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What’s been happening at Enzon?

November 4, 2011

From my previous posts on Enzon (ENZN) you will remember that this is a ‘coat-tails’ position. That’s right, I borrowed an investment idea from Seth Klarman and I’m riding on his coat-tails. So let’s this review by taking a quick look at Baupost’s holdings of ENZN, when they were established and at what prices. According to Dataroma (which I use for these sort of things; it’s a great website for tracking important ‘guru’ holdings – thank you Dataroma!) Klarman opened a 2 million share position in ENZN in the 3rd quarter of 2009, upped it to 8 million shares in the 4th quarter of 2009, added an additional 2 million shares over the next two quarters then gradually reduced his total holdings to the current 9 million shares. What is his average cost? We’ll never really know, but I always assume it’s towards the low-end of quarterly price ranges (below).

 ENZN share prices by quarter

3Q ’09 4Q ’09 1Q ’10 2Q ’10
High $8.66 $10.77 $11.28 $11.45
Low $7.38 $8.20 $9.04 $10.07
Average $8.02 $9.49 $10.16 $10.76

What’s got me looking at this position again is that over the past 6 months the ENZN’s share price has dropped from about $11.50 to the current $7.30, some 35%. With this kind of price drop I feel it’s time to review my investment thesis and see whether it still holds or not. If it doesn’t and the price decline reflects a permanent impairment in company value, it is time to sell and take the loss.

What’s been happening at Enzon, the company, over the past 6 months which might account for the price decline? Below is a timeline of public corporate announcements.

May    

  • 10th – Annual Meeting; EVP Human Resources let go and not replaced
  • 19th – Announcement that PEG-SN38 clinical program would be
    discontinued after end of phase II clinical trials
  • 26th – Ana Stancic hired as new CFO (outside hire)

July     

  • 2nd Quarter earnings – higher quarterly loss and continued repurchase of shares

Aug.     Harold Levy steps down from the Board and is not replaced

Sept.   

  • Executive deferred compensation plan is terminated
  • Company announces plan to reduce workforce almost 50%

Oct. 

  • CEO (Ralph del Campo) steps down
  • Ana Stancic becomes COO as well as CFO

Hmmm…interesting. Nothing that shouts out value impairment except maybe the part about discontinuing the PEG-SN38 clinical program. But maybe we need to put these things in the context of what happened previously and who the major actors are at Enzon.

Recent Historical perspective:

In January 2010 the company sold its product and contract manufacturing business for $308 million. This left the company two major assets; the royalty stream from its Customized Linker Technology (the ‘PegIntron’ royalties) and a research and development effort with 4 identified compounds in early clinical trials as well as other potential compounds and processes still under development.

Ownership:

There is a concentration of large investors. As of June 30, 2011 the top 5 institutional owners were:

  • Baupost                     18.5%
  • Icahn                         12%
  • Iridian                        9%
  • Vanguard                     6%
  • Artisian Ptrs                 5%

Note that the 5 largest owners account for more than 50% of ownership and that 4 out of these 5 are hedge funds or similar. We can also update this slightly as in the 3rd quarter Iridian increased its ownership to over 10%. Also note that Icahn has Board representation (after a 2009 proxy contest), and I am assuming that he has significant influence on capital allocation decisions (as I’m sure does Klarman).

Given this context, how should one interpret the actions and announcements since May? It seems to me that each announcement in some way hints at a shift in focus away from operations and drug development  and towards value realization. The clinical program for PEG-SN38 is discontinued to because it is too expensive relative to potential payoff. The Board brings in an outside CFO. Operating executives are let go, the head of personnel then the CEO. No new CEO is hired; instead the CFO becomes the COO. An announcement that 50% of staff related to drug development is to be let go. Aren’t these steps all ones that might precede a company sale or some sort of transaction geared towards value realization?

Let’s focus a moment on the decision regarding PEG-SN38. I think there is a direct relationship between this announcement and the share price decline. I also think that perhaps the price decline was due to a misinterpretation of the press release. The press release quotes the Vice Chairman, Richard Mulligan, Ph.D, as saying “While we may evaluate PEG-SN38 in earlier lines of colorectal cancer treatment in future clinical trials, at this time, resources associated with such trials are better directed toward areas of study with nearer-term commercial potential.” First, it should be noted that the press release quotes the Vice-Chairman, not the CEO, perhaps presaging the dismissal of the CEO in September. Second, it states that the clinical trials were being discontinued to focus resources on areas where there is potentially greater early economic benefit, not that the drug has no value. Is the price swoon the result of Mr. Market thinking this drug was about to come to market (generate revenue) and being disillusioned? Perhaps. It could also be that a quick read of the press release resulted in a general interpretation that developmental spending on the compound was wasted money. I would argue that this was not the statement made.

Third Quarter results

Operating results for the third quarter have just been released. The operating loss continued at 2nd quarter levels (staff downsizing has not yet been implemented and won’t be complete until 6/12) and the share repurchase program continued with the purchase of  2.5 million shares at an average cost of $10. In October the share repurchase program was suspended to evaluate how best to allocate remaining cash [Ah… nice timing guys!]. At the quarter-end, cash and marketable securities have been reduced to $333 million

Valuation

I find it extremely difficult if not impossible to value ENZN. What do I know about the probability of some drug under development being approved and generating a significant return on investment? That’s the issue here isn’t it? Thus, in retrospect I’m kicking myself for taking a position. But if I had to give some value parameters I would do so as follows. There are three readily discernible components of value: 1) Net cash or the amount of cash left after liquidation of marketable securities and repayment of the LT debt and other liabilities, 2) The royalty revenue stream from the patented Customised Linker Technology (the PegIntron royalties) and 3) the intellectual property related to the four compounds currently in clinical trials as well as any other compounds in pre-clinical development. In a liquidation scenario (which I think we are closing in on) I would make the following simplification: assume PP&E ($21 million) is liquidated at 50 cents on the dollar and the resulting funds used to pay wind down costs.

Net cash value is easily calculated from quarter-end financials. For a valuation of the PegIntron royalty stream I have made the following simplified calculation: Using the current run rate of approx $10 million a quarter, I have assumed royalties decrease at 15% annually for the length of the patent (2016 for the US, 2018 for europe) then capitalized this cash flow stream at 10% to arrive at a value of approx. $116 million. As for the value of the remaining IP, I really have no idea to value it. I know that at least $250 million has been spent on developing it ($45 million for at least 5 years), but as to actual value we will have to wait and see what can be realized in the marketplace.

Instead of trying to value the IP I thought I might look at how Mr. Market has valued the IP at the end of the last 4 quarters (I’ve used the announcement date rather than the quarter-end date for price as that is when investors were privy to what was happening). I’ve done this on a per share basis as the ongoing buyback program (almost 20% of shares outstanding at the end of 2010 have now been repurchased) would otherwise have somewhat distorted the analysis.

Enzon Balance Sheet Valuation
All figures are per share except shares outstanding

3Q ’11 2Q ’11 1Q’11 YE 2010
Shares outstanding (mil) 48.1 50.6 55.1 58.8
Cash & Mkt Sec $6.92 $7.16 $7.61 $7.82
LT Debt ($2.80) ($2.66) ($2.44) ($2.29)
Other liab. net of st assets ($0.25) ($0.23) ($0.24) ($0.26)
Balance sheet liquidation $3.88 $4.27 $4.93 $5.28
PEGINTRON royalty $2.40 $2.28 $2.10 $1.97
Announcement date 10/3/11 8/5/11 5/19/11 3/16/11
Share price $7.31 $8.35 $10.61 $10.21
Implied value of IP $1.03 $1.80 $3.58 $2.97

Note that the implied value of the IP has fallen by over 60% since the end of last year. Does the discontinuance of the PEG-SN38 clinical trials account for this? To some degree I would have to say probably (really going out on a limb there).

In any case, the proof will be in the pudding. We’ll just have to wait and see what happens. My interpretation or recent corporate events is that value realization for holders of ENZN is nearer than ever, and I’m a bit more comfortable as I feel that capital allocation decisions are now in the hands of experienced capital allocators. I view recent developments in a positive light and have therefore slightly increased my position at these price levels.

Nothing said above should be construed as investment advice. Do your own analysis and come to your own conclusions.

 

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3 Comments
  1. “During the third quarter of 2011, the Company decided to suspend the repurchase program. ”

    Thoughts on that?

    • Yeah, my thought is simply this is typical corporate misallocation of resources. Company buys back a boatload of shares then the share price drops 35%! I’m suprised it took the institutional owners so long to react. What was the thinking behind the buyback in the first place? Company book value was well below the market price when the buybacks were decided. Management would have to be pretty sure that the intrinsic value was significantly higher than book to make that kind of move. Yet from my analysis (with the benefit of hindsight) this doesn’t look so obvious. Of course, I could be proved wrong if current management succeeds in liquidating the company at significantly more that $11.50 a share.

      But maybe you were referring to why they suspended the buyback now that the price has declined so much. I guess they are looking at alternatives. What if the company was to make a tender for the non-institutional float? Could they take the company private or reduce the ownership enough to delist? (and screw the public shareholders in the process) Anything’s possible. They certainly still have more cash than they need for drug development, especially given the layoffs coming. So I think something is up. Should become visible in the next 6 months or so. I’m looking forward to reading the full 10Q to see if there are any tidbits that might give us more to chew on.

      • Hmm maybe things aren’t so peachy?

        1- Many key people with very, very high salaries stepped down. It is unusual for ambitious people to leave high-paying jobs.

        -Jeffrey Buchalter (second last CEO) resigned, though with a $3.5M+ severance package.
        -On July 1, 2010, Craig Tooman tendered his resignation as Executive Vice President, Finance and Chief Financial Officer, effective July 23, 2010. Mr. Tooman did not receive any severance payment or equity acceleration in connection with his separation from the Company.
        -On March 21, 2011, Ivan D. Horak tendered his resignation as President of Research and Development and Chief Scientific Officer, effective April 4, 2011. Dr. Horak did not receive any severance payment or equity acceleration in connection with his separation from the Company.

        2- Harold Levy stepping down from the board is a bad sign? It may be that Iridian is ditching its position (actually I would bet on a 90% probability of that). There are less legal liabilities when you are no longer an insider (though insiders are allowed to and do sell stock). Iridian/Levy probably fought hard to get a seat on the board… for Levy to leave is unusual.

        3- The wave of layoffs: This is very demoralizing for the person doing the firing. And it is demoralizing for the employees who see half their friends get fired.

        If you were an employee, you would probably be incredibly confused as you have seen all of your bosses leave (with rumours that they got pushed out).

        4- If you want to sell the company, you usually do not fire people first. You want to ‘window dress’ the company to look more attractive… you don’t want their due diligence team running into an organization with extremely low morale and confusion. Also, few human beings enjoy firing other people (some of whom are probably their friends)… it is easier to let the acquirer do it.

        *I can’t figure out if this stock is under or overvalued, nor have I done much research on it.

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