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By Ivan Deryugin

Shares of Auxilium Pharmaceuticals (AUXL) fell nearly 13% on April 29 after the company released weak Q1 earnings, and are down around 12% since our original report on the company. While the timing of our report may have been early, several elements to this story have played out as we predicted, including the assertion that Auxilium will do a major deal and that CEO Adrian Adams will continue to impose discipline on the company's cost structure. Shares tumbled in-part due to a lack of granular detail regarding the company's takeover of Actient (more on this later), and a sense among some sell-side analysts that the company's acquisition of Actient, announced alongside Q1 results, was a defensive move. Although Auxilium's first quarter results failed to meet expectations, the company is continuing to move forward with its long-term strategy, and if CEO Adrian Adams, who has a track record of quality deal-making, can successfully diversify Auxilium, the long-term potential for shareholder value creation remains intact.

Q1 2013: Identifying Weakness And Pockets of Strength

Q1 was a challenging quarter for Auxilium, marked by several headwinds. For Q1 2013, Auxilium posted revenue of $66.2 million and a pro forma loss of 5 cents/share, missing consensus estimates of $81.23 million in revenue and a pro forma profit of 2 cents/share. Revenue fell 10.05% year-over-year, driven in large part by weakness in the company's Testim franchise, where sales fell 22.49% to $45.5 million. Core U.S. sales of Xiaflex fell 4.76% year-over-year to $12 million. Although international sales rose 276% to $8.8 million, $7.4 million of this revenue relates to amortization of deferred revenue from Auxilium's collaboration with Pfizer. Excluding these effects, international revenues fell 39.13% (in fairness to Auxilium, Q1 2012 revenue also includes an undisclosed amount of Pfizer revenue amortization, thereby making year-over-year comparisons somewhat unclear).

Full-year sales guidance for both Xiaflex and Testim was also lowered; Testim sales are now forecasted to be between $210-$240 million, versus $250-$265 million originally, and Xiaflex sales are forecasted to range between $65-$80 million, down from $75-$90 million originally.

Within the Testim franchise, there were several underlying causes of weakness, with the most notable weakness occurring outside of Auxilium. The company noted a slowdown in the global TRT (testosterone replacement therapy) market, with prescriptions growing by just 11% year-over-year in Q1 2013, versus a 27% increase in Q4 2012. CEO Adrian Adams stated that the underlying reasons for this slowdown, which affected more than just Auxilium, are not yet clear; although Auxilium forecasted a slowdown in TRT growth on its Q4 2012 call (calling for 15-20% growth in 2013), growth in Q1 came in below even the low-end of the company's guidance. Testim's market share fell to 14.2% in Q1 2013, versus 19% in Q1 2012, and although the company has continued to narrow its share losses for 4 consecutive quarters, with only around 25 basis points of share loss in Q1 2013, a slowdown in overall market growth made this share loss much more visible in the company's results.

But unanticipated weakness within the managed care market also played a role. In Q1 2013, Testim was accessible to 71% of covered lives in the United States, down from 83% sequentially. Competition from Fortesta, manufactured by Endo Pharmaceuticals (ENDP), has been cited as a potential factor in managed care share losses. That said, Auxilium is rolling out new sales practices and tools that could lead to this market share being recaptured. In addition, inventory destocking of $3-$4 million may have occurred, given an increase in speculative buying that occurred during Q4 2012.

Within the Xiaflex franchise, revenues fell despite a 6.5% increase in vial shipments relative to Q1 2012. Here, the issues seem to be mixed between internal and external. Total Dupuytren's contracture procedures over the past 12 months have increased 5.1% relative to the prior 12 months, and 121 new sites utilized Xiaflex (in addition to 1,025 existing sites) in Q1 2013. However, physicians have shown a larger than expected sensitivity to the price increase Auxilium instituted in January, with volumes being pressured as a result. While full treatment data for Q1 is not yet available, Adams noted that through anecdotal conversations with physicians, it appears that patient visits were down in Q1 2013, which partially pressured Xiaflex's market share. However, Auxilium forecast that it will regain lost Xiaflex market share and gain market share over the course of 2013 as a whole.

While Auxilium's sales were weaker than expected during Q1, there were several pockets of strength, such as the company's cost structure. As we noted in our last report, Adams has imposed meaningful cost discipline at Auxilium, and this trend continued during Q1 2013. SG&A expenses fell 5.92% year-over-year, and R&D expenses fell by 1.75% year-over-year. In addition, Auxilium's balance sheet remained solid; net cash and investments totaled $182.4 million at the end of the quarter, versus $158.872 million at the end of Q4 2012. And although Auxilium's balance of cash and investments will be drained by its takeover of Actient, it's a deal that will yield meaningful short-term and long-term benefits for Auxilium.

Actient Acquisition Means Increased Profits and Diversification

Alongside its Q1 2013 earnings, Auxilium announced that it had completed the $585 million takeover of Actient Holdings, with an additional $50 million in potential milestone payments, as well as 1.25 million Auxilium warrants struck at $17.80 per share. The transaction will be funded in-part by Auxilium's existing cash balance, as well as a new $225 million 5% term loan. The takeover of Actient will be immediately accretive to Auxilium's 2013 earnings and revenues, with $85-$95 million of incremental revenue (around 8 months of sales) to be recognized over the remainder of 2013. We believe that part of Auxilium's post-earning selloff was due in part to a lack of meaningful specifics related to the transaction, with CFO James Fickenscher pledging to provide more meaningful guidance and details on Auxilium's 2nd quarter call. The relative lack of detail, combined with a weak Q1, has served to create an aura of uncertainty around Auxilium. However, the company provided several key pieces of information regarding Actient, and the details it revealed suggest that this acquisition is meaningfully positive.

Auxilium will receive "significant" tax benefits as part of its takeover of Actient, with a net present value of around $60 million. Actient's product portfolio contains 9 products (6 promoted and 3 non-promoted products), with $125.3 million in total 2012 sales. The company's portfolio is anchored by Testopel, which is the only FDA approved long-acting testosterone replacement implant, capable of delivering 3-6 months of treatment in the form of an implantable pellet (Testopel generated $58 million of revenue in 2012, or 46.29% of Actient's total sales). Actient's other key products include Edex ($25 million in 2012 sales), the market leading non-oral erectile dysfunction treatment, designed for men who, for a variety of reasons, are unable to take oral erectile dysfunction pills (Edex has been on the market for over 15 years). Actient's promoted products target markets similar to Auxilium's existing focus on male health.

However, the company also has a non-promoted respiratory franchise that contributes $25 million, or 19.95% of Actient's total sales. Auxilium's revised 2013 guidance includes 8 months of Actient sales, $85-$95 million. Full-year revenue for the combined company is forecast to reach $387.5 million at the midpoint of guidance. At that rate, Actient's 2013 sales would equal $135 million, implying 2013 sales growth of just 7.74%. It's important to note that Actient's year-over-year growth rates are made less clear by the fact that the company itself was created through multiple mergers and acquisitions, and several of the company's products, such as Testopel, are not tracked by IMS. CFO James Fickenscher has pledged to work on this issue so that analysts have access to more real-time data regarding Auxilium's product portfolio.

However, what Actient lacks in double-digit revenue growth, the company more than makes up for with double digit EBITDA margins. For 2012, Actient posted an EBITDA margin of 48.84%, versus 8.54% for Auxilium on a standalone basis. This transaction will be immediately accretive to Auxilium; utilizing 2012 results, the combined company's pro forma EBITDA margin comes in at 20.32%, more than double that of Auxilium on a standalone basis. And with $20 million in forecasted cost synergies by 2014, EBITDA margins will likely rise further, excluding any potential revenue synergies as well. Actient will also boost Auxilium's pro forma net income from the present $18-$23 million the company is forecasting, although AUXL declined to state the degree of the increase. By 2014, Auxilium's ROIC is set to exceed its cost of capital (around 8%-9%), even without the effects of cost synergies. Fickenscher has also pledged that Auxilium will deleverage itself fairly quickly (due to the ability to utilize net operating losses, as well as incremental increases in cash flow), stating that by 2014-2015, Auxilium's balance sheet will be back to levels that "allow us (Auxilium) a lot of flexibility with respect to running the business." With the $225 million term loan the company took out to finance the purchase of Actient, Auxilium's net debt now stands at around $43 million on a pro forma basis (the company's 10-Q for the quarter has not yet been filed), and no debt is being assumed as part of the takeover of Actient.

With the acquisition, TRT-based products will account for 71% of Auxilium's pro forma sales, down from 78% on a standalone basis, and Testim itself will account for 55% of total sales, thereby reducing the risk of further weakness within that franchise. Adams noted that both Testopel and Edex have stronger protections against generic competition than Testim does, pledging to provide further detail about Actient's portfolio and broader barriers to competition on the company's Q2 earnings call. Auxilium's current guidance does not incorporate any potential revenue synergies from an expanded TRT and urology franchise, but the company does note that as it works to integrate both Actient's sales force and product portfolio into its own, it expects to generate revenue synergies over time, the probability of which can increase if Xiaflex secures approval for the treatment of Peyronie's disease.

Conclusions

It is true that Auxilium's Q1 results were weaker than expected, for a variety of reasons. But, the takeover of Actient should position the company for longer-term success. This deal is immediately accretive to the company, and based on 2012 results, more than double Auxilium's EBITDA margins. Much more detail will be provided on the company's Q2 2013 earnings call, and we believe that the takeover of Actient is a positive development for Auxilium, both in terms of financial metrics and strategic opportunities. The company has committed itself to deleveraging by 2014-2015, and Actient should yield synergies over time. Earnings estimates are set to rise, with Merrill Lynch, for example, already raising its forward estimates. The firm has raised its 2013 EPS forecast to $0.41 (up from a loss of 7 cents), and its 2014 EPS forecast to $1.38, from a previous $0.73. Based on currently available information regarding Actient, the deal seems to contain multiple benefits for Auxilium, and when the company provides greater detail, we believe that further benefits will be uncovered. The company is continuing to show discipline regarding its cost structure, and we expect such discipline to remain in place as Actient is integrated into Auxilium. The company's new CEO Adrian Adams is focused on building a business for the long-term, and the takeover of Actient is a key step in his plan to turn Auxilium around.

Source: Weak Quarter At Auxilium Overshadows Execution On Long-Term Strategy

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