Controversial Questcor Still Looks Like A Buy

| About: Mallinckrodt PLC (MNK)
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Questcor (QCOR) investors have had quite the ride over the past year. In addition to positive clinical data, the company has seen encouraging success in expanding its business in nephrology and rheumatology, but investors will not soon forget the nearly two-thirds dive that the stock took on word that Aetna (NYSE:AET) was essentially dropping coverage on the company's only product.

There's no doubt that Questcor is a risky stock. All of the company's revenue comes from a single product that is off-patent (but very hard to manufacture) and the company has no pipeline to speak of. Even so, the shares appear undervalued with relatively little downside at present.

Q4 Gives A Glimpse Of The New, Better, Questcor

With the health and stability of the company's MS franchise in some doubt (more on this later), it is critical for the company to grow its business. The fourth quarter of 2012 looks like a success in that regard.

Revenue more than doubled this quarter (up 113%) on an 88% increase in the number of vials sold. While the multiple sclerosis indication continues to grow on a year-over-year basis (up more than 40%), the biggest incremental contribution was from nephrology, which has grown to nearly half of sales. Regrettably, Questcor doesn't provide detailed revenue breakouts, but I would estimate that sales in nephrology increased by about 150% from last year. The company's efforts in rheumatology have also gotten off to a good start, making up about 5% of revenue this quarter.

Questcor also continues to deliver very strong margins. Gross margin fell a bit (about 40bp), but remains above 94%. Likewise, despite ongoing investments in R&D and marketing, operating income rose 122%, resulting in a hard-to-believe operating margin of 59%.

Clinical Efforts Should Drive Prescriptions And Ease Reimbursement Fears

Questcor markets and prices its lone drug, Acthar Gel, like an orphan drug - charging about $29,000 per vial (though rebates reduce the effective price). As investors in Sanofi (NYSE:SNY), Alexion (NASDAQ:ALXN), BioMarin (NASDAQ:BMRN), and Shire (NASDAQ:SHPG) know perfectly well, payers are willing to pony up large amounts of money for treatments for rare conditions. The key, though, is that the payers have to be confident that the drug/treatment actually works, and that's where Questcor's extensive Phase IV program comes into place.

While Acthar Gel has FDA labeling for 19 conditions, there is relatively little clinical data supporting any of them. That, I believe, is a big part of the reason Aetna felt justified in cutting off reimbursement, and it increases the significance of ongoing studies.

Questcor has a Phase IV study underway in treatment-resistant idiopathic membranous nephropathy and lupus, and will be starting a nine-month study in ALS later this year. This will all be small studies (if for no other reason than there aren't a lot of patients), but potentially highly impactful - if the company can demonstrate real, sustained benefits, doctors will be much more likely to prescribe Acthar and insurance companies will be more likely to approve reimbursement. At the same time, this isn't a risk-free proposition - while a failed Phase IV nephropathy study wouldn't wipe out the sales Questcor gets from nephrology, it would certainly force doctors (and payers) to reexamine their positions.

One Old Drug, Multiple New Opportunities?

Nothing about the Questcor story is typical for the pharma space. Very few companies build their business around just one product, fewer still around a product that isn't protected with patents, and almost no one around a drug that's decades old. And yet, from the time Questcor bought this drug from Sanofi back in 2001, management has really managed to make something of it.

Acthar (or Acthar gel) is basically a highly purified analog of adrenocorticotropic hormone. Taken from the pituitary glands of pigs, it is extremely difficult to manufacture, but it has shown to have intriguing efficacy and safety benefits in applications where patients have failed to respond to (or tolerate) various corticosteroid or immunosuppressant treatments.

The biggest change that Questcor made, apart from finding a company that could effectively manufacture the drug (something Sanofi struggled with), was repositioning the drug as an orphan drug treating rare conditions. After its acquisition, Questcor worked with the FDA to get an updated label that carries FDA approval for use in 19 indications. To that end, Acthar has been used for some time now in treating acute exacerbations of multiple sclerosis (MS), infantile spasms, and more recently in various nephropathies.

MS - Will Aetna Be The First, Or The Only?

Until the recent growth of the nephrology/nephropathy indication, MS was the primary revenue driver for Questcor and Acthar.

While drugs like Teva's (NYSE:TEVA) Copaxone, Novartis' (NYSE:NVS) Gilenya, and Biogen Idec's (NASDAQ:BIIB) Tysabri and Tecfidera have significantly reduced the incidence of flares for MS patients, they still happen - to the tune of about 200,000 cases per year. The standard treatment for these flares is steroids, but about one-fifth either do not respond or cannot tolerate steroids.

Although this has proven to be a lucrative market for Questcor (worth over $200 million a year), it's not a cheap option. A treatment course of Acthar in MS costs about $27,000 to $60,000 - against an annual cost of about $50,000 for newer MS treatments.

Not only does that make Acthar quite an expensive treatment option, but it's a largely unproven one. While I've spoken to neurologists who've used this drug for some time and seen it work in their own practice, there is a lack of controlled studies. A poster presentation from mid-2012 discussed its use in 18 patients (17 of whom had good-to-excellent responses), but this combination of high price and scant data could prove to be inherently unstable - especially if newer MS drugs can meaningfully reduce flares.

New Markets Hold Real Potential

Questcor has not stinted in trying to move beyond MS as a primary driver for Acthar revenue.

At present, the biggest opportunities are in nephropathies like idiopathic membranous nephropathy and focal segmental glomerulosclerosis. These are not common conditions (all inclusive, there are probably about 20,000 cases per year), and there are very few treatment options. Corticosteroids and immunosuppressants are the common first-line approaches, but as in the case of MS not all patients respond to them or can tolerate them. What's more, attempts to use other drugs like Roche's (OTCQX:RHHBY) Rituxan haven't shown all that much benefit.

Acthar is an expensive option. Treating these conditions frequently requires around eight vials of the drug, or around $160,000 to $240,000. To offer a little perspective, though, Alexion's Soliris (a drug approved for even rarer nephropathies) costs more than $400,000 per year. I'm not trying to say that the two drugs are identical, have the same sort of clinical data supporting them, or anything of the sort. Rather, I'm merely trying to suggest that there is precedence for high-priced drugs in nephrology. What's more, without adequate treatment, most of these patients are on a one-way path to end-stage renal disease (and dialysis).

In terms of efficacy, here too there is a lack of data. A small study from Dr. Hladunewich showed a 75% response rate (65% partial, 10% complete) in treatment-resistant idiopathic membranous nephropathy, while a different study from Dr. Bomback showed partial remission of refractory focal segmental glomerulosclerosis in five of 12 patients. And as I said before, Questcor is sponsoring a Phase IV study in treatment-resistant idiopathic membranous nephropathy to further support its place in treatment protocols.

Questcor is now also looking to expand the use of Acthar in rheumatology, with an initial focus on lupus and dermatomyositis and polymyositis (DM/PM). There are estimated to be about 30,000 non-responsive DM/PM patients in the U.S., with a course of treatment likely costing around $125,000 to $150,000. The lupus opportunity is harder for me to assess at this point - the market is theoretically large (over 300,000), but Glaxo's (NYSE:GSK) Benlysta has struggled to find its footing. Even so, as a specialty treatment for even a very small number of patients (10,000, for instance), the revenue potential could be meaningful.

Down the road, I would think the company would also explore the use of the drug in rheumatoid arthritis, psoriatic arthritis, juvenile and ankylosing spondylitis - all of which would likely be in indications where patients haven't responded to corticosteroids, immune treatments like Abbot's (NYSE:ABT) Humira, or oral JAK inhibitors like Pfizer's (NYSE:PFE) Xeljanz.

Twin Challenges - Reimbursement And Competitors

Arguably the biggest threat to Questcor, and the one that knocked the stock down hard in 2012, is reimbursement. As mentioned several times already, this is an expensive drug with relatively scant supporting clinical data. Virtually every insurance company requires prior authorization before reimbursing for this drug, but the success rate has run about 85%.

Is that about to change? In September of 2012 Aetna announced that it was dropping coverage for all indications except infantile spasms based in part on the cost, lack of clinical data, and lack of support from medical societies. While I can appreciate Aetna's position vis a vis Acthar's use in MS, I find the decision for nephropathies to be more surprising and disappointing.

Even so, other insurers have not followed Aetna's lead at this point - though clearly the risk remains. A few, like UnitedHealth (NYSE:UNH), have shortened the time they'll cover Acthar without re-authorization, and many have claimed that the use for MS is unsupported by data, but the nephrology indications could be on better footing pending the outcome of Questcor's Phase IV study. It's also worth noting that Questcor's pricing leaves room for rebating, should the company wish to ease insurers' concerns by going that route.

Competition is also a risk to Questcor, given that there are no patents covering Acthar. The key, though, is that Acthar is protected by a potentially higher wall - it is very difficult to manufacture. Questcor recently announced the acquisition of BioVectra, the company that has been supplying the extracted and refined hormone to Questcor, and it's unclear if other manufacturers could profitably replicate this know-how. Even if they could, though, there's the question of what sort of labeling a biosimilar product would get.

Longer term, I'm still a bit concerned about potential competition. I'm not worried about a straight-up generic knock-off of Acthar, but I would be more concerned about a recombinant product. My expertise in chemistry and biochemical engineering doesn't go nearly far enough to properly assess how easy (or difficult) that would be, but were I thinking of launching a competing product, that's probably the route I'd go (as companies like Sanofi and Novo Nordisk (NYSE:NVO) largely replaced porcine-derived insulin with recombinant human analogs).

Last and not least, investors should be aware of a government investigation of Questcor's marketing practices for Acthar. Details are still pretty scarce (and the drug is approved for the indications which generate the bulk of revenue), but past experience with fraudulent marketing cases in Big Pharma would point to a likely downside risk of one year's revenue in fines.

Estimates Demand Guesswork

The problem in assessing Questcor is the huge range in potential outcomes. Will the MS business hold up? Can Questcor take real share in nephropathies? Will the rheumatology indications generate similar levels of growth?

I've chosen to examine the possibilities through a bull/base/bear care scenario analysis. In the bull case, I see the MS business holding up, the nephrology business continuing to grow, and rheumatology adding real and significant revenue. Under this scenario, revenue could grow to over $1 billion by the end of the next ten years. In a bear scenario, Questcor sees the MS business basically fade away and the rheumatology business never amount to much - leading to a long-term revenue target around $350 million (built largely around nephrology).

And then there's the base case scenario. Here I assume that the MS business basically hits a wall and declines modestly, but the nephrology business more than compensates and the rheumatology indications kick in some solid revenue. I also forecast that the company will maintain very strong margins and free cash flow generation. In this scenario, revenue grows at a low rate (only about 2%) to about $650 million, with free cash flow growing at a slightly slower rate (but still growing).

The Bottom Line

The base-case scenario suggests a fair value of about $42, with the bear-case scenario suggesting a floor near $28 and the bull case scenario driving a target north of $70. Given what I see as worthwhile upside and relatively low downside, I'd be inclined to own these shares today.

Keep in mind, though, that Questcor is not a normal drug company. Perhaps Questcor will attract a bid from a company looking to add an orphan drug business, but that's inherently unpredictable. Management's decision to put all its eggs in one basket changes the risk profile significantly; there's very little pipeline risk (since there's no pipeline outside of follow-on indications), but if something goes wrong with Acthar it would be disastrous. Invest accordingly.

Disclosure: I am long OTCQX:RHHBY. 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.