Markets misprice risk in circumstances such as these, because many market participants cannot or are loathe to invest in a security in which there is a reasonable probability the investment will have zero value, i.e. the investment outcome is binary—big win or total loss. That is clearly the case with Lemtrada and its related CVRs. What is the expected value of an investment today in these CVRs?
There is a $1 milestone payment if FDA approval is received by March 31, 2014. Yesterday, the reviewing panel recommended, by a 14-0 vote, with one abstention to approve the drug. If one assigns only a 75% probability to the likelihood of FDA approval by the end of March given the panel’s recommendation, then the expected value of this milestone payment is $0.75, i.e. .75*$1.00. This discount takes into account the possibility that approval occurs after the milestone payment date, and/or does not occur. No present value discount is used for this calculation given money market rates and the short time to payout.
The next milestone payment is $2.00 when sales reach $400 million. I assign a probability of 1.0 to achieving this payment, if approval is granted. Moreover, my expectation is this milestone will be reached by the end of 2015, i.e. in two years. Thus, the expected value of this payment is .75*1.0*$2.00=$1.50, [probability of FDA approval (.75)*probability of meeting sales threshold (1.0)* payout, $2.00]. Using 31 basis points (current yield on a two year zero coupon treasury) as the present value discount, this payment has an expected present value payout of $1.49.
The next sales threshold payout is $3.00 upon reaching $1.8 billion in sales during any 4 consecutive calendar quarters. For this analysis, I will arbitrarily assign a 25% probability of achieving this threshold and that it happens at the end of 2020. The expected value of this payout is $0.5625, CONTINUES
calculated as [.75*.25*$3.00=$0.5625], i.e. probability of FDA approval, .75, times probability of milestone achievement, .25, times payout, $3.00. The present value of this payment, discounted at 2.16 percent (the current yield on a 7 year zero coupon treasury), is $2.30
I am not going to continue the analysis with the remaining milestone payments, see below.
Milestone--$2.3 Billion in Sales during any 4 consecutive calendar quarters, (cannot count sales used in the $1.8 billion milestone) Payout=$4.00
Milestone--$2.8 Billion Sales during any 4 consecutive calendar quarters, (cannot count sales used in the $2.3 billion milestone) Payout=$3.00
Using the analysis from above, i.e. disregarding the remaining $7.00 in possible milestone payments, one reaches an expected value of $4.28. Finally, assigning $0.00 to this security if FDA approval is not granted at this time, is probably harsh. There will likely be an opportunity to address issues resulting from denial, meaning that approval could be given later. Clearly this would result in holders missing the $1.00 payout for February, 2014, but would still bring into play the remaining sales milestone payments. Note also that if the $1.00 FDA milestone is missed, but the subsequent, $400 million milestone is met, holders are entitled to clawback on the $1.00 FDA milestone payment, i.e. the $400 million payout becomes $3.00, not $2.00.
I am not going to speculate on the value of the CVRs if the FDA milestone for 2014 is not met. No doubt, however, the value would fall precipitously, but to what level one can only speculate. Importantly, it should not fall to zero, but will likely fall well below expected value.
What am I doing? I increased my position by a factor of 1.5 today.
My apologies to those who read my post” entitled one man’s view…” It had a math error relating to the present value of the $1.8B milestone payment. The present value of that payment based on the assumptions noted is $0.48. The correct total in my post should be $2.72.
I think you have the right idea in terms of analysis.
However, your discount rate should be a lot higher. It should not be the risk free rate but an appropriate hurdle rate that takes into account the equity risks.
Clearly the market is assigning a much lower probability to the FDA approving the drug.
It is true that the advisory committee voted for approval but those that were at the meeting and watch them professionally give them a 20-30% chance of approval. Given what decision the advisory committee reached, it might seem logical to give a relatively high chance for approval but that is a superficial logic. Professionals who watched the FDA question the advisory committee and have a better sense of how they operate feel differently. During the Kennedy-Nixon debates in 1960, those who heard the debate on radio felt that Nixon won but those who watched on TV felt that Kennedy did. In other words, you get a better feel from professionally watching the process than by just reading about the results.
Even if the FDA rejects approval, the CVRs still have value as you point out. SNY can try again and the CVRs don't expire for a long time.
a question before any news was out pps was stable around 2.00 area ...then pannel news came out dropped to .57 cents low.. no posotive news comes out yesterday...in your opinion what price do u think gcvrz should be trading at today?