Description

Cipher Pharmaceuticals is a highly attractive and exceptionally cheap company possessing:

• a core Canadian dermatology business growing organically at a 27% CAGR with a market leading product, consistent share gains, no patent risk, and high barriers to entry

• additional high margin licensing revenue streams

• sizeable cash holdings of $29mm, 51% of the market cap

• $211mm USD in NOLs, which will shield income taxes for a very long time

• two phase III new product candidates with significant revenue potential and no development risk to Cipher

• a management team and board with 40%+ insider ownership that has been relentlessly buying back stock for the last 18 months or so

Despite all of these positive attributes, Cipher trades for an exceptionally cheap valuation of only 1.7x EV/FCF.  

I believe that a large number of common misunderstandings about the business have caused investors to completely overlook the company and its high quality assets.  I believe that the business is worth around $6.00 per share, which is more than 2.5x the current share price and is only 7.8x FCF.

Shares trades as CPH on the TSX in Canada and as CPHRF on OTC Markets in the US. 

Epuris

Cipher’s crown jewel is Epuris, a product marketed in Canada for the treatment of severe nodular acne based on the active ingredient isotretinoin.  The Epuris franchise plus cash holdings alone comprise around 75% of my estimated value of the company, ~$4.60 per share, more than double the current share price.

Epuris is a highly attractive asset because it is a significant growth business with high potential for future growth.  Launched in July 2013, it has grown at a very high rate every year – a 27% CAGR over the last 6 years – benefiting both from a growing market and consistent market share gains.  More importantly, Epuris is the market leader with 43% share in its category, and as it is positioned as the best product in the market by far, Epuris is poised to continue growing at high rates for the foreseeable future.

Epuris’ revenues have grown at a consistently high rate in each of the last six years:

The isotretinoin market in Canada has only two other approved alternatives, Roche’s Accutane and Viatrus’ Claris.  Epuris, however, is the best product on the market for severe nodular acne because it has a superior delivery system that doesn’t require you to eat food with it.  This is a more important advantage than you might initially think when you remember that the target market is often young girls that are less likely to consistently comply with the eating requirements.  As a result, since being launched into the market in July 2013, it has taken market share from its two competitors and is poised to continue the trend going forward:

It’s also important to note that the underlying isotretinoin market in Canada has also had strong growth trends, increasing at a 14% CAGR over the last 6 years, and by 20% in 2021.  So Epuris’ impressive growth trajectory is a combination of both a strong underlying market and consistently taking share from competitors due to it being the best product on the market.

Most importantly, Epuris has high barriers to entry with no patent risk as there is not any patent protection on the product in Canada.  The high barriers are a result of the target market simply not being large enough to justify the investment it would take to bring a new competitor to market.  For example, Health Canada would require a clinical trial that management believes on its own would cost over $30mm to conduct.

Why Is The Stock So Cheap?

The stock price is so dramatically mispriced that I think it’s important, and particularly helpful, to understand the many common misunderstandings about the company that have led to it being completely orphaned in the market. These misunderstandings are of course based on what I’ve found from speaking with other investors, but it’s surprising how common they are.

1. Investors often believe Cipher is mainly just Absorica and they hate Absorica.  Absorica, however, is only ~12% of the value of the company and even if you valued it at zero, the rest of the business would still be worth over $5 per share IMO.

Absorica is an isotretinoin product that Cipher has licensed to Sun Pharmaceuticals for the US market.  This common misunderstanding makes more sense if you understand the history of the company.  As recently as 2017, Absorica was generating $39mm ($30mm USD) in essentially 100% margin royalty revenues.  For most of Cipher’s recent existence, Absorica was so large and wildly profitable that it truly was almost the entire company.

Since that time, however, Absorica’s patents expired and generic competition flooded the US market, driving those $30mm USD in royalty revenues down to the current level of ~$6mm USD per year.  As a result, while Absorica still has value, it's already been so decimated that it’s now only a very minor contributor to the value of Cipher.

In short, investors seem to often believe that Cipher is mainly just Absorica, and as a result they deem the company essentially uninvestable at any price because they believe Absorica cash flows will soon be zero given the recent history of the product.

2. As mentioned above, investors often believe that Absorica cash flows will soon be zero and the product is essentially worthless.  This is not the case.

First of all, the steepest Absorica revenue declines from the launch of generic competition are now in the past. I think that with the market maturing we’ll likely see the rate of erosion taper off if not somewhat stabilize near current levels.  Nonetheless, I have valued Absorica at a multiple that assumes meaningful continued revenue declines to be conservative, but I would admittedly be surprised if its licensing revenues didn’t outperform my modeling assumption.

Secondly, the biggest reason why investors seem to think Absorica is so worthless is because they believe the remaining life of the product will be extremely short.  I think part of the reason for this is because the agreement with Sun was set to expire this year, and many assumed it wouldn’t be extended.  Even at reduced performance levels, however, Absorica is clearly still very profitable for Sun and earlier this year they in fact extended the agreement with Cipher out to 2026.  

3. Investors that recognize that Cipher is not just Absorica but Epuris too, often believe that since Absorica is an isotretinoin product that is now “worthless” because it lost patent protection, since Epuris is just the same product in a different market, it is also “worthless” because it will undoubtedly soon experience the same series of events.  This is obviously just a fundamental misunderstanding about the two products and their respective markets.

As mentioned above, Epuris doesn’t have patent protection in Canada, so there is no “patent expiration cliff” in the future to fear.  Secondly, the price in Canada is 1/10th of Absorica – like many other pharmaceuticals, the pricing dynamics in Canada are in a completely different world from the US.  With pricing so low in comparison, the competitive risks that are often feared in many pharma categories in the US are significantly more unlikely for a dominant product in a small, niche market. 

4. The company has a development pipeline with two products in Phase III that I don’t think investors give them any credit for.

Neither of the products have development risk to Cipher as they just have the Canadian marketing rights.  MOB-015 is a topical formula for the treatment of a common nail fungus that they’ve partnered with Moberg Pharmaceuticals for.  CF101 is a treatment for plaque psoriasis and rheumatoid arthritis that they’ve partnered with Can-Fite BioPharma for.   They also have some earlier stage products in their pipeline too.

I’m most excited about MOB-015 (“MOB”) so it’s the only one I’m going to elaborate on.  MOB is addressing a $75mm prescription market for Onychomycosis in Canada, with a single product having over 90% market share.  Importantly, that single product – Bausch Health’s Jublia – is generally regarded by dermatologists as being not a great product, but the best one available to them.  Moberg has already conducted one Phase III trial that resulted in a mycological cure rate that was substantially higher than Jublia.  The only issue that MOB had is that it failed the cosmetic parameter – what the nail looks like.  As a result, they’re conducting a 2nd trial that lowers the dosage so that it will hopefully not affect nail coloring too much while still maintaining a superior mycological cure rate.  If Moberg can hit that complete cure rate target, MOB will be positioned for a lot of success and Cipher’s marketing rights in Canada should be quite valuable.  Assuming all goes well, this product is roughly 24-30 months away from commercialization.

5. The company reports its financials in USD but its stock is priced in CAD.  There is a ~30% difference between the two currencies.  It may seem silly, but I think you would be shocked at the number of investors that forget to convert currencies, making the company appear 30% more expensive on every metric.

6. The company accrues for taxes on their financial statements but does not pay cash taxes due to $211mm USD in NOLs.  Many investors seem to not even recognize that the company doesn’t pay cash taxes and as a result they significantly underestimate FCF generation.

7. Prior management did a poor job attempting to diversify the company and many investors fear more ineptitude, not realizing that the Mull’s took the reins back in 2019.  

John Mull was the founder of CML HealthCare, a diagnostics services provider that was acquired by LifeLabs in 2013 for $1.22 billion.  Cipher was previously spun out of CML HealthCare.  John Mull owns 39% of the Cipher and was the former CEO, and his son Craig is the current CEO and owns another 2%.  

In between the two of them, however, there were a couple of poor acquisitions made by other CEOs.  In April 2015, then CEO Shawn O’Brien acquired Innocutis for $45.5mm USD.  The target company seems to have had a weak product portfolio and so the acquisition performed very poorly.  In May 2018, then CEO Robert Tessarolo acquired the Canadian business portfolio of Cardiome for $25.5mm.  This acquisition did get them the hospital products (Brinavess and Aggrastat) and the tax assets, but the development pipeline never materialized so the price paid looks steep in retrospect.

I’ve found that a lot of investors don’t even realize that the Mull’s are managing the company again and prior CEOs left a very bad taste in their mouth – making the company seem, once again, “uninvestable” at seemingly almost any price due to the potential for poor capital allocation.  

To his credit, however, Craig Mull has made all the right moves since taking over as CEO IMO.  He cut corporate costs significantly to bolster cash flows, he’s maintained the strong Epuris growth trajectory, he extended the Absorica license, he signed a new distribution and supply agreement for Lipofen with ANI Pharmaceuticals, and most interestingly, he’s recognized the extreme mispricing of Cipher in the market and repurchased shares very aggressively over the last 18 months and counting.  He repurchased around 1mm shares last year and almost another 500k shares in Q1.

Valuation

Growth in Epuris and cost cutting, partly offset by declines in licensing revenue have led to consistently strong EBITDA and FCF over the last three years.

At the current market cap of $56mm with $29mm in cash, Cipher has an EV of $27mm and is poised to generate roughly $16mm in FCF this year, making the current valuation only ~1.7x EV/FCF.

I believe that Cipher is worth roughly $6.00 per share, which implies a valuation of ~7.8x FCF.  This is also supported by a sum of the parts valuation, as shown below.

I feel that this sum of the parts valuation is quite conservative as it implies a fairly dire outlook for the licensing portfolio, gives only nominal value to MOB-015, gives no value to any other pipeline assets, and gives no value to the NOLs which on their own are arguably worth $40-50mm.

Finally, I believe that there is potentially very material acquisition-related upside not accounted for in these valuations.  The company has extremely large cash holdings, generates significant FCF, and has a very concentrated portfolio of assets; it is a near certainty that management will eventually use its resources to make one or more acquisitions to create a larger, more diversified pharma company.

What’s particularly interesting about this strategy is that the timing perhaps could not be more perfect.  Cipher is poised to be a major buyer in a market that is presenting more opportunities with less competition and lower valuations.  Management is targeting already commercialized products in North America at 4-6x EBITDA.  With layoffs at larger pharma companies starting to increase now, this tends to be the sort of environment that leads to an increased interest in product divestments; management has noted that they’re seeing a lot more opportunities in the Canadian specialty pharma market in particular.

While I haven’t ascribed any value to it, I don’t think it’s difficult to see how a few decent sized, well-priced acquisitions could create very significant additional value.  Management has the ability to deploy a lot of capital relative to the size of the existing business, and a more diversified product portfolio would certainly command a higher valuation multiple than the one I’ve modeled.  With the Mull’s owning 40%+ of the company, focusing on more mature / lower risk cash flow-based assets, in a clear buyer’s market, and with Craig Mull’s excellent stewardship thus far, I feel very comfortable in the potential realization of this upside.  Risks of course remain in any acquisition, but I think the deck is stacked in investors’ favor far more than usual.

Risks

• Epuris’ growth could slow materially for the first time in its history.  It’s difficult to predict the future growth of the isotretinoin market and whether Epuris will continue to gain market share.

• A superior product for severe nodular acne could be commercialized in Canada that takes meaningful market share from Epuris.

• Management could invest its cash holdings and future FCF in unattractive acquisitions that destroy value.

• Revenues from the licensing portfolio could decline even faster than anticipated.

• MOB-015 and all other new product candidates could fail to reach the commercialization stage.

Catalyst

• Every quarterly report should serve as a catalyst due to the sheer magnitude of cash flow generated.  The FCF yield on the enterprise value is almost 15% per quarter.

• Announcement of an acquisition.  Anything that gets investors just to look at the company again I think has the potential to serve as a catalyst, but an acquisition in particular I believe would get investors most excited as it would serve to both grow the company’s cash flows and perhaps more importantly diversify them.

• Commercialization of a product in their pipeline.  I don’t believe investors are giving the company any value for its pipeline, so any success here would likely serve as a catalyst.

• A substantial issuer bid (i.e. tender offer).  I personally don’t think this is likely, but it’s certainly possible.  Management has shown that they have a significant interest in buying back as much stock as possible, including at prices well above current levels.  Last fall they were a significant repurchaser at $2.50+ per share and the company has meaningfully increased its value since then IMO.  Any substantial issuer bid would have to be priced at a large premium to current levels, and would almost certainly result in a sharp revaluation of the stock.

• Payment of a large special dividend.  I personally don’t think this is likely either, but again it’s certainly possible.  The Mull’s own 40%+ of the stock and might want some of the cash personally for some reason.  With over 50% of the market cap in cash, it could potentially be a very large dividend.  And with the market seemingly giving the company little to no value for its cash, I believe it would serve as a strong catalyst. 

• A sale of the company.  John Mull owns 39% and I believe is 87 years old.  I would be very surprised if the plan wasn’t to make a few large acquisitions over the next several years to grow and diversify the company’s cash flows and to then sell the company at a large premium.