Depomed: Light-Risk Small Pharma With Huge Potential

| About: Depomed Inc. (DEPO)

After reading several good Seeking Alpha articles (thanks to Jason Napodano and Tro Kalayjian) and completing my own due diligence, I am convinced that Depomed has the best risk/reward profile I have ever found in an investment.

From its current share price ($8.48) and market cap ($454 million) I have mapped out three scenarios for Depomed over the next few years. I assign a 10% probability to the baseline scenario, which would see DEPO rise to ~$13.30 (up 57%). The moderate scenario has a 30% probability, and puts DEPO at $16.60 (up 97%). The best case scenario (60% probability) sees it rise to almost $45.50 (up 437%). I'll admit that those predictions seem wildly optimistic, but I reach them with modest-seeming estimates.

Let's review DEPO's background to see how I come to those estimates.

DEPO uses what they call AcuForm technology to develop long-lasting formulations of quickly-metabolized drugs. Their first product is a once-a-day formulation of the diabetes drug metformin called Glumetza. Traditional metformin formulations require them to be taken twice a day. DEPO's Glumetza pill swells in the stomach to a size that doesn't allow it to pass into the small intestine. While in the stomach, it slowly releases metformin to maintain effective drug levels for a full day. Although metformin is an old drug with many generics and several extended-release formulations, DEPO has partnered Glumetza with Santarus (NASDAQ:SNTS), and expects to make $13-15 million in net profit off it this year.

But the real story with DEPO is its AcuForm version of gabapentin. Gabapentin was a blockbuster drug for Pfizer, sold under the brand name Neurontin. It is currently generic, dosed 3-4 times a day for the treatment of epilepsy, pain (especially neuropathic pain), and depression, and a once-a-day version from Xenoport (NASDAQ:XNPT) and GlaxoSmithKline (NYSE:GSK) was recently approved for restless leg syndrome. Depomed's version, known as Gralise, was approved for postherpetic neuralgia (PHN) in January. This should be a very profitable drug for Depomed.

Lyrica (pregabalin) is a second-generation molecule from Pfizer with the same mechanism as gabapentin, and it has almost 10 million prescriptions/year, generating $1.5 billion in revenue in the U.S. Generic gabapentin has roughly 29 million prescriptions per year. Gralise should compete very well in this market, as it has a more convenient dosing schedule, and significantly reduced side-effects compared to Lyrica and gabapentin. An obvious disadvantage is that Gralise is only approved for PHN, while Lyrica and gabapentin are approved for a handful of other indications. I argue that this is not a significant disadvantage. Lidoderm, a pain patch from Endo Pharmaceuticals (NASDAQ:ENDP), is also only approved for PHN, and it sold over $750 million in 2009. The majority of Lidoderm's prescriptions are off-label for other pain indications.

The best part is that Depomed owns 100% of the rights to Gralise. However, the story of how DEPO acquired all rights to Gralise caused some investor anxiety. Depomed partnered Gralise with the specialty pharmaceutical company Solvay in 2008, with a $25 million upfront payment, significant milestone payments, and 14-20% royalties included in the deal. Since then, Abbott (NYSE:ABT) bought Solvay, taking over the partnership contract with Depomed. After paying DEPO a $48 million milestone payment for the FDA approval of Gralise, ABT paid DEPO an additional $40 million to get out of the contract, returning all Gralise rights to Depomed. From one perspective this was a huge windfall for Depomed - it received $88 million plus complete ownership of Gralise instead of the modest royalties it was entitled to in the partnership. However, many investors seem taken a more pessimistic interpretation - Gralise must not have very good sales prospects if ABT was willing to pay to walk away from it.

I have two counterarguments to this pessimistic view. First, as I will argue later, Abbott and Depomed have very different definitions of "good sales prospects." A sales level that would be a miserable failure for Abbott ($120 million/year) would generate significant upside for DEPO. Also, Depomed has a second gabapentin-based drug called Serada, which, if approved might have significantly reduced the value of Gralise to Abbott. Serada is also an AcuForm version of gabapentin, but it is being developed as an alternative to hormone replacement therapy (HRT) for post-menopausal hot flashes. It is currently in phase III, and if approved, it would likely launch in early 2013. The problem for Abbott was that Serada would be the same drug as Gralise (gabapentin), with a similar formulation (600 mgs in the morning, 1200 mgs at night for Serada, vs. 1800 mgs at night for Gralise), but at a lower price. Off-label use of Serada for pain might have significantly hurt Abbott's Gralise sales, so they walked away rather than continue investing in it.

Now let's get to my scenarios and estimates. I don't assign any value to most of DEPO's partnerships in these estimates. These include AcuForm co-formulations of metformin with development-phase diabetes drugs with Janssen & Boehringer Ingelheim, and AcuForm co-formulations of acetaminophen and opiates (equivalent to twice-a-day formulations of Vicodin and Percocet) with Covidien (COV). These deals might eventually contribute modestly to profits, but only modestly and only in 2014 and later. I also don't assign any value to the ~$175 million in cash that Depomed currently has on the books (total liability are $64 million). I assume it will be used for the launch of Gralise.

I do include $20 million/year of net profits for their Janumet XR product with Merck, which is currently expecting an FDA decision in July 2011. This is a once-a-day formulation of Janumet (a combination of Merck's diabetes drug Januvia with metformin), which sold $954 million for Merck in 2010. Janumet's sales are still growing rapidly (up 41% from Q4 2009 to Q4 2010), and I expect Janumet XR to be approved and replace Janumet quickly. DEPO will receive "modest single digit royalties" on this product, so I'm estimating 2% on $1 billion.

In each of the scenarios, Depomed's ~$14 million (and growing) profit from Glumetza goes to cover SG&A for the company. (The remainder of their SG&A is just pre-profit selling expense for Glumetza that goes to Santarus.) I'm assuming that R&D expenses drop to $5 million/year once all late phase trials are completed. I subtract that $5 million from the $20 million/year Janumet XR profit to give a baseline $15 million of profit to each scenario.

For the worst-case scenario, I assume the following: Depomed never finds a partner for Gralise, and Serada is never approved. Depomed launches Gralise on their own in Q4 2011 (as is currently planned) with a sales force targeting pain specialists, neurologists and "thought leaders" in pain. In 2014 or 2015, they get up to a meager $120 million in sales (remember the comparators, $1.5 billion for Lyrica, and $763 million for Lidoderm). Subtract $25 million for cost of goods and $50 million for SG&A and you have $45 million of pre-tax profit. For this scenario only, I'm counting on DEPO's $168 million in tax loss carry forwards, so I'll make no allowances for taxes. With the $15 million baseline profit, we have a total of $60 million in profits. A 12X multiple on that gives DEPO a market cap of $720 million, or $13.30/share. That's a 57% gain from today's levels. I assign this scenario a 10% probability because I think Gralise is actually a very attractive drug and DEPO should have little trouble partnering it.

For the moderate scenario, I envision Depomed finding a mid-tier partner for primary care marketing of Gralise and that it reaches $400 million in sales. I'm modeling this as a joint-venture partnership, where costs are deducted and profits are shared 50-50. Assuming $80 million for cost of goods, and $120 million SG&A, the joint venture makes $200 million in profit, with $100 million going to DEPO. (If you prefer, you can get to the same number with $400 million in sales and DEPO earning a 25% royalty.) $100 million plus the $15 million from Janumet XR, minus $40 million for tax gives $75 million of earnings. A 12X multiple then gives DEPO a market cap of $900 million, or $16.70/share, a 97% gain from current levels.

For the best-case scenario, I need to give some more background on Serada and the hormone replacement therapy (HRT) market. In 2001, HRT was a $2+ billion dollar market and still growing. Then in 2003, a Women's Health Initiative study found that HRT increased the risk of blood clots, strokes and breast cancer. Since then, the HRT market has shrunk from over 90 million prescriptions per year to roughly 33 million, leaving few good treatment options for post-menopausal hot flash. Serada is among the most advanced non-hormonal treatments in development for this market, and showed good results in its first two phase III trials. The Serada section of this article gives a good explanation of the reasons DEPO's third phase III trial for Serada (called Breeze 3) is very likely to yield strong positive results. I am assigning an 85% probability that the trial results are favorable, and a 75% chance of FDA approval, assuming favorable results. These numbers are the basis for my 60% probability for the best case scenario of Serada approval.

In this best case scenario, I'm envisioning that Depomed has the same partner for Serada that they do for Gralise (this eliminates the conflict that arose with Abbott and Gralise). It is a joint venture once again, but with 60% of profits going to DEPO and 40% going to the partner. Combined sales of the two drugs are $800 million, minus $150 million for cost of goods and $150 million for SG&A leaves $500 million, with $300 million going to DEPO. Adding in the baseline $15 million, and subtracting $110 million for taxes leaves $205 million of profit. A 12X multiple gives DEPO a $2.46 billion market cap and a $45.50 share price, a 437% gain from current levels.

To recap the numbers: 10% chance of a 57% gain, 30% chance of 97% return and 60% of 437% profit. Feel free to adjust those estimates according to your best judgment.

For more information, there are several good articles on Seeking Alpha, but this webcast (with slides) is a great introduction to Depomed, its drugs, clinical trials and partnerships.

Disclosure: I am long DEPO, ABT.

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