Recent Positive News
Cadence's (CADX) stock has strengthened recently on the basis of two new pieces of information. The first deals with market research numbers from Wolters Kluwer; its estimates for vials shipped in July indicate Ofirmev is on track to meet management guidance for a sequential quarterly increase of 23% to 28% in 3Q, 2012 sales to $13.7 million to $14.2 million, up from $11.1 million in 2Q, 2012.
The second comes from a Markman hearing, which is preparatory to the trial on the generic challenge to Ofirmev scheduled for May 2013. My sources report that the hearing appeared to go well for Cadence and this bodes positive for the upcoming trial. The discussion at the hearing also led them to believe that the Ofirmev process patent (the 218 patent) may be stronger than they had believed. I have been skeptical that 218 would be upheld upon challenge by generic companies and felt that the formulation patent (the 222 patent) was the best hope for Cadence to stave off generic competition. The significance is that the 218 patent expires on December 6, 2021, and the 222 patent expires on February 5, 2018. If the court were to rule that 218 is valid, it would afford three years more of patent protection than I had been expecting. However, I cannot predict the ultimate ruling by a trial judge with any confidence.
Ofirmev Performance in July
July and January are two months of the year in which hospital products usually experience sequential decreases from the prior months. July is a disruptive month in the hospital as new residents come on the floor and it is a big month for vacations; surgical procedural volumes usually decline sequentially from June. August is better particularly in the second half because in many areas of the country children go back to school and parents back to work. August is generally better than July and September is usually a very strong month.
Wolters Kluwer estimates that there were 413,216 vials of Ofirmev sold in July versus 426,403 in June for a sequential decrease of 3%. Based on a price increase of 10% and a slightly lower discount from gross sales, I think that the sequential sales increase was 7% to 8%. I would not have been shocked to see a decline in Ofirmev vial sales of 8% or more as occurred in January of 2012.
The results in July also showed an increase in market share. This was encouraging because the dominant NSAID used in the hospital injectable analgesic market, ketorolac, had been experiencing supply issues. In July, it was fully available.
Cadence has given guidance that 3Q Ofirmev sales will increase 23% to 28% sequentially relative to 2Q. I don't know exactly what their expectation was for July, but I think that they might have been looking for somewhere between a slight decrease and slight increase. If so, they appear to be on track to meet or hopefully exceed guidance of $13.7 million to $14.2 million.
The Markman Hearing
The Markman hearing is a proceeding that is held prior to the start of a trial in which a generic is challenging a branded drug. The patent trial on Ofirmev is scheduled for May of 2013. The purpose of the Markman hearing is essentially one to resolve definitional issues. This is kind of an exercise in determining what the meaning of "is" is. Cadence and the generic challengers each try to sway the court on definitions of words used in the patent that pertain to claims. My sources indicate that Cadence seemed to persuade the court to accept its definitions in most cases, which increases the chances of success in the actual trial.
My sources were also impressed by the way that the hearing discussions went on the two patents that protect Ofirmev. The first is a patent relating to the formulation of Ofirmev which expires on February 8, 2018, (with the pediatric extension). The second is a process patent that expires on December 6, 2021 (with the pediatric extension). Wall Street has generally dismissed the process patent as having any significant value. However, the strength of the arguments on the process patent suggests that it may be quite strong, at least according to my sources.
The trial is scheduled to begin in May 2013. There could be a settlement between now and then in which Cadence and the generic challenger agree on a certain date on which the generic can enter. I think that Cadence is confident of its patents and is willing to fight to the finish on defending its patents. However, there is the possibility of a settlement if the terms were favorable. This would take away uncertainty on the patent situation as one never can be fully confident of any trial outcome.
The decision from the court may come out in early 2014, and I can't rule out the risk that the patents are ruled invalid. In that event, I think that the headline news would drive the stock to the $1.50 to $2.00 price range. However, as I pointed out in my last report, I think that generic erosion for Ofirmev would not be as extreme as that seen for oral branded products. As far as I have been able to determine, Cadence currently has sewed up almost all of the world capacity and I think that a generic company would have to await the building and regulatory certification of a "greenfield" plant before launching, which could take year or more. It might also be the case that lack of supply would limit competition to one or two generics initially which would greatly reduce price competition.
In the event that the patents are ruled invalid, my best judgment is that Ofirmev will achieve sales of $342 million in 2015, the same level I am projecting if they win the trial and there is no generic challenge. I would expect generic competition to begin in 2016 and drop Ofirmev sales to $170 million in 2016 and perhaps $135 million in 2017 and cause a measured rate of decline thereafter. At this level of sales, Cadence would likely have positive earnings and cash flow if Ofirmev were its only product, but it is likely that the attraction of its sales force would allow Cadence to bring in other products. If all of this comes to pass, I think that investors would view Cadence in a better light and the stock should rebound off of the $1.50 to $2.00 range, the extent depending on what kind of new products are brought in.
I think that I can live with the risk of this reasonably bad case scenario when I look at the upside if I am correct that the patents either hold up in trial or Cadence reaches a favorable settlement prior to the trial with the generic challengers that delays their entry perhaps until 2018 or later. I see the upside as $15 to $20 in the case of no generic competition. I think the upside reward substantially offsets the risk, and this is the basis of my Buy recommendation.
I am estimating that Cadence will reach cash flow break-even in 3Q, 2013 and will achieve EPS of $0.73 on an untaxed basis and $0.50 on a fully-taxed basis in 2014. In 2015, I project untaxed EPS of $1.50 and fully-taxed EPS of $1.02. If Cadence wins the patent case or reaches a favorable settlement, this could have a powerful effect on the P/E ratio placed on projected 2015 fully-taxed EPS. Investors would be looking at as much as three to six more years of patent life and strong cash flow. Based on a look at comparable companies, I think that in this case in 2H, 2014 investors would pay as much as 15 to 20 times projected 2015 fully-taxed EPS. This results in a price target of $15 to $20.
Note: The Wolters Kluwer estimates are available through subscription. Cadence is a subscriber and regularly distributes these estimates to investors with the permission of Wolters Kluwer. They are also available on Bloomberg. There is no link.
Disclosure: I am long CADX.