Depomed: Focus On Nucynta Litigation Outcome

| About: Depomed Inc. (DEPO)
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Summary

Depomed delivered a roughly in-line second quarter.

The company lowered the full-year revenue and EBITDA guidance due to opioid market-related headwinds.

However, investor focus turned to Nucynta litigation and the growing prospects of a favorable outcome.

The rest of the product portfolio is growing nicely; Depomed looking to reinvigorate Gralise’s growth in 2H 2016.

No word on proxy fight; Depomed remains an attractive takeover target with several value-creating catalysts in the following months.

Depomed (NASDAQ:DEPO) delivered Q2 EPS slightly above the analyst consensus, revenues were in line. The company lowered the full-year revenue and EBITDA guidance but the stock was up post-earnings due to a shift in focus from the lower guidance due to Nucynta litigation. Management made some reassuring statements on the Q2 conference call and I think that patent protection through at least 2025 is all but certain. Nucynta and the rest of the product portfolio have performed well in the second quarter and are well positioned to grow in 2H 2016. The company is also looking to reaccelerate Gralise's growth in the following months. Management once again declined to comment about Starboard's intentions of replacing them. The next few months should be very interesting for Depomed shareholders, and there are several catalysts that could unlock additional shareholder value before the year is over.

Good Q2 results and lower FY revenue and EBITDA guidance

Depomed's Q2 revenues rose 23% Y/Y to $117 million, while EPS was down from $0.28 in Q2 2015 to $0.27. The company reduced both the FY revenue and EBITDA guidance by $12.5 million at mid-point. Nucynta is the main culprit for the lower guidance:

  • The opioid market is under pressure. It was growing around 1% in early 2016 and was down 4-5% Y/Y in recent months. The company did not anticipate this.
  • The average dose per day for Nucynta ER is down from 270 milligrams per day to around 258-260 milligrams in Q2 as physicians are becoming very cautious about raising the opioid dose. This is the second important headwind for Nucynta since the company actually expected the average dose per day to rise in 2016.

However, the Nucynta franchise is growing despite the mentioned headwinds and is positioned to grow substantially in the following years. Here are some of the key growth drivers:

  • Primary care physicians are reducing their use of long-acting opioids and sending patients to specialists. This is a favorable trend for Depomed since its market share with pain specialists now exceeds 3% of the long-acting opioid market. Depomed also has 3x the market share with pain specialists than with primary care physicians.
  • Nucynta IR reversed the prescription decline (around 10% at re-launch last year) - prescriptions have grown 2% Y/Y in the last two months. As of June 1, sales reps are spending more time on Nucynta IR, which is still responsible for the majority of revenues for the franchise. The reversal is even more impressive considering the overall decline of the opioid market this year.
  • Nucynta will retain good formulary coverage in 2017.
  • The company has analyzed patient assistance and co-pay programs and will make some adjustments intended to improve gross to nets in 2H 2016.
  • No prices increases were implemented this year, a small price hike is possible in 2H 2016.

Taking the overall decline of the opioid market this year into consideration, I would argue that Depomed has done really well with Nucynta.

All the other products have grown sequentially and Y/Y. The company is trying to reinvigorate Gralise's growth in the second half of the year. The first step involves a changed focus for the sales team with Gralise being a priority for the CNS team as well as revamped compensation for driving Gralise prescription growth. The second step was two months of additional training in Q2. These changes should lead to higher prescription growth for Gralise in 2H 2016.

Investor focus turns to Nucynta litigation

When a company reports a largely in-line quarter and reduces FY revenue and EBITDA guidance, the share price the next day is down in most cases. But not Depomed. The stock finished the day 4% higher as the focus turned to Nucynta litigation. CEO Schoeneck was very optimistic on the Q2 call (emphasis mine):

The defendants in the litigation have conceded infringement of both the 2023 and 2025 patents. So the District Court is only considering whether those patents are valid, and whether the polymorph patent is enforceable. In that regard, as we disclosed on July 18, the Patent Trial and Appeal Board denied the IPR petition filed in January 2016, challenging the validity of the polymorph patent.

Though the IPR proceeding in the ANDA Litigation are unrelated procedurally, the invalidity arguments made in the IPR petition were duplicative of many of the invalidity arguments the defendants made to the District Court in the ANDA Litigation… We believe the fact that the PTAB declined to review the patent altogether indicates our confidence that our polymorph patent is well-placed.

As to the other arguments the defendants asserted in the ANDA Litigation, we are unaware of any court invalidating a polymorph patent on those grounds. As for the 2029 method-of-use patent covering NUCYNTA ER, we believe we presented a strong case demonstrating them the claims of the patent are invalid and infringed. So we feel we have a very good chance of securing nearly 13 more years of exclusivity from NUCYNTA ER. We look forward to the court's decision. In the meanwhile, we remain amenable to any settlement opportunities in line with the merits of the case.

Based on these comments, I think there is a very good chance for Nucynta to retain exclusivity through at least 2025, and possibly even through early 2029. The court should make a decision before September 30, which should remove a major overhang on the stock.

Plenty of value creating catalysts ahead

The outcome of the Nucynta litigation is the first and most important near-term catalyst for Depomed. I think that exclusivity through 2025 could drive the stock 10%-20% higher and that exclusivity through early 2029 could drive the stock up to 30% higher.

The second important catalyst is the proxy fight. Starboard Value is not backing down and has added fuel to the fire with the latest letter. If Starboard is successful, I think the company will get acquired over the next 6-12 months. There was some speculation earlier this year that Horizon (NASDAQ:HZNP) is once again interested and if a management change occurs, I suspect that the new board will engage in discussions with Horizon. I was in favor of this deal last year and still am, as it should result in significant cost and tax synergies. I believe that the combined company would be more successful at increasing shareholder value through better execution. Horizon has not made acquisitions since December 2015 - maybe they are waiting to see what happens with this proxy fight.

Depomed could also become active on the M&A front as a buyer in the following months. This is the third potential value creating catalyst. The company has reduced its debt by $100 million in Q2 and should delever quickly in the following quarters.

And, finally, Depomed could also get a juicy settlement from Purdue. In late March, "the U.S. Court of Appeals for the Federal Circuit has affirmed the decisions of the Patent Trial And Appeal Board of the United States Patent and Trademark Office (PTAB) confirming the patentability of two Depomed patents." The two patents are related to a reformulated version of Oxycontin. Purdue challenged the patents in an IPR proceeding, but the PTAB upheld the patents. Here is what CEO Schoeneck said on the Q2 call (emphasis mine):

The total amount sold for that version of OxyContin would be approaching $15 billion in aggregate, since 2010. We at - on the same patterns, we had received a small royalty that we described as low-single-digit from J&J on NUCYNTA ER. And so each percentage of that type of numbers are 150 million bucks. And so you can decide what we meant is low-single-digit, but if it's $200 million versus $300 million, if it's 3%, it's $450 million. So we're talking about some very large numbers.

A substantial settlement payment could wipe the slate clean when it comes to Depomed's indebtedness.

Conclusion

I am satisfied with how this growth story is progressing. The Q2 results were not impressive and the FY guidance cut is disappointing, but the overall trends remain positive. The Nucynta litigation outcome stands to unlock significant shareholder value in the following months and at the same time represents a major risk for Depomed. The worst case scenario is probably the loss of exclusivity in 2023 and I think there is a high probability for Nucynta to retain exclusivity through at least 2025 and maybe even 2029, which could drive the stock substantially higher in the next few months. The proxy fight should heat up after the court's decision and I think Starboard has a good chance to prevail given its successful activist track record.

Disclosure: I am/we are long DEPO, HZNP.

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 reflects the author's personal opinion and should not be regarded as a buy or sell recommendation or investment advice in any way.