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Shares of Avanir Pharmaceuticals (NASDAQ:AVNR) represent a compelling short sale opportunity. I calculate fair value of AVNR at just $1 per share, versus the current market price of $4.62. Importantly, I think the price will approach this value rapidly given weak Nuedexta sales and short intellectual property life.

Nuedexta is the combination of dextromethorphan and quinidine for the treatment of a neurological condition called ‘pseudobulbar affect’. This is a rare condition which results in uncontrolled laughing or crying in patients with neurological damage (multiple sclerosis, ALS, stroke, etc.). Nuedexta is Avanir’s only drug, either approved or in development. In clinical study, the efficacy of Nuedexta was modest. For example, after 12 weeks of treatment, the average number of laughing/crying incidences for placebo patients decreased by 3, while the average number for patients on Nuedexta decreased by 4.

Put another way (as described in an AVNR press release in October 2009), after 12 weeks of clinical study, 61% of patients on placebo had had no PBA episode in the prior 2 weeks, compared to 80% on Nuedexta. That is, Nuedexta provided 19% fewer emotional outbursts than did a sugar pill. Nuedexta also provided an advantage in another measure, the least squares CNS-L score (Center for Neurologic Studies Liability Scale, a seven-item self-report questionnaire with 3 items assessing crying and 4 assessing laughter). At week 12, CNS-L improved in placebo patients by 6 points, compared to 8 points in Nuedexta patients.

Having only one approved drug, with nothing else in its pipeline, makes calculating the value of Avanir relatively easy.

Top 10 Slowest Pharma Launches in the Last 4 Years – All U.S. Drugs – First 13 Weeks Summed TRX * AWP

1. Nuedexta - $582,888

2. Zuplenz - $619,494

3. Vimovo - $806,400

4. Toviaz - $987,644

5. Oravig - $1,088,826

6. Silenor -$1,274,000

7. Selzentry - $1,324,827

8. Promacta - $1,429,900

9. Effient - $1,727,562

10. Fanapt - $1,865,682

Avanir’s second quarter launch isn’t going much better than the first. “Better” is all relative of course as you’ll see in the valuation section. The discontinuation rate of Nuedexta is quite high – NRx (new prescriptions) are not translating into TRX (total prescriptions), which, as one analyst put it, describes the “episodic” nature of how these patients take this drug. It appears many patients feel Nuedexta is worse than their PBA symptoms. Because there has never been a drug for PBA, there should have been a bolus in patients at the launch who quickly came on to Nuedexta. With only 300-400 TRx weekly (at $490 a Rx that is a paltry $10 million/year sales run-rate), we are left to ask, “that’s it? Those are all the patients who have been waiting and clamoring for a PBA drug? Definitely a head-scratcher.

The notion that Avanir has to educate physicians to bring the PBA out of their patients in testimonials is a tough sell. MS and ALS patients see their physicians often. The discontinuation rate, coupled with the idea that PBA is simply not a common condition – neurological issues are rare to begin with, and PBA so severe it merits special pharmacokinetic intervention with a relatively cheap drug ($5,000 annual cost) spells a product that can’t support its associated sales force cost. Finally, I wouldn’t underestimate that sales reps are “journeymen”. Once they realize their drug isn’t hitting targets, they leave for the next gig.

Valuation – IP

Let’s remember the enterprise value (market cap minus cash plus debt) of Avanir is $450 million. My favorite part of the drug business is the relative ease with which one can value approved drug assets. Drugs have finite lives which are easily determined, and sales trajectories which are predictable and can be estimated both conservatively and aggressively.

The poor launch of Avanir is just half of the short thesis. The other half, which seems less appreciated, is intellectual property. A key determining factor of the value of any pharmaceutical asset is the life of the asset. Recall the Buffett moat. There is no moat in the drug business. Your product disappears and you know when it disappears. Sometimes it’s not so clear, as in this case. However, a good rule of thumb is that if there is no new chemical entity present in a drug, and it’s a small molecule (in this case, two), the life of the drug is going to be pretty short.

The statutory exclusivity for a new combination is three years—so that’s the shortest amount of time Nuedexta can be on the market without generics. An “ANDA” paragraph IV filing can be filed quickly after approval. For instance, Somaxon (NASDAQ:SOMX) received a paragraph IV filing for Silenor just weeks after FDA approval. I expect a Paragraph IV ANDA filer to appear for Nuedexta soon. This begins a 30-month-stay clock during which the ANDA filer and the innovator litigate over IP.

The IP for Nuedexta is extremely weak. Avanir invented nothing in combining dextromethorphan and quinidine. Their four patents, 7,659,282, RE38,115, 5,166,207, and 5,206,248 all are preceded by prior art easily found here. The concept of metabolic enablers and the use of dextromethorphan in pseudobulbar affect was well known before these patents were filed. There are a number of papers that are easy examples of prior art showing CYP450 bioconversion of dextromethorphan. Avanir has been working on this drug for quite some time. Remember that for a patent filing to be valid, there cannot be public "prior art" which would invalidate that patent.

The '282 patent, which was filed in 2005, has claims which are questionable given the prior art revealed in the work Avanir published in 2004. Read these claims from RE38,115:

We claim:

1. A method of increasing the effectiveness of dextromethorphan in treating chronic or intractable pain, comprising administering to a patient suffering from chronic or intractable pain a therapeutically effective dosage of dextromethorphan or a pharmaceutically acceptable salt thereof, in combination with a therapeutically effective dosage of a debrisoquin hydroxylase inhibitor.

2. The method of claim 1 wherein the debrisoquin hydroxylase inhibitor is selected from the group consisting of quinidine, quinine, and pharmaceutically acceptable salts thereof.

And contrast with the claims in 5,166,207 (expired in 2009 or 2014 with full Hatch-Waxman restoration, too soon to stop a generic):

What is claimed is:

1. A method for enhancing the systemic delivery of dextromethorphan for the treatment of a neurological disorder resulting in injury to nervous tissue, which comprises:

administering to a patient suffering from said neurological disorder an amount of a cytochrome P450IID6 enzyme inhibitor, sufficient to block dextromethorphan metabolism, and an amount of dextromethorphan, sufficient to treat said neurological disorder.

2. The method of claim 1, wherein said inhibitor is quinidine.

This is an obvious genus/species patent mistake that likely should have never been issued. RE38,115 is "anticipated" in patent speak, by '207. One can't claim "enhancing the systemic delivery of dextro with quinidine for neurological conditions" in one patent granted in 1992 and then try again to claim "increasing the effectiveness of dextro with quinidine in pain" in a new patent in 2003. Sadly, this innovation is indeed 19+ years old. A few years too old for Avanir to fight off generics in just a few years.

Valuation – Based on sales, earnings, cash flow, fair value with asset life determined at roughly 3 to 5 years, we can easily determine the fair value of the stream of cash flows that encompass Avanir. While I contest Avanir will never be profitable, and ride off into the sunset like Nitromed (NTMD) and other woe-be-gone companies, let’s assume Avanir is purchased by a company who would almost eliminate all of their costs. This might be a more fair way to value Avanir since a buyer could afford to pay an enhanced price using this methodology. Top funds employ frameworks like this to allow them to figure out fair value when it is obscured by investment. Let’s be very kind to Avanir and see what happens.

Sales

Gross Profit

SG&A

Operating Income

Net Income

2012

34

31

10

21

21

2013

70

63

10

53

53

2014

104

94

10

84

67

2015

136

122

10

112

90

2016

176

159

10

149

119

I’m being very generous to Avanir to illustrate a point. I don’t think Avanir will achieve these sales estimates – the current sales trend suggests they’d be very lucky to achieve half or a quarter of these estimates. Valuing Avanir assuming a takeout and almost zero costs (SG&A is actually 5x what I am estimating) is also aggressive. The NPV of these 5 years of cash flows plus the current cash is just $321 million or $2.64 per share (10% discount rate). If you don't know how to calculate NPVs, please learn as it is 1) easy and 2) the cornerstone of finance. In Microsoft Excel, type =NPV(discount rate, stream of cash flows).

For example, in the above cash flow table, try =NPV(10%,21,53,67,90,119). You can use your own estimates, of course, and toy with the discount rate. Keep in mind AVNR is losing lots of money at the moment, so any forecast of cash flow is aggressive, and in my mind, unlikely.

Part of my goal writing here is not only to "show my work", but also to teach how a fund like mine values a firm like Avanir. This is my 12th year in the hedge fund business and I am happy to share what I've learned and my experiences (good and bad!) with you all.

Avanir is likely the next Somaxon

The similarities between Somaxon and Avanir are uncanny. Somaxon is a stock that has fallen 75% since approval of their only drug, Silenor. Like Silenor, Nuedexta is not a new drug, per se. It is a combination of two old drugs for a new indication. Silenor is one old drug for a new indication. Both drugs have questionable intellectual property protection. As mentioned elsewhere in this report, Somaxon received paragraph IV generic ANDA filings for their drug just six weeks into their launch.

The weak sales of Silenor were evident early - as a matter of fact, Silenor actually out-sold Nuedexta in its first quarter by a large margin ($1.274 million for Silenor versus $0.583 million for Nuedexta). The companies have very similar expense structures as well. Sadly, Silenor will likely outsell Nuedexta as well in their second launch quarter. What does this all mean? Well, Somaxon's market cap is $100 million, 1/5th of that of Avanir. This suggests AVNR may fall 80% as investors realize the companies' prospects are not too different.

When the best case scenario for a stock you own is you will lose 40%, you should sell. The worst case scenario is the Nuedexta launch continues to be poor. At $490 per prescription, the company would need to generate (on average) 10x the prescriptions it is generating now to achieve these numbers. This would require a miracle ramp in sales never seen before in the drug business (I’ve done every permutation possible a very rich data set and I can say with confidence, the numbers above are BEST CASE)—all to result in a 40% loss for shareholders, mind you. Because the drug will go generic in just a few years (find a combination of two really old drugs that lasted longer than five years—you won’t), and Avanir is spending quite a lot on their infrastructure (at this rate, the company will be out of money soon), I suspect the stock will be down at least 50% in the next 6 to 12 months.

Source: Avanir Pharmaceuticals: Compelling Short Sale Opportunity

Additional disclosure: I promise to donate 50% of my personal AVNR-related profits to charity. I agree to be held accountable to this.