-recurring they ought to be excluded when evaluating IMCL’s earning power. In addition, the last of these payments- $250 million- was received in 2006. These payments have been and will continue to be amortized into earnings. Beyond 2006, all license and milestone revenue is expected to be non-cash.   Excluding these payments from 2005, earnings would have been roughly break-even vs. reported results of $1.18/share; excluding these payments from 2006, earnings would be slashed to $0.43/share vs. expected results of $2.95/share.
 
The following table displays how much of IMCL’s  earnings come from license fees and milestones.
 

Earnings Adjusted to Exclude Licensing Revenue
 
 
 
 
 
 
 
2004
2005
2006
2007
2008
2009
2010
2011
Income (loss) before tax
    134
    100
    298
    184
    201
    235
    272
    281
less:
 
 
 
 
 
 
 
 
License fees and milestone revenue
   (129)
     (97)
   (241)
     (90)
     (72)
     (54)
     (36)
     (18)
equal:
 
 
 
 
 
 
 
 
Adjusted Pretax Income
       5
       3
      57
      94
    129
    181
    236
    263
Tax Rate
      -  
      -  
9%
30%
30%
30%
30%
30%
Provision for income taxes
       1
       1
      17
      28
      39
      54
      71
      79
Adjusted Net Income
       3
       2
      40
      65
      91
    126
    165
    184
Adjusted EPS
 $0.04
 $0.03
 $0.43
 $0.70
 $0.95
 $1.30
 $1.66
 $1.82

 
 
 
 
Both the bulls and the bears have roughly equivalent estimates going through 2010- all agreeing that earnings will reach between $1.75- $2.10. Yet the bulls arrive at a target price north of $45, while the bears end up with a target price south of $25. The divergence between the bulls and bears is based upon how each camp sees earnings growing between 2010 and beyond, with the bulls assuming that earnings will grow 15% per year for the decade following 2010 and the bears assuming roughly 5%. We think the bearish case is more logical since there is no basis upon which to assume such growth beyond 2010 other than an unproven pipeline.
 
 

 
 
 
INCOME STATEMENT
 
 
 
 
 
 
 
 
 
 
 
 
 
2004A
2005A
2006E
2007E
2008E
2009E
2010E
2011E
Erbitux Revenue Model
 
 
 
 
 
 
 
 
U.S. sales:
 
 
 
 
 
 
 
 
Colorectal cancer
253
357
400
384
507
503
581
571
Head and neck cancer
8
56
282
321
229
234
243
251
Pancreatic, lung, other off-label
0
0
5
57
122
210
243
257
Total U.S. sales
261
413
687
762
858
946
1066
1078
Europe sales
102
267
430
503
575
644
725
733
 
 
61%
62%
 
 
 
 
 
WW Sales of Erbitux
    363
    680
 1,117
 1,265
 1,433
 1,590
 1,791
 1,811
License fees and milestone revenue
129
97
241
90
72
54
36
18
 
 
 
 
 
 
 
 
 
BMY Royalties
102
161
268
297
335
369
416
420
Merck KGA* Royalties
4
16
41
48
55
61
69
70
Royalty revenue
106
177
304
345
389
430
485
490
 
 
 
 
 
 
 
 
 
Collaborative agreement revenue
49
65
66
74
77
80
84
74
Manufacturing Revenue
99
44
110
121
137
151
170
172
Total revenues
383
383
721
630
675
715
775
754
 
 
 
 
 
 
 
 
 
Operating expenses:
 
 
 
 
 
 
 
 
Cost of Erbitux sold
1
16.4
84.3
83.8
102.9
113.6
128
118.6
Research and development
113
150.6
208.4
229.8
225.3
211
207
193.1
Marketing, general and administrative
60
72.3
81.5
85.5
89.8
94.3
99
100
Patent Royalty Expense
36.1
58.4
79.2
81.5
92.0
101.7
114.6
115.8
 
54
6.2
0
0
0
0
0
0
Total operating expenses
258
303.9
453.4
480.6
510.0
520.6
548.6
527.5
Operating Income (loss)
125.3
79
268
149.6
164.9
194.5
226
226.5
Net interest and other expense
    (9.0)
  (21.3)
  (30.5)
  (33.9)
  (36.4)
  (40.2)
  (45.5)
  (54.0)
 
 
 
 
 
 
 
 
 
Income (loss) before tax
 134.3
 100.4
 298.1
 183.5
 201.3
 234.7
 271.5
 280.5
Provision for income taxes
   17.0
     1.3
   26.2
   55.1
   60.4
   70.4
   81.5
   84.2
Net Income (loss)
 117.1
   99.1
 271.9
 128.5
 141.0
 164.2
 190.1
 196.4
EPS
$1.94
$1.07
$2.95
$1.54
$1.65
$1.86
$2.10
$2.12
Shares outstanding (Diluted in millions)
88
92
92
94
96
97
99
101
 
 
 
 
 
 
 
 
 

 
 
 
 
 
From the model above we can see how all the revenues are derived from Erbitux and how most of the revenues and profits come from their partner BMY.
 
 
 
OUR THESIS STRENGTHENS THE CASE
What we add to the story is the notion that the current price does not take into account the prospect of Yeda (the licensing arm of the Weizmann institute in Israel) extracting a meaningful economic bite from IMCL’s cash hoard or earnings stream going forward nor, much more importantly, does it contemplate the prospect of BMY demanding financial damages resulting from IMCL breaching its representations and warranties of the original 2001 Distribution Agreement.
 
This whole mess begins with the lawsuit filed in 2003 by Yeda claiming that the 866 patent relating to combination therapy of Erbitux + a chemo-therapeutic agent) properly belongs to Yeda and not to Aventis/IMCL. Aventis/IMCL tried and failed repeatedly to get their specific EGFR antibody approved (9 times) for composition of matter claims. The Patent Office regarded the specific antibody being submitted as insufficiently distinct from a previously patented EGFR antibody.  It turns out that the only meaningful Erbitux patent relates to the synergistic effect seen when mixing Erbitux with a chemotherapeutic agent. IMCL ultimately filed for and received the 866’ patent covering combination therapy.
 
Yeda made an extremely convincing case that it was their scientists that conceived of the ideas underlying the 866 patent and not the scientists of  Meloy (that was subsequently acquired by Aventis).  The judge determined that even the contribution of the antibody was deemed to be a non-material inventive contribution. Consequently, Aventis/IMCL were unable to retain even co-ownership to the 866 patent.
 
The following are the representations and warranties included in the Sept 2001 Distribution Agreement between BMY and IMCL.
 
 
 
11.2 REPRESENTATIONS AND WARRANTIES OF THE COMPANY.
 The Company (IMCL) represents and warrants to each of ERS and BMS (Bristol Myers), as of the Effective Date, that, except as disclosed in Company SEC Documents or in the disclosure letter previously delivered by the Company to BMS:
(a) The Company is the owner of, or has exclusive rights to, all of the Patents and Trademarks in existence on the Effective Date, and has the exclusive right to grant the rights granted under this Agreement therefor. To the knowledge of the Company, all of the Patents and Trademarks are valid, in full force and effect and have been maintained to date, and are not the subject of any interference or opposition proceedings;
(b) To the knowledge of the Company, the Company (i) is not aware of any asserted or unasserted claims, interferences, oppositions or demands of any Third Party against the Technology or the Trademarks in existence as of the Effective Date; and (ii) to the knowledge of the Company, the Parties' practice of any invention claimed in the Patents or the exercise of any rights to the Technology or the Trademarks as contemplated by this Agreement will not infringe any patent or other intellectual property right of any Third Party:
 
IMCL appears to be guilty of breach as:
 
a)it does not own or have exclusive rights to the 866’ patent. Thus, section 11.2(a) is breached.
 
b)IMCL was aware of unasserted claims against the Technology. Thus 11.2(b)is breached. (There was an email exchange between IMCL’s in-house patent attorney and patent council for Yeda that took place in 2000 which highlights that Imclone was aware that the Weizmann scientists might contest inventorship of the 866 patent before IMCL signed its distribution agreement with BMY. This email exchange was a significant blow to IMCL’s attempt to assert the Laches Defense)
 
What are the consequences of breach? The answer to this question can also be found in the September 2001 Distribution Agreement in Section 12.3.
 
12.3 INDEMNIFICATION BY THE COMPANY
The Company (IMCL) shall indemnify, defend and hold harmless ERS,BMS (Bristol Myers)….from and against any and all liabilities, damages, losses, costs and expenses (including the reasonable fees of attorneys and other professionals) to the extent arising out of or resulting from … any breach of any representation or warranty made by the Company (Imclone) under Section 11.1 or 11.2.
 
It is not a question of if Bristol Myers will take an action; it is a question of when. The excerpt below from BMY’s September 10Q make it very clear what BMY’s legal strategy is relative to the Yeda situation. Namely, that Imclone is responsible for all damages that result from breaching its representations and warranties. It strongly implies that BMY regards the entrance of Amgen’s competitive product to the market a damaging consequence of having breached the representations and warranties.
 
EXCERPT FROM BMY Q306 10Q
“On September 18, 2006, the Court issued an opinion and order in which it held that three researchers at Yeda were the sole inventors of the subject matter of the ‘866 patent, and giving complete ownership of the patent to Yeda. ImClone has filed an appeal of the Court’s decision. ImClone also filed a declaratory judgment action in the United States District Court for the Southern District of New York. The complaint alleges that if the Yeda researchers remain sole inventors of the ‘866 patent, the patent is invalid. The Company, which is not a party to this action, is unable to predict the outcome of these proceedings.
As a result of the Court’s decision, Yeda may seek damages for infringement with respect to past ERBITUX* sales and royalties on future ERBITUX* sales. Yeda also has the right to license the patent to others. Yeda’s license of the patent to third parties could result in product competition for ERBITUX* that might not otherwise occur. It is too early to assess whether and to what extent any such competitive impact will occur or to quantify any such impact.  However, Yeda has announced that it has licensed the patent to Amgen Inc. (Amgen). Amgen recently received FDA approval to market an EGFR product that competes with ERBITUX*. Under its commercial agreement with ImClone, the Company pays a royalty to ImClone on sales of ERBITUX* that is not impacted by the Court’s decision.
The agreement between ImClone and the Company(BMY) also includes provisions pursuant to which certain financial consequences to the Company(BMY) resulting from the decision would be the responsibility of ImClone.”
 
The last italicized paragraph of the above excerpt is clearly alluding to Section 12.3 INDEMNIFICATION BY THE COMPANY (IMCL) of the 2001 Distribution Agreement-  Taking that together with “Yeda’s license of the patent to third parties could result in product competition for ERBITUX* that might not otherwise occur. It is too early to assess whether and to what extent any such competitive impact will occur or to quantify any such impact.”- it is clear that BMY believes that if damage (in the form of lost market share) results from Amgen entering the market, then IMCL will be responsible for those damages commensurate with the extent of lost sales and margins. One can theorize that BMY has not aggressively matched price of Erbitux to match the price of Amgen’s Vectibix because the more market share BMY loses the more damage it can claim against IMCL. BMY controls pricing and marketing of Erbitux in the US; this is their leverage on IMCL. One can speculate that BMY is not spending any more money on marketing than it was before AMGN entered the market – so as to be able to demonstrate and quantify damages stemming from the breach.
 
While the preceding is the most compelling evidence that Imclone is in trouble, there are additional, albeit more anecdotal pieces of evidence which make the same point.
 
  • The sudden resignation of a series of senior executives including Ron Martell, who had been the Sr. VP of Commercial Operations but was, in fact, IMCL’s de-facto CEO, and Michael Howerton, the CFO. Both sold all their shares immediately after resignation.
 
  • The sudden and immediate resignation and abdication of Board control by David Kiess, the former Chairman and William Crouse, after posturing aggressively that the existing Board was going to fight Carl Icahn’s effort to take control.
 
  • Once Carl Icahn takes control of the Board and is provided with an inside perspective he puts out an extremely unusual comment: “My immediate priorities as chairman are to 1) investigate the reasons for why the relationship between ImClone Systems and its partner Bristol-Myers Squibb has seriously deteriorated over the past few years …”  This comment is highly unusual because typically a new leader would put a positive spin on a repairable situation. A comment one might expect would have been: “We hope to strengthen the relationship with Bristol Myers.”  The comment as written indicates that perhaps Carl Icahn was surprised by the status of the relationship and furthermore, that it is not repairable.
 
 
QUANTIFYING BMY’s DAMAGES CLAIM
 
We believe the claim of damages from BMY runs into the billions. BMY has invested enormous sums in Imclone including:
 
a) $1 billion in cash was paid for 14.4 million shares at $70 per share in 2001
b) $900 million in license fees and milestone payments were paid to Imclone since 2001 
c) An extremely high (by industry standards) royalty rate of 39%
 
The present value of damages from 2004 through 2018 (agreement expiration)- using a 7% discount rate, is $3.1 billion. In this calculation we assumed that US Erbitux sales would grow gradually and hit $1.5 billion by 2018. We assumed Erbitux would lose 50% market share to other EGFR products and that SG&A would have remained constant in dollar terms with or without competition.
 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
2004
2005
2006E
2007E
2008E
2009E
2010E
2011E
2012E
2013E
2014E
2015E
2016E
2017E
2018E
 
BMY Erbitux Sales
261
413
687
762
858
946
1066
1078
1132
1188
1248
1310
1376
1445
1517
 
COGS
99
44
110
121
137
151
170
172
181
190
199
209
220
230
242
 
IMCL Royalties
102
161
268
297
335
369
416
420
441
464
487
511
537
563
592
 
BMY Gross Profit
60
208
309
344
386
426
480
486
510
535
562
590
620
651
683
 
SG&A Estimated
52
62
82
91
103
114
128
129
136
143
150
157
165
173
182
 
Operating Profit
8
146
227
252
283
313
352
356
374
393
412
433
455
477
501
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Op Profit No Comp.
68
354
536
596
670
739
833
842
884
928
974
  1,023
  1,074
  1,128
  1,184
 
(Assumes sales are doubled SG&A remains constant)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Damage Claim
60
208
309
344
386
426
480
486
510
535
562
590
620
651
683
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
NPV w/ 7% discount rate
$3,126
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

 
 
 
BMY can reasonably ask for a return of 50% of its milestones ($450 million) 50% of its money back on its purchase of common stock ($500 million) plus $3.1 billion for damages on account of lost market share to competitive EGFR products.  Taken together, the damages exceed $4 billion. This all assumes that Erbitux maintains 50% market share. If it manages to maintain less than 50% market share the claim for damages can be higher.
 
The following table illustrates what would happen to IMCL’s earnings power if the royalty rate were to be cut in half upon renegotiation.
 

Earnings Adjusted to Reflect 50% Reduction in Royalty Rate from BMY
 
 
 
 
2004
2005
2006
2007
2008
2009
2010
2011
 
 
 
 
BMY Royalties
102
161
268
297
335
369
416
420
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Income (loss) before tax
    134
    100
    298
    184
    201
    235
    272
    281
 
 
 
 
less:
 
 
 
 
 
 
 
 
 
 
 
 
50% haircut on Royalty Income from BMY
     (51)
     (81)
   (134)
   (149)
   (167)
   (184)
   (208)
   (210)
 
 
 
 
equal:
 
 
 
 
 
 
 
 
 
 
 
 
Adjusted Pretax Income
      83
      20
    164
      35
      34
      50
      64
      70
 
 
 
 
Provision for income taxes
      25
       6
      49
      10
      10
      15
      19
      21
 
 
 
 
Adjusted Net Income
      58
      14
    115
      24
      24
      35
      45
      49
 
 
 
 
Adjusted EPS
 $0.67
 $0.15
 $1.25
 $0.26
 $0.25
 $0.36
 $0.45
 $0.49
 
 
 
 

 
 
 
 
 
Based upon all of the foregoing we think that the true intrinsic value of IMCL could ultimately be less than $10 per share. This is based on a 20x multiple of what IMCL could earn in 2011 with a 50% reduction in royalty rate from BMY.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

Catalyst

Deteriorating relationship between IMCL and BMY explodes into litigation or substantial downward revision of royalty rate to IMCL.
Decelerating revenue growth due to entrance of competitive product and indifference by marketing partner BMY
Success in litigation by Yeda claiming unjust enrichment and patent infringement
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