Penwest Pharmaceutical PPCO W
November 07, 2002 - 7:12pm EST by
kurran363
2002 2003
Price: 8.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 123 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

I believe this is one of the best "high volatility" risk/rewards I have seen in some time. I posted this idea over a year ago. In that time, almost everything has worked out as planned, except PPCO’s stock has gone down, along with the rest of the market.

Penwest Pharmaceuticals Co. is engaged in the research, development and commercialization of novel drug delivery technologies. Based on its fundamental expertise in tabletting ingredients, the Company has developed its proprietary Timerx controlled-release drug delivery technology, which is applicable to a broad range of orally administered drugs. The Company is utilizing the Timerx system to formulate generic versions of branded controlled-release drugs, controlled-release formulations of marketed immediate-release drugs and New Chemical Entities.

The Problem:
The stock has been under pressure for two main reasons lately. First, it has fallen along with the broader market and more specifically with the bio-tech market, which has gotten crushed. Second, PPCO was viewed as not having enough cash to get through til their big drug hit the market. The fear of a dilutive stock offering pushed the stock down. As the stock fell, the dilution problem obviously appeared to get even worse and became a self-fulfilling cycle. The result is a severely depressed stock.

The Solution:
PPCO recently announced a transaction to sell their Excipients business for $42mm ($2.70/share). This sale is fantastic news. PPCO now has enough money to complete their R&D projects and the threat of dilutive stock offerings is gone.

The Opportunity:
PPCO’s other business is a new drug pipeline, primarily utilizing their patented Timerex technology. Timerex is a patented oral controlled-release technology that allows drugs to be released into the body at varying rates. The process is much more simple and cost-effective than most currently available controlled-release processes.

Their strategy is to formulate generic versions of branded controlled-release drugs, controlled-release formulations of marketed immediate-release drugs and New Chemical Entities. Generally, they will partner with another drug firm in producing these new drugs.

Theoretically, most immediate-release drugs could be re-formulated to take advantage of the benefits of a controlled-release system. The opportunities for the technology are large.

Pipeline:
The key to this investment is PPCO's Oxymorphone drug. They have a 50/50 joint venture with ENDP (Endo Pharmaceuticals). The drug will compete in the moderate to severe pain area. It will compete against other controlled-release opiod pain medications.

At this point, Oxymorphone has already successfully completed all clinical trials. Yes, done with all trials! Results of one large phase III study were released a few weeks ago and the drug performed at or above all expectations. You can read the press release yourself, if you’re interested. The results were even better than most people expected. Full results from all trials will be announced in about 3 weeks.

PPCO also has two anti-hypertension drugs in clinical development. The first drug is a reformulation of an existing therapy and is eligible to be filed by a 505(b)(2) NDA application. Such an application requires that only pivotal Phase III efficacy trials need to be conducted. I expect this molecule to enter Phase III testing during 1Q03. The second molecule is a novel combination anti-hypertensive therapy that should enter Phase II during 2H03.

PPCO also a small royalty stream from a drug currently on the market, Nifedipine XL. In addition, PPCO has eight other drug partnerships at various stages of development. Either these drugs will materialize and build value or they won’t. Because PPCO has not gone into much detail on any of these, it is difficult to quantify them.

Because PPCO tends to focus on “re-developing” existing drugs using their patented technology, their R&D efforts tend to be very low risk and success rates tend to be very high.

Oxymorphone:
Currently there is only one drug that dominates the controlled-release opioid pain market -- Oxycontin (by Purdue Fredrick). Oxycontin is a $1.5 billion drug.

The opportunity here is two-fold: 1) Oxymorphone should be able to compete in an enormous arena (pain management) simply by being a new drug in a relatively uncompetitive market, and 2) and more importantly, Oxymorphone overcomes some of the serious problems of Oxycontin.

Despite doing $1.5 billion in sales, Oxycontin currently has a serious publicity problem. Thousands of people in the US are addicted to it. Addicts say it is better than herione. For about a year, there was a story in some newspaper, including a cover story in Time, in the US almost every week about the problems of people dying from over-doses of this drug. Some local politicians in the south called it an epidemic and there was even talk of banning the drug completely by some. Some doctors have even been sued for prescribing it, after their patients over-dosed.

Yet despite all the negative publicity, and despite doctor reluctance to prescribe it, Oxycontin still does $1.5 billion in sales. The reason is simple, demand for pain medication is huge. Oxycontin is also currently the only real alternative for a strong oral time-release pain medication.

The broadly defined pain treatment market is over $13 billion per year and has been growing 25%+ per year. However, almost the entire opioid analgesic market is generic. There have been NO NEW OPIODS invented in over 20 years! The market would probably be 4-10x bigger if it was "branded," so for new branded drugs, like Oxymorphone, the opportunity is equivalent to a $50-$100 billion industry.

Why approval of Oxymorphone is almost guaranteed:
1) Oxymorphone has already been approved. Oxymorphone is currently on the market and has been for many years under the name Neumorphan. However, it is only approved for suppository form, so sales are very small. The fact that Neumophan has already been approved and is proven to work makes an FDA approval almost a sure thing. The only real issue is the new delivery mechanism, Timerex, which has also already been approved, in other drugs.

2) Clinical trials are already done and the data was excellent.

2) Oxymorphone solves some of the most serious problems of Oxycontin. Namely, Oxymorphone’s Timerex technology makes it more difficult to abuse than Oxycontin. Unlike Oxycontin, it cannot be dissolved in water, so it cannot be injected. This is a major benefit since most serious drug addicts prefer to inject it. Also, snorting Oxycontin is another popular method of abuse. Timerex also makes this much more difficult.

The real issue amongst doctors and analysts I’ve spoken to is not whether the FDA will approve the drug, but rather whether the FDA will “fast-track” the drug.


Why Oxymorphone will be successful:
1) The primary reason Oxymorphone will be successful is that doctors who have been reluctant or afraid to prescribe Oxycontin will now have a much safer alternative. Doctors have been screaming for an alternative for years. Now they will have it.

2) Oxymorphone will be the first “new” opioid introduced in over 20 years. While not truly new since it already exists in supposity form, the oral formulation should attract much attention.

3) Oxymorphone could get some media attention as an alternative to the much reviled Oxycontin.

4) Their Partner on the drug, ENDP, already has a full sales staff that specializes in pain medication. ENDP will be able to market Oxymorphone will little incremental costs.

5) Oxycontin’s maker, Purdue Fredrick, has been trying to come up with a safer delivery mechanism for their drug, but do not have the technology. They are now estimating it won’t be on the market until at least 2005/2006.

Numbers:

After the recently announced transaction, PPCO will have about $3.50/share in cash.

Shares: 15.5
Price: $8
Market Value: $123
Cash: $55 ($3.50/share)
Adjusted Market Value: $68mm = $4.50/share

Projections:
Oxymorphone should be able to quickly take Oxycontin market share.

Assume a modest market share: 20%
Sales: $300mm
Gross margin: 90%
Operating Margin: 65%
After tax Margin: 42.3%
PPCO’s 50% share after tax: $63mm
EPS: $4.10

P/E (net of cash) = 1.1x


At 25% market share:
EPS: $5.12

P/E = 0.9x


Even if Oxymorphone only achieves a tiny 5% market share, PPCO would still be cheap:
EPS: $1.00

P/E (net of cash) = 4.5x

I think 4.5x worst case earnings is still way too low.

Another look at Valuation:

PPCO gets about $4mm per year in royalties from currently marketed drugs and license fees. I’ll ascribe a small 4x multiple to this stream. So its probably worth about $16mm, or $1/share.

Other drugs in development are difficult to value. A simplistic approach is to assume that the drugs are only worth the money spent on R&D to produce them. Due to PPCO’s low risk approach to drug development, and due to their proven Timerex technology, it is very conservative to assume the R&D produces no value. PPCO has spent over $50mm in R&D in the past 4 years. Assuming $25mm of that was spent on the drugs in the pipeline other than Oxymorphone, I ascribe a tiny $1.50/share to all pipeline drugs.

PPCO has about $4.50/share in cash now. While this will probably all be spent on R&D for new drugs, using the same assumption as above, it should produce at least $4.50/share in value.

That gives about $7/share in value, excluding Oxymorphone.

Thus Oxymorphone is being valued at only $1/share, or $15.5mm. For a potential blockbuster drug only one year from approval with successful Phase III’s completed, this is absurdly low.
The analyst at National Securities (October 16, 2002) values Oxymorphone at $13.40/share based on his DCF, which assumes a modest 15% market share by 2006. This is extremely conservative to me. My DCF assumes a 20% market share by 2005, and values Oxymorphone at about $30/share.

Conclusion:

I have never seen a pharmaceutical company with such a big drug that has already completed successful Phase III trials, trading this cheaply. I believe the timing is perfect right now, given the imminent release of the full trial data and the imminent FDA filing. The risks of non-approval are very low and the commercial opportunity is very high, yet the market is ascribing almost no value to this drug.

I know VIC members tend to be hate pharmaceuticals and tend to focus only on assets and current cash flow. However, on a true risk/reward basis, at this price PPCO is one of the best values I’ve seen in some time.

Catalyst:

PPCO will announce full results of the Phase III clinical trials in only 3 weeks.

ENDP will file an NDA with FDA at about the same time, in 3 weeks.

FDA should approve Oxymorphone in about 12 months. Could be faster if it gets “fast-tracked”.

I have heard that Castlerock Management, the second largest shareholder, has been selling their position due to fund related problems. My guess is that this has helped create the current opportunity.

Catalyst

PPCO will announce full results of the Phase III clinical trials in about 3 weeks.

ENDP will file an NDA with FDA at about the same time, in 3 weeks.

FDA should approve Oxymorphone in about 12 months. Could be faster if it gets “fast-tracked”.

I have heard that Castlerock Management, the second largest shareholder, has been selling their position due to fund related problems. My guess is that this has helped create the current opportunity.
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