Why I'm Upgrading Adolor to a Buy

| About: Merck & (MRK)

Investment Thesis

Adolor has gained back Glaxo’s (NYSE:GSK) rights to Entereg (alvimopan) in a transaction that I regard as a highly positive, company changing event. Entereg has the critical sales mass to enable Adolor to be a self-sufficient, cash flow positive company. I believe that the Entereg sales run rate entering 2012 could be on the order of $40 million, $50 million entering 2013, and over the next several years could grow to $100 million.

The terms of the deal were amazingly favorable to Adolor, and the company has much for which to thank Glaxo. On its own, Adolor could not have brought Entereg to this sales level and might not have been able to launch it in the first place. The difficulties of introducing a first-in-class drug to an increasingly cost-conscious hospital marketplace has made the launch and sales ramp of a new product much more difficult, and it can be prohibitively expensive for a small company. Hiring and training a sales force, and then going through the time consuming process of gaining formulary acceptance and implementing the REMS program which was required for Entereg, is something that Adolor could probably not have done on its own. Now after three years of heavy lifting Glaxo is handing this very valuable asset to Adolor on a cheaply bought silver platter.

Based on Entereg potential alone, Adolor is a very interesting company. The patent position of the product is expected to extend protection from generics until 2020. One way of estimating its value is to estimate a multiple of enterprise value to sales based on what comparable companies sell for. Because of its strong patent position, I think that either the stock market or a potential acquirer might value Entereg at a multiplier of 3.0 to 3.5 times (or possibly higher). Appyling the 3.0 to 3.5 multiplier to my year-end 2011 sales run rate estimate of about $40 million results in a potential market capitalization of $120 to $140 million, or a stock price potential of $2.57 to $3.00 per share. This compares to the current stock price of $1.60.

While the above scenario addresses the potential value of Entereg, it does not attribute any value to the sales force that Entereg supports. This sales force provides additional value in that it allows Adolor to acquire or co-promote additional products. Over time, I could argue that the financial leverage of the sales force might have value approaching that of Entereg. Of course, there are so many unknowns that I can’t easily assign a value to this proprietary sales force. I just know that there is substantial value.

Adolor is fast approaching a binary clinical trial event that can significantly impact the investment outlook. The company is developing a new opioid induced constipation product called ADL 5945, and the results of a key phase II trial will be reported in 3Q, 2011. The company would prefer to partner ADL 5945, as the anticipated development cost of around $50 million is probably too much for Adolor to assume on its own. It is not possible for me to predict how positive the results might be-- or even if they will be successful. Investors must be prepared for either a success or failure scenario. Partnering the product-- even with successful phase II results-- is also not a given.

If the trial is reasonably successful, it can only be perceived as adding value and therefore maintaining or increasing the stock price. However, if the trial fails and ADL 5945 is abandoned, there remains an interesting scenario for 2012. As shown later in this report, I am estimating Entereg sales of $45 million in 2012. In the unlikely event that company were to decide to fund all future development of ADL 5945, it might spend about $30 million on R&D, leading to an operating loss of $26 million in 2012. A partnering deal could reduce this amount of R&D spend. If ADL 5945 fails, it is likely that the R&D spend could drop, perhaps to as low as $5 million. Based on my $45 million sales estimate for Entereg in 2012 this could produce an operating loss of $515,000 and EPS of $0.00. For investors, it would highlight the value of Entereg.

The third factor to consider in looking at Adolor is the potential that the company might do a financing regardless of ADL 5945 success or failure. The company ended the first quarter of 2011 with $39.3 million of cash. Assuming quarterly burn rates of $7.0 million in 2Q, 2011, $5.0 million in 3Q, 2011 $6.0 million in 4Q, 2011 and the $2.5 million payment to Glaxo, the company could end the year with $18.8 million of cash. Although it is not a certainty that the company will have to raise cash, it is a possibility that worries some investors.

I think the concern about financing is impacting the stock at this time, so let’s examine the possibilities. If the trial results of ADL 5945 are sufficiently positive to allow a partnering deal, the upfront payment could alleviate the need for any new equity offering. Nektar (NASDAQ:NKTR) received an upfront payment of $125 million from Astra Zeneca (NYSE:AZN) over one year ago for a drug similar to ADL 5945 that was just coming off of positive phase II results. If Adolor could strike a deal with an upfront of just $25 million or higher, it would probably obviate the need for an equity raise.

If ADL 5945 fails, Adolor might be able to avoid an equity offering, but there would be some financial brinksmanship involved. However, I think the company would easily qualify for a debt financing given the predictable cash flow of Entereg. This might allow the company to avoid an equity offering altogether, or to do a much smaller one.

My fundamental judgment is that the intrinsic value of Entereg offsets the risk of the ADL 5945 trial failing or the potential for an equity offering, and so I regard the stock as attractive whether or not the ADL 5945 trial is successful. However, I acknowledge that there remains the headline risk that news of the trial failure or of an equity offering could cause a decline from the current price. I am recommending purchase, but there is a chance that the stock could decline on unfavorable headline news before it meets my expectation of going higher.

Adolor Gains Glaxo’s Rights to Entereg

Adolor has entered into an agreement to acquire Glaxo’s ownership share of Entereg. The two companies have been co-promoting Entereg on a profit / loss sharing basis since its introduction in 3Q 2008. Adolor will pay Glaxo $25 million spread over six years, with the initial payment of $2.5 million payable upon closing the transaction in September of 2011. I assume that none of the subsequent six annual payments will exceed $4.0 million. There may also be a payment of $15 million dependent upon the achievement of certain sales milestones, but this will be some years off. Adolor will also pay Glaxo a mid-single digit royalty on sales that will increase with sales levels.

The initial focus of the Entereg launch was on gaining hospital registration for the REMS program, hospital formulary approval and educating the hospital staff about the product’s attributes. Being first in class and first to market is not an easy road. The early years of a product launch in the hospital marketplace are a daunting challenge. Adolor is acquiring Glaxo’s rights to Entereg after most of the heavy lifting has been done.

Entereg sales were at a run rate of $30 million in the first quarter of 2011 and I believe that run rate entering 2012 will be about $40 million. The previously expressed long term goal is to grow Entereg sales to a level of $100 million. With this new arrangement, management expects that Entereg will contribute meaningful cash flow in year one and into the future. Allowing for the royalty payment to Glaxo, the product contribution to sales in 2012 could be on the order of 30% and longer term it could reach 50%. The new Glaxo arrangement will be accretive over the next year.

The Transition of Entereg to the Adolor Sales Force

The hospital market is focused on post-operative care pathways more than ever, and in particular, length of stay; this is the raison d’etre for Entereg. There has been a continual string of studies done by third party physicians and hospitals that conclude that Entereg can meaningfully shorten length of stay for bowel resection patients. The market place should be increasingly receptive to Entereg.

Adolor has always played an active role and is up to the challenge of taking over marketing Entereg. The NDA approval was obtained by Adolor and they also ran the clinical trial program that led to that approval. They have also managed pharmaco-vigilance programs, administered the REMS program and have driven medical affairs initiatives. Adolor has also been responsible for manufacturing and has led the marketing effort since launch.

The major change going forward will be on detailing. Whereas Adolor has been detailing alongside Glaxo, they will now be solely responsible. The expansion of the sales force is the largest part of this transitional effort, but it is a relatively straightforward process. Up to now, the Adolor account managers have been working alongside the Glaxo account managers in large metropolitan areas where Entereg is being used in several hospitals. It is believed that increased promotional effort will have the greatest impact in this account base. This is based on the premise that your best new customer for Entereg is the best current customer. The current Adolor account managers will remain in their current account geographies. New reps will be added in geographies which were previously only covered by Glaxo representatives.

The company has already started the process to double the size of the field force to 50. They expect to have the sales personnel trained and calling on customers by September 1. The new account structure will be optimized to cover the vast majority of existing customers. Adolor is also planning to increase investment in non-personnel promotional efforts for existing accounts that will not initially be covered by Adolor account managers.

The target list of hospitals that perform 80% of bowel resection procedures in the U.S. is 1600. Adolor currently has 25 people in the field that layer on top of the Glaxo national sales force. The Adolor / Glaxo strategy up to now has been focused on “same store sales” growth in key existing accounts. Over 70% of the targeted 1600 accounts are registered in the EASE program and 50% either have added Entereg to their formularies or otherwise have made Entereg available to their surgeons. There is much growth potential in exisitng accounts, and importantly, they have passed use hurdles and formulary access.

Adolor will also be taking over physical distribution of Entereg and the contracts with GPOs, federal accounts, wholesalers and hospital systems by September 1. Distribution will be largely a turnkey transition using an established third party logistics company that has a proven distribution platform.

On a full time employee basis, management believes that the new Adolor sales force will be nearly identical in account impact to the former combined Adolor / Glaxo sales force. Each Adolor employee will spend 100% of their time on promoting Entereg, as opposed to Glaxo reps who had to focus on a number of other products. Adolor believes that increased productivity in the smaller sales force will compensate for the smaller head count.

Financial Impact of the Entereg Deal

This deal has lowered the bar to cash flow breakeven. Management now believes that the company could reach breakeven somewhere in the area of $40 to $45 million of Entereg sales. However, this excludes expenses for the potential phase III program of ADL 5945.

Sales and Earnings Model for Adolor if the Company Decides to Fund All ADL 5945 Development
FY 2008 FY 2009 FY 2010 FY 2011 FY 2012 FY 2013
Revenues:
Product sales, net 1,247,271 14,609,022 25,386,285 35,671,286 45,000,000 54,000,000
Contract revenues 48,208,224 22,751,584 17,916,233 4,738,944 0 0
Total revenues, net 49,455,495 37,360,606 43,302,518 40,410,230 45,000,000 54,000,000
Operating expenses incurred:
Cost of product sales 203,972 1,515,073 2,876,503 5,146,076 7,515,000 9,018,000
Research and development 52,664,213 43,930,303 33,210,404 26,251,146 30,000,000 32,000,000
Selling, general and administrative 31,114,718 36,947,749 34,053,247 34,197,318 33,000,000 35,000,000
Restructuring charge 0 3,932,582 1,918,701 0 0 0
Total operating expenses 83,982,903 86,325,707 72,058,855 65,594,540 70,515,000 76,018,000
Loss from operations (34,527,408) (48,965,101) (28,756,337) (25,184,310) (25,515,000) (22,018,000)
Non-operating income 4,405,148 1,050,787 1,482,269 476,514 450,000 400,000
Net loss (30,122,260) (47,914,314) (27,274,068) (24,707,796) (25,065,000) (21,618,000)
Basic and diluted net loss per share ($0.65) ($1.03) ($0.59) ($0.53) ($0.53) ($0.45)
Basic and diluted shares 46,158,458 46,296,235 46,338,538 46,738,381 47,205,765 47,677,822
Click to enlarge

This next model presents a very different scenario in which I assume that ADL 5945 development is abandoned, and the company is based exclusively on Entereg.

Sales and Earnings Model for Adolor if the ADL 5945 Development is Abandoned
FY 2008 FY 2009 FY 2010 FY 2011 FY 2012 FY 2013
Revenues:
Product sales, net 1,247,271 14,609,022 25,386,285 35,671,286 45,000,000 54,000,000
Contract revenues 48,208,224 22,751,584 17,916,233 4,738,944 0 0
Total revenues, net 49,455,495 37,360,606 43,302,518 40,410,230 45,000,000 54,000,000
Operating expenses incurred:
Cost of product sales 203,972 1,515,073 2,876,503 5,146,076 7,515,000 9,018,000
Research and development 52,664,213 43,930,303 33,210,404 26,251,146 5,000,000 7,000,000
Selling, general and administrative 31,114,718 36,947,749 34,053,247 34,197,318 33,000,000 35,000,000
Restructuring charge 0 3,932,582 1,918,701 0 0 0
Total operating expenses 83,982,903 86,325,707 72,058,855 65,594,540 45,515,000 51,018,000
Loss from operations (34,527,408) (48,965,101) (28,756,337) (25,184,310) (515,000) 2,982,000
Non-operating income 4,405,148 1,050,787 1,482,269 476,514 450,000 400,000
Net loss (30,122,260) (47,914,314) (27,274,068) (24,707,796) (65,000) 3,382,000
Basic and diluted net loss per share ($0.65) ($1.03) ($0.59) ($0.53) ($0.00) $0.07
Basic and diluted shares 46,158,458 46,296,235 46,338,538 46,738,381 47,205,765 47,677,822
Click to enlarge

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