Description

AVDL is a bet with asymmetric upside, given two relatively high probability business transforming shots on goal with two new drugs. Success on either of those fronts represents more than 50% upside from the current share price, and success on both could result in more than a doubling from the current share price. If the company misses on both drugs, the stock could trade from its current price of $7 to roughly 0.5x its base business sales, or around $2 per share – roughly 70% downside. That said, I think the chance the company misses on both shots on goal is substantially below 50%, creating the upside asymmetry. Note that one of these drugs (Noctiva for Nocturia) has already begun marketing and the other (FT-218 for Narcolepsy) could be launched late next year so the price events are near term.

Note that I don’t give the company much credit for net cash of just over $2/share given that cash will be largely used to finance the rollout of its new products.

I estimate values as follows:

Noctiva (Desmopressin): $11

FT-218 (Sodium Oxybate): $11

Base business at 0.50x 2018 sales of $120 million, plus residual cash and IP: $2

While there’s no science behind the following, as a rough guide if you assign a 50% probability of success to each of the two opportunities, you have a 25% chance they both hit ($23 value for +230% gain), a 50% chance one but not the other hits ($13 value for +86% gain), and a 25% chance neither hits ($2 value for -70% loss) and stock trades to the existing products valued at 0.5x sales plus residual cash. From the current price of $7/share, that implies probability weights of .25*-70%+.25*230%+.5*86% = 83%

As to why the opportunity exists, investors have justifiably lost confidence in management. There have been a series of strategic whiffs, some trivial, some important. In addition, the current revenue producing product portfolio, aside from the just launched Noctiva, has no patent protection, and should grind steadily lower over the next few years. So there is not much of a floor here if both growth initiatives miss. As a result, I size the position like an option that could lose most of its value. That said, an objective review of their current initiatives suggests the upside/downside asymmetry is attractive and worth a small position.

What are the two shots on goal?

Shot on goal 1 – FT-218, Sodium Oxybate, worth $11 per share if approved:

Avadel has a single dose version of Jazz’ twice a night orphan drug for Narcolepsy, Xyrem. Narcolepsy is a sleep disorder mainly characterized by excessive daytime sleepiness, but which also causes disrupted sleep at night. It’s much better if you’re dealing with a sleep disorder not to have to get up in the middle of the night to take a second drug dose. Avadel’s phase 2 data indicates comparable or even better efficacy than Xyrem with a single dose, as well as high levels of tolerability.

Given that this is essentially a reformulation of the compound used by Jazz in Xyrem (Sodium Oxybate), and given excellent efficacy in phase 2, there would appear to be a higher than normal probability of eventual product success. The drug has been granted Orphan Drug status by the FDA, which should provide an expedited review post submission for approval. That said, Avadel has faced several delays so far in its efforts to bring the drug to market.  First the company delayed trial enrollment until the FDA had given pre-approval to the trial design, a process that took several months longer than expected. Next, the trials were structured to test Xyrem naïve patients, however given the rarity of Narcolepsy and the fact that many Narcoleptics have already tried Xyrem, this made it difficult to identify and enroll sufficient trial subjects. As a result, the trials are taking longer than planned, although they are progressing. Where previously Avadel had planned to file with the FDA this year, that submission has now slipped into 2019.

All that said, there has been nothing to date to suggest any efficacy or safety issues with the drug itself.

Avadel is filing the drug as a new indication, in an effort to avoid any patent dispute with Jazz. Note that it is Jazz’ formulation of Sodium Oxybate which is patented, not the compound itself. Several generics companies have already sued Jazz and Jazz reached a settlement with Hikma Pharmaceuticals allowing a 2023 launch of generic Xyrem.

Sodium Oxybate has also been used as a ‘date rape’ drug, and as such its distribution requires an approved REMS tracking system. Hikma will license Jazz’ REMS protocol post launch in exchange for a royalty. Avadel has not yet provided detail on how it will address the REMS requirements claiming the information has competitive value. It is entirely possible it will enter into a REMS licensing agreement with Jazz.

The revenue opportunity for a better version is Xyrem is large. Xyrem itself generated $1.2 billion in sales in 2017. If Avadel could capture 20% of those sales, it would represent $240 million in sales. Assuming a 70% gross margin on the product plus $50 million incremental SG&A would imply incremental earnings of $90 million, or $2.30 per share. Even assuming only five years of US IP protection, that that approval should justify a value above $11 (ie the earnings realization over the minimum exclusivity period), given there will likely be some residual value post patent expiration.

In addition, a best in class treatment for Narcolepsy would make the company a more attractive M&A candidate for Jazz or one of the generic players currently planning to launch a Xyrem generic.

Regarding IP protection, if Avadel can demonstrate superiority for FT 218 to Xyrem it could be granted an Orphan Drug marketing exclusivity period of 7 years. Because the drug would not represent a first to market application of Sodium Oxybate for Narcolepsy, the seven year orphan drug exclusivity window is at the FDA’s discretion, based on their assessment of the drug’s differentiation and superiority to existing treatments. Failing that exclusivity period, the company’s micropump technology used to deliver the drug has patent protection until 2025 in the US and 2023 outside the US. That would imply if the company can launch the drug by early 2020 it would have a minimum of five years of exclusive marketing in the US and two years outside the US. Most of the revenue opportunity for this product is in the US, so that is the more relevant IP.

Shot on goal 2 – Noctiva, worth $13 per share at estimated peak sales of $250 million – discounted two years at 10%, roughly $11 today

Nocturia is defined as waking up two or more times per night to ‘void’ (Avadel’s term). The company reports that forty million people have the condition representing a $2 billion annual market. In many instances the condition is treated with generic desmopressin, however at high doses desmopressin can cause headache, nausea, upset stomach, and in rare cases life threatening low levels of sodium in the blood (Hyponatremia). The risk of Hyponatremia at high doses of desmopressin was one reason a formulation developed by Ferring for Nocturia was not approved in the US, although it was approved in the EU. Noctiva is essentially desmopressin engineered to maximize its effectiveness at a low dose, with rapid absorption into the bloodstream after being nasally inhaled.

The company is first targeting specialists, which they see as a peak sales opportunity of $250 to $400 million with a few years to ramp to peak sales. They then see a larger expanded market opportunity but I’ve excluded that. They have guided gross margins, inclusive of a royalty due to Serenity Pharmaceuticals, at 70%.

The product launched in the quarter ending March 2018, and SG&A for the whole business was $24 million. Assuming go forward annual SG&A associated with Noctiva distribution of $100 million annually, the product would contribute roughly $1.60 per share in EPS at $250 million in sales. Given the longer patent protection on this drug, I think an eight times multiple is reasonable, implying a $13 value, or 85% upside.

The company is forecasting $10-$20 million Noctiva revenues this year. First quarter sales (product launched in January) were $0.7 million.

Regarding IP, Noctiva has four patents ranging from 2023 to 2030. It should be noted there has been past litigation with Ferring, who has sued on various grounds including patent infringement and obviousness of the Noctiva patent. Those claims were dismissed in an initial hearing, but Ferring is expected to appeal the rulings.

Note also that if Noctiva is moderately successful, it improves the company’s ability to efficiently bring FT-218 to market because there will already be a sales and marketing team in place.

As far as risks related to ramping the product, given the absence of a clear current therapy for Nocturia, Avadel will be partially creating a new market (although clinicians do report nightime urination as a major patient complaint). It is also worth noting that Allergan previously shared the rights for the drug with Serenity, and forfeited its share, so that was one vote of non-confidence. It may be the shared net profit potential of the drug was too small to warrant the management attention it would require relative to the rest of Allergan's portfolio, or its possible they had more substantive concerns.

Legacy / Base Business

The legacy business involves seeking FDA approval and marketing drugs that were ‘grandfathered’ in pre FDA and are marketed by other manufacturers without approval. When a manufacture subsequently gets FDA approval for these products, they have a brief window as a sole supplier until other manufacturers, including the original manufacturer, can get FDA approval. Usually it’s a matter of months before at least one and sometimes more manufacturers get approval, quickly driving down sales and margins. It is a short product life, low quality business – as such I give it very little value in my valuation of the company (less than 0.5x sales after adjusting for excess cash). I think the market perceives this business similarly.

Catalyst

Sales progress on Noctiva, approval of FT-218