In this article, we describe our investment thesis and valuation for Ocera Therapeutics (NASDAQ: OCRX), an emerging biopharmaceutical company based in Palo Alta, California. We are initiating coverage on Ocera Therapeutics with a speculative buy rating and common share price target of $3.40-$5.50.
Figure 1: Market data for Ocera Therapeutics
Figure 2: Daily stock price chart for Ocera Therapeutics
Background of hepatic encephalopathy
Hepatic Encephalopathy (HE) is a spectrum of neuropsychiatric disorders seen in patients with liver dysfunction and/or porto-systemic shunting. Overt HE develops in 30-45% of patients with cirrhosis (Source). Some patients with cirrhosis have subtle findings of HE, a condition known as minimal HE, which may be seen in up to 80% of patients with cirrhosis. The prevalence of cirrhosis is believed to be about 5.5 million cases in the U.S. (Source). The clinical presentation of HE may range from minimal symptoms (with the diagnosis made only on neuropsychological testing) to marked confusion and lethargy and even coma in severe cases.
Elevated arterial/venous ammonia is usually seen in acute HE and normal ammonia level might lead the clinician to question a diagnosis of acute HE (Source). Ammonia is produced by intestinal cells from glutamine, an amino acid and by colon bacteria by metabolism of nitrogenous sources like ingested protein. Ammonia is completely cleared by normal liver by converting it into glutamine or urea. The liver is unable to clear the ammonia in acute or chronic liver failure, thus leading to elevated ammonia level. Although elevated serum ammonia level correlated with the severity of hepatic encephalopathy in some studies (Source), serial monitoring of serum ammonia level is controversial in the management of acute hepatic encephalopathy. Although the guidelines for the management of hepatic encephalopathy by the American Association for Liver Disease (AASLD) in 2014 mentioned that elevated blood ammonia level alone do not add any diagnostic, staging or prognostic value in chronic liver disease (Source), a school of thought believes that elevated ammonia level might play a role in cerebral dysfunction in HE through propagation of inhibitory signals modulated by GABA and serotonin (Source). In addition, neuro-inflammation and altered gut flora also play a role.
Management of acute hepatic encephalopathy is targeted at managing precipitating factors of HE, for example, gastrointestinal bleeding, infection of peritoneal fluid (spontaneous bacterial peritonitis), electrolyte disturbances etc. Lactulose, a non-absorbable disaccharide, is widely used. In the gut, lactulose is catabolized by the gut flora to short-chain fatty acids, thus lowering the colon pH. The reduction in pH favors the formation of ammonium ion from ammonia, thus trapping ammonia in the colon. Rifaximin, a non-absorbable oral antibiotic is approved for the prevention of recurrent HE, although it is also used in the management of acute HAE.
Ammonia scavenging agents in the management of HE
Oral L-ornithine-L-aspartate (LOLA) lowers serum ammonia concentration by converting ammonia to glutamine. LOLA is not available in the U.S., although it is used in the treatment of acute HE outside the U.S. Some clinical studies have shown some benefit of LOLA in mild hepatic encephalopathy in cirrhosis, though data in severe HE is limited (Source (log-in required)). The drug was also not found to be effective in the management of acute HE in acute liver failure (Source), for example Tylenol toxicity.
Glycerol Phenylbutyrate (Trade name: Ravicti) is another ammonia scavenging agent which is currently approved for the treatment of acute hyper-ammonemia in urea cycle disorders. The drug was acquired by Horizon Pharma (NASDAQ: HZNP) through the acquisition of Hyperion Therapeutics. Although the drug was found to be useful in the prevention of recurrent HE in cirrhosis in a phase 2b study (Source), currently it is not being tested in the treatment of acute HE or prevention of recurrent HE in cirrhosis.
Ammonul (sodium phenylacetate and sodium benzoate) is another agent in this category which is approved for the treatment of hyper-ammonemia in urea cycle disorders. The drug was planned to be tested in patients with grade 3 or 4 HE but the study was terminated due to lack of enrollment and business decisions (Source). The drug is given intravenously only through a central line and is contraindicated in cirrhosis due to high sodium load.
OCR-002, (ornithine phenylacetate)
OCR-002 was licensed by Ocera Therapeutics from University College, London, and Ocera owes royalty and milestone payments from the development of this product as a part of the licensing agreement. The drug is currently being tested in a phase 2b study in intravenous form to treat acute HE in cirrhosis in addition to standard care (STOP-HE study). An interim analysis of the trial in March 2015 recommended increasing sample size to 230 patients. About 150 patients have been enrolled as of February 2016 and the trial enrollment is expected to complete in the fourth quarter of 2016. The study results are expected in the first half of 2017 (Source: Ocera Therapeutics Annual Report, 2015, available here).
OCR-002 was tested in a phase 2a study in Spain in cirrhotic patients with gastrointestinal bleeding to lower serum ammonia but the results did not reach statistical significance. After evaluating the results of this trial, Ocera concluded that the dose of OCR-002 was too low. Ocera has increased the dose of OCR-002 being tested in the STOP-HE study to achieve similar phenylacetate level (metabolite of OCR-002) as the Ravicti, phase 2 study that showed clinical benefit in the prevention of recurrent HE in cirrhosis (Source: Ocera's Corporate presentation, available here).
Ocera is also testing oral form of OCR-002 in the prevention of recurrent HE in cirrhosis but the product is still in early stage and has been successful in a phase 1 study.
OCR-002 has FDA Orphan drug status in the U.S. for the treatment of hyperammonemia and resultant hepatic encephalopathy in patients with acute liver failure and acute on chronic liver disease (Source). The product is also being tested in a NIH-sponsored trial for the treatment of elevated ammonia level in acute liver failure, however, Ocera currently has no plan to commercialize the drug for this indication.
Figure 3: Ongoing clinical trials of OCR-002.
Valuation of common stock
o Only likely future revenue from intravenous OCR-002 in acute HE in cirrhosis was included in our valuation model. We do not expect any revenue from this indication till 2019.
o Our calculations included probability of OCR-002 being commercialized for this indication at only 10% at this stage (probability of success in phase 2 trial= 60%, probability of success in phase 3 trial=60%, and if approved, probability of being commercially approved by insurers and used by clinicians <30%).
o The market share gained by the drug for this indication was assumed as 10% starting in 2019 and then increasing by 10% per year till 2023 when the sales reach a mature level and then 3% terminal revenue growth rate.
o The drug price used in the model was $1300/day for 5 days for the above indication per patient (as per the company's corporate presentation).
o Any future likely revenue from commercialization of oral OCR-002 in prevention of recurrent HE was not included in the model since the drug has not been tested in phase 2 trials yet. We will monitor further clinical developments in this indication and update our model as needed.
o Working capital and capital expenditure were assumed to change little in the model.
Figure 4: Forecasted operating free cash flows for Ocera Therapeutics
Weighted average cost of capital calculation (WACC)
Assumptions: The input data is given in the figure given below. The model calculated WACC for the company = 10.7% which is in line with the risk and opportunity cost associated with investing in a small company like Ocera Therapeutics.
Figure 5: Calculating weighted average cost of capital for Ocera Therapeutics.
The values of debt, share count etc. were derived from the 10-Q for 2015. Using the discounted cash flow method and WACC of 10.7%, our model calculated an intrinsic value of $3.40 per common share for Ocera Therapeutics at the lower end of our assumptions.
Relative valuation method
Using the estimated EBITDA in 2023 (at mature stage) and discounting it back to present at a WACC of 10.7% at an average EV/EBITDA ratio of 12 (average for pharmaceuticals, Source 1 and 2), we estimated the common share price= $ 5.57.
Figure 6: Valuation of Ocera Therapeutics common share
Risks in the investment
Ocera Therapeutics is a high-risk, speculative investment and I will not recommend allotting more than 0.5% of investing capital in this stock. At its current stock price, the stock appears to have an upside but like any company with products in the development stage, this investment has its risks. The company has currently little revenue and had operating losses which are expected to continue in the near future. There is no guarantee that its product candidates will be successful in clinical trials and even if successful, there is no guarantee that they will be approved by FDA and be covered by commercial health insurers or adopted for clinical use by clinicians. In addition, the company is likely to require significant debt and/or equity financing in near future, which may put pressure on the stock price.
Investors should also consider potential competition from other existing ammonia scavenging drugs, for example, if a company licenses LOLA for U.S. use or if Horizon Pharma decides to develop Ravicti for HE.
Conclusion: We are including Ocera Therapeutics in our model portfolio as of 4/13/2016 at a stock price of $2.89 and price target of $3.40-$5.57, however, investors should consider this as a speculative investment.
Disclosure: I am/we are long OCRX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article represents my own opinion and is not an investment advice or solicitation to buy or sell any security. Investors should do their own research and consult their financial adviser before making any investment.