Seeking Alpha
Long/short equity, deep value, contrarian
Profile| Send Message| ()  

Upcoming events: PDUFA Date: January 30th, 2011

Depomed (DEPO) – based in Menlo Park, California, engages in the development of enhanced pharmaceuticals to improve the efficacy, convenience, and safety of existing treatments. Utilizing their proprietary AcuForm technology, the company aims to leverage this platform to provide enhanced therapeutics.

Recently, all the pieces seemed to be coming together: Glumetza resumed 500 mg doses, numerous milestone payments were received for various formulations, and promising trial results were announced. In addition, the company’s lead candidate, DM-1796, appeared headed for approval. Investors took note, and the stock has more than doubled since July 2010. Then came Tuesday’s announcement. Abbott (ABT) decided that they would not market DM-1796. Shares immediately fell in after hours trading, and opened the next day dramatically lower. Ultimately, the shares ended the week approximately 18% lower than Monday’s closing price.

A flurry of news stories followed, putting forth a number of different theories. First, the CEO of DEPO seemed the most confused:

"We see a significant market opportunity for DM-1796, one that would offer a healthy return on investment for both companies. We are perplexed by Abbott's reluctance to adhere to their contract obligations given the in-depth market research previously undertaken regarding this product. We are disappointed that the product does not appear to fit into the Abbott commercial portfolio and that they have chosen to contest what we believe are clear and unambiguous contractual terms. We are very willing to work collaboratively with Abbott to resolve this matter quickly, fairly and equitably."

One reason in waiting to write this article was to see the initial reactions of other market observers and get a consensus on prevailing theories. One theory is Abbott is simply trying to get a better deal. Possibly they aren’t happy about the 14-20% royalties they will owe on the sales (this deal was not negotiated by Abbott, but by Solvay Pharmaceuticals, which Abbott acquired). Possibly they will use this opportunity to negotiate ex-North American rights or rights for other, future indications? I'm not sure how hardball makes for effective partnerships though. As pointed out in a note by Roth, DEPO appears to have a crack legal team with an impressive track record, so that must be figured in any analysis as well.

Furthermore, has DEPO’s and Solvay’s due diligence on market potential been that off, as suggested by DEPO’s CEO? Tough to say; the drug recently received orphan drug status in November (which provides for 7 years of market exclusivity) and DEPO has said nothing has changed in terms of market size. The market would have to be significantly smaller than calculated for Abbott to lose money on this deal, in my opinion.

Abbott doesn’t seem to be contesting the milestone payment of $35-60 MM upon approval, however. By DEPO’s interpretation, Abbott is obligated to spend $85 - $135 MM for marketing for the first two years. If Abbott decides to walk away and/or give the rights back to DEPO, DEPO might be able to use the funds to launch the product itself, or license all the rights (North America and the rest of the world).

Financially, the company’s position is currently strong with approximately $76 MM in cash and securities on the balance sheet at the end of q3. The company’s operating expenses of approximately $18 - $19 MM a quarter imply that DEPO can survive well into 2011 without dilution. An increase for legal expenses or other arrangements still leaves DEPO with a strong financial footing, evening the potential “David vs. Goliath” showdown. Currently, the issue is headed for arbitration, and hopefully we will have resolution in a few weeks. I believe the recent (relatively modest) drop in the price to be indicative of DEPO’s upper hand in the negotiations; the stock could have sold off much more.

Furthermore, the timing of this arrangement is interesting. Why now? Clearly, waiting until FDA approval strengthens DEPO’s case in damages, whereas rejection would greatly strengthen Abbott’s position. This seems to suggest Abbott believes the drug will be approved (consistent with my previous analysis as well).

Conclusion and Future Directions: In the long term, I have a favorable opinion of DEPO’s proprietary technology and believe that current blockbusters coming off patent will be a source of growth for DEPO. Furthermore, I view the commercial success of Glumetza favorably and believe it will continue to gain market share, providing a stable revenue source. Significant near-term uncertainty remains with the dispute over Abbott, and while favorable resolution would boost DEPO’s fortunes, significant risk remains, including the upcoming PDUFA date of January 30, 2011.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Investors Feeling Pain of Depomed vs. Abbott