Evotec. Innovating for the changing market. CureX to overcome slowdown in outsourcing. Major pharma alliances expected in next two years

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1 Evotec Innovating for the changing market Corporate outlook Pharma & biotech Evotec has accelerated its CureX strategy to counteract the more uncertain outlook in drug discovery outsourcing and enhance its long-term growth prospects. CureX collaborations should result in several major alliances with pharmaceutical companies in the next two years due to their innovative nature. Data are also due from the second Phase III trial with DiaPep277 in Type I diabetes (T1D) in Q414 and the Phase II study with EVT302 in Alzheimer s disease (AD) in mid We raise our valuation to 521m. 4 February 2014 Price 4.0 Market cap 520m Net cash ( m) on 30 September Shares in issue 130.0m Free float 69% Year end Revenue ( m) PBT* ( m) EPS* (c) 12/ N/A 12/ N/A N/A 12/13e N/A N/A 12/14e N/A Note: *PBT and EPS are normalised, excluding intangible amortisation, exceptional items and share-based payments. DPS (c) P/E (x) Yield (%) Code Primary exchange Secondary exchange Share price performance EVT Frankfurt N/A CureX to overcome slowdown in outsourcing Evotec s CureX collaborations with leading academic institutions aim to develop innovative drug discovery programmes. These discovery programmes form the basis of high-value integrated alliances with pharmaceutical companies, such as Janssen with CureBeta. The growth in drug discovery outsourcing is more volatile, affecting Evotec s growth, but the expansion of its CureX initiatives should accelerate the company s long-term growth. Major pharma alliances expected in next two years Evotec has 12 CureX/TargetX programmes underway and the open innovation alliance with Yale. These should form the basis of several major integrated alliances in the coming years. The terms of any deals will vary; however, the CureBeta/Janssen alliance ($8m upfront, FTE payments, milestones of up to m per product plus royalties) provides an indication of potential deal terms. An important 18 months for the clinical pipeline In Q414, data from the second Phase III trial in T1D with DiaPep277 are due, which could lead to the approval of Evotec s first product, triggering milestone payments and a royalty stream. In mid-2015, data from the Phase IIb trial in AD with EVT302 could be reported and cause Roche to initiate Phase III studies. Unfortunately, the pipeline had a setback in December when Janssen decided not to start the planned Phase II study with EVT103, due to data from confirmatory preclinical studies. Valuation: Revised DCF valuation of 521m We increase our valuation by c 40m to 521m ( 4.00 per share), after taking into account the acceleration of the CureX strategy, slowdown in outsourcing and setback with EVT103. This suggests that the shares are fairly valued; however, our valuation could increase to over 700m, if data from the trials with DiaPep277 and EVT302 are positive. % 1m 3m 12m Abs 5.0 (9.8) 40.4 Rel (local) 7.8 (11.6) week high/low Business description Evotec is a drug discovery business that provides outsourcing solutions to pharmaceutical and biotech companies, including Boehringer Ingelheim and J&J. It also has innovative drug discovery CureX collaborations with academic institutions. It has operations in Germany, UK and US. Next events FY13 results 25 March 2014 Q114 results 14 May 2014 AGM 17 June 2014 Q214 results 12 August 2014 Analysts Dr Mick Cooper +44 (0) Dr Philippa Gardner +44 (0) Robin Davison +44 (0) healthcare@edisongroup.com Edison profile page Evotec is a research client of Edison Investment Research Limited

2 Investment summary Company description: A leading drug discovery company Evotec is a German biotechnology company that provides high-quality drug discovery services to the pharmaceutical industry and has collaborations with academic institutions to create novel drug discovery programmes. It was founded in 1993 by a group of eminent German scientists, including the Nobel Laureate Professor Manfred Eigen, and employs c 600 people in Germany, UK and the US. It can undertake all parts of the drug discovery process and has particular expertise in pain, CNS, immunology, metabolic and oncology indications and regenerative medicine. It has a broad range of long-term collaborations with pharmaceutical companies, including Genentech (Roche), Janssen (J&J) and Boehringer Ingelheim. Its business strategy, Action Plan 2016, has three components: EVT Execute, focused on providing specific drug discovery services on an FTE basis; EVT Integrate, which conducts the entire preclinical development programmes; and EVT Innovate, which aims to discover novel therapies through its CureX initiatives with academic institutions. Valuation: 521m based on DCF We have raised our valuation of Evotec by 40m to 521m ( 4.00 per share), after taking into account the improved long-term growth prospects due to the acceleration of the CureX strategy, the setback with EVT103 (after confirmatory preclinical studies by Janssen failed to justify the initiation of the planned Phase II trial) and progress with the rest of the pipeline. The shares appear to be fairly valued currently. However, if the data from the second Phase III trial in Type 1 diabetes with DiaPep277 (due in Q414) and the Phase II study in Alzheimer s disease with EVT302 (due in mid-2015) are positive, our valuation could increase to over 700m in Q315. Sensitivities Unlike most biotechnology companies, Evotec is profitable so has a lower risk profile than most companies in the sector. All of its clinical programmes are partnered, so the company bears none of the financial risk associated with clinical trials. However, its value is clearly still affected by the outcome of studies, especially those with DiaPep277 and EVT302. Evotec s future growth, driven by EVT Execute and EVT Integrate contracts, is more uncertain, due to various changes in the drug discovery outsourcing market. To reduce its sensitivity to the market conditions, it has accelerated its CureX initiatives so that pharmaceutical companies partner with Evotec primarily to obtain novel development programmes, rather than just to reduce costs and improve the efficiency of drug discovery. So, Evotec s long-term growth will in part be determined by the success of the CureX projects in generating sought-after drug discovery programmes. Financials The slowdown in drug discovery outsourcing and missed milestone following Janssen s decision not to go ahead with the Phase II study with EVT103 has led to sales forecasts being reduced by 9.1% and 5.4% and adjusted EPS by 69.4% and 39.2% in FY13 and FY14 respectively. But we expect the long-term growth prospects to have been improved by the expansion of the CureX strategy, so we have increased our forecast sales growth from 10.5% to 15.9% in FY15. Evotec strengthened its capital position with the 30m private placement in September 2013 and we estimate it will have a gross cash position of 93m at FY13. Despite its cash position, the company is expected to maintain its profitability and use its capital to carry out bolt-on acquisitions to maintain its technological leadership in drug discovery. Evotec 4 February

3 Outlook: Innovating to prosper in a changing market Evotec remains a leader in the field of drug discovery, but a reduction in the outsourcing of drug discovery has caused its growth to slow. To respond to the new market conditions, the company has expanded its CureX initiatives, innovative drug discovery alliances with academic institutions. Evotec has accelerated its CureX strategy in H213 with four new programmes, and we believe that this should enable it to form more high-value collaborations with pharmaceutical companies, improving its long-term growth prospects. Its clinical pipeline is also developing well, despite the setback with EVT103 partnered with Janssen, and Phase III data on its lead product DiaPep277 for Type 1 diabetes, due in Q414, could result in its first product being approved in Action Plan 2016 update Evotec began implementing Action Plan 2016 in Q112; this is a strategic initiative that builds on the transformation of Evotec that occurred with Action Plan The strategic objectives are wideranging, and affect most aspects of the company s activities, but essentially affect the three principal activities as follows: EVT Execute continual investment in best-in-class technology so that Evotec can provide its clients with the highest quality and most capital efficient services. EVT Integrate development of drug development processes across more therapeutic fields so it can form more long-term, integrated, performance-based alliances. EVT Innovate development of novel approaches to treat indications with major unmet medical need. The target of the Action Plan 2016 is to double revenues by 2016 at the latest (including improving the quality of the revenue mix by the addition of royalties), achieve an operating margin of c 15% (6.5% in FY11) and accelerate cash generation. Other goals include maintaining its position as a leading drug discovery company through innovation and building a more mature partnered pipeline, without increasing its financial risk. Evotec s strategy has adapted to reflect the changing market dynamics, although the goals remain the same. There are various trends affecting outsourcing of drug development, including a greater focus on biologic products than small molecules (the majority of high-throughput screening of small molecule libraries is already outsourced), continuing restructuring programmes by big pharma, a preference for outsourcing to European and US companies and different services being outsourced (eg biomarker programmes). It also appears that the overall cost savings of outsourcing are becoming smaller due to the fixed costs associated with running an R&D facility, as well as the understandable desire of big pharma to maintain their knowledge base in early drug development, which is particularly affecting the complete outsourcing of drug development programmes with integrated alliances. Some of these changes are beneficial to Evotec (eg preference for western partners), while others are not (eg strength in small molecules, fewer integrated alliances); but overall they are making the market more volatile and its growth less predictable. Evotec s response has been to expand EVT Innovate significantly with its CureX strategy. This involves the formation of true partnerships with academic institutions, to identify novel targets and develop treatments addressing the underlying causes of diseases with large unmet medical needs. From these academic alliances, Evotec aims to form subsequent integrated partnerships with pharmaceutical companies, in which it receives FTE (full time equivalent) payments with the potential of significant milestones (similar to those with EVT Integrate), as it has done with CureBeta and Janssen. Importantly, the success of CureBeta and novel structure of the CureX alliances is making Evotec the partner of choice for academia. There are currently 12 CureX/TargetX alliances, which could result in more corporate alliances in the next two years. Evotec 4 February

4 To facilitate the amendment to the strategy, the organisation of Evotec is also adapting. Mario Polywka will be responsible for the services provided by EVT Execute and EVT Integrate, and Cord Dohrmann will be in charge of EVT Innovate. The former relies on the industrialisation of drug discovery with a focus on the efficient reproduction of processes. In contrast, EVT Innovate requires novel approaches to discover truly innovative approaches. Also, EVT Innovate could become the most important client of EVT Execute & Integrate, if the CureX strategy evolves as expected. EVT Execute: Pre-clinical functions on a fee-for-service basis The EVT Execute operations offer a comprehensive range of high-tech services that are performed efficiently and reproducibly on an industrial scale. These functions can be accessed flexibly, for instance as an integrated project or each can be a standalone service, with payments being purely on a fee-for-service basis. Although having a lower margin (around 25%) and no scope for success milestones and royalties, EVT Execute revenues have no development risk exposure and the numerous and varied projects generate a long-term, recurring income stream. Importantly, these also underpin the building up and maintenance of a world-class expertise, capability and infrastructure for drug discovery. EVT Execute provides a complete range of preclinical development services to biotech and pharmaceutical companies; these include: assay development and screening, fragment-based drug discovery, medicinal chemistry, and ADMET (absorption, distribution, metabolism, excretion and toxicology assays). They can all be carried out reproducibly and efficiently to the scale and standards required by large pharmaceutical companies. This has resulted in Evotec developing a strong reputation and discovering over 100 lead compounds, 20 preclinical drugs and 15 clinical compounds. The rate of technological change means that much of this market can become commoditised; hence EVT Execute, despite its proven track record and history of repeat business, needs to continuously develop new capabilities to maintain its competitive advantage. Evotec invests c 8m a year developing new services, and extending its current offering (eg opening a compound management facility in Branford Connecticut to service the US East Coast). This is supplemented by bolt-on acquisitions. For example, Cell Culture Service was acquired in January 2013 for 1.2m in cash and potential earn-outs to strengthen its cell-based screening and reagent platform. Collaborations are also an important method in developing the capabilities of EVT Execute. The company formed a strategic collaboration, EVOmAb, with 4-Antibody (acquired by Agenus in January 2014) in May 2012 so that it can select antibodies from an extensive antibody library using high-throughput screening. The latter alliance could be particularly valuable with the expansion of the CureX initiatives, as it enables Evotec to develop small molecules or monoclonal antibodies against targets identified, depending on which strategy is most appropriate. In the future, Evotec will report sales from EVT Execute contracts with those from EVT Integrate. EVT Integrate: Integrated drug discovery alliances Evotec continues to make good progress with existing alliances, having achieved various milestones and extended alliances. However, in FY13 Evotec only reported forming a major new alliance with AstraZeneca and three smaller collaborations with Apeiron Dow Agrochemicals and the Leukemia & Lymphoma Society, excluding the CureX/TargetX initiatives. This compares to seven new reported corporate collaborations in 2010, including major ones with Vifor Pharma and Genentech (extended in April 2013). Evotec 4 February

5 These alliances are more extensive that EVT Execute contracts, and include success based payments. They tend to be initiated by a pharmaceutical/biotech company providing a target to Evotec, which then conducts the entire drug preclinical drug development process. Evotec can earn milestone payments and royalties, as well as FTE payments from these alliances. The FTE rates are slightly lower on average than those for fee-for-service alliances, but Evotec can make a better return, because of the potential milestone payments and royalties, and longer duration of alliances (circa three years). Inevitably some programmes are terminated, so Evotec likes to have at least three targets included in an integrated alliance deal to increase the likelihood of it achieving a favourable return. During FY13, Evotec received five milestone payments from integrated alliances with UCB, Ono Pharmaceuticals and Boehringer Ingelheim including 2m from Boehringer for an oncology product advancing into clinical development. There was also the extension of the Genentech collaboration, expansion of the diabetes alliance with MedImmune (AstraZeneca) and extension of the collaboration with the Jain Foundation in skeletal muscular dystrophy diseases. However, the rate at which Evotec can form new integrated alliances has slowed as pharmaceutical companies have reduced the amount of such integrated drug development that they outsource. In the past, Evotec was able to form new integrated alliances because of the cost effectiveness, efficiency and quality of its core drug development capabilities. This appears to be no longer sufficient and deep therapeutic expertise is required now, as Evotec has in diabetes (Exhibit 1). Also the new integrated alliance with AstraZeneca, which began in October 2013, is in the field of kidney disease and follows the formation of the CureNephron collaboration in January So, it is most likely that Evotec will form new integrated alliances in therapeutic areas where it has already had corporate collaborations or there are CureX initiatives (Exhibit 2). Exhibit 1: Evotec s diabetes pipeline targets multiple disease pathways Source: Evotec. Note: DiaPep277 is in Phase III and partnered with Andromeda/Teva; EVT770 is in lead optimisation and partnered with MedImmune (AstraZeneca); EVT070 is in lead optimisation and partnered with Boehringer Ingelheim; CureBeta is in target identification/validation and is an alliance with Janssen and Harvard University; and TargetEEM is in the discovery phase and is an alliance with Harvard University. EVT Innovate CureX and TargetX fuel pipeline EVT Innovate has developed considerably since the formation in Q112 of Action Plan 2016, and is now an important growth driver for Evotec. This should be very apparent as the company will report revenues from EVT Innovate separate to those from EVT Execute. The cornerstones of EVT Innovate are the CureX and TargetX collaborations with leading academic centres (Exhibit 3), in which Evotec and its partners work in an integrated manner to enable efficient innovation. These alliances give Evotec access to the work and expertise of professors so that they can develop truly novel therapies, which address the underlying causes of diseases. Evotec 4 February

6 Exhibit 2: Main therapeutic areas of expertise Therapeutic area Alliances Notes Neurology Roche, Ono, Genentech, CHDI, Takeda, UCB, TargetAD, TargetASIC, CureMN EVT302 is partnered with Roche for Alzheimer s disease and in Phase IIb. EVT-201 is in Phase II for insomnia and partnered with Jingxin Pharmaceutical (Chinese rights only). Diabetes and complications of diabetes AstraZeneca Andromeda (Teva), Boehringer Ingelheim, Janssen (J&J), MedImmune, Takeda, CureBeta, CureNephron, TargetEEM Evotec acquired the alliances with Boehringer Ingelheim and Andromeda with the purchase of DeveloGen. The collaboration with MedImmune (AstraZeneca) is to develop EVT770, created by DeveloGen. The Janssen alliance was a result of the CureBeta collaboration with Harvard. Immunology and Inflammation Boehringer Ingelheim, Shionogi, UCB, Bayer EVT401, a P2X7 antagonist, is partnered with Conba Pharma (Chinese rights only), which is conducting a Phase I/II study. Oncology Pain Boehringer Ingelheim, Roche, Apeiron Biologics, Aspireo, TargetCbl-b, TargetKDM, TargetFGFR3, TargetIDH Novartis, Pfizer, Boehringer Ingelheim, Apeiron Biologics Alliance with Boehringer Ingelheim in oncology formed in Expertise was enhanced in this field with the proposed acquisition of Kinaxo Biotechnologies GmbH, and Evotec subsequently formed a biomarker discovery alliance with Roche in June Evotec has two unpartnered preclinical programmes (B1 antagonist and P2X2/3 antagonists), which it hopes to partner for pain indications. Respiratory Boehringer Ingelheim, Almirall Evotec has a strategic alliance with IR Pharma, because of the latter s expertise in in vitro and in vivo respiratory pharmacology. Source: Edison Investment Research. Note: Evotec has alliances in contraception (Spermatech) and anaemia (Vifor). Exhibit 3: CureX/TargetX initiatives and academic collaborations Collaboration Partners Disease area Notes CureBeta Harvard University/ Howard Hughes Medical Institute (HHMI)/ Janssen (J&J) Diabetes Formed in March 2011 to develop novel treatments for diabetes which cause beta cell regeneration. Evotec is working with Prof Doug Melton and his laboratories. 16 months after the start of the collaboration, a strategic alliance was established with Janssen with an upfront payment of $8m; milestones up to $ m per product and royalties could be paid to Evotec, HHMI and Harvard University. The programme is at the target identification and validation stage. CureNephron CureMN (CureMotorNeuron) TargetASIC Harvard University/Brigham and Women s Hospital Harvard Stem Cell Institute Undisclosed pharmaceutical company / BMBF Kidney disease Neurology Neurology Formed in January 2012 to discover and develop new biomarkers and therapies to enable more accurate diagnosis and treatment of chronic and acute kidney disease. Evotec is working with Prof Andy McMahon and Prof Ben Humphreys. The programme is in the discovery phase. Formed in September 2013 to identify compounds that prevent or slow down the loss of motor neurons, which is characteristic of amyotrophic lateral sclerosis (ALS). Collaborating with Dr Lee Rubin of HSCI and Dr Kevin Eggan of HHMI, HSCI and Harvard University. The programme is in the discovery phase. TargetASIC evolved from the work conducted within the Neu2 consortium, which included MerckSerono, began in November 2009 and is funded by the BMBF (Federal Ministry of Education and Research). The current pharmaceutical partnership was not reported and research costs are now shared. Programme is in lead generation. TargetCbl-b Apeiron Biologics Cancer Formed in October 2011 to develop a cancer immunotherapy, which targets the Cbl-b protein (a negative regulator of cytotoxic lymphocytes). Research costs and potential milestones and royalties will be shared. Programme is in preclinical development; next milestone is a partnership with a pharmaceutical company. TargetAD TargetKDM Johnson & Johnson Innovation Centre (California) Belfer Institute/Dana- Farber Cancer Institute Neurology Cancer Formed in November 2013 to identify new targets for Alzheimer's disease drug discovery and development by analysing high-quality brain samples from the Netherlands Brain Bank. J&J will fund target discovery research with FTE and success based payments totalling up to $10m; Evotec can also earn potential milestones worth $ m in total and royalties. Programme is in discovery phase. Formed in April 2013 to discover novel cancer treatments based on epigenetic drug mechanisms. It is focused on lysine demethylases, a class of histone deacetylases (HDACs, c 18 members). Programme is in preclinical development; next milestone is a partnership with a pharmaceutical company. TargetPGB Harvard University Anti-bacterial Formed in May 2013 to discover novel anti-bacterial agents based on a highly validated target family involved in bacterial cell wall biosynthesis (peptidoglycan biosynthesis). Collaboration is with Prof Daniel Kahne and Prof Suzanne Walker of Harvard University. Programme is in discovery phase. Target EEM (Enteroendocrine Mechanisms) Harvard University/HHMI Diabetes Formed in October 2013 to identify enteroendocrine signals and mechanisms, which are involved in regulating key metabolic process and thereby develop compounds with disease-modifying potential in diabetic patients. Collaboration is with Prof Doug Melton. The programme is in the discovery phase. TargetDBR Yale University Cancer Formed in December 2013 to discover novel mechanisms, targets and compounds that interfere with DNA repair and could increase the effectiveness of radiotherapy and chemotherapy. The initial focus will be on glioblastomas but could be expanded to other tumours. Programme is in discovery phase. TargetFGF3 Unpartnered Cancer Programme for bladder cancer, in hit-to-lead stage of early drug discovery. TargetIDH Unpartnered Cancer Cancer programme via the epigenetic factors, isocitrate dehydrogenases (IDH), in hit-to-lead stage of early drug discovery. Yale Open Innovation Alliance Yale University N/A An alliance formed in January 2013, in which Evotec and Yale jointly access the potential of novel assays, screens, models and most importantly drug targets and compounds, so that Evotec s drug discovery infrastructure can be seamlessly integrated into projects to facilitate the commercialisation of discoveries. The collaboration covers many fields, including metabolism, neurology, immunology and oncology. So far, it has led to the formation of TargetDBR. Source: Edison Investment Research Evotec 4 February

7 The academic groups benefit from being able to commercialise their research in a capital-efficient manner, without requiring venture capitalists, while still being able to advance their careers by publishing scientific papers (this is often not possible if academic groups form alliances with pharmaceutical companies). They can also advance their research more quickly using Evotec's expertise in high content screening assays to carry out systematic, unbiased and comprehensive discovery platforms. The first CureX alliance was CureBeta with Prof Doug Melton of Harvard University and Howard Hughes Medical Institute (HHMI, Exhibit 4). After investing less than $2m in the project with the academic institutions over 16 months, the programme was partnered with Janssen for $8m, high margin research payments to fund research until the end of preclinical development, potential milestone payments of up to $ m per product and royalties (the upfront payment, milestone payments and royalties are shared equally between Evotec and Harvard University/HHMI). The paper published in the journal Cell in May 2013 also indicates that the products originating from the CureBeta programme could slow or even reverse the progression of diabetes. Exhibit 4: Case study of CureBeta Notes Objective of Objective To develop novel oral treatments for diabetes that trigger or support beta cell replication alliance and Status Programme is in target identification and validation progress Validation of programme Data from the CureBeta programme, which was published in Cell, shows that the protein Betatrophin causes an increase in beta cell replication and higher levels of insulin production (see below; GFP is an inert protein that was used as a control to measure the effects of increasing levels of Betatrophin). It was also shown that Betatrophin caused an increase in glucose tolerance in fasted mice. Potential of programme Products that mimic the effects of Betatrophin could delay or even reverse the progression diabetes by causing an increase in beta cells and restoring (albeit partially) correct insulin production in diabetics. Timeline March 2011 Evotec forms a research collaboration with Harvard University and Howard Hughes Medical Institute (HHMI) with Prof Doug Melton as the principal investigator from Harvard and HHMI July 2012 The collaboration was expanded to include Janssen (J&J), which in-licensed a portfolio of small molecules and biologics designed to trigger the regeneration of beta cells, which produce insulin. May 2013 Data from the programme was published in the leading scientific paper Cell. Terms of deals Harvard University/HHMI alliance Janssen alliance Source: Edison Investment Research; Evotec; Yi et al, Cell (2013) Doug Melton and his laboratory contributed their expertise in beta cell regeneration to the collaboration and Evotec provided its expertise in high content screening assays. Academics in Doug Melton's lab are able to publish their results in scientific journals. No specific commercial terms were disclosed. Janssen paid $8m upfront and could pay milestones totalling $ m and royalties per product from the alliance; these payments are divided equally between Evotec and Harvard/HHMI. Janssen also pays high-margin research fees to advance products to the end of preclinical development. The success of the CureBeta alliance has led to Evotec forming many other similar alliances with the same ambitious aims in therapeutic fields with considerable unmet medical need. It is also making Evotec the partner of choice for many academic institutions, giving it potentially a significant first-mover advantage over competitors, such as Galapagos, for this type of alliance. Not all of the collaborations will be as successful as CureBeta has been so far, but it is likely that some of them will be expanded to include a pharmaceutical partner in the coming two years. Pharmaceutical companies are becoming more focused on developing innovative therapies. Pressure from regulators and reimbursement agencies means that new treatments need to have significant benefits over existing treatments to be approved and reimbursed at favourable levels. All of Evotec's cure initiatives are designed to generate first-in-class products to meet this demand from pharmaceutical companies. Evotec 4 February

8 Evotec appears to be the partner of choice for many academic institutes, given the innovative structure of the alliances, which allow researchers to continue their academic careers. Other companies will try to imitate these CureX initiatives, which is why it was sensible of Evotec to accelerate its CureX strategy following the 30m capital raise in August The stronger balance sheet will also allow Evotec to advance more CureX programmes later in preclinical development (such as TargetCbl-b and TargetKDM), perhaps all the way to the IND stage, before it looks for a partner so that it can achieve an even greater return. Broad pipeline focus on four disease areas An important goal of Action Plan 2016 is to expand its clinical pipeline (Exhibit 5), with its partners bearing the financial risk involved. There was the setback with EVT103, an NMDA antagonist, which has not resumed Phase II development as expected. But, Phase IIa proof of concept data was reported with Somatoprim in April 2013 and Boehringer Ingelheim advanced an oncology product into Phase I development. Also, the Phase III trial with DiaPep277 in Type1 diabetes (T1D) and the Phase II with EVT302 in AD, are progressing well and data from the former study due in Q414 could lead in 2015 to the approval of Evotec's first product. Exhibit 5: Summary of clinical R&D pipeline Product Development Indication/ partner Notes stage DiaPep277 Phase III Type I diabetes/ Andromeda (Teva) A synthetic peptide of 24 amino acids derived from human Hsp60, dosed every three months. Successfully completed the first pivotal Phase III study, DIA-AID (n=457): significant reduction in the decline in C-peptide levels (marker for endogenous insulin secretion, primary endpoint) compared to placebo (p=0.0374) and more patients maintained good glucose control (HbA1c levels of 7% after two years; p=0.035, 45.5% vs 35.7%). The improvement in glucose control was maintained during the following two years in the extension study (n=43, HbA1c levels of 7%; p=0.035, 45.5% vs 35.7%). Enrolment for second pivotal study, DIA-AID2 (n=450), is complete and data is expected in H214. The product is licensed to Andromeda Biotech, which has sub-licensed the marketing rights to Teva. Evotec earned 3.9m from the successful completion of DIA-AID, and could earn significant mid-term milestones (up to 40m) and single-digit royalties, 30% of which are payable to original shareholders of DeveloGen. Market size up to 500m. Potential launch in EVT302/ RG1577/ RO Phase II Alzheimer s disease/ Roche EVT201 Phase II Insomnia/ Jingxin Pharma Somatoprim (DG3173) Phase II Acromegaly and other growth hormone related indications/ Aspireo Pharmaceuticals EVT401 Phase I/II Rheumatoid arthritis, inflammatory diseases/ Conba Pharmaceutical Not disclosed Phase I Oncology/ Boehringer Ingelheim Monoamine oxidase-b (MAO-B) inhibitor, initially licensed from Roche in Evotec licensed EVT302 back to Roche in 2011 for development in Alzheimer s disease (AD). Evotec was paid $12m upfront and could receive $170m in development milestones, $650m in commercial milestones and tiered double-digit royalties on sales. The Phase IIb MAyflOwer RoAD trial was initiated in September 2012 in moderately severe AD (n=420); trial due to be completed in June Potential launch GABAA receptor modulator, shown efficacy in two Phase II trials. In one trial, 75 adults, doses 1.5mg and 2.5mg, increased total sleep time (TST, 33.1, 45.0 min; both p<0.0001) and reduced wake after sleep onset (-16.7, -25.7min; p<0.0001) in a dose responsive manner. In second trial, 149 elderly pts, doses 1.5mg and 2.5mg, TST increased (30.9, 56.4min; p=0.0001, p<0.0001). No serious or unexpected adverse events. Jingxin Pharma in-licensed the exclusive rights to the drug in China and is due to initiate Phase IIb trials in China; Evotec received a small upfront payment and could receive milestones and significant royalties. Development outside China is on hold. A novel somatostatin (growth hormone inhibiting hormone) analogue being developed to compete against Novartis's octreotide (Sandostatin) and Ipsen's lanreotide (Somatuline) in the $1.7bn market. A Phase IIa study in acromegaly demonstrated a dose dependent lowering of excess growth hormone in treatment-naive patients, with no serious adverse events and the reported events were mild-tomoderate and transient in nature. A pharmaceutical partner is sought for further development. Evotec is providing Aspireo with strategic and operational advice. Antagonist of P2X7 ATP-gated ion channel. Phase I trial: 96 healthy males with ascending doses, no serious adverse events or withdrawals occurred. Conba Pharmaceutical in-licensed the exclusive rights to the drug in China and is preparing a Phase II trial using the Green Path fast track of the CFDA. Evotec received a small upfront payment and could receive milestones up to 60m and tiered double-digit royalties. Further development in the rest of the world is on hold until the drug is partnered. Boehringer Ingelheim initiated a Phase I trial with an oncology compound in September 2013, triggering a 2m payment to Evotec. No further details have been disclosed. Source: Edison Investment Research; Note: EVT100 series (NMDA antagonists) was expected to resume clinical development in 2013 with a Phase II study with EVT103 in treatment resistant depression, but certain characteristics of the compounds were not confirmed in preclinical studies. DiaPep277 is a peptide that appears to reduce the level of destruction of beta cells by altering T-cell reactivity, thereby slowing the progression of T1D. In Phase II, patients receiving DiaPep277 were shown to maintain better beta cell function (measured by recording c-peptide concentration after a glucagon stimulation) than those on placebo. These findings have been confirmed in the first Phase Evotec 4 February

9 III study, DIA-AID, and more patients on DiaPep277 maintained good glucose control than those on placebo (HbA1c levels of 7% after two years; p=0.035, 45.5% vs 35.7%). The second Phase III study, DIA-AID2, is identical in design to the completed Phase III study, is fully recruited and data are due in Q414. If the results from this study are consistent with the DiaPep277 and is shown to confer similar benefits on patients with T1D, the product could be approved in H215. There are limited treatments available to type 1 diabetics, and this would be the first drug that would have been shown to slow disease progression. It would also be the first Evotec product to be launched, potentially triggering milestone payments and generating a royalty stream. EVT302 (RG1577) could be the first product approved for the treatment of patients with moderate AD, which alters disease progression. The rationale for EVT302 (a highly selective MAO-B inhibitor) in AD is that the expression of MAO-B is up-regulated around amyloid plaques (Exhibit 6), which is thought to cause oxidative damage to neurons around them. Data from the current Phase IIb trial could be reported in mid-2015, which could lead to EVT302 advancing into pivotal Phase III studies. Exhibit 6: Up-regulation of MAO-B in brain tissue with amyloid plaques Source: Evotec Evotec s clinical pipeline should be expanded over the next 12 months, as around five products are in the final stage of preclinical development ahead of IND submission. But, it appears to be unlikely now that EVT103 will resume clinical development because the results of confirmatory preclinical studies failed to justify Janssen going ahead with the planned Phase II study in treatment resistant depression at the end of last year. Sensitivities Evotec s risk profile is considerably lower than that of most companies in the biotechnology sector because of its drug discovery alliance strategy. It is undertaking a large number of discovery projects at once, so that the inevitable failure of some programmes should not undermine the business. Evotec also spreads the risk associated with the majority of its projects with a partner. The company does not take unpartnered assets into clinical development, so it is not exposed to the significant financial risk associated with clinical development, while retaining some of the upside linked with successful clinical development. However, its value will still be affected by the outcome of clinical trials, in particular the results of the current Phase III DIA-AID2 study with DiaPep277 in T1D in Q414 and the Phase IIb of EVT302 in AD in mid The company s revenues have grown at a CAGR of 21.8% between FY08 and FY12 and it has been profitable since FY10. Sales are expected to fall by 2.7% in FY13 before resuming their growth trajectory. The rate of revenue increase, given the increased uncertainty in the outsourcing market, depends more on Evotec achieving milestones from existing alliances and the company s ability to find pharmaceutical partners for its CureX programmes. Evotec 4 February

10 Valuation We have increased our valuation of Evotec from 480m to 521 ( 4.00 per share, Exhibit 7). The removal of EVT103 from our valuation has been more than offset by the improved long-term growth prospects of the drug alliance business, following the acceleration of the CureX strategy (see Financials section below), inclusion of Somatoprim and Boehringer Ingelheim s undisclosed oncology product, and adjustments to the discount factors due to the progression of time. Exhibit 7: Summary of risk-adjusted DCF valuation Value ( m) Value per Notes share ( ) Drug alliance business Three-stage DCF valuation, terminal growth rate: 2.5% DiaPep Expected launch: 2016; peak sales: $1.2bn; risk adjustment: 65%; royalties: 5% EVT Expected launch: 2019; peak sales: $3.2bn; risk adjustment: 20%; royalties: 12.5% (excludes potential commercial milestones) Other clinical assets (EVT201, EVT401, Somatoprim, undisclosed oncology asset) EVT201: Expected launch: 2018; peak sales: $100m; risk adjustment: 30%; royalties: 5% EVT401: Expected launch: 2018; peak sales: $200m; risk adjustment: 30%; royalties: 5% Somatoprim: Expected launch: 2016; peak sales: $295m; risk adjustment: 30%; royalties: 5% Undisclosed asset: Expected launch: 2016; peak sales: $750m; risk adjustment: 10%; royalties: 5% EVT070, EVT770 milestones Estimated clinical milestones risk-adjusted by industry standards Net cash Estimated net cash position at FY13 Total Source: Edison Investment Research; Note: For drug discovery business: WACC=10%; for product valuations: WACC=12.5%. Our valuation suggests the shares are currently at fair value, with potential upside if the expansion of the CureX initiatives drives revenue growth faster than we forecast and the successful completion of the Phase III trial with DiaPep277 in Q414 and Phase IIb study with EVT302 in mid If data from the two trials is positive, our valuation could increase to over 700m in Q315. Financials We have adjusted our estimates to take into account the missed milestone following Janssen s decision not to initiate the Phase II study with EVT103, the greater volatility in the drug outsourcing market and the effect of the expansion of the CureX strategy. Until FY15, the effect of the first two issues has led to a reduction in forecasts (Exhibit 8); but in the longer term, Evotec s growth prospects should be improved by the expansion of the CureX strategy announced in Q313. If CureX programmes are partnered on the same terms as CureBeta with Janssen, Evotec will generate over 4m in revenues in the year of the deal, and several such partnerships are expected in the coming years, which is why our forecast sales growth in FY16 has increased from 11% to 15%. It is possible that Evotec s FY13 results will include an impairment charge of up to 22m, if it is considered unlikely that a member of the EVT100 series will resume clinical development. Exhibit 8: Summary of changes to estimates Sales ( m) PBT ( m) EPS (c) Old New % chg. Old New % chg. Old New % chg. 2013e (9.1) (69.6) (69.4) 2014e (5.4) (35.6) (39.2) 2015e (0.7) (13.6) (14.0) Source: Edison Investment Research; Note: Figures in m except per share data which is in cents. Evotec s balance sheet, which was enhanced in September 2013 with the 30m capital raise, remains strong with an estimated net cash position of 75.9m and gross cash of 93.1m. Despite its financial strength, we expect Evotec to maintain its tight cost control, remain profitable and only gradually increase the proportion of CureX initiatives that it takes towards the IND phase of development, before looking for a pharmaceutical partner. Instead, it will probably use its cash pile Evotec 4 February

11 Exhibit 9: Financial summary to make more bolt-on acquisitions to develop its expertise and ensure that it remains a technological leader in the field of drug discovery. 000s e 2014e 2015e Year end 31 December IFRS IFRS IFRS IFRS IFRS PROFIT & LOSS Revenue 80,128 87,265 84,875 95, ,661 Cost of Sales (45,143) (56,242) (53,813) (58,065) (66,467) Gross Profit 34,985 31,023 31,062 37,428 44,193 EBITDA 11,971 9,119 10,020 12,237 17,606 Operating Profit (before GW and except.) 7,467 3,071 4,101 6,223 11,474 Intangible Amortisation (1,703) (2,768) (3,118) (2,719) (2,599) Other (3,321) (3,311) (251) 0 0 Exceptionals (557) (3,505) (3,404) 0 0 Operating Profit 5,207 (3,202) (2,421) 3,504 8,876 Net Interest (1,445) (1,204) (1,117) (909) (871) Other 1,494 (608) (567) 0 0 Profit Before Tax (norm) 7,516 1,259 2,417 5,314 10,603 Profit Before Tax (FRS 3) 5,256 (5,014) (4,105) 2,595 8,005 Tax (1,153) (793) (160) (859) (996) Deferred tax 2,548 8, (0) (0) Profit After Tax (norm) 6, ,257 4,454 9,607 Profit After Tax (FRS 3) 6,651 2,478 (3,506) 1,735 7,009 Average Number of Shares Outstanding (m) EPS - normalised (c) EPS - FRS 3 (c) (2.9) Dividend per share (c) Gross Margin (%) EBITDA Margin (%) Operating Margin (before GW and except.) (%) BALANCE SHEET Fixed Assets 137, , , , ,082 Intangible Assets 109, , ,084 99,365 96,766 Tangible Assets 24,946 27,181 25,024 25,361 26,504 Other 2,453 4,534 3,811 3,811 3,811 Current Assets 80,960 88, , , ,633 Stocks 3,556 2,445 2,654 2,863 3,278 Debtors 10,393 15,053 13,952 15,698 18,191 Cash 62,428 64,159 93,119 98, ,129 Other 4,583 6,447 7,035 7,035 7,035 Current Liabilities (42,833) (33,882) (32,775) (36,640) (44,467) Creditors (29,659) (20,659) (19,552) (23,417) (31,244) Short term borrowings (13,174) (13,223) (13,223) (13,223) (13,223) Long Term Liabilities (28,135) (38,998) (35,728) (34,528) (33,328) Long term borrowings (2,359) (4,178) (4,043) (4,043) (4,043) Other long term liabilities (25,776) (34,820) (31,685) (30,485) (29,285) Net Assets 147, , , , ,919 CASH FLOW Operating Cash Flow 10,659 12,175 6,586 13,316 21,751 Net Interest (38) 111 (239) (909) (871) Tax (475) (329) (100) (729) (922) Capex (7,577) (10,129) (5,947) (6,351) (7,275) Acquisitions/disposals (12,196) (3,000) (1,359) 0 0 Financing , Dividends Other (1,700) Net Cash Flow (11,096) (471) 29,638 5,328 12,682 Opening net debt/(cash) (58,545) (46,895) (46,758) (75,853) (81,181) HP finance leases initiated Exchange rate movements 531 (953) Other (1,085) 1,287 (892) 0 0 Closing net debt/(cash) (46,895) (46,758) (75,853) (81,181) (93,863) Source: Edison Investment Research, Evotec. Note: The 3.4m exceptional charge in FY13 is for the closing of Evotec s operations in India for commercial reasons. Evotec 4 February

12 Contact details Manfred Eigen Campus Essener Bogen Hamburg Germany +49 (0) Revenue by geography 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Europe US Other CAGR metrics Profitability metrics Balance sheet metrics Sensitivities evaluation EPS 10-14e N/A EPS 12-14e 193.3% EBITDA 10-14e 17.2% EBITDA 12-14e 15.8% Sales 10-14e 14.7% Sales 12-14e 4.6% Management team CEO: Dr Werner Lanthaler ROCE 13e 3.7% Avg ROCE 10-14e 3.9% ROE 13e 1.3% Gross margin 13e 36.6% Operating margin 13e 4.8% Gr mgn / Op mgn 13e 7.6x Dr Werner Lanthaler became CEO in March 2009, having been CFO of Intercell for the previous eight years. Between 1995 and 1998 he was a senior consultant at McKinsey & Co. He holds a doctorate in economics from Vienna University. CSO: Dr Cord Dohrmann Dr Cord Dohrmann became CSO in September 2010 following the acquisition of DeveloGen, where he was CEO. He had worked at DeveloGen from 1999 in various management positions. Previously he was a research fellow at the Massachusetts General Hospital. Gearing 13e N/A Interest cover 13e 3.7 CA/CL 13e 3.6 Stock days 13e 11.4 Debtor days 13e 60.0 Creditor days 13e 25.4 CFO: Colin Bond Litigation/regulatory Pensions Currency Stock overhang Interest rates Oil/commodity prices Colin Bond became CFO in August Previously he was CFO at Novelis Europe in Switzerland; he was also CFO EMEA for Ecolab and CFO for Jet Aviation Group. He is a chartered accountant and pharmacist. Chairman: Dr Walter Wenninger Dr Wenninger became chairman of the supervisory board in June He worked at Bayer AG for over 30 years and was a member of the management board responsible for the healthcare sector from 1994 until Since then, he has advised many life sciences organisations on corporate development. Principal shareholders (%) Biotechnology Value Fund 18.1 Roland Oetker 13.3 Bellevue Asset Management 3.6 Deutsche Bank 2.8 Companies named in this report Almirall (SM:ALM), Andromeda, AstraZeneca (LON:AZN), Boehringer Ingelheim, Conda Pharmaceuticals, Galapagos (BB:GLPG), Jingxin Pharma (CH:002020), Novartis (VX:NOVN), Pfizer (US:PFE), Roche (VX:ROG), Shionogi (JP:4507), Takeda (JP:4502), Teva (US:TEVA), UCB (BB:UCB) Edison, the investment intelligence firm, is the future of investor interaction with corporates. Our team of over 100 analysts and investment professionals work with leading companies, fund managers and investment banks worldwide to support their capital markets activity. We provide services to more than 400 retained corporate and investor clients from our offices in London, New York, Frankfurt, Sydney and Wellington. 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