On 2nd May 2008 the pharmaceutical contract research and drug development company Sareum announced that it had received a number of approaches for its drug discovery unit and that as a result it would be initiating a strategic review and was considering a number of options including significant refinancing or the sale of all or part of the business. The company has also embarked on a staff restructuring programme which is expected to reduce its cost base by almost a third. This review has the potential to unlock clear value in Sareum and our stance, at 0.35p, is speculative buy.

Founded in August 2003, Sareum has developed two distinct businesses under one corporate roof. An in-house, oncology focussed, drug discovery and development business on the verge of signing its first licensing deal with a pharmaceutical company partner to accelerate the exploitation of its novel technology. The second operating unit is a profitable fee-for-service business providing structure based drug discovery aid which works for companies such as Johnson & Johnson, Roche and Genentech. The business model is that a growing contract research business would generate an increasing proportion – and eventually all – of the cash the in house drug development business needs to survive. The belief is that with licensing deals for early stage oncology products typically securing up front payments of $5 million or more plus ongoing milestone payments and potentially a royalty stream, it is the drug development business which can be a company maker for Sareum.

However the large scale corporate activity among the pharmaceutical majors has meant that demand for Sareum’s contract research activities has not met expectations. The business is still profitable and the past year has seen an extension of many collaborations which provides validation of Sareum’s technology and expertise. However it is not generating the cash needed to fund the in house drug discovery programme and this trading disappointment has caused Sareum’s share price to fall sharply over the past 18 months. Oddly this fall has happened at a time when the in-house drug discovery side of the business, the key driver of value, has achieved significant progress.

The Company’s lead programme is carried out in conjunction with the Institute of Cancer Research and it has five other drug discovery programmes in its pipeline with Checkpoint Kinase 1, FLT4 and Aurora Kinases leading the way followed by Polo-like Kinase 1, B-RAF Kinase and Fatty Acid Synthase which are at the early stages of development. Sareum aims to commercialise 2 or 3 of its drug pipelines with one compound being nominated to enter pre-clinical development during 2008. At that stage it has a very real commercial value and any upfront payments received from majors seeking to buy in at that stage, will be used by Sareum to drive the remaining pipelines forward. The accelerating R&D on novel treatments for cancer has – combined with weaker than anticipated results from the contract development business – caused a sharp uplift in both operating losses and cash consumption. However such investment is needed to realise value for shareholders. Although Sareum has net cash of £700,000 if it is unable to secure a commercial partnership with a significant upfront payment on one of its novel compounds, or be acquired or refinanced as part of its strategic review, then it will need to raise additional equity funding in the second half of 2008.

We value Sareum on a sum of parts basis – looking in isolation at its contract business side, its net cash and its in house discovery programmes. We believe the company’s contract research business is worth around £1.9 million - one times current year revenues. With a current market capitalisation of £2.74 million and a cash position of £700,000 the market is valuing the novel drug discovery programme at virtually nothing. A string of recent deals between majors and drug development companies on oncology products at the pre-clinical phase have involved up front payments of $5 - $25 million plus further milestone payments and the potential for eventual sales royalties. On that basis we think the market valuation of this business is unduly harsh and we are not surprised that it has attracted a number of potential corporate purchasers. On a heavily risk weighted basis, we value the in house research at around £3.3 million. Our total value of the company is therefore £5.9 million or 0.72p per share. However we note that the individual parts may be worth significantly more to suitable corporates in a break-up situation and this may well be the conclusion of the ongoing strategic review. Our stance, at 0.34p, is therefore speculative buy.

Forecast Table Year to 30th June Sales (£ million) Post-Tax Profits (£ million) Earnings per share (pence) 2005A 0.3 (1.24) (0.42) 2006A 1.5 (0.62) (0.18) 2007A 2.5 (0.53) (0.12) 2008E 1.45 (1.95) (0.24)   2009E 1.5 (1.0) (0.12)

 

Background

Sareum was formed in August 2003 by Dr Tim Mitchell, Dr David Williams and Dr John Reader when their employer, Millennium Pharmaceuticals, decided to close its UK operations. Sareum began its operations in Cambridgeshire in August 2004 aided by an agreement with Millennium to equip Sareum’s laboratories at a relatively low cost. Millennium also provided one of the first research contracts. Although it was unable to find initial venture capital support, Sareum gained early stage backing from Zyzygy plc, a small AIM listed investment vehicle which was looking for opportunities in the scientific arena. With additional funding provided by founding partners, staff, family and colleagues Sareum raised £1 million in pre IPO funding with the original backers gaining an 11.76% stake for their money. The company listed on AIM in October 2004 following a fund raising which raised £2 million gross (£1.75 million net) at 2p per share.

By the end of 2004, following on from the initial contract with Millennium, the company had booked four fee earning deals. This part of the business really started to take off in 2005 when Sareum entered into numerous collaborative agreements including two with Idenix Pharmaceuticals, to provide support for Idenix’s program to discover new drug candidates for the treatment of patients with HIV/AIDS, and a $5 million deal to aid Idenix in its discovery of novel hepatitis C compounds. An agreement with Organon, a human health care business unit of Akzo Nobel, was also concluded which saw Sareum committed to dedicating a multi-disciplinary research team to generate therapies for diseases such as rheumatoid arthritis. This was closely followed by a third agreement with H. Lundbeck A/S, an international pharmaceutical company with sales of approximately €1.3 billion in 2004, to provide protein structure determination capabilities.

Sareum further cemented the growing strength of its business operations with a deal with UCB, a global biopharmaceutical leader. This agreement saw Sareum provide UCB with access to its Crystal Bank protein structures - drug discovery targets in several therapeutic areas. Significant collaborations with Roche and Piramed followed along with a multi target research services agreement with Genentech in November 2006 to aid Genentech in designated drug discovery targets.

2006 was also a year of substantial progress. In June, Sareum achieved key success milestones in its collaboration programme with Schering AG which began in 2005. This was a real breakthrough for the company as Sareum was the only organisation to successfully determine the structure of this target. As a result of this achievement, the company received one of its first success milestone payments. On the in-house drug discovery side, the company also achieved substantial progress with its joint cancer drug collaboration with The Institute of Cancer Research which it had begun in July 2005. A novel compound series which showed efficacy in cancer models was discovered.

In January 2007, Sareum announced the first of a series of investments made by Mr and Mrs Leonard Licht. Leonard Licht is a highly respected veteran fund manager and his personal endorsement and continuing support has added real credibility to the Sareum investment case. In the same month Sareum also announced another collaborative agreement with Johnson & Johnson Pharmaceutical Research and Development under which Sareum will help the company to develop new and improved therapeutics to help patients suffering from diseases of the central nervous system.

Operations

Sareum has two main business operations: contract research (known as Fee for Service) and its own in house drug discovery programmes.

Fee for Service

The company generates revenue from its fee for service route through its numerous collaborative agreements with big name pharma companies such as Johnson & Johnson, Genentech and Schering. Sareum aids the companies in protein structure determination and pre-clinical drug discoveries in return for contracted research fees as well as milestone payments should the programme achieve certain pre-determined points of success. Sareum’s fee-for-service business is of significant value as the cash generated is then used to support its in house drug discovery programmes. Of the revenue generated for the six months to 31st December 1007, £222,000 arose from success based payments. The operating margin on this part of the business is 52%.

Many of Sareum’s collaborative contracts have been renewed which provides validation of Sareum’s competency in this area. For example, the major CNS research agreement with Johnson & Johnson was extended in March 2008 and there is an option for a further extension from 2009. A contract with H. Lundbeck, which covers work on developing new and improved therapeutics to help patients suffering from neurological conditions such as Alzheimer’s disease, was extended in July 2007. An agreement with Genentech, was also extended at the end of December 2007 following the success of an initial contract which was signed in November 2006.

In House Drug Discovery

Sareum has always regarded its cancer focused, in house drug development pipeline has the key value creator for its shareholders. The company has three strategies for generating new treatments for cancer. Sareum works on novel drugs which target enzyme pathways within cancer cells which will then be used in combination with existing drugs to improve the effect of these drugs ( e.g. Chk1). Secondly, the company is working on drugs that target biochemical pathways such as Aurora, PLK-1 and B-RAF which can be used as single agent therapies in cancer patients or in combination with other cancer drugs. Thirdly, the company is working on a therapeutic approach via inhibition of the enzyme FLT4 to regulate the process of metastasis, the main cause of death from cancer.

Sareum currently has six drug development programmes in its oncology pipeline:

1) Chk1 (Checkpoint Kinase 1) is aimed to increase the effectiveness of chemotherapy treatment. This drug was discovered in July 2005 via a joint collaboration with The Institute of Cancer Research (ICR) and Cancer Research Technology (CRT). The drug has been shown to have efficacy in cancer cell models and synergy with existing chemotherapeutics. So far four patent applications have been filed. This is Sareum’s most advanced programme and is now progressing towards candidate selection and clinical trials.

2) PLK 1 (Polo-like Kinase 1) is a key regulator of cell division and higher levels of the PLK 1 protein have been shown to be present in many types of cancer. Reducing PLK 1 enzyme activity or protein levels has been shown to induce tumour cell death in a variety of biological model systems.

3) B-Raf (B-Raf Kinase). Many cancers have been shows to have mutations in the B-raf gene which causes a large increase in the enzyme activity of the B-raf protein kinase. These mutations have been observed in over 60% of malignant melanomas. Introduction of these mutant forms of B-raf into experimental models have reproduced and sustained tumourigenesis.

4) FLT4 controls the mobilization of cancer cells, a key process involved in metastasis. A drug inhibiting Flt4 should prevent tumour spread and provide an invaluable therapy for the management of many cancer types.

5) Aurora Kinases A and B are required for cells to both enter and proceed through mitosis. Aurora kinases are over expressed in a variety of cancers including pancreatic, ovarian, colon, breast and liver cancer. These cellular proteins therefore represent attractive targets for treating a wide range of cancers. It is found to be more potent than the current leading clinical candidate. Two patent applications have already been filed.

6) FASN (Fatty Acid Synthase). High levels of FASN are present in most cancer types and are associated with diminished patient survival. Reduction of FASN activity has been reported to lead to cancer cell death and decreased tumour size. applications were filed this year.

It is important to note that Sareum’s compounds are currently only being tested for efficacy in mouse models, let alone human beings, but notable progress has been made in Sareum’s programmes in modelling and laboratory work and this has led to a decision to increase investment in drug discovery and development activity, adding new programmes and increasing the resource applied to existing programmes. The company expects to be able to nominate a compound to enter pre-clinical development during 2008. Sareum has also received expressions of interest from pharmaceutical and biotechnology companies about buying into three of its programmes and early stage licensing discussions are taking place. The statement made on May 2nd 2008 makes it clear that a number of corporate parties have expressed an interest in buying this entire division.

 

Risk and Opportunities

The high level of M&A activity among Sareum’s Fee for Service customer group and a general nervous about committing new expenditure on R&D work in a harsher economic climate has led to a reduction in new orders for this business. With relatively high fixed costs that has led to a sharp fall in profitability and in its ability to generate cash to support Sareum’s other activities. It is to be hoped that the order flow improves and this would quickly feed through to increased cash generation but there can be no certainty of this.

If order flow remains depressed in the Fee for Service business, Sareum will have to either restrict its R&D expenditure or to seek additional external funding at some stage over the next 12 months. The one event which could mitigate the need for external funding is if Sareum manages to sign a deal with a pharma major to commercialise one of its in-house drugs. Such deals typically involve material up-front payments, ongoing milestone payments during development plus, potentially royalty payments if the product reaches the market. However Sareum has yet to sign a deal and if it does, the timing cannot be guaranteed.

By its nature, drug development is high risk. The vast majority of pre clinical compounds never reaches phase III of trials, let alone market. That is however, why the rewards for success are so high. Moreover that is also why pharma-majors seek to maximise their own R&D returns by buying in products at various stages of development rather than developing all products from scratch themselves.

 

Strategy for Growth

Sareum is currently undertaking a strategic review of its options and it may be that shareholder value is maximised by the sale of all, or part, of its business. In our view, the stockmarket has not valued this company fairly and it may be that corporate transactions will be needed for shareholders to realise value. Following the announcement of the strategic review the company has implemented a staff restructuring process that is expected to reduce its cost base by almost a third and place it in a better position to acquire suitable targets.

However, if the company continues in its present form it is funded to undertake a clear strategy for growth. The Fee for Service business will seek to win new contracts which allow it to generate sufficient cash to fund Sareum’s corporate overhead and all, or part, of its in-house discovery programme. And Sareum’s primary objective has always been to advance its in house drug discovery pipeline so that it has a number of pre-clinical candidates which are well positioned to attract lucrative partnering deals with pharmaceutical companies. Sareum’s aim is to attract partners for each of its compounds under development in deals which would see it earn significant up-front fees ($5 million to $25 million are not uncommon in oncology) as well as, potentially, additional milestone payments as the drugs pass various stages of clinical development and royalties should there be any commercial sales. The cash generated by such commercial agreements could fund an acceleration and widening of Sareum’s R&D programme or could be returned to shareholders.

 

Shareholders

The company’s total issued share capital consists of 818,097,713 shares with none held in treasury. The shareholders deemed to be significant with more than a 3% holding in the company are as follows:

Mr & Mrs Leonard Licht - 9.8%
Drs John & Valerie Reader - 5.3%
Dr Tim Mitchell - 5.2%
Dr David Williams - 5.2%
Mr Joseph Craven - 4.6%

Senior Management


Tim Mitchell, Founder and CEO. Aged 46. Mitchell has 18 years experience in the industry with key management and business expertise gained from his positions at Cambridge Discovery Chemistry and his roles at Millennium as a member of the management team and in forming the integrated Structure-Based Discovery department. As Director of the Millennium Structure-Based Discovery department, Mitchell was responsible for global provision of Protein Structure and High Throughput Chemical Synthesis for Millennium as well as for local Computational Chemistry, Informatics and Automation capabilities. Prior to that, he was Director of Computational Chemistry at Cambridge Discovery Chemistry Ltd, and a team leader in the Computational and Structural Sciences department at SmithKline Beecham Pharmaceuticals. Mitchell has a PhD in Computational Chemistry and a BSc in Chemistry.

David Williams, Founder and VP Biological and Structural Sciences. Aged 44. Williams has 22 years experience in the Pharmaceutical and Biotechnology sectors, establishing and running teams of drug discovery scientists, as well as managing pre-clinical pipelines. Williams was Director of Structural Sciences at Millennium Pharmaceuticals, a world-class department that he built in both the UK and US to service the needs of the company's four therapeutic areas. Prior to this role, he was Associate Director of Biomolecular Sciences at Medivir, Section Head of Molecular Immunology at Peptide Therapeutics (Acambis) and a Research Scientist at Roche Discovery Research. Williams has a PhD in Cell Signalling obtained with the former Imperial Cancer Research Fund and a BSc in Applied Biology.

John Reader PhD. Founder and VP Chemistry. Aged 40. Reader has 13 years' experience within the industry and was formerly Associate Director, Chemical Technologies at Millennium Pharmaceuticals Research and Development Ltd, prior to which he worked with Pharmacopeia Inc. and Cambridge Discovery Chemistry in the provision of high throughput chemistry services to external and internal clients. Reader has extensive experience of leading large research teams and in the invention and application of new technologies to the drug-discovery process, with an excellent track record of delivering successful projects to clients and has authored or co-authored many patents and publications. The majority of patents granted to Reader cover composition of matter discovered in the multiple projects in which he has worked, with further patents covering technological innovations in the field. Reader is a member of the EPSRC Peer Review College and has a PhD in Chemistry and a BSc in Applied Chemistry.

Giorgio Reggiani, Finance Director. Aged 43. Reggiani is a Chartered Management Accountant with over 17 years of senior financial experience, gained mostly in hi-tech and high-growth companies. Reggiani completed his MBA at London Business School in 1992 and has since worked for companies including Vidus, a scheduling software company which he helped to spin-out of British Telecom and grow before selling to @Road inc and Mobile Systems International plc, a GSM network planning company which was acquired by Marconi for $690m. Most recently, he was a founding partner of Esprit Capital Partners LLP, a Venture Capital firm which manages over $500m in capital funds.

Martin Gouldstone. Director, Business Development. Aged 40. Gouldstone has 16 years experience in the industry and his role at Sareum is to drive the Business Development strategy, looking for significant new Research Collaborations utilizing Sareum's structure based drug discovery expertise. In addition he focuses on seeking in-licensing opportunities to continue the growth of Sareum's oncology portfolio. Prior to Sareum, Gouldstone was the Business Development lead in Europe for Pharmacopeia Inc and a Director of Business Development for Confirmant, a spin out from Oxford Glycosciences and Marconi.

Results, balance sheet and cashflow

In the company’s most recent results statement, covering the six months ended 31st December 2007, Sareum cited difficult trading conditions in the Fee for Service unit as it reported a disappointing set of numbers. Revenues fell from £1.205 million to £1.096 million and the loss after tax increased from £208,000 to £674,000 reflecting both operational gearing within Fee for service and also an increase in R&D spend on the in-house programme with the commencement of two further oncology drug discovery programmes. Sareum finished the period with net current assets of £1.11 million and £920,000 in cash. A placing of £1.25 million in October contributed materially to the Company’s cash position as the cash outflow from operating activities was £930,000, up from £415,000 although a £123,000 R&D tax credit reduced the net cash burn. Due to the Company’s accounting policies, there was no significant financial impact as a result of adopting IFRS.

Forecasts, valuation and conclusion

The recently announced strategic review creates some uncertainty but with the research operation having attracted significant corporate interest and with the share price materially undervaluing Sareum’s inherent value, the announcement should not be viewed as too much of a shock. We have assumed that the company continues to operate in its present format and have valued it on that basis although we believe that a break-up could well unlock hidden value.

We assume, for the purposes of our forecasts that Sareum does not sign a deal with a corporate major on its in-house drug discovery programme. This is arguably an overly conservative assumption and if one such deal is signed then it could potentially more than double annual revenues and move Sareum sharply into the black. If however no such deal is signed and there is no great recovery in Fee for Service business then the company will almost certainly need to issue fresh equity during the next 12 months.

We value Sareum on a sum of parts basis – looking in isolation at its contract business side, its net cash and its in house discovery programmes. We believe the company’s contract research business is worth around £1.9 million - one times current year revenues. With a present market capitalisation of £2.74 million and a cash position of £700,000 the market is valuing the novel drug discovery programme at virtually nothing. A string of recent deals between majors and drug development companies on oncology products at the pre-clinical phase have involved up front payments of $5 - $25 million plus further milestone payments and the potential for eventual sales royalties. On that basis we think the market valuation of this business is unduly harsh and we are not surprised that it has attracted a number of potential corporate purchasers. On a heavily risk weighted basis, we value the in house research at around £3.3 million. Our total value of the company is therefore £5.9 million or 0.72p per share. However we note that the individual parts may be worth significantly more to suitable corporates in a break-up situation on the basis that they can strip costs from combining businesses and this may well be the conclusion of the ongoing strategic review. Our stance, at 0.34p, is therefore speculative buy.

Forecast Table Year to 30th June Sales (£ million) Post-Tax Profits (£ million) Earnings per share (pence) 2005A 0.3 (1.24) (0.42) 2006A 1.5 (0.62) (0.18) 2007A 2.5 (0.53) (0.12) 2008E 1.45 (1.95) (0.24)   2009E 1.5 (1.0) (0.12)