XenoPort Arguably Undervalued, But Low On Options

| About: XenoPort, Inc. (XNPT)
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Summary

XenoPort has effectively ceased operating as a biotech and has switched to a specialty pharmaceutical model to maximize the value of Horizant.

Boosting XenoPort to $100 million or more in annual revenue could easily require $125 million to $150 million in annual spending, limiting XenoPort's operating and bargaining leverage.

A company with an established primary care sales force should be able to wring more value out of Horizant, leading to $6.50/share in value for XenoPort.

The days of talking about XenoPort (NASDAQ:XNPT) as a biotech are pretty much over, as the company has given up developing '829 and '279 on its own and refocused its efforts on maximizing the potential of its restless leg and postherpetic neuralgia (or PHN) drug Horizant. Unfortunately, XenoPort also really isn't a specialty pharmaceutical company either, as the company has no other marketed products and still lacks the scale (and the resources) to market Horizant to full effect.

The best outcome for XenoPort would appear to be a sale of the company to another pharmaceutical company with the primary care sales infrastructure to make Horizant a lucrative "drag and drop" addition. I believe such a transaction is worth about $6.50 to Horizant today, but I believe the shares would be worth far less in a go-it-alone scenario due to a slower revenue ramp and a lack of operating leverage. I don't presently see any meaningful value in out-licensing the portfolio.

Horizant Still Growing… But It Needs More Investment

With a midyear expansion in the sales force from 70 to 120, XenoPort is certainly doing its part to help Horizant sales accelerate. Horizant revenue grew 94% in the third quarter of 2015, with underlying prescriptions up 50% year over year. The drug remains very profitable to manufacture, with a gross margin in the mid-90%s.

The question is how much further XenoPort can take it (or afford to take it) on its own. The newly-expanded sales force should be adequate to cover about one-quarter of the prescribing base of primary care physicians that make up the principal market for Horizant. The real-world numbers are probably better than this, though, as the company can focus its efforts on those doctors who treat more restless leg/PHN, those who already prescribe gabapentin, and so on. Said differently, XenoPort is a long way from total market coverage, but covering primary care physicians in the rural Midwest or Mountain states is not really necessary or value-added.

That said, I believe XenoPort is fundamentally limited by its scale and lack of resources. It often takes $150 million or more to support a national drug marketing effort to primary care physicians, and marketing a drug where there is significant generic competition and/or payer resistance (as is the case with Horizant) can require considerably more spending. Think about it like this - investors have probably noticed TV ads for drugs like Linzess and Brintellix. The companies behind these drugs are spending the $110,000 or so it costs for a 30-second prime time slot (each) because they need to raise patient awareness, stand out from the crowd, and coax patients to go to their doctor and specifically ask about/for the drug. The problem for XenoPort is that the company just doesn't have the resources to invest in those types of activities.

Farewell To Being A Biotech

Due to a combination of limited company resources and limited clinical progress, XenoPort has announced that it will no longer be pursuing the development of its own R&D assets. While these programs are not being scrapped outright, the company is now looking for partners to take these assets forward. I am not optimistic about the prospects of meaningful out-licensing opportunities.

This decision was based, at least in part, on the disappointing results of XenoPort's methyl hydrogen fumarate prodrug XP23829 (or '829) in psoriasis announced back in September. While the drug did show statistically significant mean reductions in PASI scores from baseline, the overall results were not impressive. On a placebo-adjusted basis, only 4% to 13% of '829 patients achieved a 75% or greater reduction in their PASI score, well below AbbVie's (NYSE:ABBV) Humira and Johnson & Johnson's (NYSE:JNJ) Stelara, but also below the 23% to 28% range for Celgene's (NASDAQ:CELG) Otezla.

While that efficacy could arguably still be good enough for approval, the tolerability of the drug is a big problem. Rates of diarrhea ranged as high as 40% and the trial saw a 33% drop-out rate (versus 10% to 13% for Otezla). Although there may be ways to administer/dose the drug that would improve the tolerability, I don't see why a company would pay real money for a drug that seems to have a very limited (at best) role to play in psoriasis treatment.

I likewise see little value in XP21279 (or '279), XenoPort's levodopa prodrug for Parkinson's disease. A Phase II study supported the idea that '279 can achieve more consistent levels of levodopa in patients' blood, it didn't seem to produce meaningful improvements in outcomes.

What's It All Worth?

I believe Horizant is a good example of a drug that could possibly be worth more to an established company. The key here is that a would-be buyer must have an established primary care sales force where it can basically just drop the drug into its existing operations with minimal additional expense. There are a lot of companies out there with the right sort of established sales force, so it comes down to the perceived value of the drug.

I took a go at calculating the prospective value of Horizant on the basis of assuming mid-90%s gross margins, minimal incremental structural SG&A costs (2% of sales), and advanced marketing spending requirements of 15% of sales (to fund direct-to-consumer ads, more aggressive sampling and copay assistance, etc.). While the bottom line assumptions are sensitive to the tax rate, I elected to go with the more favorable (to XenoPort) assumption that a company in a low-tax jurisdiction could do the deal and I ended up with the conclusion that Horizant could be worth more than $0.60 per dollar of revenue to an acquiring company.

I then calculated the discounted cash flow value of the drug on the assumption of Year Three revenues of $100 million, $150 million, and $200 million and a revenue peak in 2025. For purposes of valuation, I assumed that an acquiring company would demand a mid-teens return on investment as adequate compensation for the risk of the deal.

If I weight the odds of Year Three revenue of $150M at 50%, $100M at 35%, and $200M at 15%, I come up with a value of $6.50 today (including net cash as of the last quarter). Giving equal weight to all three outcomes would boost the value to $6.75 and the $200M scenario topped out at $8.50/share. None of these scenarios assume any value for the pipeline assets, and I do not believe that an acquirer of Horizant is going to be interested in paying much (if anything) for those assets.

Were XenoPort to try going it alone, I believe it would take at least five years to achieve positive cash flow and I'm not entirely certain that the company could ever achieve meaningful operating expense leverage.

I will also note that a clinical trial of Horizant in alcohol abuse is underway (and was one-third enrolled as of the last quarterly report in early November). The National Institute on Alcohol Abuse and Alcoholism is sponsoring the study and while a strong outcome could certainly increase the prospective value of Horizant, the history of drug development and commercialization for drugs targeting alcohol abuse is not encouraging.

The Bottom Line

XenoPort shares are currently trading in line with my $100M revenue buyout scenario ($5/share), so there would seem to be some upside from here. If the company can in fact partner or sell its pipeline assets, that would represent incremental added value, but I'd be shocked if the company managed to get $0.50/share in upfront payments.

In my view, XenoPort is now a bet on a buyout. While I certainly think that a deal is possible, I think it is worth noting that GlaxoSmithKline (NYSE:GSK), which does have a primary care sales force, didn't make much headway with the drug (leading to the termination of the marketing partnership between the two companies). I generally find it to be good advice to avoid making investment decisions solely on the basis of M&A and I'm not convinced that would-be buyers will see the upside in Horizant. With that, this isn't a stock that interests me much today.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.