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Investment Overview

In the aftermath of the 70% meltdown in the price of Dendreon (NASDAQ:DNDN) stock caused by sharp lowering in expected sales of Provenge in 2011, investors are struggling to balance the positives and negatives of the investment case. I believe that the essential starting point for arriving at a new investment thesis is to listen closely to what management is saying about its business. It is naïve to think that an outsider can independently gather all of the information needed to make a sound investment judgment without management input. However, managements can be and often are wrong in their outlook. While it is critically important to understand what management believes is going on in its business as a starting point, it is the job of the investor to judge whether the company’s expectations are realistic.

The purpose of this report is to understand the expectations of management. It does not look at the critical question of the potential demand for Provenge. That will be the subject of another report that I am working on. Investors should view this report as only one part of an effort to frame the investment thesis for Dendreon and Provenge. After listening to recent management presentations, the most significant takeaways for me were:

  1. Provenge sales in 3Q, 2011 are trending better than the consensus expectations that were formed following August 4th when management reported Provenge 2Q, 2011 sales that were below expectations and withdrew its guidance for the year. Consensus expectations subsequently settled in at around $55 million. They have since increased to $62 to $65 million based on data on actual July and August sales that management released. In the same way, expectations for 2011 sales have increased to $215 million from $195 million.
  2. Barriers to reimbursement seem to be coming down as a result of the national coverage decision of CMS and the implementation of a Q code. Dendreon believes that the average time for reimbursement is now about 30 days and said that there was a recent report of reimbursement being received in eight days.
  3. Dendreon has undergone a restructuring so that it now projects that it can achieve break even cash flow at $500 million of U.S. sales; foreign sales would be incremental. The restructuring will keep all three manufacturing plants operating. The company does not believe that shutting a facility would have any meaningful effect on cash flow.
  4. Financial management stated that with the restructuring, it does not anticipate that it will have to do a financing before it achieves break even and does not anticipate cash dropping below one year of projected cash needs.
  5. For the first time since introduction, urologists and oncologist in the community setting are accounting for more sales than academic centers. This is an indication of easing reimbursement concerns in the commercially much more community setting. Sales in academic centers are reported to be flat to up.
  6. The company continues to anticipate that Provenge will be approved in Europe in 2013. It will use a contract manufacturer in Europe. It has not ruled out finding a marketing partner in Europe. The commercial opportunity in Europe is significant, approaching that of the US.
  7. According to Dendron, Johnson & Johnson’s (NYSE:JNJ) Zytiga is being used in a third and fourth line setting in accordance with its label and ha not competed in the Provenge segment of the market. Zytiga from other sources is reported to have an annual run rate of about $200 million.

Reimbursement Trends

Dendreon believes that the critical mistake it made in overestimating demand for Provenge in 2011 was that it did not understand the concern of community urology and oncology practices as to whether they would be reimbursed if they prescribed Provenge. There was the fear that they could be on the hook for $90,000 for each patient whom Medicare or managed care chose not to reimburse.

CEO Mitch Gold has repeatedly stated that he hears clearly from physicians that they need to have confidence that they're going to get reimbursed when they prescribe Provenge. He believes that once they have a number of positive experiences with reimbursement, they will be much more confident prescribing Provenge more broadly in their practice. In his opinion, this is far and away the most consistent theme that the company hears when interfacing with physicians. They have patients sitting in their practice who are candidates for Provenge, but they want to make sure they are going to get paid before they start to more broadly prescribe it.

In November of last year, CMS scheduled a hearing on Provenge reimbursement. This hearing was unprecedented and led to widespread concern in the medical and investment communities that Provenge might be subjected to restrictions on how it could be used and perhaps that CMS might demand a price reduction.

CMS issued its final national coverage decision in March, 2011 and stated that treatment with Provenge is reasonable and necessary. This uneventful decision assured providers that they would be reimbursed for Medicare beneficiaries when Provenge is used on-label to treat asymptomatic and minimally symptomatic castrate resistant prostate cancer patients. This meant that all 15 local Medicare administrative contractors would continue to pay for Provenge treatment. Private payors generally follow the lead of Medicare so that this decision holds for the entire U.S. patient population.

Provenge has also been issued a product specific Q-code which allows for electronic submission of claims and should accelerate payment times for physicians. This is also a positive as it reduces accounts receivable outstanding for doctors. In dealing with Medicare, injectable products that cannot be self-administered (which describe Provenge) are eventually assigned a J code that precisely states what Medicare will reimburse for the product. The physician enters the appropriate J code and reimbursement proceeds routinely. However, it often takes a year or more to get a J code for a new product. Hence during the launch of a product there is an awkward period in which there is no J code and the physician has to request coverage under a J code for a similar product. This creates a lot of confusion, excess paperwork and back and forth between payor and provider. Before the J code is issued, there is an interim period in which a Q code is issued that is a temporary billing measure before the final J code is issued. I hope I have got this right. It is more than a little confusing.

Mr. Gold believes that the national coverage decision by CMS has helped to create a much more consistent coverage process for Provenge nationwide that reinforces and improves the confidence in reimbursement for physicians. As important, the Q code makes billing Medicare quicker and easier. Dendreon is educating physicians on the now active Q-code and has a call center that works closely with accounts to make sure that they understand the implications of the national coverage decision and the Q-code.

The barriers to prompt reimbursement are coming down. The company reports that it is now hearing from various physician organizations that the average time to payment is approximately 30 days. Earlier in the launch, there were anecdotal reports that reimbursement was taking as long as 90 days. The company noted that one of its customers notified Dendreon that they were recently paid in 8 days. That being said, Dendreon believes that physicians would like to see evidence of this expedited reimbursement experience occurring several times before they more broadly adopt Provenge.

For the first time now Dendreon is starting to see the community oncology and urology practices surpass the sales to academic centers. This suggests that they are becoming more and more comfortable with the reimbursement situation around Provenge.

Restructuring and Financial Issues

Management was expecting that Provenge would end 2011 with a sales run rate of around $800 million. In anticipation, the company expanded from its New Jersey manufacturing location by adding facilities in Atlanta and Los Angeles. The company also increased employees in the manufacturing facilities that would be capable of manufacturing $800 million of Provenge sales. These employees were brought in six to nine months in advance of the expected revenue target to assure that the work force was adequately trained.

The run rate going into 2012 is now expected to be more on the order of $240 million. This lower sales trajectory means that Dendreon is overstaffed in its manufacturing facilities and Seattle administrative functions. This has necessitated a restructuring that will result in eliminating 500 employees, or 25% of the employee base. The reductions will not affect sales, marketing and other factors which create demand. Dendreon anticipates that this will result in $120 million of annual cost reductions divided between manufacturing and administrative expenses.

With this restructuring, the company believes that it can reach cash flow break even at a $500 million sales level. This guidance is based solely on the outlook for U.S. operations. It does not include any assumptions for Provenge’s European commercialization. However, they are expecting to do a partnering in Europe on the manufacturing side and haven’t ruled out a marketing partnership. Provenge is expected to be introduced in Europe in 2013.

It is complicated when one tries to reconcile what costs may look like at this $500 million level. There are about $100 million of annual non-cash charges divided between cost of goods sold and S,G&A. Management has been asked several times what costs would have to be to achieve this breakeven goal and the answers have been a little confusing. I think that management is indicating that on a cash basis that cost of goods sold would be $250 million (50% of sales), research would be $80 million and S,G &A would be $170 million.

The actual reported cost structure would be higher because it would include the $100 million of non-cash items. On a GAAP basis at a sales level of $500 million, cost of goods sold might be $300 million, research $80 million and S,G&A $220 million. This would result in a GAAP pretax loss of $100 million even though the company was at breakeven on a cash flow basis.

I realize that this is getting a bit complicated, but there is also another consideration. If the company is ramping sales rapidly to reach the $500 million sales goal, it means that working capital requirements led by accounts receivable and inventory, would also be ramping rapidly and this would require considerable cash. Because of this, the company as it first reached the $500 million sales level would still have negative cash flow. Once the sales level is sustained, there would be no need to increase working capital to support this level of sales and the company would be at cash flow break even.

The company has stated that with the restructuring it can achieve a cash flow break-even position in the U.S., without having to access the capital markets. As of August 31, the company had cash and cash equivalents of approximately $600 million. It expects that this is sufficient cash to enable the company to achieve a cash flow break-even position in the U.S. without bringing in cash in a partnering deal or through having to raise equity or debt in the capital markets. It further stated that it did not expect cash at any time to fall below one year of cash needed to fund operations in the following year.

Size of the Market That Provenge Addresses

The downward revision in Provenge sales guidance has raised investor concern that about the number of patients who are appropriate for Provenge. In particular, they want to know if assumptions have changed and if the patients are actually out there?

Dendreon has done a great deal of market research studies and continues to believe that its original assessment of the patient population was accurate. In terms of prevalence, it believes that there are about 100,000 prostate cancer patients in the U.S. are eligible for treatment under the Provenge label. In addition, the company feels that each year about 30,000 to 35,000 new patients become eligible. In dollar terms the addressable market based on 100,000 patient prevalence would be $9 billion. The addressable market for new patients each year would be $3 billion to $3.5 billion.

Price

Analysts are anxious to know if there is any push-back from accounts demanding a lower price. Based on the extensive amount of time that Dendreon has spent interfacing with the physician community, it believes that price is not the major issue. Rather it is the concern about reimbursement. The company continues to maintain that the benefit that Provenge is providing patients in terms of its improvement in quality of life and overall survival: the minimal supportive care required: and the rapid course of treatment indicates that Provenge is fairly priced.

Zytiga (abiraterone)

Dendreon has done a lot of research on Zytiga and believes that it is currently being used in the third or fourth line setting in accordance with its label. So far, Zytiga has not expanded into the patient population that Provenge is indicated for. Of course, down the road, Zytiga will be approved in this patient population.

Dendreon has spent a lot of time working with the key thought leaders in oncology to discuss the sequencing of Provenge and Zytiga. Management believes that there is a clear consensus to use Provenge first, getting it on board, and getting it done quickly in one month's time. Then physicians can go on to Zytiga.

European Operations

Dendreon plans on filing the Provenge MAA in Europe in late in 2011 or early 2012 with the expectation of approval sometime in 2013. Dendreon will almost certainly partner with a third-party contract manufacturing organization to establish a commercial infrastructure in Europe. This means that the Provenge launch in Europe should not lead to any substantial manufacturing expenses. Dendreon also believes that SG&A expenses are going to increase much as move overseas. They see considerable operating leverage.

Marketing

The sales force is targeting community oncologists and urologists who will play the critical role in identifying patients who will benefit from Provenge. Dendreon has identified 1,000 accounts that represent approximately 80% of the prostate cancer prescriptions in the United States. The sales force is being positioned to better target the community oncologists and urologists, where the majority of Provenge opportunity lies.

Dendreon is exploring alternative channels to maximize market penetration in the community setting. One example is collaborations with major oncology group purchasing organizations. In addition, they are increasing direct to patient campaigns to drive awareness and pull-through in the physicians' community offices.

Manufacturing

The three current manufacturing facilities are capable of supporting end sales of a minimum of $1.2 billion and perhaps as much as $2.4 billion. Management explains that closing one of these facilities would not significantly alter cash usage. Fixed charges for rent, depreciation and utilities would be unchanged and there would be no change in variable costs which are highly labor intensive. They do not plan to close any of their manufacturing operations. The facilities are FDA approved, all the work stations are validated and they plan to keep each facility fully operational.

The company was originally looking to build another facility in Europe. However, the company has previously been approached by large-scale commercial contract manufacturing organizations that would build a facility and act as a vendor. In Europe, it is now highly likely that the company will use a contract manufacturing organization. This would allow the company to establish a commercial manufacturing footprint prior to approval. They don’t envision the need for additional capital for European manufacturing. The company continues to expect that it will file an MAA late this year or early next year, with a potential approval in early to mid-2013.

With the New Jersey facility alone, Dendreon was able to generate about $10 million per month based on operating 12 work stations. Management believes that it can increase output so that these same 12 work stations can produce $20 million of sales per month. This increase the amount of production per work station would be achieved with little incremental cost. This factor is the single greatest leverage point in terms of leveraging cost of goods sold.

Personnel Changes

Hans Bishop who had been leading the commercial and operational efforts for nearly two years is no longer with the company. He was given a severance package which suggests that he was fired. He would seem to be the person most responsible for the poor projections on demand. The company is looking for a new chief operating officer.

Research

Dendreon is working with regulatory authorities to plan a worldwide clinical trial of Provenge in metastatic prostate cancer patients who are responsive to hormone therapy. This is an earlier stage of the disease than the current indication which is for patients who are no longer responsive to hormone therapy. Success would dramatically expand the addressable market for Provenge. This is a Phase II trial that will enroll 180 patients in 15 sites.

The DN24-02 Phase II trial began a Phase II trial in 3Q, 2011 with its second active cellular immunotherapy (ACI) product. Patients with HER2/neu positive bladder, colon and breast cancer will be randomized to DN24-02. The trial will follow patients for overall survival and disease free survival.

Source: Dendreon Revisited: What Management Is Saying About Provenge