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Overview

I recommended the purchase of Adolor in a report issued on June 19. This followed my initiation report of February 18. The catalyst for my upgrade was the announcement that Adolor was successful in regaining all rights to Entereg from GlaxoSmithKline (NYSE:GSK) on favorable terms. The two companies had been co-marketing the drug and sharing profits and losses since Entereg’s introduction in May 2008. This report updates my investment outlook following the release of Q2, 2011 results and re-iterates my buy recommendation.

The third quarter will be an extremely important one for Adolor. On September 1, it will take over full responsibility for marketing and distribution of Entereg. Earlier, in August it will report topline results from two phase II trials of ADL 5945 for treating opioid induced constipation in non-cancer patients. Investors will closely watch the Entereg transition unfold in the third quarter and will be especially attuned to the topline data from ADL 5945, which if positive could lead to an important partnering deal.

Investment Thesis

I believe that regaining full control of Entereg was a game changer for Adolor. Management projects that Entereg will be cash flow positive its first year under Adolor control even though Adolor is taking on significant new costs by expanding its sales force from 25 to 50 salespeople and taking on responsibility for distribution. These new expenses are more than offset by lower amounts that will be paid to Glaxo under the restructured deal between the two companies. Hence, the deal should also be accretive.

Entereg’s sales are currently annualizing at $33 million per year and in one year I project that they will reach about $42 million. Management has a stated goal to grow sales of Entereg to $100 million; at the current rate of sales increase this would occur by 2016. The combination of a strong cash flow contribution from Entereg and the strategic advantage of having a proprietary sales force could enable the company to attract other hospital based products to its portfolio through licensing and acquisition.

This has been a consistent and often successful strategy for emerging pharmaceutical firms that have come before. Some of the earliest and most successful implementers of this strategy have been Cephalon, which is in the process of being acquired by Teva (NYSE:TEVA); Forest Laboratories (NYSE:FRX); and King Pharmaceuticals, which was recently acquired by Pfizer (NYSE:PFE).

Intellectual Property Position is Good and Possibly Very Good

In looking at any potential investment in a company, intellectual property protection (patents) is an important consideration. Entereg enjoys strong patent protection through a composition of matter patent that runs through Q1, 2016 thanks to patent term restoration that should add five years of patent life. A method of use patent runs until March of 2020, but these types of patents are less reliable than composition of matter.

However, in the past Glaxo and Adolor have maintained that the March 2020 patent will be proven valid. In addition, the company has filed a patent covering its REMS program. This could provide another level of protection if issued. Celgene (NASDAQ:CELG) has been successful in using such a patent to help fend off competition from generics for Thalomid.

Even in the case in which patent protection ends in Q1, 2016, there is ample time to broaden the product line and position the company to withstand the loss of Entereg sales through generic competition. It is also possible that even without patent protection beyond Q1, 2016, Entereg might avoid being genericized. It has modest sales volume making it of less interest to a generic manufacturer, but more importantly it is subject to a REMS program that is meant to assure on label usage of the product and control distribution.

It would be difficult and expensive for a generic competitor to implement a REMS program. Another important consideration is that the FDA is perceived to move slowly and with reluctance to allow generic competition when a REMS program is involved. Having two REMS programs from two separate manufacturers can lead to confusion and loss of product control in the distribution channel.

Subdued Base Case Assumptions Produce $4.50 Price Target in 2013

With these considerations in mind, let me set up a conservative, base case valuation for Adolor based on a hypothetical scenario in which:

  1. It is able to continue growing Entereg at 25% to 30% per year through 2014.
  2. The company is not able to bring in meaningful products through licensing or acquisition.
  3. The internal product pipeline is unproductive.
  4. There is uncertainty as to whether there will or will not be generic competition in 2016.

What might the value be for Adolor in these situations?

Specifically, I will try to set a price target for 2013. Before presenting any arguments, my conclusion is that Adolor in 2013 might sell at 3.0 times projected Entereg revenues of $71 million for 2014. Doing the math would result in a market capitalization of $213 million in 2013 or a stock price of $4.50 per share. The estimate of a valuation of 3.0 times market capitalization is a judgment call based on experience with comparable companies. I will try to give one specific example of a comparable situation to illustrate my thought process.

No two companies and their stock outlooks are truly comparable, but I think that a look at how the market is now viewing JAZZ Pharmaceuticals (NASDAQ:JAZZ) helps to estimate how the market might value Adolor in 2013. Some key considerations are:

  1. Jazz is driven by one dominant product Xyrem as would be the 2013 case for Adolor with Entereg based on my assumptions.
  2. Xyrem has no composition of matter patent and is the subject of a generic challenge. Investors are relying on a REMS requirement for patent protection, but can’t be sure if this will actually provide protection. Entereg in 2013 will have at least three, possibly seven, years of patent life and it also has a REMS in place.
  3. Xyrem’s active ingredient is sodium oxybate, the date rape drug. The FDA might be more concerned with the potential for abuse with Xyrem than Entereg and therefore less likely to approve a generic competitor. There is probably no Street demand for a drug to treat opioid induced constipation.
  4. Jazz does not have a product pipeline that excites investors and remember in this scenario, we are assuming this will be the case for Adolor in 2013.
  5. Jazz does have exceptional cash flow which increases the chances of its being able to make a major product acquisition(s).

With these points in mind let’s look at the current valuation of Jazz and use this to project market capitalization of Adolor in 2013. Jazz is projected to have sales of its lead product Xyrem of $350 to $400 million in 2012 and is selling at a market capitalization of $1.6 billion. Hence, the market capitalization to projected one year forward sales is 4.0 to 4.6 times. In 2013, if my assumptions are correct, the market will be expecting sales of $72 million for Entereg. My feeling is that the Jazz valuation is aggressive and I would prefer to use a more conservative 3.0 times sales to estimate market value. This results in a calculation of $216 million for Adolor market capitalization in 2013. If the company is successful in avoiding a new equity offering (a subject I will discuss shortly) the per share price of Adolor in 2013 could reach $4.50

Let me reiterate that the $4.50 price target assumes that no exciting additional product opportunities occur through in-licensing or acquisition. History would suggest that this is a conservative assumption, but at this point there is no basis to make any projections. The other element of the investment equation is the pending release of topline phase II data of a new drug for opioid induced constipation called ADL 5945 could produce considerable investor excitement with the internal pipeline. The just presented scenario assumes that this trial will be unsuccessful.

ADL 5945 Has an Imminent Binary Trial Event

Biotechnology investors know from experience that clinical trials can be negative with painful investment consequences. However, I think that the potential of Entereg justifies taking the risk that the imminent trial results of ADL 5945 come out negative. Remember that my price target for 2013 is $4.50 under the assumption that no new products arise from any source. There is near tem risk for a failed trial and I think that the headline effect could take the price down to the $1.25 to $1.75 level. However, as focus then returned to Entereg and its potential I think that such a loss would be recouped over a few months and the stock could then perform well if Entereg achieves the company’s goals and my projections.

While I acknowledge the risk of a trial failure, I think that the odds favor success. Clinical trials fail for two major reasons: (1) the drug doesn’t work and (2) the clinical trial is poorly designed and/ or poorly executed. Taking the latter point first, Adolor has already successfully run phase III trials for Entereg in opioid induced constipation. It knows what to do. Adolor has invaluable experience in developing a drug in this category. And of course, the phase I and pre-clinical studies were encouraging. All in all, I think that the odds favor success in the phase II trials.

Probably No Need for Equity Raise Regardless of Outcome of ADL 5945 Trial

Management intends to partner the development of ADL 5945 and is confident that they will do so by the end of Q1, 2012 and possibly by the end of the year. This is important to the stock because it validates the potential for a substantial stream of royalties beginning in four years or so. This would have a positive impact on the stock price. It is also important from a financial standpoint because an upfront payment could add substantially to cash and prevent the need for new equity. The company has about $32 million of cash and the burn rate is on target for a burn of about $25 million over the next year. An upfront payment of $20 million or so would maintain a comfortable cash balance and Entereg will be turning cash flow positive. If the trial is unsuccessful the burn rate would come down so that under either scenario, the company believes that the chances are excellent that it will not need to raise more equity. There seems an excellent chance that the company will not have to raise equity in the event that the ADL 5945 trials are successful or unsuccessful.

Second Quarter Results and Comments from Conference Call

Adolor reported that product sales (all of which are from Entereg) in Q2, 2011 were $8.2 million. This represented a year over year increase of 31%. The following table shows the quarterly sales trends for Entereg since Q1, 2009. It shows steady progress in growing sales.

Entereg Quarterly Sales Increase
Sales % increase Sequential Increase
Q4, 2011 E $9,573,856 31.0% $1,021,526
Q3, 2011 E $8,552,330 31.0% $329,465
Q2, 2011 $8,222,865 31.4% $772,015
Q1, 2011 $7,450,850 40.8% $142,563
Q4, 2010 $7,308,287 -1.9% $779,791
Q3, 2010 $6,528,496 95.2% $269,225
Q2, 2010 $6,259,271 162.7% $969,040
Q1, 2010 $5,290,231 269.4% -$2,160,112
Q4, 2009 $7,450,343 $4,106,396
Q3, 2009 $3,343,947 $961,398
Q2, 2009 $2,382,549 $950,366
Q1, 2009 $1,432,183

I have also included a calculation showing trailing 12 months sales. This smooths the distortions that can occur in any one quarter. It shows that sales are annualizing at $33 million and trailing twelve month sales are $30 million. The company has a goal of eventually achieving $100 million of sales for Entereg.

Trailing 12 Months Entereg Sales
Q4, 2011 $33,799,901
Q3, 2011 $31,534,332
Q2, 2011 $29,510,498
Q1, 2011 $27,546,904
Q4, 2010 $25,386,285
Q3, 2010 $25,528,341
Q2, 2010 $22,343,792
Q1, 2010 $18,467,070
Q4, 2009 $14,609,022

There are two very big events coming up for Adolor. On September 1, it will take over full control of Entereg as Glaxo exits the previous partnership. Investors will watch closely to see how Adolor handles the transition. It expects to bring on 25 new salesmen in a bolus in the near term bringing its total sales force to 50 and will be responsible for all sales efforts going forward. There will be a learning curve for these new salesmen and the possibility for loss of momentum on Entereg.

Management states that the infrastructure to handle the handoff from GSK is in place and Adolor is comfortable that it can take over operational responsibility. They have selected 3PL, a nationally known third party to handle physical distribution, billings, accounts receivable collection and warehousing of Entereg.

Adolor has been paying Glaxo a profit split on Entereg which amounted to $3.2 million in Q2, 2011 and $2.9 million in Q1, 2011 which was included in S, G& A. This will now go away and in its place the company will now pay GSK a modest royalty on sales. Taking into account the increased size of the sales force and other new operational expenses, management still expects this deal to be accretive in the first year for Adolor.

Marketing Strategy for Entereg

Adolor’s sales strategy for Entereg is to focus marketing efforts on existing accounts that have already registered with the REMS program and have put Entereg on formulary. Adolor is targeting about 1600 hospitals that perform 80% of bowel resection procedures in the US. Entereg is registered for its REMS program and on the formulary in about 800 of these. I think that the strategy of going deep in existing accounts is one that has proven successful with other products and is sound strategy for Entereg. As an example, management stated on the second quarter conference call that a major Midwest account is expanding the usage of Entereg from its flagship hospital to ten smaller satellites. The potential in the satellites is equivalent to that of the main hospital.

The company is focused on encouraging or supporting physician sponsored studies that investigate the pharmacoeconomics of Entereg. It cited a positive real world study presented at the May Annual Meeting of Colon and Rectal Surgeons which evaluated length of stay and estimated total hospital cost in bowel resection patients with and without exposure to Entereg. The study concluded that Entereg reduces hospital length of stay by 1.1 days relative to placebo. In its presentation to an advisory committee in January 2008, the clinical data indicated that length of stay was decreased by 0.8 days. The takeaway is that real world experience may be better than what the clinical trials suggested. CMS reimbursement is closely tied to outcomes and this type of study also provides traction with the non-clinical audience in the hospital.

Imminent Results Expected from ADLR 5945 Clinical Trials

Opiate based pain relievers have annual, worldwide sales of about $10 billion and it is estimated that the cost of treating opioid induced constipation is $1.5 billion per year. Opioids achieve their pain relieving effect by binding to central μ-opioid receptors in the brain. However, they also bind to μ-opioid receptors in the intestines. This results in slow gastrointestinal (GI) motility and reduced intestinal secretion, often leading to opiate induced constipation (OIC).

The OIC development program of the Adolor’s μ opioid receptor antagonist ADLR 5945 will report topline data in August as enrollment in two phase II studies is complete. The top line data will be released through a press release. There are two studies to be reported on. The first is looking at two separate doses of 0.25 mg and 0.1 mg given twice a day. The second study is 0.25 mg per day given once a day. They are looking for a dose and dosing schedule that will provide efficacy and safety while giving GI comfort.

The primary objective of these double blind studies is to compare ADL5945 with placebo in the treatment of opioid-induced constipation (OIC) in adults taking long-term opioid therapy for chronic non-cancer pain. The primary endpoint is the change from baseline in the weekly average of spontaneous bowel movements through four weeks of treatment. During the baseline period, the number of bowel movements per week is measured. Then during each of the four weeks of therapy, the number of bowel movements is recorded. An average is calculated for each of weeks 1, 2, 3 and 4 and then averaged again for the four week period. The trial design expectation is that this four week average of daily bowel movements will exceed the baseline period by 2.0 or more. In both studies, the sample size provides 80% power to show a two bowel movement difference in weekly average over the four weeks of therapy as compared to baseline.

Source: Adolor: Key Catalysts Are Looming in Q3, Buy Reiterated