Arquitos Capital Management commentary for the third quarter ended September 30, 2024.
Dear Partner:
Arquitos returned -15.5% net of fees in the third quarter of 2024, bringing the year-to-date return to 4.5%.
As usual, we have seen quite a bit of volatility this year. At one point, we were up more than 40% on the year before the drop this summer. We are running strong again since the close of the 3rd quarter, and I expect a strong finish to the end of the year.
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Arquitos Performance Since Inception
While we continue to own some of our longer term holdings, I have transitioned part of the portfolio into new opportunities. One that I am especially excited about is below.
New Position
We have a new position in a very small company that recently won a court case involving a patent dispute. I would like to continue to acquire shares, so I’ll keep the name of the company under wraps for now. However, I would like to lay out the opportunity as I believe that the company is worth multiples of where it currently trades.
The company recently won a jury award totally approximately $30 million. This included a one-time $25 million licensing fee and interest from the time of the initial infringement. The market cap of the entire company is currently less than $20 million. There are several outstanding claims that will be resolved by the judge over the next several months:
- An as yet to be determined royalty rate on the sales of the drug that relies on the infringed patent. The present value of this award will likely be between $10 million and $20 million, though it could be higher, perhaps significantly so, if sales for the drug increase.
- There is a significantly higher than usual chance that the judge will grant enhanced damages, doubling or tripling the original $25 million award. Interest would be added to this amount as well, so this could add $30 million to $60 million to the award. The offending company and their counsel objectively acted in an egregious manner, even being called out by the judge during the trial, so I would be surprised if there is not some sort of enhanced damages. The question is how much.
- Attorney’s fees may also be granted. This amount could be in excess of $20 million. Again, during the trial the judge pointed out outrageous behavior by the offending party’s legal counsel. This behavior rose to the level where a bar complaint is possible. So, again, I would be surprised if at least some attorney’s fees are not granted.
The company has about $10 million in cash and limited operations. They have some lease obligations and would owe some money to the university where the patent was developed if the award goes above a certain level.
Taking all of this into account, the possible outcomes range from approximately $25 per share on the low end to more than $75 per share on the high end. Shares currently trade at $12.
It will take several months to go through the post-trial items. Once those are complete, the judge will determine the ongoing royalty rate and the enhanced damages. The offending party will surely appeal, but interest will continue to accumulate. Interest is currently running at 75 cents per share annually. If the high end of enhanced damages are found, that number could rise to $2.25 per share. Because of this, an appeal is not the worst thing for the company, assuming they eventually prevail. In the meantime, there also is the possibility of a settlement. If that were to occur, it would likely be for multiples of the current market cap.
There may be other opportunities for the company to enforce its patents against other parties as well. The CEO is experienced in patent litigation and is not a “product guy.” The board is made up of finance experts, so I am not concerned that the company will use these or any future proceeds to attempt to restart its drug development.
Again, this company is very small and relatively illiquid, but I have already acquired a 3% allocation in the fund and believe I can continue to acquire more shares until it is a more meaningful position. This company is my favorite position at the moment.
ENDI Corp. (ENDI)
Enterprise Diversified Inc (OTCMKTS:ENDI) is our largest position. It ended the quarter at $8.25 per share.
ENDI manages six mutual funds and has more than $3.2 billion in assets under management. The most recent fund was launched on September 30 with a focus on income producing bonds in the Nordic region: Denmark, Finland, Iceland, Norway, and Sweden. One year ago, assets under management stood at approximately $1.7 billion, so we have seen tremendous growth. I continue to be extremely optimistic on ENDI’s future.
Liquidia (LQDA)
The saga at Liquidia Corp (NASDAQ:LQDA) continues. Everyone involved is deeply disappointed by recent developments delaying the release of their life-saving PAH and PH-ILD drug, Yutrepia, until May 2025. However, we now know when the FDA will give final approval and when Liquidia can launch. Our patience will be rewarded.
Because the market is forward-looking, we should see share appreciation in advance of that launch date. In fact, there have been a variety of sell-side research reports from respected firms with price targets between $19 and $30. Shares currently trade for $11.14 after ending the third quarter at $10.00.
We were expecting final FDA approval during the quarter, which would have allowed Liquidia to launch Yutrepia into the market. Shockingly, the FDA delayed approval until May 23, 2025, citing a three-year exclusivity period for Yutrepia’s competitor drug, Tyvaso. This was not an outcome previously indicated as possible by the FDA and wholly unexpected by Liquidia and their competitor, United Therapeutics.
The FDA based its decision on a study by United Therapeutics conducted in 2021 to evaluate the safety and tolerability of treprostinil (the generic drug underpinning Yutrepia and Tyvaso) inhalation powder in patients currently treated with a trepostinil inhalation solution. United Therapeutics had developed a dry powder formulation of Tyvaso which would allow some patients to switch to an inhaler from a nebulizer. United Therapeutics had received approval for its inhaler product in May 2022 based on this study.
A three-year exclusivity would apply only if there was a “New Clinical Investigation.” The FDA decided that essentially changing the delivery method applied. That is a big stretch and has far reaching negative effects across the industry if more widely applied. This finding was also contrary to the FDA’s previous findings. It appears that political pressure was put on the FDA to change course to benefit United Therapeutics.
Liquidia responded by suing the FDA. In order for a court to order that the FDA’s decision be vacated, it must be shown that the FDA acted in an arbitrary and capricious manner. Liquidia’s brief on the subject makes a compelling case. However, even if Liquidia is successful, there will undoubtedly be post-trial items that will delay enforcement until we approach the May 2025 FDA approval. So, while it is possible that a launch could happen sooner, I am not optimistic.
Why continue to own shares in the interim? I do not believe this is dead money until May. First, as I mentioned, shares will begin to reflect the company’s future potential prior to May. Second, there is a possibility, even if it is low, that FDA approval and Liquidia’s launch could come sooner. And, third, a buyout of Liquidia prior to launch is not totally off the table. I would not expect it, but it is possible and if it came, it would be multiples of today’s share price.
We have owned the position for years with various starts and stops due to delay tactics from United Therapeutics. The reason why it is worth it is that I strongly believe that Liquidia has the superior product. United Therapeutics and their leadership also appear to believe this. And, the market for PAH and PH-ILD is large and growing relative to the size of Liquidia.
I believe that Liquidia can capture market share of at least 50%. This is not like a typical new competitor coming onto the market. There is a 50% to 60% drop out rate for United Therapeutics’ drug as patients are unable to tolerate it. Liquidia’s drug has been shown to be easier for patients to tolerate. Liquidia has a patented manufacturing process that allows the drug to provide higher dosage and better titration, meaning that patients receive the maximum benefit of the drug with the lowest chance of adverse effects. Liquidia has a better chance of serving these patients who cannot tolerate the current medication from its competitor, and patients may stay on the Liquidia drug longer than their current medication because it is more effective.
If Liquidia takes 50% market share, their annual profit potential in a static market is equal to their current enterprise value. Of course, the market is not static, it is growing significantly. Share would appreciate considerably even if they end up taking only a 10% or 20% market share. For context, Liquidia’s CEO thinks they can take 80% to 90% of the market. This is why United Therapeutics has been so aggressive. And, it is why it is worth the wait to hold Liquidia shares until at least the launch.
We owned a significant number of shares and call options that were negatively affected this quarter by the FDA. I have rolled many of the call options to later dates and lower strike prices. I will note that we first started buying shares at around $5 per share so though we had a drop for the quarter on the shares, our average purchase price is still far below today’s price. It has been a frustrating wait, but the end is in sight. I continue to strongly believe that our patience will be rewarded.
Lifecore (LFCR)
Lifecore Biomedical Inc (NASDAQ:LFCR) had a transformational year last year. It divested its non-core businesses and put itself up for sale. Unfortunately, that sales process coincided with an extended restatement delay and, eventually, a change in auditors. The restatement was related to their divested businesses, but rightfully caused concern among potential buyers.
Earlier this year, the company withdrew its attempts to sell itself. While unconfirmed, I understand that there were offers, but they were too low for the company to accept. At the time, shares were measurably higher than where they are now and conceivably higher than the potential offers. Investors were obviously disappointed and shares sold off to where they trade today.
An activist investor eventually got more involved and had several representatives appointed to the board. Management has also changed, with more experienced leadership in charge, and the financial restatement was completed.
Earlier this month, the company completed a smallish capital raise at $4.10 per share. Shares have rallied a bit since then and now trade higher than where they did at the end of the 3rd quarter. The company believes they have enough cash to last them the next several years when their operations should support positive free cash flow.
I still believe in the story long term. Lifecore has dramatically increased its fill/finish capacity in an industry where the lead time to increase capacity is long. Fill/finish is the process of filling vials and needles with drug substances and packaging them for distribution. There appears to also be demand, especially among companies that sell weight loss drugs. The problem is that there are long lead times for these contracts.
For Lifecore, the capacity is there , but they still require signed contracts to fill that capacity. I believe that they will get them and, longer term, the outcome for the company is an outright sale. However, I am pessimistic on the timing. We have recently largely exited in the interim. I may decide to re-enter once execution improves, but in the meantime I am finding better opportunities to allocate to. Our average sale price is slightly above our average purchase price.
Thank you for your investment in Arquitos. I also appreciate your patience with what sometimes must feel like a roller coaster ride due to the portfolio’s volatility. As I mentioned, the fourth quarter has started strong, and I look forward to reporting back to you at the end of the year.
Best regards,
Steven Kiel
Arquitos Capital Management