QLT's Attractive Risk / Reward Profile

| About: QLT Inc. (QLTI)

QLT, Inc. (NASDAQ:QLTI) will look to some like a failed pharmaceutical company with only one drug on the market, the sales of which have dropped almost 80% over the past 4 years. I propose another perspective: a small biotech with huge amounts of cash, one product on the market covering most of their expenses, a promising pipeline, plus enough past successes to suggest they can bring some more drugs out of the pipeline.

In early 2008 QLT was a small pharmaceutical company with three drugs on the market. The three drugs were Aczone for acne, Eligard for prostate cancer and Visudyne for AMD (age-related macular degeneration). QLT was small, so they hadn't developed them all alone, but they had 50% or larger stakes in each.

But at that time they were also in the middle of a significant restructuring effort, sales of their largest drug (Visudyne) were declining, and they were the target of a lawsuit seeking $113 million in Visudyne royalties. In the restructuring, QLT sold Aczone for $150 million in July 2008, and Eligard in October 2009 for payments expected to total $230 million. Then in November 2009 a final settlement of $20 million was reached on the Visudyne royalties. All of that was good news, except that Visudyne sales continued to fall. As these changes were unfolding, QLT's share price dropped from a recent high of just under $10 in early 2007, to $1.41 in April of 2009, and back up to the $4.55-$5.10 range since the lawsuit was settled.

So where does that leave QLT now? Let's look at the balance sheet first. As of the end of September they had $285 million in current assets (including $194 million in cash) and $22 million in total liabilities. That gives them $263 million of net liquid assets, compared to the company's market value of $251 million.

How are QLT's earnings prospects? Well, as of their last earnings report, they had not yet made the sale of Eligard, so at the very least they have those $230 million coming (assuming they receive the full $230 million; it will come as royalty payments). I will quote Cameron Nelson, CFO, on the earnings from the Eligard sale:

you can expect to see a gain of over $100 million within disc[continued] ops which will reflect the difference between the estimated present value of the expected net proceeds from the deal relative to the net book value of all the assets sold.

So adding the (at least) $100 million net present value of those cash flows to the $263 millon of net liquid assets, less $20 million for the lawsuit settlement, we get $343 million. With a market cap of $251 million, QLT is trading at a 37% discount to its net present tangible value.

How about earnings from continuing operations? They still have one marketed drug, Visudyne, contributing to their earnings. Its revenues have declined from a peak of $484 million in 2005 to approximately $100 million over the past year. The decline is the result of two events. First, the anti-VEGF drug Lucentis was approved for AMD in June 2006. It is a superior treatment to Visudyne, taking an increasing market share and leaving Visudyne to treat the minority of patients who fail to respond to Lucentis. Second, in October of 2008, Novartis (NYSE:NVS) eliminated the sales force that had been promoting Visudyne. With no active promotion, sales declined 28% over the past year.

However, there are reasons to expect that Visudyne sales could turn up again. QLT and Novartis, their partner in the development and marketing of Visudyne, recently renegotiated the terms of their partnership. Previously, Novartis was responsible for marketing Visudyne, with QLT entitled to 50% of all post-expense (marketing, third party royalty, etc.) sales worldwide. Based on the new agreement, QLT is entitled to only 20% of gross sales outside of the US, but 100% of sales in the US, and QLT is now responsible for marketing Visudyne in the US. This has two benefits for QLT. First, the 15-member sales force QLT is currently building may be able to halt the decline of Visudyne sales, and perhaps even begin to grow them. Remember, there have been no marketing efforts behind Visudyne for over a year now. Second, at least based on current sales levels, the share of Visudyne worldwide sales that go to QLT will increase, from roughly 35% to roughly 49%. Obviously this gain will be offset somewhat by the costs of their new marketing efforts.

Furthermore, QLT and Novartis are continuing to conduct clinical trials on Visudyne to expand its market opportunity. Recent trials of AMD therapy combining Lucentis and Visudyne have shown small (statistically insignificant) improvements in visual acuity and a 50% reduction in the frequency of Lucentis dosing compared to Lucentis alone. This result could encourage Visudyne-Lucentis combination therapy to reduce the doctor's visit, cost ($1950/dose) and eyeball injection required for each Lucentis treatment. If Visudyne is approved for combination therapy, the new marketing team may be able to grow Visudyne sales significantly.

Finally, for such a small company, QLT has a fairly strong development pipeline. They are developing a punctal plug (a tiny medical device inserted in the tear duct) drug delivery platform, with Latanoprost plugs currently in phase II proof-of-concept trials. Latanoprost is a $1.6 billion/year eyedrop-formulated glaucoma drug marketed by Pfizer (NYSE:PFE). QLT's preliminary results have shown the Latanoprost plugs to be well tolerated and efficacious, though not as efficacious as the eyedrop formulation of Latanoprost (3.5 mmHG average pressure drop compared to 5 mmHg for the eyedrop formulation). The studies so far have used relatively low doses of Latanoprost in the plugs, and there have been some problems with the plugs falling out. Ongoing studies are aimed at improving plug design for increased staying power and increasing Latanoprost doses. Since they are working with a drug known to be safe and effective, QLT's problem here seems to be one of engineering better punctal plugs. Such an engineering project seems much more likely to succeed than the typical drug development project, where both safety and efficacy have significant probabilities of derailing the program. And if this program succeeds, QLT has plans to develop numerous other eyedrop-formulated drugs with their puntal plug technology.

QLT also has QLT091001 in a Phase Ib proof-of-concept clinical trial in pediatric patients with Leber Congenital Amaurosis (LCA), an inherited progressive retinal degenerative disease that leads to retinal dysfunction and visual impairment beginning at birth. And they recently purchased OT-730 from Othera Pharmaceuticals for $7.5 million. OT-730 is a novel ocular-selective beta-blocker that has been through a phase I/II trial for glaucoma.

That's the whole QLT story, to the best of my knowledge.

Small-cap biotech investing is usually very risky. Stock prices are highly volatile, precariously balancing huge upsides and downsides, with a tendency soar on good news and crash on bad. I expect QLT to behave differently. QLT's cash on hand, plus cash flows from the Eligard sale and Visudyne, are such that QLT can continue developing their pipeline for several years without taking their (mostly cash) tangible assets below their current market cap.
During that time, QLT's share price would turn up strongly if any of the following would occur: 1) Visudyne sales started moving up again, 2) Proof-of-concept was achieved with Latanoprost punctal plugs, 3) proof-of-concept was achieved with QLT091001, or 4) proof-of-concept was achieved with OT-730. On the other hand, a failure in any one or two of these areas would be unlikely to send the share price down much due to the huge cash cushion. To me, it's an attractive risk-reward profile.

Disclosure: Long QLTI