Investment Perspective and Opinion
I continue with my buy recommendation on Cadence Pharmaceuticals (CADX).
Cadence introduced its first and only product, the hospital analgesic Ofirmev (intravenous acetaminophen), in January 2011 when the stock was trading at about $7.00. The price climbed steadily and reached about $9.00 in mid-2011. Then sentiment began to shift sharply negative. The sales ramp for Ofirmev was slower than expected leading to downward revisions in sales projections and in June, 2011, Ofirmev's patents were challenged by generic drug companies.
Bearish sentiment took control and the stock drifted steadily and sharply lower to a 2011 year end close of $4.00 and for most of 2012 has traded in a range of $2.50 to $4.50. The bears argued that sales expectations were still too high and more importantly they predicted that generic competition could begin as early as 2014 in the worst case but almost certainly in 2015 or 2016. This would cause a rapid meltdown in Ofirmev sales. The 90% drop in sales suffered by Plavix in the first year it faced generic competition was sometimes cited as a precedent for what might happen to its Ofirmev.
I believe that consensus opinion is now in the process of changing from bearish to a more bullish tone. I have been writing for some time that the rubber has finally met the road with the Ofirmev launch and as time goes by, I am more convinced. Metrics relating to sales progress has been impressive in 2012 as was shown by results for 3Q, 2012 relative to 2Q, 2012: (1) the sequential increase in sales was 25% helped by a 6% price increase in July, (2) the sequential increase in vials sold was 20%, (3) the number of customers increased 10% to about 3,500, and (4) market share increased in the hospital analgesic market increased from 1.93% to 2.35%. Management has given guidance for 4Q, 2012 sales of $15.9 million to $16.4 million which is an annualized rate of $64 to $66 million; I think this is pretty impressive given that Ofirmev is just in its eighth quarter of commercialization.
I believe that sales of Ofirmev are on a strong upward trajectory. Sales in 2011 were $11 million. My projections for 2012, 2013, 2014, 2015 and 2016 are $49 million, $101 million, $168 million, $237 million and $332 million, respectively. I project that the company will be modestly cash flow positive in 4Q, 2013 on sales of $39 million; my model shows that the lowest cash position will be $45 million in 3Q, 2013 and by 4Q, 2014 cash levels will reach $77 million. The company has tax loss carry-forwards that could shield profits through 2016. My untaxed EPS estimates for 2013, 2014, 2015 and 2016 are ($0.34), $0.21, $0.65 and $1.20, respectively. My price range target for 2015 is $12 to $16 based on an estimated P/E ratio of 17 to 22 applied to 2016 adjusted EPS of $0.73, which is my estimate of what EPS would be if fully taxed.
My sales, EPS and cash flow estimates for 2013 to 2016 haven't changed much since mid-2012, but they assume no generic competition. Bulls on the stock have been looking for generic competition to begin in 2018 and bears have argued for 2014, 2015 or 2016. All of this uncertainty on the timing of generic competition subdued the reaction to the Ofirmev launch gaining traction, but recently there has been positive news on the patent litigation front. This has caused the stock to move from a close of $3.93 on November 28 to a recent price of $4.90.
On November 28, Cadence announced that it had reached a settlement with Perrigo (PRGO), one of two generic challengers to Ofirmev's patents. Perrigo essentially agreed to not market a generic version of Ofirmev until December 6, 2020. Later in this article, I describe why I think that the second generic challenger, Exela Pharma, may enter into a similar settlement. If so, Ofirmev might not face generics until late 2020. Remember that the bulls were looking for generic completion in 2018 and the bears in 2014, 2015 or 2016. If I am correct, this is a huge positive for Cadence.
The trial on the patent litigation is scheduled to start in May of 2013. If Cadence and Exela are going to settle, I would expect an announcement before then. If the settlement is in line with my thinking, I think the stock might initially overreact on the upside, but would settle in at $7 to $8 in 1H, 2013 and then steadily climb toward my 2015 price target of $12 to $16. I want to caution readers that while these numbers appear to be precise, they are just my best guesses and I would urge you to take them with a grain of salt. Still, I think that they may capture the magnitude and trend of the stock price for the next three years.
Patent Settlement with Perrigo
The intellectual property protection (patents) for Ofirmev is not based on composition of matter claims which are the most rigorous of patents. Acetaminophen is a generic drug that has been on the market for more than 60 years as an oral product. Attempts to produce an intravenous formulation repeatedly failed because acetaminophen readily breaks down when exposed to oxygen or water. The key inventions underlying and allowing for the commercialization of Ofirmev were developing a stable formulation and manufacturing process.
Ofirmev is protected by two key patents. The 6,028,222 patent covers the formulation of Ofirmev; with a pediatric extension, it will expire on February 15, 2018. The second is the 6,992,218 patent covering manufacturing of Ofirmev, which expires on December 6, 2021 with the pediatric extension. Bulls have generally believed that the '222 patent was defensible, but believed the '218 was weaker and might be broken. Bears on the stock believe that neither will block generics.
Cadence has consistently maintained that Ofirmev's patents are so broad that it would be very difficult for a generic company to work around. They believe that the formulation patent covers all excipients needed to produce the Ofirmev formulation and in order to bring a generic form of intravenous acetaminophen to market without infringing their patents, a generic company would have to develop an entirely new formulation and manufacturing process. The manufacturing process used by Cadence, to my knowledge, is the only one that has resulted in a stable intravenous formulation of acetaminophen. It seems unlikely that a generic firm has suddenly discovered an entirely new formulation and manufacturing process that doesn't infringe when others have failed for decades. Had anyone else identified a suitable process for stabilizing IV acetaminophen, they would have used that technology to create an intravenous acetaminophen long ago.
In what I regard as extremely positive news, Cadence announced on November 28, 2012 that it had entered into a settlement in which Perrigo has essentially agreed not to market a generic until late 2020. According to the agreement, Perrigo in return has the right of first refusal to negotiate an agreement to market an authorized generic version of Ofirmev in the U.S, if Cadence decides to do so. It also has the non-exclusive right to market a generic in the U.S. under Cadence's NDA after December 6, 2020 or at such a time as the patents covering Ofirmev are ruled invalid. If this agreement is exercised, Perrigo will purchase product exclusively from Cadence and will pay Cadence for product costs plus an administrative fee, as well as a royalty payment based on the net profits achieved by Perrigo.
Litigation remains ongoing with a second company. There were two firms that filed paragraph IV challenges against Ofirmev: one was Paddock which was subsequently acquired by Perrigo and the second was the privately owned firm Exela Pharma. It is uncertain as to which of these two companies was first to file as the FDA has not yet designated who was the first filer. If it is Perrigo, it will enjoy the 180 days of exclusivity awarded to the first filer and Exela would not be able to launch until after Perrigo. While the status of first filer in uncertain, the timing of notifications of a paragraph IV filing to Cadence by the FDA suggests that Exela was first to file. If so, it could still proceed to trial and, if successful, go on to launch its generic in perhaps 2015 or 2016.
Regardless who was first to file, this settlement is a very positive development that puts great pressure on Exela to also settle. Exela is a small, privately owned company; I have not seen any financial information on the company but I would think that it has limited financial resources. With Perrigo/Paddock exiting the stage, Exela is left to carry on the patent battle by itself whereas there would likely have been cost sharing with Perrigo had it not folded its cards. Preparation for the trial could take perhaps $2 to $5 million of legal expenses which might be a pretty significant amount of money for a private company like Exela. Moreover, even if Exela were to win the trial, Cadence would appeal the decision and this would result in still further legal expenses.
It seems to me that the decision of Perrigo to settle with Cadence has significant ramifications. It is a large publicly traded company with huge resources and the infrastructure needed to genericize Ofirmev. Remember that it was Paddock and not Perrigo that filed the paragraph IV challenge. Thus Perrigo's decision is one of a company that is not influenced by the need to justify a previous decision and perhaps can be more objective. It is also a company with great expertise in the field of patent challenges. I can only conclude that Perrigo judged the patents for Ofirmev as being strong and defendable and that there was a good chance of losing if it went to trial. This can't help Exela's confidence in its position.
As I previously mentioned, consensus thinking of bulls on Cadence has been that only the '222 formulation patent expiring in 2018 would offer meaningful protection and generally dismissed the '218 patent expiring in 2021 as being weak. Bears of course thought that neither patent was valid. However, after the Markman hearing last summer that was preparatory to the patent trial scheduled for May 2013, some observers came away feeling that the '218 patent was much stronger than generally believed. The action of Perrigo to settle in a time frame of 2020 supports this thinking. Court cases are always difficult to predict, but having to overturn two strong patents increases the problems for Exela.
Perrigo's actions can be explained by the hypothesis that it judged the patents to be strong and that fighting the legal battle was a poor use of funds, even though it easily has the resources to wage a legal battle. In any event, settling is not such a bad deal for Perrigo. It can forgo the legal expenses, risk of losing the trial and can ultimately rely on Cadence to supply product rather than going through the costly process of building its own manufacturing capacity. It also allows Cadence more time to build the usage of Ofirmev in the marketplace. I estimate that in 2015, Ofirmev could have sales of about $235 million, but the level could increase to $500 million by 2020 substantially increasing the size of the Ofirmev generization opportunity.
The key remaining question is how this will affect Exela in its decision to settle or go to trial. As background, most paragraph IV challenges are resolved through settlements. Given its presumably limited resources, settlement might have been Exela's strategy all along. And the decision of Perrigo to settle has to persuade Exela that there is a good chance that it could lose and incur sizable legal expenses in going to trial. Some investors have raised the question that Exela might choose to partner or license whatever rights it obtains from this paragraph IV challenge to another company in return for that company helping with the costs of the trial and of course the considerable expense of building manufacturing. However, there might not be a long lineup of potential licensees in the wake of Perrigo's actions and the margins realized by Exela on such a deal could be paper thin.
My best judgment is that Exela will elect to settle and obviously the announcement must be made before the trial scheduled for May 2013 and probably before its lawyers start the costly process of depositions and trial preparations. The next question is if they settle what kind of terms would there be? I think that Cadence and Exela each have something of considerable value to offer the other. If Exela agrees to a settlement that prevents marketing until 2020, it would be huge win for Cadence. Remember that the bears have been saying there will be generics in 2014, 2015 or 2016 and the bulls have been expecting generic competition in 2018. Clarity on the patent situation and two more years of patent life longer than even the bulls were expecting would be a huge win for Cadence; this substantially increases the net present value of future Ofirmev cash flows.
The question is what might there be in this for Exela? First of all, like Cadence, it takes away the uncertainty of the outcome of a trial and associated expenses. Remember also that if Cadence were to lose, it would certainly appeal the decision resulting in still more legal expenses. Cadence will not discuss what it might be willing to do for concern that it might be tipping its hand in any negotiations. I have seen in other settlements that the brand name manufacturer has been willing to help a generic company set up production to become a source of product supply for the branded product. This manufacturing would be in place at the time the brand name drug goes generic and, along the way, the generic company would be making manufacturing profits. Exela might respond favorably to such an offer from Cadence. I don't propose this as the probable outcome, but it is representative of a settlement that is in the interest of both Cadence and Exela.
Peak Sales Potential for Ofirmev
Ofirmev has significant sales potential in the U.S. Perfalgan (the brand name of the drug in Europe) has obtained 22% of the European intravenous analgesic market as measured by units. Ofirmev currently has just 2.35% of the U.S. market and is annualizing at about $65 million of sales. At a 22% market share, sales would approach $600+ million. There is reason to believe that it could obtain an even higher market share in the US.
The Therapeutic Need Filled by Ofirmev
Ofirmev is initially being marketed as an intravenous formulation for the control of post-operative pain. It can be used before and during an operation and also in recovery if the patients are physically unable to swallow or too nauseous to keep an oral medication down. The current standard of care in this setting is opioids with some usage of NSAIDs. Hospitals are seeking to reduce narcotics use without sacrificing pain relief. One of the major problems with opioids is that they cause constipation. The gating factor for any surgical patient to be discharged is to have a natural bowel movement and Ofirmev, through reducing opioid usage, can speed the time to the first bowel movement. It can also reduce the mental confusion and grogginess associated with opioids that makes patient care more difficult. NSAIDs are associated with increased bleeding that in the surgical setting can be a problem.
Acetaminophen has a long history of safe and effective use. In its oral form, it is sold as Tylenol and is an ingredient in many other OTC products. The oral is also widely used in the hospitals. There is a need for an intravenous form of acetaminophen in the hospital, but until Ofirmev, none was available. Clinical trials conducted by Cadence showed that it was effective in both relieving pain and reducing the use of opioids. As I did my early field checks, I was struck by how receptive physicians and nurses were to the idea of an intravenous acetaminophen. Continuing checks after the introduction showed satisfaction and heightened enthusiasm for Ofirmev.
Sales Erosion Following Generic Entry May be More Modest than That Seen with Oral Products
Investors have come to expect rapid sales declines when a generic to an oral dosage form comes to market. It is frequently the case that an oral dosage form of a brand name drug loses 90% of its sales volume in 18 months. There is reason to believe that this could be different for an injectable product like Ofirmev.
For another company to manufacture this product, it would need specialized equipment in addition to what it might already have in place for injectable manufacturing. Capacity for injectables is more difficult to find than with solid oral dosage forms because of its greater complexity. Worldwide, the capacity for injectables is dramatically less than for solid dosage forms so that it takes several years for capacity to be built up and for generics to gain significant share. Moreover, the two largest suppliers of intravenous acetaminophen, Baxter (BAX) and Bristol-Myers Squibb (BMY), are barred from providing product to a generic company in the U.S. Because of these factors, generic penetration post entry of the first generic should be much slower than with solids; there is not likely to be 90% erosion in the first year and one half. As a guess, sales might erode at a 20% to 30% rate over the first three years, which if I am correct, would be through 2023.
Dynamics of the Ofirmev Launch
One of the major negative investment themes in bio-pharma that has developed over the last few years is that the first year for new product launches for the majority of new products has been disappointing. Many hedge funds have now adopted the routine practice of shorting companies with new product launches. There are several factors that have been responsible for this with the increased role of formularies being the most important. In what now seems to be the distant past, there was little that stood between regulatory approval of a new drug and physician prescribing. Formulary access and restraints placed on drug usage even after formulary acceptance now looms as a large boulder.
Ofirmev is sold within a hospital and the continual pressure on hospital revenues and costs has made the formulary a major tool to control money spent on drugs. Before a doctor can prescribe a drug it must first be approved and on formulary. The formularies are usually controlled by pharmacists who often are judged on cost control and not necessarily on therapeutic outcomes. I would hasten to add that I am not saying that formularies are a bad thing; the control of costs is an important aspect of medicine. However, in the zeal to control costs, a collateral effect is that it takes a long time to get a product on formulary and additional time to make it available for broad prescribing in the hospital.
There is no set way that a formulary operates, but a typical one might require that a physician or group of physicians sponsor a new drug for formulary inclusion. This triggers off one or a series of committee meetings that try to determine the therapeutic importance of the drug and its cost effectiveness. This process can take some time, usually several months. There seems to be an informal rule emerging at some institutions that a new drug has to be on the market for six months or so in order to gauge the potential for side effects before formulary access is considered.
After leaping over the hurdle of gaining formulary access, the drug marketer must then broaden usage throughout the hospital and beyond the original product champion. This is followed by marketing efforts that expand the patient usage and increase doses per patient. This must be in accordance with the product label, of course. All of this adds additional time.
In the case of Ofirmev, concern by pharmacists that Ofirmev would be used in place of oral acetaminophen created a new wrinkle. Most patients in a hospital have an IV line in place, and it is easy to give them a vial of Ofirmev, possibly more so than getting them to swallow a pill. Pharmacists feared that instead of giving Tylenol tablets, which cost the hospital pennies, many patients would get Ofirmev at $11 per vial and thereby severely impact pharmacy budgets. This was an unexpected, major factor in a slower than expected launch that prompted many investors to judge the launch as disappointing or a failure.