Value, or an EPIC Failure? : Ariad in focus

Disclaimer: I am long $ARIA.

Their name/symbol is pretty cool,
you can read about it here.

I want to start here by addressing the fact that I'm doing the one thing that I hate to do: following the herd. Ariad Pharmaceuticals (ARIA) is a play that is beloved by small-time, retail investors, and seems to be institutionally uningestable; it currently has a short float of nearly a quarter of all shares, and has recently been on a strong negative rip after some set-backs. Typically, I'm of the opinion that the people smarter than me that devote all of their time to understanding biotechs probably know more than I do, and have more tools than I do. So, this is definitely not a play that makes me comfortable; sometimes, though, the market is wrong, and I'm a believer that this is one of those times. Additionally, this is a classic story of people not understanding where the upside of Ariad exists, and there's a lot of really crappy (and I mean REALLY truly awful) understanding of various cancers and cancer therapeutics on sites like Seeking Alpha and Motley Fool, who tend to dominate the discussion on this topic. Other than those two sites, most of the discussion on Ariad comes from looney message board posters, who claim that Iclusig is better than Gleevec (it's not) or that Gleevec should be pulled from the market (lol). But I'm getting ahead of myself here; let's start from the beginning.


The Recent History of Ariad

Among the alphabet soup of various leukemias (AML, CML, CLL, and ALL), a somewhat common player has emerged: the Philadelphia Chromosome. Essentially, the Philadelphia Chromosome is a chromosomal translocation that was discovered to be common to essentially all cases of CML; this translocation causes the production of a mutant protein (BCR-ABL) that drives the overproduction of white blood cells from the bone marrow. Initially, the prognosis for CML was poor due to the lack of drugs available; median survival was less than 5 years. However, in the 90s Novartis discovered a drug that inhibited the BCR-ABL protein from functioning, Gleevec. Gleevec has been one of the greatest success stories of  medicine, from the early preclinical discovery of the BCR-ABL translocation protein to the development of a specific inhibitor of BCR-ABL. Gleevec is somewhat of a wonder drug; ask any oncologist, and they will speak glowingly ad nauseum about the lives nearly indefinitely extended with Gleevec. However, as is true with many cancer sub-types, eventually some cases of CML were found to become resistant to the effects of Gleevec; thus, other "second-generation" tyrosine kinase inhibitors (the drugs that target the BCR-ABL protein) were developed to deal with these new drug resistant cases. However, a smaller subset of CML cases were still resistant, especially those with a particular "T315I" mutation in the BCR-ABL protein. Thus, Ariad developed a drug (Iclusig) that can target the T315I mutation in patients that were otherwise unable to be treated. As an additional benefit, it was found that Iclusig was potent against all forms of BCR-ABL; it was thus thought that Iclusig could be used at any stage of therapy for CML. As we will see, this was not to be the case.

Initially, Iclusig was only approved as a treatment for CML or Philadelphia Chromosome positive ALL (a small subsection of ALL cases) after previous treatment with a tyrosine kinase inhibitor had failed; thus, Iclusig was relegated to the second/third-line treatment status which drastically reduces the number of sales to be made. In order to move to a first-line therapy, Iclusig had to be proven as effective as (or more effective than) Gleevec: the EPIC trial was carried out to compare efficacy between the two drugs. Unfortunately for Ariad, EPIC had to be discontinued early due to a significant (and not minor) increase in adverse cardiovascular events with the treatment of Iclusig. Shortly after this, Iclusig marketing was halted in the USA due to concerns from the FDA over these same adverse events.

Ariad's recent price per share action.

However, within a few months Ariad was able to add a "black box" warning for Iclusig to include warnings on the danger of cardiovascular events with Iclusig, and within two months marketing for Ariad was resumed with the blessing of the FDA.

So, where does that leave Ariad today?

Iclusig has been seemingly relegated to a second/third-line therapy status, as it will likely only be prescribed as a last resort for patients with CML that are unresponsive to either Gleevec or the other tyrosine kinase inhibitors. So, to try and model revenue from Iclusig (from CML), I'll assume that Iclusig, as a 3rd-line treatment, will capture 5% of the CML market (i.e. patients newly diagnosed with CML per year). In the US, that works out to be ~300 patients per year (Ariad recently reported that at the end of Q1 2014 there were more than 300 patients currently being prescribed Iclusig; additionally, at a recent conference an Ariad representative reported that the eligible patient population is approximately 1300 in the US alone). At a cost of ~ $120k per year, that works out to a revenue of $36 million per year. However, patients on other tyrosine kinase inhibitors will often stay on those inhibitors for longer periods of time than just one year. For example, Ariad's phase I trial of Iclusig has had 50% of patients continue on Iclusig for the 3.5 years that have passed since the beginning of the trial; thus the $36 million per year accounts for only revenue from new patients. Of course, some patients will discontinue treatment, so if we model a loss of 20% per year in revenue from each year's new crop of patients (which gives us around 50% of the first year's revenue after 3 years from each cohort, or a conservative similar estimate based on the number of patients still on Iclusig from the PACE phase I trial), we find that Ariad can conservatively expect revenues of $100 million per year in a little after 3 years. This estimate only includes US sales, however; Iclusig is also approved in Europe, and with double the population of the US and an identical (to my understanding) list of indications it is approved for, I expect Iclusig to generate revenues of $200 million per year from Europe by 2018. Thus, for the use of Iclusig in both the US and EU, I project approximately $300 million in revenue by 2018. Additionally, Iclusig can be prescribed for a small proportion of ALL cases; for the purposes of keeping the model conservative, we'll completely neglect those as well. With the average price/sales ratio for biotechs trading around 10, Ariad's market cap should be ~ $3 billion by 2018; we'll cut that in half because of Ariad's small pipeline (and thus limited future growth) to come up with a projected market cap of ~ $1.5 billion by 2018. Ariad currently trades at a market cap of approximately $1 billion today, implying a 50% upside by 2018 due to the sales of Iclusig alone!

Further catalysts for growth...are not great due to Ariad's small pipeline

The greatest weakness in Ariad's prospects are, in my opinion, its limited pipeline. According to the company website and press releases, the only product other than Iclusig currently under development is an inhibitor of ALK, a protein similar to BCR-ABL that can drive various cancers. However, the ALK inhibitor space is occupied by a number of other companies that are developing second-generation ALK inhibitors. This leads me to my second point: I do not see Ariad as a takeover target by larger pharma firms. There has been a lot of speculation/rumor about Ariad being bought out by mega-cap company like Novartis or Merck. The typical purpose for a large pharmaceutical to buy out a small one is to expand a pipeline lacking in candidates. Ariad is essentially a two-trick pony: Iclusig, and the ALK inhibitor under development. With the ALK inhibitor still being in Phase II testing, it is far from a sure bet. A takeover is always a possibility, but I just can't see a $2+ billion dollar takeover for a company with one 3rd line drug approved and a 2nd line drug still in early clinical trials, and without breakthrough designation. If it happens, I'll be happy, but I don't see it yet.

Outside of a takeover, Ariad's ALK inhibitor (AP26113) is their greatest hope for astronomic growth. Currently, Xalkori is the only approved first-line treatment for non-small-cell lung cancers, while another ALK inhibitor is approved as a 2nd-line treatment. Ariad's AP26113 was developed to treat patients that develop resistance to Xalkori. Due to the size of the lung cancer patient population, even a small slice of the market would likely surpass Iclusig in terms of revenue generated for Ariad. Due to its early stage, however, I do not think it wise yet to include AP26113 in any sort of revenue, as a Phase I/II clinical trial leaves a lot of room for failure before approval.

The most likely, conservative growth driver for Ariad outside of adding patients for Iclusig's approved indications will be an expansion of Iclusig's approval to other markets and an expansion of indications for which Iclusig is approved. Ariad has chosen the intelligent route of following Gleevec into another cancer type for which Gleevec has been approved (gastrointestinal stromal tumors (GIST)), and also a smorgasbord of other cancer types, as is typical of most approved cancer treatments. I expect Iclusig to have a similar relation to Gleevec in GIST, as a second/third-line therapy, as clinical benefit was recently demonstrated in their ASCO presentation. In regards to market expansion, I fully expect an approval for marketing of Iclusig in Japan within a year.

Finally, the company is in a decent cash position, with about $180 million in cash at the end of Q1 2014, and will raise around $200 million with convertible notes. With a quarterly cash burn of $50 million, and the expansion of revenue from Iclusig, I expect Ariad to not need further financing for at least 2 years.

I believe that in the most conservative growth model of Iclusig, Ariad will achieve a valuation at minimum 50% greater than its current near billion dollars within 4 years, neglecting any potential for surprise positive catalysts such as success in AP26113 or any newly revealed lead compounds that Ariad has discovered/developed. Finally, the huge percentage of shares sold short are an inherent added value themselves. Thus, I am adding Ariad to my model portfolio, at its closing price of $5.20 per share from last Friday.

Happy Investing!

JVS



This is a trade analysis, not recommendation.