Santen - An Overlooked Play On An Overlooked Space

| About: Santen Pharmaceutical (SNPHY)
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Santen holds over 40% share in Japan's ophthalmic drug market and is generating double-digit growth as the #2 player in China, and is one of three fully-diversified ophthalmic drug players.

Santen is still pondering its strategy for the U.S., but could see multiple introductions for retinal disease and glaucoma into the world's largest ophthalmic drug market over five years.

With decent revenue growth and margin leverage driving potential double-digit FCF growth, Santen looks undervalued today even with high discounting on the opportunities in retinal disease.

Ophthalmology doesn't really get much attention from most drug companies, and I suppose I can't blame them - the entire global market is estimated to be worth around $25 billion in 2017 while Celgene's (NASDAQ:CELG) cancer drug Revlimid annualizes close to $8 billion in sales alone. In other words, relative to the opportunities in disease categories like cancer and auto-immune, it's not necessarily a huge moneymaker. Nevertheless, just because the space doesn't have broad appeal doesn't mean that there aren't money-making opportunities, and I think you could argue that the avoidance of the area works in the favor of companies like Japan's Santen Pharmaceutical Co. Ltd. (OTCPK:SNPHY).

While Santen's U.S. ADRs have decent liquidity, I don't think many investors pay much attention to this company, even though it is one of only three companies in the world with a full range of ophthalmic drugs. With the company holding strong share in Japan and China, building its business in the EU, and about to enter the U.S., I believe Santen could be looking at some meaningful growth opportunities in the coming years that aren't fully reflected in the share price.

Focused And Building From Local Leadership

With the sale of autoimmune drug assets ("anti-rheumatics") back in 2015, Santen became a pure-play on ophthalmic drugs and one of only three companies in the world (including Novartis (NYSE:NVS) and Valeant (NYSE:VRX)) to offer drugs across the spectrum of ophthalmic disease. While internal drug development has been important to Santen, the company has also been a relatively enthusiastic in-licensor of drugs, including the Japanese rights to wet AMD treatment Eylea, which it licensed from Bayer (OTCPK:BAYRY) and launched back in 2012.

Santen has established itself as the leading ophthalmology player in Japan, with approximately 45% share as of the last quarter. Novartis and Senju (which has a relationship with Valeant/Bausch & Lomb) are Santen's prime competitors in Japan, but neither is even half the size of Santen in market share terms. Santen has also become increasingly global, as it is the #2 player in ophthalmic drugs in China (behind Novartis) and the acquisition of ophthalmology drug assets from Merck (NYSE:MRK) a few years ago accelerated the company's expansion in Asia and the EU.

Eylea is far and away the biggest driver for Santen today, as it is not only nearly a quarter of revenue, but also a strong grower (up 13% in the last quarter). Cosopt, a drug for glaucoma, is about half the size of Eylea in terms of revenue contribution and is a solid grower as well, while Hyalein, Tapros, and Cravit (drugs for corneal disease, glaucoma, and infections, respectively) are collectively about the size of Eylea and only Tapros grew in the last quarter.

Looking To The Pipeline

Santen has several drugs in development that could make a meaningful difference in its sales outlook. One of the complicated factors with looking at Santen's pipeline is that it develops multiple drugs for multiple markets (Japan, the EU, the U.S., China, and other countries), but doesn't always look to develop drugs for all of the markets it serves.

The lead drug in the pipeline now is Opsiria, a formulation of sirolimus for uveitis. Santen is developing this drug for all of its target markets, with a U.S. filing expected this month and an EU filing expected next year. Unlike AbbVie's (NYSE:ABBV) Humira, Opsiria's effects are localized (not systemic), which reduces side-effects, and its lower cost of manufacture means it can be priced lower than Humira. Unfortunately, there's a "but" here - while the first U.S. Phase III trial was a success, the second failed to reach statistical significance. Santen is going forward with a filing based upon pooling the two trials together, which shows statistical significance (a p-value of 0.038), and the company claims the FDA is on board with this strategy. I think there's above-average risk that the FDA demands another study, though, so I've discounted the likelihood of success to 50/50.

Behind Opsiria, the most significant products are two candidates for wet AMD and three candidates for glaucoma. Both of these are significant markets, with the wet AMD market estimated to be worth around $7 billion today and glaucoma worth a similar amount. DE-122 is a endoglin antibody for wet AMD licensed from Tracon (NASDAQ:TCON) still early in development while DE-120 is a Phase II dual inhibitor of VEGF/PDGF wholly-owned by Santen. In glaucoma, the company has licensed a first-in-class EP2 agonist from Ube (OTCPK:UBEOY) (DE-117) and a first-in-class EP3 agonist from Ono (OTCPK:OPHLY) (DE-126), but it doesn't seem at this point as though advancing DE-117 in U.S. studies is a major priority. The company has also acquired a surgical product, MicroShunt (or DE-128), that lowers intraocular pressure by allowing aqueous humor to drain; the product is approved in the EU and in Phase III studies in the U.S.

A Careful Approach To The U.S.

Santen currently has no real presence in the U.S.; the company tried back in the early 2000s and struggled to make any headway. While the company could be in position to launch Opsiria in the U.S. in 2018, the company has yet to announce its new sales strategy. While many options are under consideration (a wholly-owned sales force, co-promotion, or out-licensing), I suspect that the company will take a hybrid approach. It likely makes more sense to use a contracted sales organization or a limited co-promotion arrangement at first, with the company slowly building a proprietary sales force and then expanding if/when compounds like DE-120, DE-122, and DE-126 achieve clinical results that suggest approval/commercialization is likely.

It is also possible that the company could turn to M&A to accelerate its growth plans in the U.S. (and globally). While there is no way Santen could hope to acquire Bausch & Lomb, Valeant may still need to consider select product divestitures to improve liquidity. What's more, if changes to the healthcare market in the U.S. encourage another wave of consolidation, Santen could be an opportunistic acquirer of assets (as likely would have been the case if Allergan (NYSE:AGN) and Pfizer (NYSE:PFE) had consummated a deal). Even if these opportunities don't pan out, there are ophthalmic drug programs or indications that come available every so often that Santen can consider.

The Opportunity

Success in the wet AMD market with an internally-developed drug would give Santen a big boost, but it's not my base-case assumption at this part. The wet AMD market is the notable exception to the rule that Big Pharma isn't so interested in ophthalmology, as companies like Roche (OTCQX:RHHBY), Regeneron (NASDAQ:REGN)/Bayer, and others have a market presence or clinical program here. This interest level is not hard to understand; Roche's Lucentis is a nearly $1.5 billion drug in the U.S., and the wet AMD market could more than triple over the next decade.

There are other operational challenges to consider as well. While China is a growth market for Santen (local sales were up 17% in the last quarter), the country is implementing strategies to manage drug prices. Japan, too, is a tricky market - a full exploration of the Japanese drug pricing system is beyond the scope of this piece, but suffice it to say it is a market where the government has significant influence. Fortunately for Santen, Japanese government policy has been rather benign for it and the threat of generic competition is less significant.

I'm looking for mid-single-digit long-term growth for Santen, as I expect growth in China and expansion into the U.S. to offset the weaker underlying growth potential in Japan (an aging, but not growing, population with increasing concerns about drug price control). Major clinical success in wet AMD could certainly offer upside, and clinical trial failure is always a risk to pharmaceutical company revenue projections. On the margin side, I expect the company's growth to support eventual FCF margins in the high teens to low 20%'s, supporting mid-teens FCF growth.

Discounted back, those cash flows suggest that Santen shares are undervalued by around 10%, and there could be upside given my heavier discounting of Opsiria and the wet AMD pipeline. I would also note that Santen could hold appeal as an acquisition candidate, though more likely for another Japanese pharmaceutical company as U.S. and EU drug companies haven't historically been eager to acquire in Japan.

The Bottom Line

I think Santen looks like an interesting opportunity. The ophthalmic drug market is growing at a mid-single-digit rate and Santen has a rare degree of diversification across the category. What's more, the company hasn't even begun to tap the potential of the U.S. market - a market that represents about a third of the global ophthalmic drug market. With the potential for above-average sales growth, margin leverage, and double-digit FCF growth, I think Santen is worth a closer look today.

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Disclosure: I am/we are long 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.

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