Expert Financial Analysis and Reporting

Investment overview

Yesterday, BMY traded down sharply due to President-elect Trump’s statements on drug pricing and Merck’s announcement that the FDA has accepted a sBLA filing for the combination of Keytruda and chemotherapy (pemetrexed plus carboplatin) for the treatment of first-line metastatic or advanced non-squamous NSCLC. This report only deals with the Merck announcement. In order to assess the importance to BMY, investors have to consider a broad number of possible investment scenarios and this report attempts to assess these.

I urge the reader to read my detailed investment thinking that is positioned at the end of this report. However, for those looking for a quick summary, here it is. The more rapid early filing of the Keytruda/ chemotherapy combination is a new and unexpected negative in the BMY investment thesis. I recognize that an argument can be made that investors should sell BMY now and then repurchase it later when the smoke clears. I respect this thinking, but let me tell you what I am going to do. I will hold my current position and possibly add to it if BMY weakens significantly. It has been my experience that in making a trading call, that it is extremely hard to identify when to get back in and more often and not, the investor does not re-establish their position. This raises the risk of missing out on an exceptional long term investment. However, it is your money and I can only tell you what I am doing.

Background on Merck Filing

The Merck filing was about nine months earlier than was generally expected. The PDUFA date is May 10th, 2017. This has implications for my recommendation of Bristol-Myers. The filing is based on data from cohort G of the phase 2 KEYNOTE-21 trial in which previously untreated patients were randomized to either: (1) platinum based chemotherapy or (2) platinum based chemotherapy combined with Keytruda. Patients were enrolled regardless of the level of PD-L1 expression although those with EGFR or ALK genomic tumor mutations were excluded.

KEYNOTE-21 enrolled a limited number of patients and the data is immature (not a long patient follow-up). It randomized 123 patients so that there were probably about 61 or 62 patients who received the Keytruda plus chemotherapy and about the same number who received just chemotherapy. The median patient follow up was only 11 months. The primary endpoint was response rate or shrinkage of the tumor and at this early look there is no evidence of an overall survival benefit.

I find it extraordinary that the FDA is willing to consider approval of this combination with such limited, early data and most notably without survival data. When viewed against other actions of the agency, it is clear that the FDA believes that checkpoint inhibitors alone and in combination with other drugs represent a major advance in cancer therapy for many, many types of tumors. Because of this, the FDA is willing to significantly drop the hurdle for regulatory approval. This has important implications for all companies involved in trials involving checkpoint inhibitors.

Implications for Bristol-Myers Squibb

The Negatives

Most analysts were expecting that filing for the Keytruda/ chemotherapy combination in first line lung cancer would be based on a phase 3 study that is scheduled to read out in September 2018. Because the FDA is willing to consider data from this phase 2 trial, Merck stands to gain approval nine months earlier than might have been expected.

With approval of the sBLA, Keytruda would be approved for use in about 90% of the first line lung cancer market with only squamous PD-L1 expression < 50% excluded from the label. The previously reported data from KEYNOTE-024 trial showed that Keytruda as a monotherapy is effective for patients expressing PD-L1 > 50% in first line lung cancer and regardless of the histology (squamous or non-squamous). For some period of time and probably at a minimum of six months, Keytruda will be the only product indicated for use in the first line lung cancer market.

What does this mean for Bristol-Myers Squibb’s Opdivo? Most of its sales in lung cancer are as monotherapy for second line patients who have failed chemotherapy in the first line setting. Approval in first line for Keytruda as monotherapy will impact the use of Opdivo in the second line. However, KEYNOTE-024 indicated that Keytruda should only be used in about 25% of the first line market. BMY management guided investors to expect that Opdivo sales in the US could flatten in 2017 because of this.

Importantly, BMY had not included in this guidance the possible approval of the Keytruda/ chemotherapy combination at mid-year and probable launch in late 2017. They had thought that about 75% of the first line market would continue to be treated with chemotherapy and patients who failed that therapy would go on to second line and be treated with a checkpoint inhibitor-either Opdivo, Keytruda or Roche’s Tecentriq. The concern is that now potentially 90% of the first line market can be treated with Keytruda. It is highly probable that Opdivo, Keytruda or Tecentriq might not be used in the second line setting if the patient is given Keytruda in the first line setting and fails treatment. This is a significant negative for BMY in the near term.

On The Positive Side

BMY believes that the future of lung cancer treatment will be in combinations of checkpoint modulators and that oncologists are anxious to move away from chemotherapy. The Company is moving at a very quick pace to bring a combination of Opdivo and Yervoy to the market. Its CHECKPOINT- 227 trial in first line lung cancer is critical for BMY and immuno-oncology as a whole. It is a multi-armed trial that will have four arms: (1) chemotherapy, (2) Opdivo alone, (3) Opdivo plus chemotherapy and (4) Opdivo plus Yervoy. This study should provide a very strong understanding of how to treat first line lung cancer patients.

It is the opinion of BMY that Opdivo combined with Yervoy will produce the best results in first line lung and will become the standard of care. The superiority of this combination in melanoma has already been established. Also, BMY has seen results for a significant number of patients treated with this combination in first line lung cancer in open label phase 1 and 2 trials which I will shortly discuss. BMY has substantial data to give them a meaningful insight into the value of the combination in first line lung. If BMY is correct, Merck’s current advantage will be fleeting and BMY’s Opdivo/ Yervoy combination will control most of the market.

The question is when will there be clinical data that supports or refutes BMY’s judgment. The all-important CHECKPOINT-227 trial should readout in 1Q, 2018 and give a definitive answer. However, the unexpected acceptance by the FDA of the Merck sBLA suggests to me that the agency may allow BMY to provide data from CHECKMATE-012 and CHECKMATE-568 more quickly to the FDA and potentially get the combination approved more quickly. As I noted earlier, I find it extraordinary that the FDA is willing to consider approval of the Keytruda/chemotherapy sBLA with such limited, early data. Obviously, the FDA wants to get these checkpoint inhibitors combinations to the oncology community as quickly as it can. This could set the course for more rapid approval of the Opdivo/ Yervoy combination that is before results are available from CHECKMATE-227.

Here is what could happen. BMY has two open label phase 2 studies underway studying the combination of Opdivo and Yervoy in first line lung cancer. They have data on about 80 patients in the phase 2 CHECKMATE -012 that is quite mature with a median patient follow-up of over 16 months. This should give an insight into overall survival. It has also tripled the number of patients in a similar phase 2 trial, CHECKMATE- 568, from 170 to 590 patients. Late last year, BMY management hinted that it might be able to file a sBLA for the Opdivo/ Yervoy combination based on data from these two phase 2 trials in mid-2018 and if so, we might see approval in late 2017 or early 2018. Since that time, management has been silent, keeping its cards close to the sleeve for competitive reasons.

What to Do With the Stock; My Investment Thoughts

Explosive Market Opportunity

Let me start with some general thoughts. The first and most important is that the market for checkpoint modulators used as monotherapy and in combination with other anti-cancer drugs is in its infancy and is poised for rapid growth. The first checkpoint inhibitor Yervoy was approved in 2011 and there are now four checkpoint inhibitors approved-BMY’s Yervoy and Opdivo, MRK’s Keytruda and Roche’s Tecentriq. Sales of these drugs were approximately $6 billion in 2016. By 2022, there should be several other drugs approved and analysts are forecasting sales for this class of drugs of $33 billion by 2022.

This is not a zero sums game in which just BMY or MRK or Roche or Astra Zeneca or some other company will win. A rising tide lifts all boats and the checkpoint modulator space is riding a wave akin to a tsunami. As first movers in the space BMY and MRK can be expected to be the two predominant players.

Creating Clinical Data Is Key

The issue we are now confronted with is one of timing of data creation. There have been no comparative studies between Opdivo and Keytruda, but most key opinion leaders consider them to be roughly equivalent in efficacy and safety. Points of differentiation are modest. The choice of which product to use in a given indication will depend on the data supporting use. Oncologists are very data driven and will use products in accordance with their approved prescribing label. Eventually, Opdivo and Keytruda will carry pretty much the same label so it is this near term period of 2017 to 2020 that the labels could differ meaningfully in some indications.

What I Believe Is the Most Likely Investment Scenarios

There are a broad number of scenarios for BMY’s stock and I can’t go over each of them. I will start with what I think is the most likely scenario. I think that the FDA will accept a filing for approval of the Opdivo/ Yervoy combination in mid-2017 in first line lung based on positive data from the two phase 2 trials and will grant approval in late 2017. This may be conditional and require collaboration from the phase 3 CHECKPOINT 227 trial which reads out in 1H, 2018. In this scenario, the Opdivo/ Yervoy combination would be used in most first line lung cancer patients and the current lead of Keytruda in this setting would be short-lived.

What Can Go Wrong

I can point to two big uncertainties in this scenario. The first is that we haven’t seen the data from the two phase 2 trials for the Opdivo/ chemotherapy combination. Maybe, it will not be as positive as I think it will be. Bear in mind that the two points that support this scenario are the extrapolation of the favorable results seen for the combination in melanoma to the lung cancer setting. The second is a reliance on the statements of BMY management that their interpretation of data created in phase 1 and 2 open label trials convinces them that the combination will be the best treatment option.

I must point out that there will be a period of uncertainty in the next six months that will weigh on the stock and may cause it to underperform. We won’t know until mid-2017 data from CHECKMATE-012 and CHECKMATE-568 and we won’t know if the FDA will accept a filing based on the data.

Let’s look at what could happen if the key assumptions underlying my investment thesis are wrong. What if the combination of Opdivo and Yervoy does not produce superior results and the Keytruda/ chemotherapy data is convincing. BMY will have data from the CHECKPOINT- 227 trial in 1H, 2018 and this will show the results of Opdivo combined with chemotherapy. In this negative scenario, I think that the Keytruda/ chemotherapy combination could be approved in May 2017 and the Opdivo/ chemotherapy combination in 2H, 2018. In this case, MRK would dominate the first line lung cancer market. I think that BMY might perform poorly in this scenario for the next year or two relative to MRK and perhaps in an absolute sense. However, even in this negative scenario, Opdivo has exceptional growth prospects over the next five years.

Bottom Line

The development with the more rapid early filing of the Keytruda/ chemotherapy combination is a new and unexpected negative in the BMY investment thesis. I recognize that an argument can be made that investors should sell BMY now and then repurchase it later when the smoke clears. I respect this thinking, but I let me tell you what I am going to do. I will hold my current position and possibly add to it if BNY weakens significantly. It has been my experience that in making a trading call like this that it is extremely hard to identify when to get back in and more often and not, the investor does not re-establish the position.