Tag Archives : GCVRZ

New year updates 1

Disclosure: Long 777 HK, long ISIG, long MOMENT 4.69% 2022, short MOMENT 11.5% 2016, short EXAS, no position in GCVRZ, 

Happy new year! My apologies for the long hiatus from blogging. It’s been a busy couple months of holiday travel and a solid finish to 2014 thanks to the performance of several long positions in December. I’m looking forward to making a fuller report in a forthcoming quarterly letter. In the meantime, I felt some quick updates on ideas that have been discussed on the blog and elsewhere were overdue.

China trip and NetDragon (777 HK)

I will be visiting Hong Kong and parts of mainland China later this month. If I have any readers there and you would like to say hello, please drop me a line. If you are a fundamental investor with interest in joining any management meetings, I have a few opportunities for that as well.

The NetDragon thesis is largely unchanged following Q3 results, which were poorly received as expense growth for the education business ramps in advance of revenue generation. NetDragon now has more than half its R&D staff working on online education initiatives. Meanwhile, the core gaming franchise remains strong and has a potential new hit that has already recorded 240,000 PCU. The company repurchased 2.8% of shares outstanding in December.


Public commentary on Insignia Systems (ISIG)

ISIG remains a significant position for Cable Car despite an unusual activist situation in the marketplace. Given recent events, Cable Car has adopted a policy of not discussing the investment thesis publicly. However, I remain open to speaking one-on-one with other investors. If you are a shareholder and would like to discuss the company, please contact me directly.


Momentive Performance Materials reorganization

I was wrong about both the legal outcome and the potential downside for the 1.5 Lien notes, at least from a mark-to-market perspective. The plan of reorganization went effective in October and the former 1.5 Lien notes (now 4.69% second lien senior secured replacement notes) traded down to the low 80s context. At last trade, the replacement notes yielded 8.3% to maturity, much wider than other similarly capitalized industrial credits. I also failed to fully account for the impact of legal fees on the post-petition accrued interest, which remains in escrow pending a partial settlement (expected to be approximately 70% of billed fees, the same as the first lien notes). There is a further fee reserve against this amount to cover pending appeals. With the intercreditor action between the secured noteholders dismissed except for one narrow class of claims, cash recoveries under the plan as implemented are uncertain and appear limited.

That being said, I continue to find the risk/reward attractive, and arguably more so today. From a purely relative value standpoint, the replacement notes seem to be considerably cheaper than they should be. Interest rate risk and concern over high yield in general could negatively impact market values, but the notes are over-secured and the recapitalized Momentive is much more conservatively levered. Unfortunately, the ratings agencies are unlikely to rate the replacement notes unless someone pays them to do so, which may limit the number of natural buyers. The new notes should otherwise be investment grade. As mentioned before, comparable high yield issuers such as Berry Plastics have notes of similar coupon, duration and position in the capital structure that trade above par, despite what appears on the surface to be a worse financial position. I’m hard pressed to think of a good fundamental reason why second lien MOMENT notes should trade 300 bps wider than second lien BERRY notes, but perhaps there are technical reasons Berry is not comparable or greater concerns about Momentive’s underlying business than I have observed.

Furthermore, the terms of the replacement notes remain open to appellate review. At current levels, that certainly seems like a free call option. The Momentive bankruptcy raised some important questions regarding the proper determination of a market rate of interest for secured creditors. Both the coupon of the replacement notes and the original make-whole claims are the subject of an appeal currently before the district court. From a naïve, non-technical standpoint, the market outcome of the legal process to date—that senior secured creditors could recover anything less than par value while junior creditors received significant recoveries—is unusual enough to lead me to believe the appeals process has potential. From a legal standpoint, it is quite a bit more difficult to handicap the odds of success on appeal, but noteholders remain highly motivated to pursue the case. There remains an outside chance at a full recovery including the make-whole payment, which could result in nearly 50% returns from current trading levels. More likely in my view is an upward adjustment to the coupon on the replacement notes. Even if the court upholds Judge Drain’s reliance on Chapter 13 precedent for his basic methodology, in my opinion the small incremental increase to the interest rate already made at the end of the confirmation process belies the objectivity of the process. The chosen 4.69% coupon is essentially arbitrary and clearly did not reflect the full market value of the notes.

I expect the appeal to survive a motion to dismiss on equitable mootness grounds, since it would be relatively straightforward to adjust the coupon. I expect the senior unsecured notes, which I am still short, to fail to clear that hurdle.


Exact Sciences (EXAS) and Cologuard reimbursement

Despite my public comment, CMS retained its original crosswalk to codes 81275, 81315, and 82274 in its 2015 payment determination for code G0464. The ultimate payment rate was the subject of some drama over the past few weeks, as the rates document was initially published on December 19 with a lower reimbursement level before being retracted. The reimbursement rate in the document was approximately 74% of the crosswalked values, an adjustment that normally only applies to tests prior to 2001. This was corrected, but several localities in the revised document have significantly lower payment rates than the National Limitation Amount (NLA), which is itself slightly lower than the sum of the three crosswalked codes. For example, reimbursement in Jurisdiction K, which contains populous states such as New York, is 45% lower than the NLA. Medicare reimbursement is based on the lower of the amount billed, the NLA, or the local payment amount. Some market commentators and even Exact’s own press release seem to imply that the NLA is the only reimbursement amount for all Medicare patients, which is not the case. It is a maximum.

Expect a further post discussing this in more detail. I am still looking into the reasons for the lower local reimbursement amounts, and Cable Car has a pending FOIA request for the other public comments on the CLFS in order to respond to potential justifications for a higher reimbursement level. I still intend to submit a reconsideration request, which could potentially impact the 2016 reimbursement level.

As a reminder, Cable Car is short EXAS primarily on the basis of lower-than-expected uptake. I believe setting a lower reimbursement rate is a public health imperative that could actually encourage wider screening.


Lemtrada approval and GCVRZ

Sure enough, not long after discussing why I was unwilling to bet on Lemtrada approval, GCVRZ had one big day after the drug was approved. It didn’t quite triple, and it now trades about 50% above the price the day before approval. I stand by the reasoning in the post and increasingly suspect I may have dodged a bullet. The price reflects considerable uncertainty over the timing and success of the US launch. My post did not address in detail the risk that Lemtrada has a slow launch in the US. However, there is a distinct chance that Lemtrada fails to achieve the $400 million first-year sales milestone even with contribution from the US. Due to the number of alternative MS treatments on the market, Lemtrada’s status as a last-line therapy emphasized on the label, and the time required for physician acceptance, US sales might not be sufficient for the milestone in the first year even if the drug is ultimately a blockbuster. In the absence of US data so far, the picture of the pace of sales from Europe does not look encouraging.

Although bound by the terms of the CVR not to deliberately interfere with sales, Sanofi’s incentives are at odds with CVR holders as well. The company could conceivably justify a slower launch, focusing on building physician relationships over meeting near-term sales goals in order to maximize the long-term value of the product. That they might avoid a ten-figure payment to CVR holders would be a nice bonus. If the $2 milestone appears more likely once sales data begin to come in, I would expect Sanofi to buy back CVRs or conduct another tender offer. Unless and until they do so with the benefit of internal sales data, I view the likelihood of GCVRZ paying more than zero to be low.

Thank you for following along last year. I look forward to many interesting investment opportunities and conversations with you in 2015.

Subjective probability and selling when the thesis has changed 5

Disclosure: No position in GCVRZ or AMBI. Thanks to Bing Ma for analytical support.

I recently made the tough call to sell a security I think is likely to triple.

Contingent value rights (CVRs) are an interesting niche security that can be very difficult to price. When a biotech company is acquired, sometimes the buyer and seller disagree about the value of a particular product candidate, or there may be uncertainty over its eventual approval and commercial potential. In these situations, the acquisition consideration may consist of cash and a CVR, which is a special security that pays a fixed amount of additional compensation in the event pre-determined sales or approval milestones are met. Due to illiquidity, uncertainty, incentive issues, and risk aversion, CVRs sometimes present interesting opportunities for patient value investors. I won’t discuss each of these factors at length, but there are many reasons why a CVR could be mispriced.


In some cases, CVRs are not even transferable, offering a speculative opportunity for investors with a long time horizon. One current example is Ambit Biosciences (AMBI), which is the subject of a pending takeover by Daiichi Sankyo. The offer is for $15.00 cash plus a non-tradeable CVR worth $0, $2.25, or $4.50 depending on whether the FDA approves quizartinib and the eventual label. Quizartinib is a treatment for a subtype of acute myeloid leukemia currently in phase 3 trials. Without getting into the merits of the drug and its prospects, the financial calculus is appealing for an investor who believes the drug will eventually be approved. AMBI trades at $15.40 today. That may reflect some degree of merger uncertainty, but assuming the transaction is likely to close, the CVR is being valued at $0.40 today. It could return 5.6x or 11x in ~2 years if the drug is approved. Even discounting back at a high required rate of return, the imputed CVR price implies a very low probability of approval. I would need a more nuanced understanding of quizartinib before committing even a small amount of capital in an all-or-nothing bet, but there is some price below which the AMBI stub would be very hard to resist even without a strong view on the likelihood of approval. Comments from subject matter experts are welcome.

But I digress.I recently sold my entire position in GCVRZ. It was a difficult decision and I thought I would try to explain why I thought it was the disciplined thing to do.

GCVRZ stock chart

GCVRZ has reacted primarily to the chances for FDA approval


GCVRZ is the CVR that was created when Sanofi bought Genzyme. At the time, Genzyme had very high hopes for Lemtrada, a treatment for multiple sclerosis (MS) that was previously marketed as an oncologic called Campath. Lemtrada is currently approved in over 40 countries, but in December of last year, the FDA rejected the drug for MS in the United States. The price has rebounded over the course of 2014 as the FDA unexpectedly allowed Sanofi to resubmit its application, rather than appeal the decision. Many investors are speculating that the FDA will bow to political pressure and reverse course to approve the drug, and recent trading may reflect increased speculation as the decision nears. More on this in a moment.

The details of the Lemtrada CVR are a bit involved and several of the potential payments are already moot (including a $1 payment had the FDA approved Lemtrada before March 31, 2014), but there remain a few rays of hope. The CVR will return $2 if Lemtrada reaches $400 million in global sales over a specified time frame. There are also several large additional potential payments if Lemtrada becomes a blockbuster, with worldwide sales of $1.8 billion or more. Given Lemtrada’s status as a second-line therapy and the increasing competitive environment for MS treatments, most observers believe the larger milestones are extremely unlikely. I agree and think GCVRZ will ultimately be worth either $2 or zero.

I first grew interested in GCVRZ in early 2014, but not because of any potential for FDA reconsideration. By my calculations, it should have been possible for Lemtrada to achieve the $400 million sales milestone irrespective of US approval. (The US is the largest potential market). This possibility seemed under-appreciated by the market and was the primary basis for my investment. Examining the relapsing MS patient population, country-by-country, and making relatively conservative market share assumptions, the sales milestone seemed achievable. I won’t rehash the details, but the numbers could work because Lemtrada is a very expensive drug and the potential market is very large. I estimated that $400 million in sales would represent less than 20% of the addressable non-US second-line relapsing MS market. News of the resubmission was a nice bonus, but as long as I felt there was a strong possibility of meeting the milestone even without US approval, I was mostly indifferent to the trading price of the CVR.

Sell Discipline

Unfortunately, I failed to account for an unexpectedly slow commercial launch. Sales in Lemtrada’s first few markets have been disappointing, and they cast serious doubt on my hypothesis. I no longer believe that the $400 million sales milestone is achievable without US approval. For example, I initially attributed slow uptake in Germany to a lack of reimbursement, but sales actually declined quarter-on-quarter in Q3 even after some of the reimbursement challenges were resolved. Initial UK sales were anemic, and they start the clock on the milestone calculation next quarter, evidently before the drug has achieved widespread acceptance. It appears doctors are (reasonably) being somewhat conservative about prescribing a new therapy. It is possible Lemtrada will eventually see broader usage, but initial indications of the speed of commercial adoption are not positive. Non-major markets are currently at an $18 million annual run-rate 3-6 months after launch. The milestone must be achieved during the first year of sales for each major market plus the period Q2 2015-Q1 2016 for all others. In short, while Lemtrada may someday be a $400 million/year drug, I don’t see it happening right off the bat. Frankly, if US sales follow a similar trajectory there is risk to the milestone payment even with US approval.

So, here I am publicly declaring that I sold GCVRZ about a month before an FDA determination that could cause it to double or triple. Won’t it be embarrassing if the FDA approves Lemtrada?

Not at all. In fact, my best guess read of the tea leaves is that Lemtrada will ultimately be approved. I just don’t want to bet on it!

If Lemtrada is not approved, my analysis suggests the CVR will be worthless. It might retain some option value on the open market, but it would result in a permanent capital impairment. If Lemtrada is approved, I expect it would trade at a modest discount to the $2 milestone payment to account for time value and the chance of a weak US launch. Assuming downside of perhaps $0.50 and upside of maybe $1.00, the risk/reward trade-off of 2:1 from $0.60 appears attractive at first glance.

Tempting as that gamble may be, however, I owned GCVRZ because I believed it could be worth $2 irrespective of approval. I no longer believe that to be true, so I sold it.

Subjective Probability

I won’t go into detail on the various arguments for and against approval. There is an interesting scientific debate on the role of blinding in the phase 3 study for those who are interested, but my personal opinion on the statistics is ultimately irrelevant. The FDA is a political institution and its decisions are historically very difficult to predict. It seems hard to imagine the agency allowing a resubmission without at least some desire to reconsider, but they have rejected resubmissions before.

Some proponents look to WMGIZ, another CVR representing a medical device that recently was approved after a similar reconsideration process, as evidence that Lemtrada will be approved. Unfortunately, this logic is not sound. Medical device reviews are conducted by a different part of the agency, and more importantly each individual approval decision is made independently. There is no reason to think that an MS treatment’s approval odds are in any way affected by a bone graft approval.

What to make of the odds of approval then? I see a lot of investors make simplistic expected value arguments that start by assuming approval has a probability distribution. This is wrong. When we talk about likelihood of an event that cannot be repeated and cannot have multiple outcomes, we use the language of probability subjectively. But there is no distribution of outcomes because there is only the one binary yes or no. The FDA will either approve Lemtrada or it will not. At best, we can draw analogies to other FDA decisions and try to make the simplifying assumption that multiple independent approval decisions add up to some sort of distribution of decisions, but I’m not sure this is helpful. If the FDA approves a certain percentage of phase 3 products, that does not provide very much information about the chances of any specific product candidate since each is considered on its merits. This is a problem that is traditionally solved through position sizing; if one could construct a portfolio of dozens of CVRs or biotech stocks at appealing odds, perhaps the overall return would justify the risks. However, with a limited number of potential investments and unique circumstances to each, results are likely to be path-dependent. Without robust probability estimates, we can’t use the Kelly criterion effectively, and the best course of action comes back to analyzing each situation individually. (For this reason, I generally invest in biotech stocks only when I believe I am getting the pipeline for free or I have a strongly differentiated viewpoint on the likelihood of eventual drug approval).

I think it is a mistake to try to calculate expected values to price a CVR. I’ve seen a number of investment theses that say approval is a toss-up and assign 50% probability to approval, then calculate expected value. Bloomberg even has a tool for doing this with GCVRZ. If you accept the roughly 2:1 odds I computed above and a 50% probability of success, the Kelly criterion would suggest allocating 25% of your portfolio to GCVRZ. Suddenly, that 50% probability estimate doesn’t seem so robust, does it? At a subjective probability below 33%, Kelly suggests not investing at all. Yet how can we reasonably discriminate between 33% and 50% odds of Lemtrada approval?

For good measure, investors will sometimes boost their price targets by assigning an arbitrary probability to the very unlikely milestone payments. GCVRZ pays $4 for $1.8 billion in annual sales—it makes a huge difference in an arbitrary valuation calculation if you assign that unlikely event 10% probability ($0.40 expected value) or 1% probability ($0.04 expected value). Yet 10% is a common subjective probability assigned to unlikely events. It doesn’t actually mean that if you could run 10 trials, 1 of them would result in the outcome. We don’t have enough information to say. While we do this colloquially all the time, it can dramatically skew a valuation exercise. A more effective way to put it as an investor is to ask: what would I be willing to pay for this unlikely event? Based on my understanding of the MS market, I would not be willing to invest more than a de minimis amount as I suspect the true chances are closer to 1% than 10%, speaking subjectively. The “right” expected value may be $0.04; it may be $0.40, but it doesn’t matter. Investors are not necessarily risk-neutral when there is no possibility of arbitrage.

My point here is not to argue that there is no price at which the odds would be compelling enough to justify the risk. Only that there is not enough data to assign a meaningful subjective probability. If GCVRZ trades below $0.50 before the decision again, perhaps I will take a flyer with a small position. Otherwise, I am satisfied to have profited from others’ subjective reduction in discount rates or increase in probability estimates.

I notice that I’ve started to ramble a bit, which is perhaps indicative of my ambivalence about GCVRZ. It is trading somewhere close to where I feel the risk/reward of FDA approval is fairly valued, perhaps a bit too optimistic. The security is in any case very clearly being treated as a bet on approval, given the sales trajectory so far. I no longer believe I have any analytical or informational advantage, and my first priority is to protect capital. My thesis changed, so I will leave it to others to underwrite event risk into which I have no insight.