Description

NOVAN

Last week, Novan, Inc. (NOVN – NASDAQ) filed their Preliminary Prospectus with an initial range of $11 - $13 per share for 3,750,000 primary shares – so $45MM offering size at the midpoint of the range. It was also mentioned that existing shareholders and related parties indicated interest in purchasing up to $25MM of the offering, leaving about $20mm in stock for the underwriters to place plus the greenshoe, so potentially an incremental 15% in new shares. https://www.sec.gov/Archives/edgar/data/1467154/000119312516705260/d233787ds1a.htm

Novan, Inc. is a late-stage pharmaceutical company focused on redefining the standard of care in dermatology through the development and commercialization of innovative therapies using the Company’s Nitric Oxide platform.  In plain English, Novan is the global leader at harnessing Nitric Oxide, which is naturally occurring in the body, and heals a wide variety of conditions.  The extensive benefits of Nitric Oxide within medicine have been widely researched and documented, with The Nobel Prize in Medicine actually being awarded in 1998 for Nitric Oxide research.  Novan’s ability to harness Nitric Oxide and its multiple mechanisms of action has enabled the company to create a platform with the potential to generate differentiated, first-in-class product candidates. The company is rapidly advancing programs for five dermatological conditions with significant unmet medical need. I believe that the company’s ability to effectively deliver nitric oxide on demand in topical formulations allows it the potential to significantly improve patient outcomes in a variety of skin diseases and positions Novan to be a commercially successful leader in the dermatology market.

INVESTMENT THESIS SUMMARY:  I believe the upcoming Novan IPO presents a very asymmetric risk/reward opportunity for investors.  After seeing the management presentation, and having been familiar with this company for the past few years, I felt compelled to present this analysis of a non-traditional “value” investment.  While “biotech” and “value” are seldom heard in the same sentence, numerous variables have converged to create a mispricing of a magnitude that cannot be ignored. I am therefore strongly encouraging investors to give this opportunity its due attention.  By carefully analyzing both trading multiples and recent acquisition multiples, it is hard to come up with a base case below 3x to 6x the current IPO valuation.  As I have watched the dermatology space continue to consolidate with several of NOVN’s competitors getting acquired in the last few months for pretty lofty valuations, I cannot ignore the significant further upside beyond my base case if the company were to be acquired.  While stocks with this type of upside are hard to come by, what is truly astounding here is that the downside risk is less than one would expect.  The company has smartly spent almost $100 million in research and development to get to where they are today and have in the process built up tremendously valuable intellectual property. My work indicates that even in the downside scenario where the trial for the company’s lead products fails, the company’s other products and its IP would still have meaningful value to a number of strategic players. In fact, one of the comparable dermatology companies actually failed its phase 3 trial but the valuation of that stock still indicates a value for Novan that is 20% higher than the current range. While comparable, none of these companies are identical, but this exercise simply illustrates how extremely mispriced the offering for Novan is at its current range.

So why is this offering so mispriced? I believe this opportunity exists because: 1. Very low interest in the IPO market over the last number of months, a dynamic that has only gotten worse as market volatility has risen (people too busy focusing on what they already own) 2. Waves of election-driven headlines about drug pricing risk. 3. Lack of a perfect comp in the space, as the various dermatology companies have different products at different stages of development, making it more difficult to assess the value without doing some real work.  4. The failed IPO of competitor Viamet.  Morgan Stanley and Goldman Sachs tried to IPO Viamet, a company with 2 products in phase 2 and one product in phase 1, trying to raise $100 million at a $270 million pre-money valuation. When the market pushed back on valuation due to the company not having any lead product in phase 3 the deal was pulled earlier this summer.  When Novan came knocking shortly thereafter, the appetite among underwriters was non-existent.  As we have seen so many times before, the pendulum swings way too far in each direction. The market said Viamet was not worth $270 million because it had no lead product in phase 3. Now Novan is being priced at $158 million despite having its lead product in phase 3 and having a more powerful platform!  While it is easy to shy away from a new stock offering when the overall macro and market risks are perceived to be high, I think ignoring this one will be a tremendous lost opportunity.

On the VIC website, (as of late Thursday night, September 15, 2016, when I logged on) 74% of VIC respondents say that they currently see little or no value.  I have been absent with a new idea for months, as I have not had a high conviction idea in a while. Though I am fortunate to have had a solid year in 2016 on a percentage return basis, my performance this year has coasted on ideas posted in 2015 or 2014 with follow-up posts. Chemical and construction equipment stocks such as TSE, TEX and OLN have worked out very well. TSE has been from the low teens to $60 with skeptics dismissing the idea from the beginning.  As I look at metrics for traditional value, I struggle surveying industries across the board, and utilizing common sense, computer and valuation screens to find companies jumping out that are clear and obvious.  Undoubtedly, there are some gems I am missing.  I am certainly willing to scour industries ranging from traditional, convention, high tech, biotech, financials, REITS, defense, utilities, industrials, machinery, etc. to find something that is very exciting and compels one to invest and to tout as a highly-vetted, highly-recommended idea.  Historically we have seen low P/E, strong cash flow stories, with changing dynamics dominating the landscape. I recall when a VIC member wrote up Senomyx (SMNX) a couple of years ago, the analysis received some of the highest ratings we have seen on VIC at the time.  Though certainly a non-traditional “value idea,” it was nice to see (regardless of whether or not the idea would ultimately work out), that members evaluated the analysis, and appreciated the perceived risk/reward at the time.

ROADSHOW:  With regard to NOVN, the roadshow is still ongoing and there remains another full day in NYC today (9/16/16).  If you have the chance to see this management team, I suggest trying to secure a spot at one of the group events, such as the lunch today.  If you cannot, you can watch the presentation to the Piper institutional sales force online here.  retailroadshow.com.  With the Novan management team, we have a rock star scientist who is the leading expert in Nitric Oxide in Nate Stasko, as well as a successful former chairman and largest shareholder in Neal Hunter, who was the co-founder and former CEO of the multi-billion dollar Raleigh-Durham LED-lighting company, CREE. The combination over the past decade has proven to be formidable in attracting science talent, and in developing a very challenging compound (Nitric Oxide) into a platform able to address a multitude of maladies with the opportunity to find success with many shots on goal.  With the additions of Brian Johnson, Joyce Rico, Rick Peterson, etc., Novan has an all-star line-up.  This blue-chip management team has the capacity to develop Novan into a multi-billion dollar company.

Below, are the reasons Novan has so much potential, followed by a discussion on the competitive landscape and the valuation comparables

1. Nitric Oxide a Challenge to Handle:  Despite increasing amount of medical and academic research documenting the benefits of Nitric Oxide in medicine, the difficulty on handling this chemical compound has until now prevented it from being used. While there is awareness broadly about the health benefits of Nitric Oxide, one need only Google “Nitric Oxide” to see search results dominated by supplements and articles touting its benefits. Again, this is serious science, and companies purporting to have Nitric Oxide “supplements” are hoping for the psychosomatic placebo effect for the snake oil they are selling.
2. Unique Position and Delivery Mechanism:  Novan is the only company that has cracked the code on how to use Nitric Oxide by developing a technology to not only effectively deliver Nitric Oxide (it is a gas so historically it has not been possible to prevent it from evaporating) but also to modulate the delivery. The IP notwithstanding, the complexity and science involved is not something another company with vast resources can simply throw a team of scientists together and say – “go develop some Nitric Oxide products that we can use.”  The complexity requires a great deal of time, research, as well as the expertise and financial resources. Novan is leading edge and has been developing and working on research and development for the past decade.
3. Platform Technology and Efficacy in Multiple Therapeutic Areas:  What makes this so valuable is that since Nitric Oxide’s positive impact on so many facets on the human body is so well documented, this technology provides for a platform to finally capitalize of Nitric Oxide’s potential across a vast number of therapeutic areas. This means that the development of these products carry less risk than usual as it is really the delivery mechanism that is being tested and refined, and not the underlying product.
4. Innovation – Not a “Me Too” Group of Products:  In addition, while several of the dermatology markets are well established with a number of competitors, there has been very little innovation in these markets over the last 20 years as the existing players are largely tweaking old formulations and indications.  As an example of this, Novan’s product for acne, will upon approval, be the first new chemical entity for the treatment of acne introduced in decades.
5. Poised to be the Leader in Acne, but also Genital Warts, Onychomycosis, Psoriasis and More:  While their product for acne is the one that is closest to FDA approval, the company is enjoying very positive results with their initial trials for other large and underserved markets, like genital warts (phase 2 results due before year end and) onychomycosis (phase 2 results due within 6 to 9 months). Additionally, the preliminary results for leveraging the platform to treat psoriasis and atopic dermatitis are also very promising.
6. 10 Years and $100MM of R&D with the “A-Team” of Nitric Oxide:  Since the company’s inception in 2006, the company’s positive clinical developments have allowed it to attract some very astute bio-pharma investors as it has raised over $100 million in private funding.  The innovation and success have also resulted in Novan being awarded government grants and contracts of $15 million.  It has also built a very solid management team (ex-CFO of Medicis, senior executives from Galderma, Astellas, Genentech, and Actavis) and board of directors (Glaxo SmithKline, EY, Elan, Abbott)
7. Extreme Valuation Dislocation – an Early Christmas Gift for Investors:  We believe the Novan IPO represents an extraordinary opportunity for investors, not only because of the potential of the platform, but also because of the mispricing due to the weak state of the IPO market, the current high level of fear in the market and the election-driven headlines about drug pricing (among other variables).  At the mid-point of the current pricing range, the company is being priced at a $158 million if you exclude the net cash it has on the balance sheet before the offering.  Let’s see how that stacks up against its closest comps:

a.    Dermira (DERM): Pretty good comp to Novan because:

                                          i.    Both companies are pre-revenue

                                         ii.    Run-rate operating loss is 56 million for DERM vs 58 million for NOVN

                                        iii.    Novan is in Phase 3 for acne; DERM is at least a year behind and does not plan to have their end of Phase 2 meeting with the FDA until 1H2017, and when they will begin Phase 3 is uncertain.  With both companies having a lead drug (acne), and DERM substantially behind, NOVN pricing seems odd to be this low.

                                       iv.    Both companies have a new chemical entity

                                        v.    Both companies have promising psoriasis products. While NOVN’s product can also treat atopic dermatitis, Dermira’s product is at a later stage of development as it is currently in phase 3, while Novan’s product is still in phase 1. 

                                       vi.    Dermira a hyperhidrosis product that had a successful phase 3 trial. Not clear how much value there is in this product as it is not clear there is much of a market here beyond the existing solutions. In fact, the stock went down 6% when they announced the successful phase 3 trial for hyperhidrosis as fast money were playing for a potential pop but there is limited long-term value here.

                                      vii.    Novan has a very promising product for genital warts in phase 2 of development

                                     viii.    Novan has a very promising product for onychomycosis in phase 2 of development

                                       ix.    Finally, the data for the lead acne product shows that NOVN’s product is both more effective in terms of reducing lesions as well as easier to use as it is once a day vs. twice a day.

                                        x.    If we assume that the acne drug for both companies is worth the same, then the question about the relative value comes down to whether the difference in development in the two companies’ psoriasis drugs and the value of Dermira’s hyperhidrosis product versus the two phase 2 products that Novan has for genital warts and onychomycosis. Regardless of where one comes out on this, we should not lose sight of the fact that most investors look at acne being the most valuable part of the portfolio for both companies. Therefore, the difference between the aggregate valuations of both companies should not be substantial.  The enterprise value of Dermira is $891 million, while the pre-money valuation of Novan at the mid-point of the range is $158 million (ratio of 5.6 to 1.  If we value Novan at the same valuation, Novan stock price would be $61.8 (891 million EV plus net cash of 19 million divided by 14.733 million shares). 

b.    Aclaris (ACRS): Also a pretty good comp to Novan:

                                          i.    Both companies are pre-revenue

                                         ii.    Run rate operating loss is 52 million for ACRS and 58 million for NOVN

                                        iii.    They are both early stage dermatology companies with their lead product in phase 3

                                       iv.    Novan should command a higher valuation because:

1.    Its lead product for acne in phase 3 is worth more than Aclaris’ lead product for seborrheic keratosis, as the acne market is almost 4x the size of the seborrheic keratosis markets, which more than offsets the fact that the acne market is more competitive.

2.    Its genital warts product in phase 2 is at least as valuable as Aclaris’ common warts product in phase 2 as the market is about the same size but Novan’s product is significantly superior to the current alternatives while Aclaris’ product for regular warts is more similar to the existing competitors.

3.    Novan has two other products that Aclaris does not have:  an onychomycosis product in phase 2 and a psoriasis and atopic dermatitis product in phase one.

                                        v.    Aclaris currently has an enterprise value of $423 million. Therefore, even if we assume that the Novan’s acne product in phase 3 and its genital warts product in phase 2 are not worth more, but rather the same as Aclaris’ seborrheic keratosis in phase 3 and its product for common warts in phase 2, the Novan stock price would be $30 (423 million EV plus net cash of 19 divided by 14.733 million shares) even before we value Novan’s other two products.  These other two products, onychomycosis in phase 2 and psoriasis in phase 1, are likely quite valuable.  In the last three months alone, two early stage dermatology companies, Anacor (6/27/2016) and Vitae (9/14/2016 – last week) have been acquired for $4.4 Billion and $524 million respectively.  Anacor had recently received approval for its onychomycosis product (explains much of the valuation delta compare do Vitae) while its psoriasis product was still in phase 2. Vitae had two products in phase 2, one for psoriasis and one for atopic dermatitis. 

c.    Anacor (ANAC): As mentioned above, Pfizer bought Anacor, which had a product for onychomycosis approved and a psoriasis & atopic dermatitis in phase 3.  We don’t know exactly what the probability is for Novan’s onychomycosis product to be approved or that its psoriasis and atopic dermatitis product gets to phase 3, let alone approved.  However, we know that for a company that had achieved those two milestones, Pfizer paid $4.4 Billion less than 3 months ago.  In terms of value per share of these two products getting to approval and phase 3, for Novan this would be $302 per share (4.429 Billion plus 19 million in net cash or $4.448 Billion / 14.733 million shares). And this is before we add in the value of Novan’s lead product in acne currently in phase 3 or its phase 2 product in genital warts.  Even if you assume there only is a 10% chance of Novan achieving these milestones, onychomycosis, and psoriasis / atopic dermatitis is worth $30.2 per share (10% *302). If we value the acne and genital warts business in line with Aclaris, we’d be looking at a $60.2 per share for Novan. And this assumes 10% probability of getting onychomycosis to approval and psoriasis to phase 3.  This means that at 0% probability you get to $30 per share and at 100% probability you get to $332 per share.  We can debate the right probability, but in no circumstances should Novan trade anywhere close to its $12 IPO price.

d.    Vitae (VTAE):  This is an interesting comp because this company was just acquired by Allergan for $524 million THIS WEEK, when its only two products are two products that Novan also has, the only difference is that Vitae has them in phase 2 and Novan still has them in phase 1. Novan expects these two products to be in phase 2 within the next 12 months.  Given that there is less uncertainty from phase 1 to phase 2 than later in the regulatory process, we are willing to assume that there is a good chance that Novan gets these two products at least to phase 2. At 100% this is worth $37 per Novan share ($524+19 or 543 / 14.733 million shares). Even under a very conservative 25% likelihood of getting to phase 2, this is worth $9.2 per share for the psoriasis and atopic dermatitis part. Then we have to add onychomycosis in phase 2, genital warts in phase 2 and the lead acne product in phase 3. If we just use Aclaris as a comp for the value of acne and genital warts, we have to add $30 per share. That gets us to $39.2 per share. And that is before we add the value of onychomycosis in phase 2. Given the value that Pfizer attributed to the onychomycosis product in its $4.4 Billion acquisition, it seems like this product could again be quite meaningful.  Just for argument’s sake, let’s say Pfizer attributed half the value of Anacor to its onychomycosis product, or $2.2 Billion. Let’s further assume that the probability for Novan’s onychomycosis product to get to approval from its current phase 2 stage is only 25%. That still adds $37 per share, on top of the $39.2 or a total value of $76.2. 

e.    Foamix (FOMX):  This is on the surface a good comp because it also has an acne product in phase 3. However, their product is just a reformulation of a 30-year-old product, Minocycline, which is successfully marketed by Medicis.  Comparing the phase 2 data between NOVN and FOMX, we see the NOVN product has better efficacy overall, in particular with non-inflammatory lesions.  Given the lack of differentiation of Foamix’s product relative to existing alternatives, we believe it has a higher risk of failure in phase 3 than average and that the market is pricing this accordingly.  In addition to their acne franchise, they have two other products going into phase 3, one for Rosacea and (redness of skin) one for Impetigo (also known as school sores, which mainly affects infants and children).  The Rosacea market is $1.2 Billion with the top 3 players controlling over 60% of the market. While it is difficult to find good data on Impetigo as it is successfully treated with various antibiotics, it is not a particularly sexy market.  In addition to the lack of innovation on acne and the less exciting end markets of Impetigo and Rosacea, Foamix is not a US company, which could drive some discount compared to the peers.  Despite what we perceive to be inferior markets and lower probability of success for acne and a product with no innovation, the market is still valuing FOMX at $227 million or an equivalent of $17 per share for NOVN. 

f.     Revance Therapeutics (RVNC):  In addition to being an early stage dermatology comp, it is interesting to look at Revance because this is a company that has a product in phase 3 (Frown lines) and two products in phase 2 (hyperhidrosis and Cervical Dystonia), which is similar to what NOVN has (NOVN also has the pre-clinical products in psoriasis and atopic dermatitis).  The important thing about RVNC is that their platform actually FAILED their phase 3 trial for Lateral Canthal Lines (Crow Feet).  This means that not only did they have very little innovation as their product and platform look like slight tweaks to Botox (successfully marketed by Allergan), but they actually failed phase 3.  Despite all of this, the company has a valuation of $191 million, or the equivalent of $14 per share.  Using RVNC as a comp, it suggests that at $12 per share, the market is pricing in a probability of failure of the NOVN platform in excess of 100%!  NOVN’s platform should be worth a lot more than RVNC, not only because it has a great chance of getting approved (instead of failing like RVNC) but also because it is a completely new chemical entity and not a tweak on something that already exists. While it hard to draw a fair value of NOVN by looking at RVNC, we can say that if NOVN fails it will trade at $14.3.  If this is a realistic downside case, then the stock seems to be pricing in more than guaranteed failure at $12 mid-point of the range. Clearly, this is absurd.

g.    Kythera (KYTH):  Kythera is a one-product dermatology company that was sold to Allergan in November of 2015. Their product addresses submental fullness, or more commonly known as excessive fat chin (“Turkey neck”).  They developed the product and got approval at the end of April of 2015 and Allergan acquired them for $1.8 Billion five months later.  The company had no revenue and had an annual operating loss of 136 million. There is no proven market for this product, only studies suggesting that a portion of Botox customers would be interested in trying this product. For reference, Allergan’s Botox revenues are $2 billion per year.  Using this valuation for NOVN would yield a price of $124 per share.   I don’t think this is a great comp but it is certainly better than RVNC and arguably better than FOMX. 

NOVN is clearly unknown, and will pique investor interest as institutions begin to see the likelihood of upside for a company that is commercializing leading edge scientific technology on a platform that has multiple formulation chances for success in a wide range of applications.  The downside risk scenario is simply not a high probability event, while the magnitude of the upside speaks for itself.  Investors have a unique situation next week, as there appears to be a dearth of detailed available comparable valuations and a lack of market knowledge regarding the quality of this management team, the benefits of nitric oxide, and the enormous potential for this platform.  In short, when the realistic downside is in the mid-teens while the upside is somewhere between $60 and $300+, the decision whether or not to buy the stock should be quite easy.  We have seen the management presentation and it is impressive. As a capitalist and investor team, we will be delighted to buy NOVN on the IPO – hopefully from the underwriters, but if not, in the open market.

Catalyst

• IPO attention next week when the deal prices
• Underwriter coverage in 30 days following the pricing of the IPO
• Clinical Data releases over the next few months and in particular, phase 3 for acne in early 2017
• Likely Large company intervention if this pricing dislocation remains in place for any length of time