Description
The Wright Medical Contingent Value Rights - WMGIZ (CVRs) present a speculative opportunity with the potential for a high return with a near term catalyst. The pending FDA final approval should trigger a payment that will leave a stub with a significant potential upside (albeit with a possibility of a 100% loss). I believe that at the current price, these CVRs offer an attractive opportunity.
Background
In conjunction with Wright Medical Group’s purchase of BioMimetic in 2013, Wright issued one contingent value right for each share of BioMimetic it acquired. The CVRs helped bridge the perceived value gap between Wright and BioMimetic which largely centered on the future value of Augment, which had been developed by BioMimetic for use as a biologic replacement for bone grafts.
Augment combines a human growth factor and synthetic bone to repair foot and ankle bones. By using Augment, a surgeon can avoid the risks associated with harvesting bone from the patient for a graft, which is the current standard procedure.
The FDA approval process was tortuous to say the least. The FDA initially denied the application, but reconsidered after Wright threatened to appeal, and eventually granted preliminary approval in October 2014 after reviewing additional radiographic evidence. In order to get final approval from the FDA, the company must pass “customary facilities inspections”. Unfortunately, one of the company’s vendors received a Form 483 notice citing 13 observations, which needed to be addressed. A response to the FDA notice was filed in January, and the company indicated on its February conference call that it expects to receive full approval to market Augment in the second quarter of this year.
Milestones
The CVRs have three milestones, each of which result in a payment to holders.
Approval Milestone - $3.50
Receipt of full approval by the FDA triggers this payment. Based on comments from management, I expect this payment to occur in the third quarter.
Product Milestone 1 – $1.50
The first product milestone requires sales of $40 million in 12 consecutive months.
Product Milestone 2 - $1.50
The second product milestone requires sales of $70 million in 12 consecutive months
The CVRs expire March 1, 2019.
Receipt of full approval from the FDA triggers the initial $3.50 payment, which leaves a stub, which results in a fairly straightforward bet. In order to break even at today’s price of $4.10, the stub would need a 40% chance of Augment reaching the $40 million sales milestone.
The company estimates the market for Augment at $300 million. The math is based on 100,000 cases at a $3,000 price per case. The $3,000 price seems reasonable given that Augment eliminates a potentially risky second procedure that is currently required to harvest bone for an autograft. The company admits that the math is a pretty rough estimate, although they do have some data from selling Augment in Canada and Australia.
In its 2014 year-end conference call, the company indicated that it expected $10 to $12 million of Augment sales in the U.S. in 2015 (assuming approval in the second quarter). Given the likely ramp up time for sales and physician training, most of these sales would be in the fourth quarter, and would suggest a run rate of $25 to $30 million at the end of 2015. Obviously, these are management’s estimates, and could certainly prove too optimistic.
Even if we assume management’s estimate of the market is 50% too high, and that the actual market is $200 million, Augment would have to achieve a 20% market share to meet the $40 million sales target for the first milestone. This seems very reasonable for a product that has equivalent outcomes with a better safety profile and less pain than the current protocol.
Risks
The FDA preliminary approval, which determined that Augment was both safe and effective has eliminated the risk that the CVR will be a zero. The main risk to the $3.50 payment is timing. At worst, failure to resolve the problems at the vendor level could delay final approval.
The risks associated with a new medical product are somewhat mitigated in the case of Augment by the fact that the product has been used for several years in Canada and Australia.
The biggest risk is that sales do not materialize fast enough to meet the milestones. I am assuming that the $40 million milestone will be met by 2019. If the $70 million milestone is hit, that would be pure upside.
There are approximately 28 million CVRs outstanding, and trading is generally thin.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.
Catalyst
Wright Medical is reporting first quarter earnings on Wednesday, and should provide an update on the status of Augment on Wednesday’s conference call.
The final approval from the FDA should come later this year (management’s last forecast was mid Q2, which may prove optimistic). The announcement of final approval, and a payment date should boost the value of the CVRs. (The price spiked into the high $4s when the preliminary approval was announced, but has drifted lower. Based on Augment’s history of delays, I suspect a lot of holders are tired of waiting for payment.)