Market Musings - February 13, 2018

We continue our blog series: Market Musings, Volume 2, Edition 9, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Clash of The (Wannabe) Titans: LGND versus INVA".

In this installment of Clash of the (Wannabe) Titans, we compare two pharma royalty companies, Innoviva, Inc. (ticker INVA) and Ligand Pharmaceuticals (ticker LGND). Below is the tale of the tape for these two entities as of 2:30 p.m. on February 12, 2018, as well as a brief description of each company's business from its respective SEC filings:

Description of INVA: Innoviva is focused on bringing compelling new medicines to patients in areas of unmet need by leveraging its significant expertise in the development, commercialization and financial management of bio-pharmaceuticals. Innoviva’s portfolio is anchored by the respiratory assets partnered with Glaxo Group Limited (GSK), including RELVAR®/BREO® ELLIPTA®, ANORO® ELLIPTA® and TRELEGY® ELLIPTA®, which were jointly developed by Innoviva and GSK. Under the agreement with GSK, Innoviva is eligible to receive associated royalty revenues from RELVAR®/BREO® ELLIPTA® and ANORO® ELLIPTA®. In addition, Innoviva retains a 15 percent economic interest in royalty payments made by GSK for TRELEGY® ELLIPTA® and earlier-stage programs partnered with Theravance BioPharma, Inc. For more information, please visit Innoviva’s website at www.inva.com.

Description of LGND: Ligand is a biopharmaceutical company focused on developing or acquiring technologies that help pharmaceutical companies discover and develop medicines. Our business model creates value for stockholders by providing a diversified portfolio of biotech and pharmaceutical product revenue streams that are supported by an efficient and low corporate cost structure. Our goal is to offer investors an opportunity to participate in the promise of the biotech industry in a profitable, diversified and lower-risk business than a typical biotech company. Our business model is based on doing what we do best: drug discovery, early-stage drug development, product reformulation and partnering. We partner with other pharmaceutical companies to leverage what they do best (late-stage development, regulatory affairs and commercialization) to ultimately generate our revenue. Ligand’s Captisol® platform technology is a patent-protected, chemically modified cyclodextrin with a structure designed to optimize the solubility and stability of drugs. OmniAb® is a patent-protected transgenic animal platform used in the discovery of fully human mono- and bispecific therapeutic antibodies. Ligand has established multiple alliances, licenses and other business relationships with the world's leading pharmaceutical companies including Novartis, Amgen, Merck, Pfizer, Celgene, Gilead, Janssen, Baxter International and Eli Lilly.

As we can see from the charts above, INVA's share price has remained relatively flat over the past 10 years, while LGND's has skyrocketed. LGND consequently has double the market cap of INVA. Neither company pays a dividend. On the surface, then, LGND looks to be the clear victor in this matchup. Below please find the most recent earnings results for the two rivals:

Looking at the respective income statements, we find that despite having approximately half of the market cap of LGND, INVA is actually the far more profitable of the two, even on a per share basis (despite having just ~1/10th of the stock price of LGND). In its most recent quarter reported for each entity, for example, INVA recorded net income of $58.4 million versus just $8.43 million for LGND. For all of 2017, INVA garnered $134.1 million in profits; in comparison, LGND registered just $19.6 million in earnings in the first 9 months of FY2017 and is expected to report $26.8 million in earnings in Q4'17, meaning that LGND's 2017 total profits should be $46.4 million, or just 35% of INVA's level. On a forward basis, LGND is supposed to earn $4.42/share in 2018 (source), or $104 million total, while INVA is expected to earn $2.28/share in 2018 (source), or $272 million total.

Thus, we find that LGND trades at a forward P/E of 35X, while INVA trades at just 7.7X. Does this make any sense at all? What could explain the disparity? If LGND were on a much faster growth trajectory than INVA, this could explain it. Looking at analysts' current estimates, however, we find that LGND is expected to grow earnings in 2018 by 43.5% ($4.42 versus $3.08 for 2017) while INVA is expected to grow earnings in 2018 by 43.6% ($2.01 versus $1.40 for 2017). So the earnings growth rates are virtually the same. Will LGND grow revenues much faster in 2018 than INVA? Not according to the analysts. LGND is expected to grow revenues from $139MM in 2017 to $167MM in 2018, a healthy growth rate of 20%. In comparison, INVA is expected to see its revenues expand from $217MM in 2017 to $289MM in 2018 (and further to $322MM in 2019), meaning that at 33% its forward revenue growth rate is actually much higher than LGND's. So based on a forward earnings and revenues analysis, there does not appear to be any reason why LGND is currently a market darling while INVA is seemingly a dud.

Perhaps INVA has much higher debt levels than LGND; if so, this could explain why the market ascribes a much higher comparative valuation to LGND's equity. Below please find the most recent respective balance sheets for the companies:

Here we find that INVA has a total of $599MM in convertible notes and term loans versus $129MM in cash, for a total of $470MM in net debt. In contrast, LGND has $222MM in convertible notes plus $5MM in other long-term contingent liabilities (for a total of $227MM) versus $202MM in cash, meaning LGND has just $20MM in net debt. Thus, to make an apples to apples enterprise level (or EV) comparison, we will need to add $470MM to INVA's market cap versus just $20MM to LGND's. Doing so, we see that, on an EV basis, INVA clocks in at $2.12B, or $1.65B for its equity (106.2MM diluted shares O/S as of 12/31/17 and a $15.50 stock price) plus $470MM of net debt. In comparison, LGND's EV is $3.23B, or $3.25B for its equity (21.1MM diluted shares O/S as of 10/31/17 and a $153.30 stock price) plus $20MM of net debt. This demonstrates that the market still values LGND at a 52% premium to INVA on an EV basis, despite their key financial metrics (revenues and earnings) being quite comparable.

Based on our limited diligence, we are stumped so far--there does not appear to be any clear reason why the market would ascribe a 35% discount to INVA's assets versus LGND's. Could it possibly be because INVA has poor corporate governance while LGND's is stellar? Looking at this issue, we note that INVA faced a proxy contest from Sarissa Capital in 2017, near the conclusion of which the company apparently reneged on an orally-agreed settlement with Sarissa, resulting in Sarissa temporarily losing out on 2 BoD seats (source):

Sarissa was eventually able to claim these seats, however, by winning a court ruling in December to this effect (source):

The court ruling enabled Mssrs. Bickerstaff and Kostas (the Sarissa nominees) to take their seats on the BoD in late December 2017 (source):

INVA's CEO's position was no longer tenable once the foregoing had occurred and he was shown the door just last week (source):

So we find that Sarissa appears to be firmly in control of INVA's BoD, meaning that the BoD should now be aligned with the interests of shareholders (note that Sarissa owned about 3.6 million shares as of the end of Q3 2017, the most recently reported quarter end portfolio - source). In other words, while corporate governance at INVA last year during the proxy contest was clearly an "F", it now appears to be at least a "B+" in our opinion. Meanwhile, LGND insiders have been selling their shares at a rapid clip recently, indicating that they believe shares are richly priced. For example, below see recent sales by the CEO, John Higgins (source):

Similarly, former large holder and director Jason Ayreh's position has shrunk dramatically due to recent share sales (source). Thus, it appears that those on the inside at LGND, through the selling down of their respective ownership stakes, are increasingly not aligned with the interests of the shareholders.

It should also be noted that LGND's internal controls have been weak in the relatively recent past, as per the following risk factors (taken from the company's most recent Form 10-Q filing):

We have restated prior consolidated financial statements, which may lead to possible additional risks and uncertainties, including possible loss of investor confidence.

We have restated our consolidated financial statements as of and for the year ended December 31, 2015 (including the third quarter within that year) and for the first and second quarters of fiscal year 2016 in order to correct certain accounting errors... As a result of the Restatement, we have become subject to possible additional costs and risks, including (a) accounting and legal fees incurred in connection with the Restatement and (b) a possible loss of investor confidence. Further, we were subject to a shareholder lawsuit related to the Restatement which, if ratified, may be costly to defend and divert our management's attention from other operating matters.

We have identified material weakness in our internal control over financial reporting that, if not remediated, could result in additional material misstatements in our financial statements.

As described in “Item 9A Controls and Procedures” of the Form 10-K filed with SEC on February 28, 2017, management concluded a control deficiency that represents a material weakness was not remediated at December 31, 2016. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. As a result of the unremediated material weaknesses, management has concluded that we did not maintain effective internal control over financial reporting as of December 31, 2016. Although management has since implemented new controls and process to remediate the material weakness, we do not believe these new controls have been in place for sufficient time for management to conclude the material weakness has been fully remediated at June 30, 2017.

We continue to refine and implement our remediation plan to address the material weakness. If our remediation efforts are insufficient or if additional material weaknesses in our internal control over financial reporting are discovered or occur in the future, our consolidated financial statements may contain material misstatements and we could be required to restate our financial results, which could materially and adversely affect our business, results of operations and financial condition, restrict our ability to access the capital markets, require us to expend significant resources to correct the material weakness, subject us to fines, penalties or judgments, harm our reputation or otherwise cause a decline in investor confidence.

As far as we can tell, INVA has had no such internal control problems. Buyer (of LGND) beware...

DISCLOSURE: Short LGND.