For an enterprise value of $42mm you can buy a growing $23mm/yr royalty that will likely last for 15 years.  Based on this royalty, CPEX Pharmaceuticals ("CPEX") is worth $40.00/sh, 87% more than today's closing price of $21.40/sh. 

CPEX is a simple business that has one main asset, a growing royalty stream on a profitable drug, Testim, for testosterone replacement in men, which is sold by Auxilium Pharmaceuticals ("AUXL").  As testosterone cannot be patented, the key ingredient in Testim is CPE-215, which enhances permeation and absorption of pharmaceutical molecules across skin, nasal mucosa and eyes.  For use of CPE-215, CPEX receives a 12% royalty on all sales of Testim from AUXL.

Our fair value target of $40.00/sh is based on a DCF and before fellow VIC members write off an analysis based on a DCF, note that it is easy to triangulate to similar values.  First, the financing proposal of Cowen Healthcare Royalty Partners, LP ("Cowen"), one of the largest and most respected royalty funds, for the tender offer an activist investor filed last week arrives at $35.00/sh, 64% above the current share price.  Second, CPEX is likely to announce it is exploring strategic alternatives in the next two weeks (RBC Capital Markets has been hired as investment banker and Goodwin Procter LLP as legal advisor) and AUXL is the most logical buyer and could pay $50.00/sh, 134% above the current share price.  Third, recent royalty transactions have occurred at 4-6x EV/revenue, more than 100% above CPEX's value of 1.8x EV/revenue.

CPEX owns the CPE-215 technology because when Bentley Pharmaceuticals ("Bentley") was acquired by Teva Pharamecueticals ("Teva") in June 2008, Teva wanted only Bentley's generic business.  CPEX was created through a taxable, 1:10 stock dividend.  The company kept a very low profile until January 7, 2010 when activist investor Richard Rofe of Arcadia Capital Advisors ("Rofe") announced that he was willing to buy CPEX for $14/sh.  On April 22^nd, Rofe raised his offer to $16/sh with the assistance of Cowen, who is financing 94% of the purchase price in return for an ownership of less than 50% of the Testim Royalty.  The financing of Cowen reveals that the royalty alone is worth $30.00/sh (there is an additional $5.00/sh of value for other assets). 

By the end of next week the Board of CPEX must reply to Rofe's offer.  The stock price is trading well above the offer and it's a fraction of the value of the royalty so they will reject it.  As the company has been under activist pressure since early January, CPEX is highly likely to run an auction, a message that the Trout Group, CPEX's outside IR firm, stated has been received from multiple large investors. 

Assuming that CPEX is sold at $40.00/sh, management and board RSUs/options will be worth $13.5mm and severance for the top three executives will be $4.9mm.  This large payout for running a microcap company for less than two years makes a sale very palatable.  A sale to AUXL at $50.00/sh takes the total value for management and the board to $24.5mm.  CEO John Sedor is 65 years old and lives in Philadelphia (350+ miles away from CPEX's office in Exeter, NH) and at a price of $40.00/sh, he will make $7.0mm from his current stock ownership, RSUs, options and severance.  I've interacted with him multiple times over the phone and in face-to-face meetings and my impression is that he's a broken man from the constant barrage of Rofe (13D filings and press releases) and other shareholders (investor meetings and letters to board members) and is very likely to acquiesce to a sale of CPEX. 

Background:

CPEX began public trading on June 19, 2008 as a sub-$40mm market cap spin-off.  As best we can tell, there was no marketing and the value of CPEX was obscured by excessive R&D and corporate overhead spending as management attempted to develop Nasulin, an inhaled insulin medication for diabetics.  After 9 years and 15 Phase I & Phase II studies, management finally killed Nasulin on April 12, 2010.  From 2007-2009, management spent 100-134% of the revenue received from the Testim royalty, which was a colossal waste of shareholder funds and resulted in CPEX reporting net income losses of $2.9-4.9mm/yr.  In our opinion, this spending on Nasulin gave management a reputation as extremely poor capital allocators as they frequently ignored shareholders that asked that the Nasulin program be discontinued - a February 11, 2009 note from Gabelli & Company highlights Nasulin as "a big gamble in a forsaken market" and the associated "excessive R&D spending representing the biggest risk to our investment thesis."  Rofe's 13D filings rail against management for this spending and provide further color. 

Business Description:

CPE-215 allows drugs to be absorbed across membranes, most frequently skin or nasal mucosa, which allows for more accurate drug dosing than drugs administered orally, which are subject to degradation initially by the stomach and secondarily to first-pass metabolism in the liver before reaching the bloodstream.  Relative to injectable drugs, CPE-215's membrane absorption avoids the pain & lower patience acceptance of an injection, the required medical personnel potentially required to administer the injection, and the higher manufacturing costs given the need for sterile conditions when manufacturing injectable drugs.

Testim is a testosterone gel used once a day for the treatment of hypogonadism in men by rubbing the gel onto shoulders or upper arms for enhanced absorption by CPE-215.  Hypogonadism leads to low energy, muscular atrophy, loss of libido, erectile dysfunction, irritability, and poor concentration.  Testim has been on the market in the U.S. since February 2003 and has a 22% share of total prescriptions for the gel segment of the U.S. testosterone replacement therapy market (per NPA data from IMS Health); Testim is also sold in Canada and 15 European countries.  While hormone replacement for women going through menopause is well known, for men hypogonadism is largely undiagnosed.  Current estimates are that 9 in 10 men with the condition are untreated; that this condition is continuing to be recognized explains past sales growth of 28% in 2009 and 31% in 2008. 

CPEX receives a 12% royalty on sales of Testim and AUXL has guided to 2010 sales of $185-195mm, 12-22% growth.  At the midpoint of $190mm, CPEX earns $22.8mm and has no expenses, aside from collecting the payment.  While I don't have direct access to the information, other sellside and buyside firms with access to weekly prescription data report that YTD Testim sales are running ahead of AUXL's guidance.  AUXL reports pre-market on Monday, May 3^rd.

CPEX's patents for the use of CPE-215 with testosterone expire in January 2025.  A recent generic application from Upsher-Smith was rejected by the FDA in August 2009 on the basis that a generic version of Testim would not be bioequivalent unless it used CPE-215.  Specifically, the FDA stated that "the practical effect of this determination is that any application for a testosterone gel product that has different penetration enhancers than the reference listed drug cannot be submitted as an abbreviated new drug application (ANDA) and, instead, will have to be submitted as a NDA under section 505(b) of the Act."  While we always hesitate to say that something is impossible, conversations with CPEX and AUXL management, life science investors, and scientists indicate that this ruling from the FDA makes it impossible to create a generic substitute for Testim without infringing CPEX's CPE-215 patent.

Our forecast of Testim revenue is based on the average of BofA/ML and Citi forecasts (small shops with more aggressive forecasts, such as Roth, are excluded) from 2010-2013 followed by flat Testim revenue for 3 years and annual sales declines of 10% through the end of 2024.  It's far more likely that Testim sales will continue to grow after 2013 and there is no obvious reason to think they will shrink.  Additionally, once the patents for CPE-215's use with testosterone expire in January 2025, CPEX will continue to receive a royalty of approximately 2% of Testim sales, but we ascribe no value to this.

Our Testim sale estimates:
2010E: $188.1mm (+17.3% yoy; as noted, YTD prescriptions are running ahead of AUXL guidance)
2011E: $209.2mm (+11.2% yoy)
2012E: $226.4mm (+8.2% yoy)
2013E: $241.9mm (+6.9% yoy)
2014E: $241.9mm (0.0% yoy)
2015E: $241.9mm (0.0% yoy)
2016E: $241.9mm (0.0% yoy)
2017E: $217.7mm (-10.0% yoy)
2018E: $195.9mm (-10.0% yoy)
2019E: $176.3mm (-10.0% yoy)
2020E: $158.7mm (-10.0% yoy)
2021E: $142.8mm (-10.0% yoy)
2022E: $128.6mm (-10.0% yoy)
2023E: $115.7mm (-10.0% yoy)
2024E: $104.1mm (-10.0% yoy)
2025E: $0.0mm (-100.0% yoy)

Valuation:

Our estimates of the value of the Testim royalty range from $30.00-45.00/sh.  Additionally, other assets at CPEX are worth $5.00/sh given:

1.       $2.50/sh of net liquid assets, which assumes more than $10.0mm for management severance, banker fees, legal fees, etc.

2.       $0.75/sh of fixed asset value, which is based on the appraised tax value of the wholly owned corporate office and 14 acres of land; no value is given to other PP&E.

3.       $1.75/sh of value for the probability weighted value of a royalty from Serenity Pharmaceutical's Phase III drug, for which CPEX holds a ~2.5% royalty (more information below).

Therefore, our estimated fair value of CPEX is $35.00-50.00/sh, which is 64-134% above today's closing price of $21.40/sh.

Based on our DCF we value the Testim royalty at $35.00/sh using the above sales forecasts for Testim, $2.0mm/yr of corporate overhead, $2.0mm/yr of R&D, a 35.0% tax rate, and a 10.0% discount rate.  There is a small deferred tax asset, but we assume it shelters no taxes. 

The value of the Testim royalty based on Cowen lending Rofe $40mm for his tender offer is $30.00/sh.  While Testim revenue is forecast to grow in the future, if we assume 2010 Testim revenue of $190mm (midpoint of AUXL guidance), CPEX will receive $22.8mm and the revenue sharing agreement will entitle Cowen to $10.5mm, which is 46% of the Testim royalty.  Cowen receives 65% of the royalty on the first $125mm of sales and 10% of the royalty on sales over $125mm.  $40mm of debt for a 46% share of the Testim royalty puts the royalty value at $87mm, which is $30.00/sh.  The Cowen loan is a senior claim, but we estimate it has been underwritten to a 20%+ IRR, which we believe offsets the seniority as this should be priced to a low teens IRR and shows that other royalty funds could bid more aggressively (recent royalty fund offering books have shown royalty debt financing at an average yield of 15).  It's interesting to note that Cowen is optically financing 94% of the $42.6mm purchase price (Rofe's equity of $2.6mm is just 6% of the purchase price).  But given the large cash balance and positive working capital of CPEX, Rofe will not need to put equity into CPEX and therefore Cowen is financing 100% of the acquisition price.  Alternatively if he did invest $2.6mm we estimate far higher net liquid assets upon close so Rofe would be able to immediately pay himself a dividend equal to or greater than his equity investment. 

We understand that it is a bit unorthodox to view the value of the financing in this manner, but we want to point out that a royalty fund is willing to underwrite $15/sh (94% of the $16/sh offer) with targeted return rates above normal royalty funds while receiving less than 50% of the royalty revenue.  Moreover, the return to equity is absurd as we estimate that Rofe would make at least 10x his investment.  This is the kind of financing LBO investors achieved in the early 1980s: 100%+ IRR on equity and 20%+ IRR on debt.  But it shows the value private market buyers see in the Testim royalty and an auction will be run to monetize this value. 

Another way to view the Cowen financing is to assume that another royalty fund or private equity buyer was able to get the same financing deal and paid $25/sh for CPEX (please note that we think other royalty funds will provide a much better financing package).  $25/sh results in CPEX purchased for a market cap of $71mm.  Assuming $40mm of Cowen-like financing and $7mm of net cash after management severance, banker & legal fees, the buyer would need to make a total equity investment of $24mm.  For this $24mm equity investment, his share of the year 1 royalty will be more than $12mm, which is >50% his equity investment.  The point of this exercise is that other buyers looking to pay a price closer to fair value, will value this royalty higher than the current price (note, they'll also likely get a better financing package).

We believe the Testim royalty is worth $45.00/sh to AUXL using the above sales forecasts for Testim, zero corporate overhead, $2.0mm/yr of R&D, a 20.0% tax rate, and a 10.0% discount rate.  While we assume a 20.0% tax rate, AUXL has very large NOLs and it's likely that AUXL's true tax rate is 0% - sellside models use tax rates of 0% or 2% in their EPS forecasts.  A sale of CPEX likely won't close until late 2010 and therefore we estimate potential accretion to 2011 EPS (also AUXL isn't expected to be EPS positive in 2010 given high spending to launch a new drug, Xiaflex).  Acquiring CPEX at $50.00/sh ($45.00 for Testim + $5.00 of other assets) would add 37c to EPS, which is 56% accretion to 2011 consensus EPS of 66c.

If anyone would like more detail about our valuation, we're happy to provide it in Q&A.

Risks:

The biggest risk is that the board ignores shareholders and refuses to run an auction.  In past conversations with CEO & President Sedor, he has personally noted that the Testim royalty is worth far more than the current share price of CPEX Pharmaceuticals - it's always possible that he ignores this value.  But, I believe it's very likely that CPEX announces it is exploring strategic alternatives at the end of next week when they reject Rofe's offer as:

1.       CPEX has been getting barraged by investors for nearly four months.  I became aware of CPEX after Rofe's initial $14/sh offer in early January and following months of interaction with the company, I believe that CPEX's board and management team realize that as long as they're a publicly traded company they're going to be under assault.  A few months ago CPEX would not have cancelled the Nasulin program or written an open letter to shareholders (http://www.cpexpharm.com/files/pdfs/pr/2010/pr-041210.pdf) stating that their strategic priorities will "consider a variety of strategic alternatives to enhance shareholder value" and that the company "will review offers to acquire CPEX."  We are optimistic about the company's recent change in tone and actions. 

2.       39% of CPEX shares have traded since Rofe's offer of $14/sh in early January and the vast majority of these shares are now in the hands of shareholders that want change.  Conversations with shareholders (both investors that owned stock before Rofe's initial offer and those that own stock after the offer) leave us confident that shareholders have little faith in the current management team and are communicating their desire for an auction to the board. 

3.       CPEX has already hired investment bankers and legal advisors. 

4.       The Trout Group, CPEX's outside IR (contact info below), noted that because CPEX management is not returning calls, large outside investors have contacted Trout Group demanding that CPEX run an auction.  While it's a stretch to extrapolate too much from investor interaction with IR, I believe that the overwhelming desire of shareholders is for a sale process. 

Assuming that CPEX does run an auction, it's possible that the process fails.  This seems very unlikely given the simplicity of running a sale (contact AUXL, half a dozen royalty funds, and a half dozen private equity firms and you'll have a number of bids) and the simplicity of valuing CPEX. 

While we believe that the threat of generics was removed last year, it's always possible that another generic drug maker targets Testim.  In addition to the FDA's rejection of Upsher-Smith, offsetting this is the relatively modest size of Testim revenue at ~$200mm/yr.  While a rough guess, a generic drug maker would likely cut the price of Testim by 80-90% taking revenue to $20-40mm/yr, which is a fairly small market.  Additionally, the Hatch-Waxman law provides a 30 month stay for any generic application so if a new generic competitor emerged tomorrow, the earliest their drug could be on the market is October 27, 2012.  Between now and then CPEX will collect more than $60mm of royalty revenue and today's enterprise value is $42mm.  Lastly, AUXL's CFO has stated that Testim is dependent on a large sales force to educate doctors about hypogonadism to drive prescriptions - a large and expensive sales force is not the business model of generic drug makers.

Lastly, while mark to market is always a risk, it's interesting to note that after Rofe's offer of $14/sh the stock has never closed below $14/sh.  It seems reasonable to assume that the stock will never close below his current offer of $16/sh, implying downside of 25%, which is far less than upside potential.  Also, the fact that the current share price is well above Rofe's offer indicates that investors aren't buying CPEX because they think the $16/sh offer is fair.

Serenity:

CPEX has the right to receive a royalty on a drug being developed by Serenity Pharmaceuticals Corporation to treat Nocturia, a condition causing an individual to wake multiple times in the night to urinate (frequently an issue for older men).  CPEX has entered into a licensing agreement with Serenity allowing Serenity to use CPE-215 to develop a nasal spray.  Under the agreement, CPEX will be entitled to certain milestone payments and a low single-digit royalty on sales of the product.  On April 1, 2010 Serenity announced that it had entered into a global agreement with Allergan, Inc. for the development and commercialization of this product, which is currently in Phase III clinical trials.  CPEX has no expenses associated with Serenity and we therefore view it as a call option. 

Valuing Serenity is a bit difficult, but we believe it is worth $1.75/sh on a probability weighted basis and could be worth significantly more.  An estimate of the probability that a Phase III drug receives FDA approval is approximately 20% although Serenity is effectively reformulating additional drugs so the probability should be higher.  Also, we estimate a market size of $250mm in annual sales, but discussions with clinicians indicate a market size many times larger.  If we assume a 2.5% royalty, $250mm of annual sales, a 10 year life for the licensing agreement, a 35% tax rate, a 10% discount rate, and a 20% chance the drug is approved by the FDA, we come to $5.0mm of value, which is worth $1.75/sh. 

While my diligence on Serenity has been limited, I did speak with CEO Sam Herschkowitz and was extremely impressed as he has decades of pharma experience and along with partners has funded more than $10mm of Serenity's development expenses.  Drug development is risky, but: (i) Serenity is led by industry veterans; (ii) is reformulating a drug, which is much lower risk than new drug development; and (iii) the recent Allergan agreement is a strong vote of confidence.  If Serenity is able to successfully commercialize this drug and it reaches its market potential (about $1 billion), this royalty stream could be as valuable as the Testim royalty.    

Summary:

This is a small stock that has averaged 21k sh/day for the past month so is likely a PA trade for many members of VIC.  But, the risk-reward is very asymmetric given fair value 64-134% above the current price and very little downside given a current EV/royalty of just 1.8x.

Contact information:

CEO/Pres John Sedor: [email protected], (603) 658 6100
CFO Robert Hebert: [email protected], (603) 658 6100
Outside IR Chad Rubin of The Trout Group: [email protected], (646) 378 2947 (CEO and CFO of CPEX are not currently returning calls, but Chad is)
AUXL IR Will Sargent (for information on Testim): [email protected], (484) 321 5926