March 28, 2010 - 4:13pm EST by
2010 2011
Price: 5.26 EPS $0.40 $0.18
Shares Out. (in M): 54 P/E 13.0x 29.0x
Market Cap (in $M): 287 P/FCF 13.0x 29.0x
Net Debt (in $M): 0 EBIT 10 10
TEV ($): -18 TEV/EBIT 0.0x 0.0x

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When a company announces three transformative corporate events in less than two quarters that impact the income statement and balance sheet, it's possible for Mr. Market to miss the boat, especially when one of those announcements signals the end of a highly punitive 10 year IP litigation and removes a significant overhang from the stock. QLTI is such a company and now  sits as a misunderstood and under-appreciated opportunity with quality downside protection and optionality on the upside.   As we all know, there is downside protection and there is downside protection. The best form  is obviously an EV trading below cash or equivalents with limited or no cash burn.  We think there is confusion surrounding  QLTI's recent $230mm sale of its subsidiary QLT USA which is carried on its balance sheet as a contingent consideration with an NPV of $150mm ($2.80/ share) . Combined with the cash on its balance sheet as of 12/31/2009 of $188mm ($3.30 / share), QLTI has over $6 of value vs. a stock price of $5.26  before giving any credit to their residual share in Visudyne ($100mm run rate sales) and their clinical pipeline which includes their highly differentiated and first in class punctal plug program.   


To fully appreciate where QLTI sits today and how it ended up with its strong financial position and a management dedicated to shareholder friendly capital allocation,  it is necessary to briefly go into the history of the company.   QLTI  began as small Canadian biotech specializing in ocular therapeutics.  In 2000, QLTI received FDA approval for Visudyne, a breakthrough treatment for the wet form of age-related macular degeneration (AMD), which they sold worldwide with their alliance partner Novartis. Today, Visudyne has been used in more than two million treatments worldwide.  Visudyne sales peaked in 2005  when it was discovered that Genetech's  Lucentis also worked in AMD and sales declined to their present run-rate of ~$100mm.  To make matters worse, in April 2000, the Massachusetts Eye and Ear Infirmary  (MEEI) and the Massachusetts General Hospital (MGH) sued QLTI for patent infringement for certain inventions relating to the use of Visudyne .  Almost a decade later, on January 12, 2009, QLTI was forced to pay  an aggregate of $127 mm to MEEI and  was potentially liable to MGH for the same amount because MGH alleged that it entered into a written agreement with QLTI that required them to pay MGH the same amount that they paid  MEEI on sales of Visudyne. On November 24, 2009, the case was settled by the parties and QLTI  paid MGH an aggregate $20.0 million. Given that a negative verdict in the MGH case could have been highly damaging, especially after the MEEI judgement, the fact that QLTI was able to exit the whole mess and still have $188mm on its balance sheet, was a major accomplishment.  Though QLTI's stock has appreciated since the favorable verdict, the risk/reward is much better without the threat of potentially losing half their cash balance.

Back to the story. Perhaps anticipating the decline in Visudyne, in 2004 QLTI completed a merger with Atrix Laboratories Inc., which became  QLT USA, Inc.,  in order to gain a new portfolio of therapeutics including Eligard, a treatment for advanced prostate cancer and Aczone a novel treatment for acne, as well as Atrigel a drug delivery technology. But this effort was short lived, and in 2006, QLTI revised its business strategy to streamline its focus, divested its generic dermatology and manufacturing business, and set out to become  an ophthalmology-focused company,  leveraging  its solid financial position to build a new pipeline of products and establish a commercial presence in the ocular space. 


As part of this multi-year corporate overhaul,  in October of 2009, QLTI announced that it had restructured its partnership with Novartis to simplify their relationship. Under the   restructuring, QLTI was given  exclusive U.S. rights to Visudyne  including rights to all end-user revenue derived from Visudyne sales in the U.S., while Novartis retained marketing and sales rights outside of the U.S. and agreed to pay QLTI a royalty of 20% of ex-US net sales.  Under the agreement  QLTI will continue to manufacture Visudyne and will supply the product at a pre-specified price to Novartis for ex-US distribution. 


The market seemingly ignored this event but the implications are favorable for QLTI because the restructuring will allow QLTI to directly influence Visudyne sales in the U.S. by establishing a small focused sales force centered on retinal specialists. Previously, Novartis was responsible for sales and marketing and they had increasingly ignored and even stopped supporting the product in the US( QLTI might have had legal recourse and we believe this is why they were able to sign such a strong deal).  Through the deal, QLTI  transformed itself overnight into a company with a sales force with 100% share of the US economics and the potential to add products down the line, i.e., their punctal plug program when it becomes marketable.  Also, previously without a commercial presence, it was virtually impossible for QLTI to be considered as a potential partner for later stage ocular products but now they have the potential to bring in other technologies to fuel future growth. For 2010 US sales guidance is $27mm to $31mm and worldwide sales guidance is $90mm to $100mm, generating total Visudyne revenues of $47mm-$53mm with cost of sales between $15mm and $17mm for a gross contribution of $32mm - $35mm.


Though we are not depending on it, we think Visudyne might even begin to grow again.  In on-going clinical trials QLTI has shown  that taking  Visudyne in  combination with Lucentis results in a statistically significant reduction in the number of Lucentis treatments, i.e half the number of treatments for the same effect.  The manuscript from trial  has been submitted to a leading peer-reviewed journal and data was presented at the  American Academy of Ophthalmology Meeting in 2009.  At the very least,  Visudyne is going to have a market  for Lucentis failures or patients who are resistant to Lucentis.  But given the cost and patient burden of Lucentis -- each treatment involves a painful injection into the back of the eye whereas Visudyne is injected into the body followed by a brief <1min laser therapy -- there is a very strong pharmo- economic case to use combo therapy. Again this would just be gravy but could be a source of incremental growth.


There's a sound principle in biotech investing that if you are going to spend the money for drug development it  should at least be a huge opportunity with little competition. QLTI's  Punctal Plug Delivery System (PPDS) has the potential to address a broad range of ocular diseases that are currently being treated with eye drops.  QLTI's punctal plugs, in contrast to currently marketed plugs, contain a  drug eluding core that slowly releases medicine into the eye.  QLTI's lead program focuses on  glaucoma, a $4 billion market, where there is a great need for alternative treatments because compliance is so poor. The onset and progression of glaucoma is asymptomatic and consistent administration of eye drops has proven to be exceedingly burdensome for patients, as nearly 50%  discontinue treatment  within 6 months.  Left untreated , glaucoma is irreversible and leads to permanent vision loss.  

QLTI's device slowly releases a highly concentrated form of the drug  Latanprost  into the eye for a 3 month period. If proven successful it would obviate the need for drops.  The plugs are inserted in a simple,  in-office, minimally  invasive procedure.  QLTI is also working on a detection device that will allow patients to detect if their plug has fallen out.   To some extent,  the whole development process is de-risked  because QLTI  is using already marketed drugs. The plug program has faced two major challenges  to date, plug retention and efficacy. Unlike other classic drug development programs, though,  punctal plugs are more of an engineering problem: the plug is extremely small and  very narrow and it needs to hold enough drug to last for three month without causing the patient discomfort (management is shooting for 90% retention after 3 months).  In their most  recent conference call QLTI reported very encouraging data: the third generation prototype achieved 81% retention after three months. The significance of these data cannot be underestimated as this is the first time in 2 years that they have even gotten close to their internal target of 90% retention.   Also they are getting very close to achieving their goal of about a 5 millimeter or 20% overall reduction in intraocular pressure. Such a reduction  from baseline would be clinically meaningful and  enable them to place this as a first-line therapy for the treatment of glaucoma. It is important to note that they are only using about 70% of the equivalent eye drop dose given over the same period of time so there is still room to show further improvement.

Even if the punctal plugs do not work in glaucoma, management feels that the program is far enough along to  move to other molecules such as olopatadine. This drug is used to treat allergic conjunctivitis, and the overall allergic conjunctivitis market is large with  about 50 million people just in the US who suffer from allergic disease. The leading product in the category is made by Alcon and US. sales last year were about $380mm. The olopatadine punctal plug delivery system is targeted to be a six week product and QLTI has already achieved  a retention rate at eight weeks of  86% and at   four weeks of 93%. So it's likely that they will have about 90% plug retention for the six-week product profile.  Moreover because of the shorter duration,  they can get a higher drug dose per day and unlike glaucoma they only need to deliver the drug to the surface of the eye.  In other words, the  punctal plug program is not subject to a binomial outcome as there are many different indications where it could show efficacy.

QLTI has two other early stage products in its pipeline. First, a  synthetic retinoid compound being developed for the treatment of Leber's Congenital Amaurosis, an inherited progressive retinal degenerative disease that leads to retinal dysfunction and visual impairment beginning at birth. It is a  small orphan indication and they expect to complete phase 1b in 2010.   Their second product  was acquired from Othera Pharamactucials in December of 2009 for $7mm. All we can say is that the drug is for glaucoma and management said they were able to get it on the cheap.

In October of 2009  TOLMAR Holding agreed to purchase QLTI's subsidiary QLT USA which included the Eligard line of products in a deal worth up to an aggregate of $230 million.  Instead of an outright sale, it was a very shareholder friendly deal as it allowed QLTI to receive 80% of their previous Eligard royalty revenue on a tax-free basis until either the earlier of 2024 or until they receive $200 million in aggregate royalty payments. This allows them to still benefit from the product growth of Eligard and earn $200 million in royalty revenue. Given the nature of the transaction, the sale price does not show up as cash on their balance sheet  and the quarterly cash payments   do not appear as revenue on  the P&L. Rather, the balance sheet has an  asset called contingent considerations which is split into short term and long term that reflect the estimated present value of the expected cash payments. As they receive the payments each quarter, the asset is drawn down. Also, on a going forward basis the company will asses the fair value of the contingent consideration which could change at anytime based on material changes in sales projections or in changes in the discount rate used.  Given the product profile of Eligard, which is still growing at a double digit rate, we are confident in the current valuation.   As of 12/31/2009  the current contingent consideration is listed at $34mm and the long-term contingent consideration is listed at $117mm for a total NPV of $150mm ($2.80 / share). Taking QLTI's current  market cap of $287mm and subtracting  cash of $188m  and subtracting  long term contingent consideration of $117mm results in  a  -$18mm TEV, ascribing less than zero value for Visudyne and QLTI's numerous clinical programs.  It would be one thing if this entity was burning cash  but management has guided that they expect adjusted EBITDA plus current contingent consideration will be $10- $15mm  for 2010 and they don't expect to pay any cash taxes in 2010.  We would expect a company with QLTI's profile to  trade conservatively at 6x EBITA  or a stock price of ~ $6.70 after adding back the cash and long term contingent consideration. Success in any of its clinical programs would make the stock move much higher, possibly even doubling.

Another way we like to look at QLTI's valuation / earning power is to evaluate what  earning power would look like  without the R&D spend on punctal plugs. For 2010 QLTI has guided for an R&D expenditure between $33-37mm.  Based upon conversations with management we estimate that over 75% of this spend is for the plug program given that most of the clinical trials for Visudyne are completed and their other programs are very early stage. Management has said that if they cannot advance the punctal plug program to the point where they are ready to take it into phase III testing they will end the program. We personally think this is unlikely given that even if the glaucoma program fails, they will try the plugs in other indications. But nonetheless just to get a sense of QLTI's earning power it is worth it to go through the exercise. In 2010, for example, EBITA without punctal plug R&D would be in the range of $36mm - $41mm.  At 6x EBITA that would result  in a stock price of ~$9.60. Again we don't think this scenario is likely but it does uncover how much they can earn relative to the current valuation. 

It's rare to find such a high quality opportunity trading at a negative EV but given how much QLTI has been through during the last ten years, in general, and what has transpired over the last two quarters, in particular,we see how the market has missed this one, especially since the strength of its balance sheet will not show up on  simple screen for cash.  We especially like the fact  that management has been an aggressive buyer of their own stock at depressed levels and anticipate future buybacks though not at the same pace as 2009.  When all is said and done, QLTI represents a very safe investment with the potential for asymmetric reward on the upside.



-stock buy backs

-data from punctal plug program, visudyne combo trials, and early stage clincal assets

-first full year of clean P&L in ten years


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