Enzon Pharmaceuticals, Inc.
Joel Greenblatt's Magic Formula Investing (MFI) screening methodology is an excellent and simple way to find great undervalued stocks, but occasionally it will screen special situation stocks that are best avoided by investors. In fact, today I want to tell you about a stock currently in MFI that is unquestionably headed for $0 in the near future.
"Does not have significant operations"
Where do those words come from? Why, the Yahoo! Finance profile for the company! Right off the bat, that doesn't give us a lot of confidence, now does it?
Enzon Pharmaceuticals (ENZN) used to be a research stage biotech firm, focusing on a technology known as PEGylation. PEGylation was used in drug development to improve numerous positive characteristics (solubility, reduced dosage, better stability, lower toxicity etc.). Prior to that, the company also had a products and contract manufacturing division that was sold in 2010.
Since then, Enzon has lived off its legacy royalty streams from products incorporating the PEGylation technology. 90% of royalties come from a single source - Merck's PegIntron hepatitis C drug. The other 10% come from Valeant/Pfizer's Macugen for macular degeneration, UCB's CIMZIA (for Chron's disease), Sigma Tau's Oncaspar (for leukemia) and Adagen, and Affymax's OMONTYS drugs.
A Firm in Run-Off Mode
In December 2012, after several clinical failures in its pipeline, Enzon announced its intention to suspend all development programs and pursue a sale of the company. In April of last year, the company concluded its strategic review without a buyer, and is now in the process of paying off its cash flow in the form of special dividends, two of which have already been paid out.
In effect, Enzon is in run-off mode, and will distribute the remainder of its royalty cash flows to shareholders as dividends. Once these royalty cash flows run their course, ENZN will trade down to $0.
Can We Get a Puff Out of This Cigar Butt?
Famed value investor Benjamin Graham - Warren Buffett's mentor - liked to invest in what he called "cigar butt" stocks. A cigar butt is the stub of a cigar that, nevertheless, might have a few puffs of smoke left in it before being fully discarded. The analogy to investing is that, while some stocks would not make good long term investments, they might provide a nice short-term gain before being discarded.
Does ENZN, trading at about $1.10 per share, fit this description?
Since there a lot of knowns here, let's go through a brief valuation. First, Enzon paid off its convertible notes in June of last year, so there is no debt or really any expenses other than employees here. Also, the December dividend liquidated $20 million in cash, so book value is essentially 0. That means Enzon's ongoing value is almost 100% congruent with the value of its royalty streams.
Second, the bulk of the 10% of royalties that are not from PegIntron expire in 2014. So, I'm modeling a 25% decline in them for the coming year and throwing them out for 2015 and beyond.
Second, we know the expiration dates on PegIntron, as well. U.S. royalties (~12% of total sales) expire in 2016, Europe (27%) in 2018, Japan (18%) in 2019, and the rest of the world (over 30%) at various points after that. Furthermore, PegIntron royalties have been declining at about 20-25% this year, which, given recent declines due to the success of competitors like Roche's Pegasys, is probably sustainable.
Incorporating these expirations and the PegIntron decline rate into a discounted free cash flow calculation, and discounting it at 12%, I come up with a valuation of $0.69/share for Enzon's future royalty cash flows.
That is well below the current stock price.
Cross It Off, Then
Another risk in Enzon stock are the NASDAQ de-listing rules, which require a stock to stay above the $1 mark. Enzon is dangerously close, and there is little doubt the stock will trade under that barrier in the future unless the company does a reverse split or goes private.
If Enzon is de-listed, the stock would likely trade on the "pink sheets", where liquidity would be virtually non-existent and you would have difficulty selling your shares.
Given all of these facts, I feel it is best for Magic FormulaŽ investors to simply cross Enzon off their list and look for more attractive opportunities in the MFI screens.
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Steve does not own ENZN.
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