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If you read the briefing documents and listened to the discussion at the arthritis advisory committee on May 9, 2012, then you know both the FDA and advisory panelists had concerns about the 10mg dose of Pfizer's (NYSE:PFE) rheumatoid arthritis (RA) drug Xeljanz (tofacitinib). I previously wrote about the contents of the briefing documents and also provided my take on the advisory panel itself. I felt quite sure the FDA would not approve the 10mg dose, but was really at a loss as to what that meant for the safer 5mg dose. Would both doses be approved? Both get rejected? Just the 5mg dose approved?

On Nov. 6, 2012, the FDA approved the 5mg, but not 10mg, dose of Xeljanz to treat adults with moderate to severe RA who no longer benefited from methotrexate (MTX). The approval comes with a black-box warning about the increased risk of serious and opportunistic infections, tuberculosis, cancers, and lymphoma. It is also associated with increases in cholesterol and decreases in blood counts. Besides approval, another big win for Pfizer is that the FDA essentially granted Xeljanz a second line label. This means it can be used before the big market leading TNF-a drugs: Humira, Enbrel, and Remicade. Despite more worrisome side effects, this broad label combined with the convenience of being a pill positions Xeljanz very well in the RA market. That rheumatologists may still want to use the safer TNF-a drugs first, at least until they become more familiar with the new drug, has not dampened enthusiasm for future sales. Priced at $2,055.13 for a 30-day supply, analysts are forecasting peak annual sales of $1.5 billion to $2.5 billion.

Wherever Xeljanz is ultimately slotted as a treatment option, the approval is very good news for RA sufferers after a couple of strike outs by other companies. In May, Chelsea Therapeutics (NASDAQ:CHTP) reported disappointing top-line Phase II results when its CH-4051 drug failed to show improvement over MTX due to a greater-than-expected response from the MTX-treated patients. Zalicus (ZLCS) missed an important secondary endpoint in its Phase II trial of Synavive in September, and although Horizon's (NASDAQ:HZNP) Lodotra was approved in July ,its impact in the RA market will be minimal.

In a couple of years, baricitinib -- from Eli Lilly (NYSE:LLY) and Incyte (NASDAQ:INCY) -- should enter the market, and its impact will not be minimal. Like Xeljanz, baricitinib has a leg up on the TNF-a drugs because it can be taken orally allowing patients to avoid the discomfort and inconvenience of injections. Both drugs are members of the janus kinase (JAK) inhibitor class, but Xeljanz inhibits JAK3 while baricitinib does not. By inhibiting only JAK1 and JAK2 the theory is baricitinib can avoid some of the side effects and risks seen with Pfizer's drug. The label for marketed Enbrel specifically says malignancy rates do not increase with extended exposure. If the theory holds true and baricitinib receives a claim like Enbrel it would be a big advantage over Xeljanz. While there is yet no long-term data to bear this out, the FDA did say during the advisory meeting it felt the malignancy risk was not specific to the JAK-inhibitor class, but rather was specific to Xeljanz itself.

The Phase II data suggests baricitinib may also be more effective than Xeljanz. The 4mg dose that Lilly and Incyte are carrying forward to Phase III trials achieved ACR20 scores of 78% after 24 weeks. In Phase III trials of similar length, Xeljanz was posting ACR20 scores of 53% to 60%. Xeljanz also had remission rates (defined as the DAS28 metric with scores below 2.6) of 11% after six months for the 5mg dose. Baricitinib had remission rates of 23% to 25% after 24 weeks.

Based on the safety and efficacy data from the Phase II studies Lilly and Incyte have moved the drug into Phase III trials. The timing worked out well because the companies were recently able to alter the designs of their planned Phase III trials based on the findings at the advisory committee for Xeljanz. Baricitinib needs to show it does not allow bone damage to progress, and in order to do that definitive progression in a placebo group needs to be observed. This is something the Xeljanz trials had trouble doing. To avoid the problem Incyte and Lilly have established more rigid inclusion/exclusion criteria, which should only allow patients who are actually at risk of bone disease progression to enter the trial. They also plan on increasing the sample size, especially in the placebo arm.

Incyte has opted to pay 30% of the costs of the Phase III development program and in return will now receive a royalty rate in the high 20s on future sales from Lilly. Even if Phase III data only puts baricitinib on par with Xeljanz there is more than enough room in the RA market for additional oral therapies. Furthermore, new RA drugs can hope for eventual approval in other autoimmune disorders. Abbott's (NYSE:ABT) Humira had its label expanded yet again by the FDA in September to include treatment of ulcerative colitis, its ninth indication.

But Lilly and Incyte are not looking at baricitinib as simply being on par with Xeljanz. It has the potential to be both safer and more effective. Despite the label, Xeljanz may still get used after the TNF-a inhibitors due to safety concerns and unfamiliarity. When baricitinib gets to market the unfamiliarity of JAK inhibitors among rheumatologists will be removed, and if data from the Phase III program supports and confirms data already seen in Phase II, then it will likely be prescribed before both Xeljanz and the TNF-a inhibitors. If baricitinib fulfills its potential in Phase III studies it will be a major force in the growing RA market making Incyte, especially at these levels, look like a great addition to any long-term portfolio.

Disclosure: I am long INCY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.