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Geron: Calculating The Potential Value Gap

Summary

Geron's shares have shrugged off a torrent of recent good news.

The stagnation of the shares has created a buying opportunity for patient investors.

This article provides a view of how the author believes Geron's shares could be priced, based on this value gap.

There is an old trial lawyer trick where the following question is asked of a witness: "Were you lying then, or are you lying now?" Once a jury hears that question, the damage is done, even though an objection will prevent any response. A similar question could be asked of Geron's shares: "Were you overvalued before all this good news, or are you undervalued now?" Unlike in the lawyer example, the answer to this question is important to investors who have, in some cases, been waiting on Geron's (NASDAQ:GERN) candidate, imetelstat (IMET), for a decade.

I will spare you the suspense. I believe the answer is that Geron is currently undervalued, perhaps very significantly so, and that the shares' muted reaction to numerous instances of good news has created a value gap. In this article, I will try to quantify just how undervalued it could be, based on the analysis I describe below.

ASH2013, and the Clinical Hold is Imposed/Lifted

Things were finally looking up for a company that, for two decades, had struggled to develop any viable pipeline candidate and engaged in numerous secondary offerings to keep the ship afloat. It was so bleak when the current CEO, Dr. Scarlett, took over, that he was forced by circumstance to divest the company's stem cell development unit and focus the company's paltry remaining resources on an "all or nothing" bet on IMET. When Dr. Scarlett was named CEO at the end of 2011, the shares were worth 2 bucks. Just a year prior, the shares traded above $5.

But things now appeared to be changing. The American Society of Hematology's 2013 Annual Meeting (ASH2013) was a high-water mark for Geron. In November 2013, an ASH2013 abstract was published that announced something unprecedented: In a small trial run by the Mayo Clinic, IMET had achieved reversal of bone marrow fibrosis in several myelofibrosis (MF) cancer sufferers. MF was, and still is, considered a terminal illness where only the symptoms (i.e., an enlarged spleen) can be treated. But the abstract detailed the properties IMET had displayed that lead the Mayo Clinic to describe it as "tantamount to a cure." The stock responded by surging from $3.40 to almost $7 after the abstract was leaked. It bounced around in the $4-5 range for four months, until the unthinkable happened.

In March 2014, the FDA issued a clinical hold on further development of IMET due to liver function test abnormalities (since described as being of the "low-grade" and "reversible" variety). There are many theories as to how and why this hold was issued, and whether someone else (like a potential competitor) was behind it. I have an opinion on that, but it is not relevant to this article. What I am focused on is the price reaction to catalysts. When the hold was announced, the share price cratered from $4.15 into the mid-$1 range. Incidentally, that was also the day I first heard about Geron. But what is more interesting than what happened to the stock the day of the hold is what happened to the stock on the days the hold was lifted.

  • It gave all those gains back, and then some, so when the full clinical hold was lifted on November 3, 2014, the stock bounced from $2.22 to $2.80, which it gave back almost immediately and settled around $2.30.

So by the end of November 2014, a stock that had been worth $4.15 the day before the FDA hold in March was now worth only $2.30 to the market, despite that hold being lifted. There is still an intrinsic value gap of at least $1.85 left on the table regarding the hold alone - a conservative figure considering the stock almost touched $7 immediately after ASH2013. Perhaps one could argue that the delay imposed by the hold strained Geron's cash position such that now, additional dilutive financing would be necessary to develop IMET, which may explain why the share price did not bounce back to pre-hold levels. However, what happened ten days after the hold was lifted defeats that otherwise sound argument.

Global Collaboration with Janssen

In November 2014, ten days after the FDA clinical hold was completely removed from IMET, Geron announced a global IMET development collaboration with Janssen - a subsidiary of Johnson & Johnson (NYSE:JNJ). There have been many great articles covering the specifics of this agreement, so I will not rehash it here. Rather, I will summarize briefly:

  • This collaboration covers all potential human indications for IMET.
  • Geron has received $35M in upfront payments (but has not booked the revenue, more on that later).
  • Up to $900M in additional payments can be made if IMET hits certain milestones.
  • The funds paid under the agreement are expected to equal or exceed Geron's cost share of IMET development going forward.
  • If IMET is commercialized and the agreement remains in effect, Geron will have the option to either: (1) opt out and receive royalty checks equivalent to a "mid-teens" percentage of IMET sales, while Janssen markets the medicine; or (2) opt in and receive a royalty percentage of sales in the "low twenties," in exchange for being actively involved in marketing.

We have already gone over the mess that Dr. Scarlett inherited. And one could be forgiven for pointing out that since his arrival, Dr. Scarlett has presided over a 75% increase in share price (18.8% annualized), so all must be good in GERN-land. However, consider that during that same time period, the iShares Nasdaq Biotechnology ETF (NASDAQ:IBB) has experienced a 275% increase and has exposed its holders to infinitely less risk and volatility in the process. If you had bought IBB at almost any time during the last four years, you are in the black. To hold a profit in Geron, you would've had to time your purchases well.

Given this tortured history, one would think a collaboration with Janssen - erasing the need for further dilution and putting IMET into the hands of those who know how to push molecules to market - would be rewarded handsomely by the market. Unfortunately, that was not the case. The day after the announcement, shares of Geron gapped up 40% ($2.31 to 3.21), before fading throughout the day to close up a mere 20% at $2.74. The stock then traded sideways for the next 110 days, hovering around $3, until a bidding war broke out over Pharmacyclics (NASDAQ:PCYC) and buyout fever gripped the sector and sent Geron's shares higher.

Finding a potential value gap for the hold was much easier, as all one has to do is compare Geron to Geron. To find a value gap here is trickier. What I present for your consideration (rightly or wrongly) is a comparison between the performance of Geron and the aforementioned PCYC 110 days after their respective collaborations with Janssen were signed (PCYC entered its own agreement with Janssen in December 2011). The results are polar opposites of each other.

Return of GERN vs. PCYC 30, 60, 90, 110 days after respective Janssen collaboration

As mentioned above, PCYC was famously bought out four years after its deal for $262 by AbbVie (NYSE:ABBV) (return of over 2,000% from December 2011). It is important to note that PCYC's deal was not identical to Geron's. It allowed a 50/50 profit/loss split, while Geron's deal is a straight-up mid-teens to low-twenties sales royalty. PCYC also received more cash up-front. Given these differences, how do we use the PCYC example to determine a potential value gap in the shares of Geron related to the Janssen deal? By being conservative, of course. The 110-day delta between Geron and PCYC performance after their collaboration was signed was 72%. PCYC received 4.3 times more cash up-front than Geron. Some bears have suggested that this shows a relative lack of confidence in IMET on behalf of Janssen. So, using a conservative model, let's divide that performance delta by half of the 4.3 cash differential (2.15). We are left with a figure of 33.5%, which translates to 77 cents of potential value gap, based on Geron's deal with Janssen in this (very) conservative model.

Orphan Drug Designation for IMET

On June 11, 2015, Geron announced that the FDA had granted IMET orphan drug designation. The stock was flat. While this is obviously great news from a development perspective, some research has shown that such designations do not usually cause a large price spike. For an excellent read on the subject, check out this article by Jason Napodano. Mr. Napodano concludes that the expected share price return after 90 days of receiving an orphan drug designation is only 4%. However, I'm going to differentiate Geron a bit from the research.

IMET is life or death for Geron. It is more important to the company than the iPhone is to Apple (NASDAQ:AAPL) or web-based advertising is to Google (NASDAQ:GOOG). If IMET fails, Geron shuts its doors. In his article, Mr. Napodano also discusses how oncological Phase II orphan-designated drugs reach approval 35% of the time. For non-orphan drugs, the number is closer to 5%.

Consider that JNJ has already presented to the market that it estimates that IMET will reach commercialization in as early as 2018 and become a blockbuster ($1B sales annually) in very short order. If you assume Geron opts in and is entitled to a low-twenties sales percentage royalty, JNJ's forecast represents $200M-250M of annual revenue to Geron, which currently has no revenues beyond collaboration payments from JNJ. Yet, the market did not react when the probability of approval increased from 5% to 35%? That is a textbook value gap.

So, what is it worth? There are two ways to consider that question. The first is more holistic and utilizes the net present value of expected revenues to arrive at a reasonable valuation. As always, I will be conservative in demonstrating that approach. I will assume $150M annual revenue to GERN (75% of JNJ's forecast). If you multiply that amount by 35% likelihood of approval, you are left with $52.5M. Assuming an annual return of 2.5% on money between now and 2018, the approximate net present value of annual IMET sales starting in 2018 is $50M, which translates to almost pure profit. With a conservative future P/E of 20, an enterprise value of $1B ($6.32/share) could easily be supported right now. However, I disfavor this approach, because it only accounts for one indication: MF. For example, we already know JNJ is launching a Phase II trial for myelodysplastic syndromes (MDS) later this year, and that IMET has already shown efficacy in treating essential thrombocythemia (ET). For this reason, I have focused on the share price reaction (or lack thereof) to recent news to determine the potential value gap.

The other method is to try to figure out what the news alone is worth on the day it was received. Maybe a global pharmaceutical company can expect a 4% return from an orphan drug designation, but for a company like Geron, that number is higher by several orders of magnitude. Determining the right amount is tricky, and forgive me for engaging in a bit of fuzzy math. I'm going to suggest that the orphan drug designation for IMET could have conservatively supported an upside move of 40%. How did I get that number? Because IMET is, at a minimum, 10 times more important to Geron and its share price than the average drug is to the average company. Even this figure is probably too low, since IMET's failure is the end of the company.

On the day of the orphan drug designation, its shares were trading at $3.86. In my very humble opinion, the value gap represented by the shares' non-reaction to the orphan drug designation is a whopping $1.54 (40% of $3.86).

New England Journal of Medicine Publishes 2 IMET Articles Confirming Durability of Complete Responses

I am not going to go very deep into this topic, because I do not have a methodology to determine a value gap based on Geron shares' non-reaction to this news. But when the finest medical journal in the world that has a reputation even with laymen (ask 10 random people on the street, at least 4 of them have heard of NEJM) highlights a company's only potential product and the stock does nothing, there might be a value gap there.

Some critics point out that the articles are a mere "rehash" of the old ASH2013 data. Even were that true, Geron still has a value gap dated from the clinical trials holds, so any buzz about this "old" data remains a positive event. I will also add that the critics have made two big mistakes in interpreting this article. First, the article is yet more evidence of the durability of patients' response to IMET. Second, the power players in the medical world are lining up solidly behind the drug:

  • The Mayo Clinic called IMET "tantamount to a cure."
  • The FDA lifted its capricious (in my opinion) clinical trial hold, and corrected its mistake by granting IMET orphan drug status.
  • The biggest pharma company in the world committed up to $935M plus 50% of the development costs to license IMET.
  • And now, the New England Journal of Medicine is on board.

What's the Total Value Gap?

Let me first say that I will be the first to admit that this analysis is very conservative. That is how I always approach investing. It is a personal choice. I prefer upside surprise to downside, and if an investment stills looks good after I impose all of my hyper-conservative conditions upon it, then I know I have found a winner. I believe Geron is that winner.

Potential Value Gap in Geron's shares created by non-reaction to positive news

I know the instinct here is to add the value gap ($4.16) to the current market price ($3.55 at the time of this writing) and say the stock should be $7.71 right now. I am not saying that the share price is going to more than double tomorrow. What I am submitting for your consideration is that a conservatively-estimated value gap of $4.16 currently exists in Geron's shares. Value gaps rarely close explosively, but rather, tend to narrow with time. I will discuss what the company can do to expedite this process below.

Is a Short Squeeze Ever Going to Happen, or What?

I'm not going to give you an answer to the question, because I do not have one. What I can do, however, is offer my opinion on how Geron, and all longs, can maximize the chances that it does occur.

Let's be honest: the company has some work to do to substantially close the value gap discussed above. There is a lot of uncertainty in the market right now. Geron has not been communicative as to what is happening in the trial, when patients will begin infusing IMET, what its plans and timing for any acquisitions are, whether the recent shelf financing filing was just a renewal of an old agreement or indicative of an imminent secondary, when will it book milestone revenue from Janssen, etc. For this value gap to close, it needs to first close the communication gap and remove uncertainty. Part of this means that despite JNJ running IMET's development, the market wants to see a fully engaged CEO. That means hosting quarterly earnings conference calls and doing other "boring," but necessary, CEO-type stuff. To those who may respond that it was not a big deal that Geron did not have a conference call two quarters in a row, because there was nothing to report, I would argue there were plenty of things Dr. Scarlett could have discussed, if he chose to (see the list at the beginning of this paragraph). Perception does matter here. When dealing with a company with as painful a history as Geron's, uncertainty is uniformly bad for the stock price.

As far as what longs can do, the best thing is to stay informed and act as proxy communicators for Geron. If the company does not, or cannot, be communicative at this time (be it on the terms of the Janssen deal, lawsuits, whatever), retail investors can help close that knowledge gap.

This leads me to my last point, which has been contentious on the SA discussion threads: dilution and an acquisition. For context, Dr. Scarlett has expressed interest in acquiring or in-licensing one or more new molecules. I am not going to belabor this point, except to express my own view and then leave it to commentators to have the floor. Now is not the time for Geron to make an acquisition. If the company were to dilute to fund an early-stage molecule, I believe the odds are much greater than not that the market will react very poorly to this news and will punish Geron unfairly due to its past missteps. An acquisition/secondary will offer the shorts (30 million shares!) a clean getaway and almost certainly send the likelihood of a near- to intermediate-term squeeze to almost 0%. If there is going to be a squeeze before commercialization, it will likely occur when and if positive data from the Phase II trial is released. I do not want Geron to remove fuel from the fire with a secondary offering before that time, at the earliest.

The road has been too long and too painful to add another unpredictable variable into the equation at this moment. We are so close to learning exactly what we have in IMET. The Phase II trial should give preliminary data readouts in a matter of a few short months. When you have your best hitter at the plate, you do not try to steal home. If IMET hits a home run, a secondary would be much more lucrative after Phase II data.

Most of the risks are what you would expect of similarly situated clinical-stage biotech companies:

  • IMET fails to meet clinical endpoints in MF Phase II trial (unlikely, as Mayo Clinic has already found efficacy, and JNJ has designed the study conservatively). However, as IMET is Geron's only pipeline candidate, this risk is multiplied.
  • Severe safety signals are found in the trials (also unlikely, as the FDA has released the clinical hold, and IMET treats very serious conditions for which some safety issues would be an acceptable trade-off).
  • Janssen withdraws from the collaboration agreement (highly unlikely unless IMET fails to meet endpoints, in which case it's a wipeout anyway).
  • Negative market forces.
  • Dilution and acquisitions (discussed above). These could, of course, also represent upside over the longer term.

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