Synergy: Why The Downgrade?

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Summary

Synergy received a downgrade to “Sell” from “Neutral” by Citigroup analyst Liav Abraham, who said its acquisition by another firm is "unlikely" and that Trulance sales will "likely disappoint.".

The commercialization process Synergy has identified is admirable, but the question remains whether the company has the capabilities to fully commercialize its products.

The evidence suggests a late-to-market entry impact on effective commercialization and attaining peak revenues.

The adaptive commercialization process employed by Allergan for Linzess should offer a learning lesson for Synergy’s management.

Background

I would be remiss in not stating clearly at the onset that I am well invested in Synergy (NASDAQ: SGYP). How I got there was through effective research, as I am certain is true of many. In my research it became clear there are issues with Synergy, as there are with all companies. Given my experience with M&A, I bring an informed opinion, one where reality (most often) triumphs over hope. So it is that I offer a view of some of the realities Synergy is facing. It does not offer a glowing account, but seeks a balanced perspective. We should begin the discussion with the question of Citigroup's downgrade of Synergy.

I would begin with the argument offered that Citigroup's position is tempered by an alleged conflict of interest. This was raised as an explanation for what seemed a contrarian, if not unsupported position that is inconsistent with that of other analysts. However, as an investor I must irritatingly admit the issues raised in the downgrade might not be all that illogical when we consider that Citigroup's investment in Allergan (NASDAQ: AGN) is about 33 times that of its investment in Synergy. This begs the question - Is this a conflict of interest or a legitimate call?

Think about it. To invest in Synergy is simply to invest in its product line for CIC, IBC, and OIC. However, an investment in Allergan is about more than Linzess, it is about its marketed drugs, successful pipeline and growth through acquisitions. It is about having confidence in a global operation that exists in more than 100 countries that includes: forty manufacturing facilities, twenty-seven R&D and marketing centers, and a plethora of products that include twenty-four blockbuster drugs; all combining to garner $15 Billion in annual revenues. How does that compare to Synergy's revenues? Well, we do not know because Trulance will be Synergy's first revenue generating product.

Clearly this raises the question as to whether the opinion expressed by the Citigroup analyst holds gravitas. But to be fair, in 2013 Ms. Abraham initiated coverage and said she expected the company's constipation drug, Plecanatide (Trulance), to reach the market in 2016 (it did, barely), with forecasted peak sales of $550 million a year (to be clear, peak sales occur close to year five…keep this in mind if you read further).

Adding to the credibility of the downgrade, Ms. Abraham stated on September 16, 2016 that she believed Synergy's cash hoard of $140 Million was not enough to successfully position Trulance against Linzess in a competition for market share.

Notice the language used? It matters. "Successfully position" does not mean Trulance is incapable of getting revenues. Clearly it will be able to do that in the near term. Rather, the issue is about the ability to compete longer-term. This is an important distinction and one of greater concern because it is questioning whether a small company can successfully compete against a larger company, one with far greater capabilities.

The two issues raised in the downgrade

Again, the issues were: 1) Synergy's acquisition by another firm is "unlikely" and, 2) Trulance sales will "likely disappoint."

Regarding the first issue, whether it is "unlikely" any company is interested in acquiring Synergy, the simple reality of M&A is that one cannot know the future or the strategic intent of pharma companies seeking to grow through acquisitions due to patent cliffs and lower R&D investments.

And, while partnerships are inherently less risky, to suggest a lack of interest in a company seeking to compete in a growing and transitional market, while in possession of one FDA approved product and another NDA just filed, defies reality.

To that end, according to McKinsey's analysis on M&A (December 2015), there are five types of successful acquisitions that can create value in one or more of the following ways: 1) improving the performance of the target company, 2) removing excess capacity from an industry, 3) creating market access for products, 4) acquiring skills or technologies more quickly or at lower cost than they could be built in-house, and 5) picking winners early and helping them develop their businesses. And, by the way, picking winners early does not always mean acquiring before an FDA approval. Companies experienced with M&A recognize there is risk mitigation that comes from waiting.

Further impetus for M&A was found by the analysts at Deloitte, who have calculated the return for drug company R&D dollars and found it continues to dwindle. Their latest numbers crunching for the world's top 12 pharma companies concludes that ROI on their cash investment in development has shrunk to 3.7%, the lowest level to date, after hitting 10.1% in 2010. Moreover, peak sales per drug asset fell 11.4% year over year since 2010.

Moreover, since 2013, pharma companies have seen a steady decrease in the proportion of projected late-stage pipeline revenues derived from internally sourced products. This decrease in returns highlights how companies are struggling to replace pipeline value through self-developed products.

Consequently, Trulance would clearly fall into a couple of the McKinsey buckets and provide the synergistic value expected from a strategic acquisition (pardon the play on words).

On the basis of facts that argue a bigger firm might be interested in a company with commercial value, I would argue that Synergy would be a logical acquisition target. Although we know there has been no formal offer made to Synergy, or we would know about it, it is not a foregone conclusion there will not be one forthcoming.

The next issue mentioned in the downgrade was that the commercialization of Trulance will "likely disappoint." Given the growing and changing market, there are concerns that commercialization requires capabilities beyond that which Synergy possesses. So, it is possible Trulance revenues just might disappoint. Consequently, this point requires a bit more discussion

The Market Competition

A new entrant into a product market is affected by the size and growth of the market, as well as the timing of market entry and, while a later entrant can still achieve success and benefit from the consumer education provided by the earlier entrants, the longer a first-in-class drug has to establish a standard of care, the greater the market-share advantage.

We need to state the obvious, that a lead-time of three years or more (think Linzess) offers a fairly sizable disadvantage to a later entrant, even in a growing market. And, that disadvantage is even greater when a small company is chasing a larger and more experienced one.

Nonetheless, Synergy is not facing a well-entrenched market that requires stealing share from a large number of competitors. Rather, this is a market at a tipping point, where the move is away from old-line over-the-counter (OTC) products toward more efficacious, prescriptive products for CIC and IBS-C. As to that market, roughly ninety-five percent (95%) is currently served by fiber supplementation (e.g., Metamucil, Citrucel, Fibercon) and laxatives (e.g., Milk of Magnesium, Fleet enema, Lactulose, Miralax, Senna, Colace, Dulcolax). Only five percent (5%) of the market is from prescription medicines, specifically: Amitiza, developed Sucampo (NASDAQ: SCMP) - approved in 2006 and partnered with Takeda (OTCPK: OTCPK:TKPHF), it is taken twice a day and marketed for IBS-C, CIC, & OIC, with US net sales of $129 Million in 2016; and Linzess, developed by Ironwood Pharma (NASDAQ: IRWD), approved in 2012 and partnered with Allergan (NASDAQ: AGN), it is taken once a day, preferably before the first meal of the day, and marketed for IBS-C and CIC, with US net sales in 2016 of $626 Million.

A little awareness of Linzess as the product leader for the currently small but competitive arena of prescribed drugs in the CIC/IBS-C market is key to understanding the challenge of commercialization.

Linzess was discovered by Ironwood and developed in partnership with Forest Labs, which was acquired by Actavis in July 2014. And, to continue the concept of growth through acquisitions, Actavis bought Allergan in March 2015 and, in what was a reverse merger, assumed their name and domicile in Ireland. This is an important factoid to consider because Linzess was slow to garner revenues following the 2012 agreement between Ironwood and Forest Labs. In 2013, the first year of sales, total revenue growth from Linzess was about $117 Million.

However, a strategic change in marketing was made that enabled the move away from the sole reliance on sales reps and more on direct to consumer advertising (DTC). This was a successful decision because by 2015 Linzess had grown 3.8 times, to annual revenues of $445 Million. In 2016, robust growth continued, as Linzess managed to bring in $626 million in U.S. sales for the full-year, a 40% increase YOY. In sum, this means Linzess increased revenues about 5.4X within four years of approval; well within the remaining time on their patent life and consistent with the 3-5 year projections for most peak revenues.

In the belief the best is yet to come courtesy of their adaptive move to DTC advertising, Ironwood and Allergan tout Linzess as having the potential for $2 Billion in annual sales, as it carves out further space from the over-the-counter palliatives. This brings us to the issue of peak sales, a concept that is often misunderstood.

(Author update, 11.48 A.M.) (Please note: A change in the patent life for Trulance was announced. Consequently, I offer this amendment and note that, accordingly, the USPTO has issued three new patents covering CIC med TRULANCE (plecanatide). The patents pertain to methods of manufacturing, methods of use and formulations. The manufacturing patent will expire on March 1, 2032, and the other two on September 15, 2031. This is wonderful news for the company, as it increases its peak sales opportunity. It is also another line of negotiations for their acquisition, as it informs the reality of peak sales.)

The Reality of Peak Sales

Peak sales are an important metric in the pharmaceutical industry and companies spend time and money on strategies to focus on the height of peak sales and the time required to achieve peak sales.

First to market companies have the burden of market education and this makes it longer for them to achieve time-to-peak sales; an important factor that creates the kind of cash burn more easily managed by Allergan than Synergy. One important benefit of being first to market that creates a barrier for followers is the first product to enter establishes brand recognition tied to the product. First to enter also benefits from attaining a longer period of time-in-peak sales.

Some clarity on peak sales was offered in an article in the January 2017 issue of "Nature Reviews: Drug Discovery" that contains projections for forecasting pharmaceutical sales in the US market.

Relying on unit sales for sixty-one innovative drugs receiving FDA approval, the authors determined that the median product follows an increasing percentage from launch-to-peak sales, achieving: 11% of peak sales in Year 1, 31% in Year 2, 58% in Year 3, 76% in Year 4, 89% in Year 5, and 100% (i.e. peak sales) in Year 6 (the magical fit to the average of 14 years from patent to approval). If we believe the above, Synergy should recognize that, as competition, neither Linzess nor Amitiza have yet to achieve peak sales and this makes the process of gaining market share harder for Trulance.

Time-to and time-in peak sales differ across brands introduced into different drug categories and countries due to a range of factors. But it remains that late entrants should expect shorter time-to but lower levels of time-in peak sales; a matter that must be considered when comparing Trulance to Linzess or Amitiza. Still, this effect may be moderated by other variables such as quality; which is considered to be the most important driver of new product success.

Whether or not Trulance is a higher quality product than its competition for prescription sales, it remains that quality brands achieve peak sales earlier and their peak-sales levels are higher.

Quality also has a positive effect on reducing time-to-peak-sales and extending peak-sales levels. In fact, adoption will be faster for products with a perceived quality advantage. Consequently, high-quality brands face lower adoption barriers leading to shorter time-to-peak-sales, as buying resistance is much lower due to a belief in quality.

The interpretation of what it means to be a high-quality brand should not be lost on a small pharma/biotech firm like Synergy, as it seeks to fight its way into the competitive marketplace and commercialize on its own.

Yet, being small and unknown can infer a lack of quality, born of some judgment the firm lacks either experience or capabilities. To make matters worse, according to the McKinsey research, smaller drug companies tend to overestimate arrival at and amount of peak sales by more than thirty percent (30%). As if not enough of a constraint, the drug industry has not yet adjusted its launch approach to the new competitive realities. One indication of this is research by Bain that shows about half of all launches that arrive at the peak sales range timeline not only miss expected sales levels they miss them by fifty percent (50%) or more. Can we expect Synergy to be any different?

Conclusion

Over the last two years the costs of launching a new drug has remained near where it was during the heyday of the blockbuster, about $1.54 billion; with the total development costs (including cost of failures) elevating the number to $2.6 Billion; 14.5 times more expensive than the 1970s and about thirty percent (30%) above where they were six years ago. Exacerbating the issue of cost is that the average forecast for peak sales of an asset declined by 43%, dropping from $816 Million in 2010 to $466 Million in 2013.

Some have argued that the time remaining on the Trulance patent (roughly 6 years) is too short to achieve effective commercialization and enable robust peak revenues. This fails to grasp the realities about the average time it takes to gain FDA approval for a novel drug is 14 years. Given the twenty-year patent life and absent the FDA granting exclusivity, this leaves an average of 6 years for commercialization without competition from generics - the exact position Trulance finds itself in. Although I would agree that this is not the longer runway that investors may have expected, it remains that this is the average for approved drugs. So, the argument is not about time left on the patent and more about the effective commercialization by Synergy of their FDA approved novel drug, Trulance.

There is a general belief that many acquisitions occur before a catalyst like an FDA approval of a novel drug because it reduces the upfront costs to the acquirer. But, it would be folly to fail to recognize that some bigger pharma firms like to see risk reduced by the proof of concept that comes from having the FDA approve a product. And, firms experienced in M&A pay attention to commercialization because a mediocre outcome can reduce the price they will pay for an acquisition.

As a result, caution should be exercised when suggesting a comparison of early Trulance sales to those of Linzess is an accurate forecast for the longer term. To that end, I would remind the reader to recognize that the big jump taken by Linzess from Year-1 to Year-4 was due to a change in market strategy rather than sheer hard work by sales reps in the field. Although Trulance might be seen as having comparable sales to Linzess over the first quarter or even the first year into the commercialization process, it is imperative to recognize that what enabled Linzess to catapult forward was the result of a smart, adaptive, clear-eyed and deep pocketed marketing prowess by Allergan, as it shifted to a direct-to-consumer approach. Allergan has the money and institutional knowledge to do that. Synergy does not.

Come on Synergy, get real and get acquired.

Disclosure: I am/we are long SGYP.

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.