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How Bristol Myers Stole Zymo

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Bristol's $885 million offer expires at midnight tonight.

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My firm has been following ZymoGenetics (ZGEN) since 2002. It has been one of my favorite companies despite difficulties in selling its sole approved product, RecoThrom. This is an experienced team responsible for developing products selling well over a billion dollars while they were part of Novo Nordisk (NVO).

ZymoGenetics (or Zymo for short) chafed under the ownership of Novo Nordisk, which is why I wasn't the only one familiar with the company who was shocked to get the news on September 8 that Bristol Myers (BMY) was buying the company. This shock turned to stunned disbelief when the purchase price was announced -- just $885 million, or $9.75 per share.

Zymo and Bristol did a huge early-stage deal over interferon-λ (lambda) in 2008. This deal was worth more than $1 billion in upfront cash, development, and sales milestones. Interferon-λ is a promising drug for the treatment of hepatitis C (HCV) and hepatitis B (HBV). Interferon-λ is intended to be a more effective substitute for interferon-α (alpha), increasing cure rates because of a lower side effect profile. Early clinical data support this thesis.

If the early data hold, which is highly likely, interferon-λ is a blockbuster drug (over $1 billion in annual sales) and would be a consistent part of HCV therapy with and without the newer direct-acting antivirals.

Zymo also generated very promising data on IL-21, a treatment for melanoma and kidney cancer. In early melanoma trials, IL-21 had significant increases in tumor shrinkage, progression-free survival, and overall survival compared to historic standard of care. While early melanoma data often turns disappointing in larger trials, there's reason to be more optimistic than normal for this drug.

Of course, both IL-21 and interferon-λ had complications due to their target diseases. For IL-21, recent data from Bristol's own ipilimumab made the regulatory path forward for IL-21 complicated. For interferon-λ, data from the direct-acting antivirals also made for an uncertain regulatory path. Both uncertainties, however, were related to trial design and not the efficacy of the drugs themselves. The means only time is needed to sort things out -- time Zymo could use to solidify the data sets for both drugs.

In a series of three SEC filings (disclosure was forced by shareholder lawsuits the last two of which), Zymo outlined the steps leading up to the acquisition. It makes for an interesting tale of how Bristol stole Zymo in what will likely go down as one of the best pharma deals of the decade.

In 2008, Novo Nordisk expressed interest in re-acquiring Zymo. As part of the process, Zymo did a strategic evaluation and allowed five firms to do due diligence. One of these was Bristol. Novo ended up not being interested despite already owning 23% of Zymo's shares from when it bought Zymo the first time.

Bristol determined Zymo was too big a risk because of uncertainties surrounding Zymo's lead product at the time, atacicept. Bristol was, however, very interested in interferon-λ and triggered the aforementioned large partnership later in 2008.

In 2009, major Zymo shareholder Warburg Pincus wanted to sell its shares and contacted Zymo management to ask if there was anyone interested. Zymo management, interested in preventing the at-market disposal of significant shares, started calling around. One of the people they contacted was Bristol.

In the meantime, Zymo had ended up converting its co-development deal on atacicept to a simpler royalty arrangement in order to save cash. It also continued to try and find a buyer for Warburg's shares. During all this, data on interferon-λ continued to mature, increasing the potential value of the drug. IL-21 data did the same.

In 2010, Bristol decided to take a run at Zymo. Before it made its offer, however, Bristol gave Novo Nordisk a call. Novo bought Zymo just before it was going to go public, spun it out again in 2001, and looked to acquire it again in 2008. Novo still owned about 23% of the company's shares, so Bristol obviously had to get Novo's buyoff before any sort of deal.

Bristol's CEO, Lamberto Andreotti, called Novo's CEO, Lars Rebien Sorensen, and asked about Novo's interest in Zymo. Sorensen told Andreotti he saw Zymo as a financial and not strategic holding. That cleared the way for Bristol to make its offer to Zymo's board. One barrier was that the deal Bristol signed for interferon-λ included a weak standstill agreement. Bristol wasn't prohibited from taking a run at acquiring Zymo, but it was prohibited from using any of the information it obtained in the interferon-λ partnership to help adequately value Zymo.

So Bristol approached Zymo about waiving this standstill. Zymo management said "no" when they learned Bristol was thinking of paying $8-$9 per share. Much legal advising and maneuvering took place, and finally Bristol said it would consider paying as much as $9.50.

More maneuvering took place, including a financial evaluation Zymo requested from Goldman Sachs. This financial analysis, in my opinion, significantly underplayed the value of Zymo -- specifically its value to Bristol given the terms of the interferon-λ contract.

Bristol eventually agreed to pay Zymo $885 million, or $9.75 per share, and Zymo's Board of Directors caved. To be fair, Bristol had Warburg's and Novo's shares -- amounting to some 36% of total voting shares -- already largely wrapped up as voting yes. For Zymo's board to trigger their poison pill at that time would have been a difficult and expensive proxy and legal battle. For long-term Zymo shareholders, however, selling at $9.75 was a bit of an insult -- particularly because Zymo keeps expressing the deal as a great bonus for shareholders.

It isn't, not by a long shot.

The most glaring error in Goldman's analysis was ascribing only a 33% chance of FDA approval for interferon-λ. I've done a pair of informal surveys -- one among biotech geeks on Twitter and the other among an unusually rational and knowledgeable set of investors participating in an online discussion I'm part of -- and the early consensus is 33% is significantly low. Over half the people in both surveys believe there's a 60% or better chance interferon-λ will be FDA approved in at least HCV.

The other error is in expressing how much Bristol is actually paying for Zymo.

At the time of the offer, Zymo had $105 million in cash. This brings the net amount Bristol is paying down to $780 million, or $8.59 per share. That's bad enough, but it ignores cash Bristol would already be paying in development milestones to Zymo as part of its 2008 interferon-λ deal. This data was missing from the initial SEC disclosures, but was made public this week after shareholders sued to get more information.

It turns out Bristol would pay an additional $137 million in interferon-λ development milestones through 2012. These milestones wouldn't include approval milestones. Instead, mere launching of trials virtually certain to happen in that time frame triggers the cash to Zymo. Netting these milestones out makes the Bristol offer just $598 million, or a puny $6.59 per share. That's a 25% increase over the prior close, but some 33% lower than the company's 52-week high.

A couple other items are worth knowing about the financial analysis done by Goldman and Zymo's own guidance. First, RecoThrom would have started throwing off free cash in 2011. Not a lot, but probably double-digit millions by the end of 2011. Second, Goldman projected Zymo would be cash-flow positive in less than five years. This means there's a solid limit to the amount of dilution. Lastly, this deal was signed before highly likely Zymo share price bumps from interferon-λ data at AASLD and the excellent full data from the IL-21 program. All of this adds up to a company and a stock price far healthier than what was indicated in the analysis.

Bristol's tender offer expires at midnight tonight, but with 36% of the necessary 56% already in hand it's almost certainly a done deal. This is especially true given the remaining 20 points needed are now in the hands of arbitrageurs. It's a sad outcome for ZymoGenetics' shareholders, who deserved a better price for a company worth far more than the net-net $6.59 per share Bristol is paying.

If you're a Bristol shareholder, however, slap the next executive you see on the back and buy them a beer. They stole one here. Mark my words. Interferon-λ alone will be selling a billion by the end of the decade, and IL-21 has a chance to be part of a new standard of care for melanoma.

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Position in ZGEN.

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