Description

Note: My model and some other charts and graphs couldn't paste into this. For a clean version of this write up please go to  http://www.scribd.com/doc/81198360/KV-Pharmaceutical

Thesis

KV is an overleveraged drug company that has failed in its attempt to launch its primary product, Makena. KV faces both a liquidity and solvency issue in the next 6 months and is likely to undergo a massive debt restructuring which will be highly if not completely dilutive to the equity. With $95MM in payments due to Hologic, the original owner of Makena over the next 7 quarters as well as free cash burn, KV will run out of cash before the end of the September quarter. In addition, KV’s $200MM in 2.5% convertible bonds are putable in May 2013 further stretching the company’s limited financial resources. KV’s assets are worth significantly less than its liabilities implying little to no equity recovery in a bankruptcy. The bond market appears to have figured this out as there is a large disconnect between KV’s implied value in the debt and equity markets. KV’s subordinated convertible bonds trade at 43% of par (85% yield), valuing the company at $475MM whereas the equity market attributes a $702MM enterprise value to the company.

Capital Structure

Go to link. Total obligations $587MM, Unrestricted cash of $73MM, Restricted cash of $22MM.

As of March 31, 2012 KV projects it will have $40-50M in unrestricted cash and $8M of restricted cash – implying operating cash burn of roughly $40MM in the March quarter. Excluding one time items, KV projects its operating cash burn rate is $25-$30MM per quarter.  

Catalyst

KV will run out of cash due to required cash payments and operating cash burn before the end of the September quarter. Given the company’s already highly levered capital structure, continued operations will require either a massive equity raise or for the company to file for bankruptcy protection. Furthermore, the company's 2.5% convertible bonds are putable in May 2013 and the company’s leverage and negative EBITDA make refinancing the bonds impossible. 

Company Overview

KV Pharmaceuticals is a specialty pharmaceutical company.  KV Pharmaceuticals has a drug approved for pre-term birth, Makena which they bought from Hologic.  When the drug got approved on February 4, 2011 it caught a lot of people by surprise.  This drug had been floating around the FDA for a long time.   This drug was originally filed for approval back in 2006.  At that point it was owned by a company called Adeza.  Adeza was then bought by Cytyc.  Cytyc was then bought by Hologic, who then sold Makena to KV Pharmaceuticals.  

Makena Overview

Makena is a once a week injection (given for approximately 15 weeks) for women who have already had a prior pre-term pregnancy and are once again pregnant with a singleton fetus (ie non-twins.)  It was shown to reduce the chance of the mother having a pre-term birth. 

Originally the medical community greeted the approval of Makena with a lot of fanfare.  Though they had been using the active ingredient in Makena (a progesterone called 17p) for years, they had had to source it from compounding pharmacies.  These are pharmacies that produce a drug to a specification of a doctor.  For example if a doctor needs to change the dose of a drug, or change it from a pill to a solution, a compounding pharmacy would do this.  This was a very common practice for 17p since this was the only way to get it.  Typically a shot of 17p from a compounded pharmacy would cost approximately $10/shot. 

Once KV announced the price of Makena though, there was a major backlash.  KV priced the drug at $1,500 per injection, ~100x the price of the compounded drug.  To be fair, KV's manufacturing facilities for Makena are FDA inspected and approved and run at very specific quality standards.  Those for compounded pharmacies, are significantly less regulated and not inspected by the FDA.  Typically when the FDA approves a product which is produced by compounding pharmacies, they will prosecute compounding pharmacies that continue to produce the drug because they want high production standards for drugs.  However, there was a huge backlash by doctors, by the March of Dimes, by politicians, by insurers, and by patients after the price of Makena was announced. 

Thus on April 1st, KV had no choice but to reduce the price from $1,500 per injection to $690 per injection.  Of course, this only emboldened everyone to call on KV to reduce the price further.  And though a big percentage decrease in price, it was still ~50x the price of the compounded so people still thought it was too much. 

As a result of the very high price of the drug relative to alternatives, KV has failed to gain any traction with their Makena launch. 

Here are the prescriptions for Makena since launch.  Notice while variable week to week, it has been relatively flat since launch with typical weekly scripts it the 60-100 range. 

See table in the link. 

Matching up the scripts with the reported vials shipped to patients shows us that each script equates to approximately 2 vials.  Thus even at 100 scripts per week, we are at 100 scripts * 2 vials/script * $3450 list price per vial * 65% to account for discounts and rebates = $448,500 per week.  Thus this is only a $23.3M run rate annually.  Since the company spent $31M on R&D and SG&A in the quarter ending December 31, 2011 this current level of sales is far too low to sustain the business. 

Makena Revenues

Makena addresses a fairly large population.  The company estimates that there are 105,000 moms that are eligible for the drug every year.  At $1,500 per shot, with ~15 shots per mom, that is ~$2.4B market if fully penetrated.  At $690 that is ~$1.1B market.  However the true penetrable market is substantially less.  For a start, 15% of patients have no insurance and so can't afford the drug at all.  Another ~50% of the market is Medicaid, which obviously with cash strapped state budgets is actively working to stop usage of the drug.  There will be some usage here, but Medicaid has been aggressive about pushing back, and this business is less profitable since the company is mandated to give a 23% rebate on the drug.  That leaves only about 40% of the market having commercial insurance and thus as able to or willing to pay.  Even commercial insurance has been not great above coverage, some of them pay right away, others will make you jump through some hoops.  So there is a market here of maybe ~$400M in annual sales at 100% usage among commercial patients, but in reality even for the best drugs, being used in 50% of the market at peak is good, and it can take 4-5 years to get to that number.   And KV only has 7 years of protection from generics, so their window of opportunity is very limited and highly dependent upon the slope of the launch.  And because of the reasons below they will be lucky to even get 10% of the commercial market. 

In a different environment, KV might have been able to eek out break even or perhaps even a small profit with their cost structure.  But because of the backlash over the price, most doctors are unwilling to use the drug.  Having spoken to a number of them, its an emotional response, that they feel that it is absurd that it can cost $1,500 for a shot when they might get in total that over 9 months of caring for a pregnant women.  Furthermore, KV didn't actually run the studies to get the drug approved by the FDA, thus they can't even argue that the price of the drug is in order to recoup their high costs of drug development.  This coupled with the fact that they are used to using the compounded version means that they have little incentive to switch, especially when their national societies are encouraging them not to use it.  In fact the national society of OB/GYN's, ACOG has banned KV from advertising in their journal - the first and only time I have ever heard of something like this happening.  KV and ACOG also decided not to have any KV presence at the ACOG annual meeting because they were worried about the safety of the KV sales representatives if they were to be at the meeting - such is the backlash and hatred of the company by some of the doctors. 

There are doctors that are willing to use Makena.  OB/GYN's are highly aware of malpractice, and very risk averse.  The vast majority of doctors view the ACOG statements as letting them prescribe as they wish, and since they are already used to the compounded drug, they see no reason to prescribe Makena.   Other doctors are worried about lawsuits or may have patients with better insurance coverage and thus prefer to prescribe Makena.  

Makena underlying demand has actually been flat.  The drug launched in late March, essentially April.  As of May the company said that 900 patients had either gotten drug, or were awaiting insurance approval.  Please note that this 900 patients is an over estimate - because some of these patients will not be eligible for drug.  But roughly speaking, ~450 patients were started or awaiting insurance approval per month for the first 2 months.  By July the company noted that 1,600 patients had gotten drug or were awaiting insurance approval.  This 1,600 is a cumulative number.  So in June and July, on average ~350 new patients got drug or were awaiting insurance approval.  This means there may have been a decrease in the number of patient prescriptions 4-5 months into the launch!  The company blames it on a slow July because of the July 4th holiday - but even accounting for some July slowdown, clearly the launch is not going well.  Thus, there was very little improvement in the slope of new patient starts from May to July.  It seems to be about flat. 

The January update shows that there were 900 additional patients that fell into the on drug or awaiting insurance approval (cumulatively) for the months of December and January.  While this is an increase from the previous few months – this is still a very difficult metric to understand.  This is because the new year typically starts with a lot of new insurance re-verifications and patients switching plans. 

The stock has been up recently because an FDA Advisory Panel voted against approval of a competitor (Prochieve) for pre-term birth.  However Prochieve is for pregnant women with a short cervix, and so while there is some overlap for women with a prior spontaneous preterm birth, it is very small.  Thus the lack of competition in the overall pre-term birth space is only a modest positive.  Furthermore, this doesn’t mean that Prochieve won’t be approved – it just means it will likely take a little bit longer.  Remember that Makena had a negative panel but eventually got approved as well. 

Here is my Makena model.  As you can see, there is no meaningful acceleration in their demand trends.  The quarter ending March 31, 2012 will be the first quarter where vials shipped will reflect underlying demand because they had overstocked the channel in March of 2011.  Also notice that the realized revenue per vial has been very low.  The list price per vial is $3,450 but they are realizing only around $2,200 because the patient mix is so poor here, with a very high percentage of uninsured as well as Medicare and Medicaid patients. 

See table in link.

Cash Flow

The company has negative EBITDA.  EBITDA for CY 2Q11 is a little misleading because they shipped ~9 months worth of Makena in March, so there was very little re-ordering in CY2Q11.  The company has stated that they don't expect significant reorders until YE 2011.  So the CY 4Q is more close to a normalized EBITDA. 

Other products

Clindesse

• Used to do $40M a year before the consent decree with the FDA in 2009 and they were forced to withdraw it from the market.
• Used for the treatment of bacterial vaginosis. 
• Competitors to Clindesse are Cleocin and Clindagel. They have limited promotional activity. 
• Expected to come back onto the market sometime in July to September of 2012. However the timeline for approval has already been pushed out twice now.
• The company says that the competitive landscape has not changed since they came off the market, but they acknowledge that it will take time to get back to those levels (which I don't think is achievable).   It will be a slow launch.  Furthermore, it will be hard to put sufficient resources behind this re-launch since they will be still focused on Makena. 

Gynazole-1 (butoconazole vaginal)

• Used to do $24M a year before the consent decree with the FDA in 2009 and they had to remove it from the market.
• Antifungal medication. 
• Used to treat vaginal candida (yeast) infections
• Expected to come back onto the market sometime in July to September of 2012. However the timeline for approval has already been pushed out twice times now.  This product will have the same slow trajectory as Clindesse upon Launch

Evamist

• A low dose testosterone delivered through the skin to treat hot flashes. 
• It has been stable at about $3M a quarter in sales.  This is a niche product which does not have much room for growth. 

Worth

Makena is not profitable to KV at the (current) $22M run rate level as you can see from the NPV analysis below.  It cannot even support the cost of the sales representatives, let alone the rest of the infrastructure.  Keep in mind this is ignoring the Hologic payments that they will have to make totaling $95M to keep the drug. 

Thus if we assume Makena is worth $0, and remove the Hologic obligation, we can see the value of their existing assets and the offsetting debt and obligations.  Even if we assume that Makena is not NPV negative, we still get a negative equity value for the company. 

The assets of the company are not sufficient to pay off the debt and obligations. The common stock is still trading at $2.61 a share, implying a marketcap of $209M and thus saying that the company has an EV of $702M including the Makena obligations.  But the value of the assets of the company only comes to $189M, even assuming Makena is break even, which it is not.  The stock should be trading at close to zero with the assets of the company clearly less than the face value of their debt and obligations and the looming need for additional capital and debt maturities. 

Cash Situation

Under our assumptions, KV will run out of cash in the CY 3Q12 due to their need to make a $14.6M payment related to the Hologic obligation and continual quarterly cash burn. 

Risks

• The FDA is currently investigating the claims made by KV that compounding pharmacies are using product that is of uncertain potency and purity.  Never mind the fact that no issues have ever arisen with the compounded 17-p despite having been on the market for 56 years.  Furthermore, the FDA’s jurisdiction over compounding pharmacies is a grey legal area.  The FDA has tried to take cases to court before and lost.  In the latest example of the FDA attempting to shut down compounding pharmacies (United States of America v. Franck’s Lab Inc; Case No. 5:10-cv-147-Oc-32TBS)  the court explained

 “Every Court that has addressed the issue—no matter what the context—has recognized that the FDA new drug approval process is an ‘especially poor fit’ for regulating traditional pharmacy compounding, one that would potentially eradicate traditional compounding despite the recognized importance, historical acceptance, and decades-long state regulation of the practice.”

 “[I]t would not make sense to require compounded drugs created to meet the unique needs of individual patients to undergo the testing required for the new drug approval process [because] requiring such testing would force pharmacists to stop providing compounded drugs” [emphasis in original Opinion].

Thus even if the FDA attempted to shut down the compounding pharmacies that are making dangerous 17-p (if there are any), they would be taken to court and this would take years to play out – by which time KV would already be bankrupt. 

Let’s say that somehow the FDA manages to obtain a preliminary injunction that forces certain compounding pharmacies to shutdown – this simply means that the remaining compounding pharmacies were able to pick up the slack. 

So it will be difficult for the FDA to shut down the compound of 17-p, and questionable from a legal perspective.  But let’s suppose that the FDA intimidates the compounding pharmacies into not producing 17-p anymore.  What would be the financial impact on KV?

On their quarter ending September 31^st, 2011 KV remarked on a study that was being presented at the 2011 Pregnancy Meeting (the annual meeting for the Society for Maternal-Fetal Medicine) that showed that 36.5% of patients eligible to receive 17-p actually receive it.  The abstract is pasted below:

The surprising thing is that this was done at the University of Pennsylvania, a leading academic medical institution!  These institutions typically have a significantly higher awareness of medicines and the treatment guidelines than the community OB/GYN or Maternal Fetal Medicine Specialist.  If the rate is 36.5% at the University of Pennsylvania, it is certainly less on a nationwide basis. 

Even if it is 25%, nationally and that all converts to Makena, a DCF still easily has the stock being worthless.  Remember, Makena only has 7 years of orphan drug exclusivity.  There is no doubt that the FDA will approve generics for this drug to be put onto the market as soon as exclusivity ends given the backlash against the price. 

• Another risk is that there is a safety issue with one of the compounded 17p products and the doctors get worried about malpractice and switch over to Makena.  This is unlikely, since it is going to be difficult to prove causality of the drug here.  Furthermore, many doctors are asking their patient to sign informed consent forms before giving the compounded 17p.  In truth the risk of this happening, regardless of proving it, is low, because this drug has been compounded for a long time without any issues.  Given the determination of the national organizations leadership in encouraging the use of 17p, it would have to be more than just one idiosyncratic case - but an outbreak of issues with the compounded 17p.  But even when there were two outbreaks of blindness and death from compounded Avastin for wet AMD, retinal specialists did not panic, and are convinced that their own compounding pharmacies are safe and clean.  Instead they are working to make sure that their compounding pharmacies are up to standard to make sure this doesn't happen again.  Furthermore, compounded 17p has been used for many years, and we haven't seen any safety problems with it. 

Appendix A: Opposition to Makena Pricing

For instance this is what the two major doctors organizations put out once they saw the price of Makena. 

Ob-Gyns Respond to High Cost of Makena™

Access to Preterm Labor Drug in Jeopardy

Washington, DC -- The American College of Obstetricians and Gynecologists (The College), along with the American Academy of Pediatrics and the Society for Maternal-Fetal Medicine, is urging Ther-Rx Corporation to reconsider its pricing of Makena™. Makena is the first FDA-approved medication to help prevent preterm birth in certain high-risk pregnant women. The College argues that the extremely high cost of Makena™ will hinder access and affordability to this treatment for both insured and uninsured patients.

To read the full letter, go to http://www.acog.org/from_home/misc/20110311GoedekeLtr.pdf

# # #

The American College of Obstetricians and Gynecologists (www.acog.org) is the nation's leading group of physicians providing health care for women. As a private, voluntary, nonprofit membership organization of approximately 55,000 members, The American College of Obstetricians and Gynecologists strongly advocates for quality health care for women, maintains the highest standards of clinical practice and continuing education of its members, promotes patient education, and increases awareness among its members and the public of the changing issues facing women's health care. Follow us on Twitter at www.twitter.com/acognews.

Pasted from <http://www.acog.org/from_home/publications/press_releases/nr03-14-11.cfm>

The March of Dimes which had originally put out a press release applauding its approval then came out with this letter:

March 23, 2011 

Greg Divis, President 

Ther-Rx Corporation 

One Corporate Woods 

Bridgeton, MO 63044 

Dear Mr. Divis: 

Thank you for your letter of March 17th. I am pleased to learn that you are ‘listening carefully to stakeholder concerns about list price, patient access, and cost to payers’. Thank you for considering additional steps to ensure that Makena is available to all eligible women, and for convening stakeholders from the March of Dimes, the American College of Obstetricians and Gynecologists, the American Academy of Pediatrics, and the Society for Maternal Fetal Medicine next week. 

In advance of that meeting, I want to go on the record that March of Dimes expects Ther-Rx to come to the table with substantive commitments including:

1. A significant reduction in the list price of Makena.
2. Adjustments to the patient assistance program to ensure adequate coverage of all patients, insured, uninsured and underinsured.
3. A method for reporting on a regular basis to stakeholders on the patient assistance program to ensure that it is meeting needs in a timely and adequate way.
4. A justification or rationale for your pricing based on your investment in the product, savings to the health care system, or other appropriate methodology, which you are prepared to make public.

Without these elements, I do not believe that Makena can succeed in the current marketplace environment, and as a result, at -risk women will be denied access to a safe and effective treatment to reduce preterm delivery. Therefore if you are unable to make a clear commit-ment to significantly address the above issues at the meeting, the March of Dimes will need to pursue alternative strategies for ensuring that this proven intervention to prevent preterm birth is made available to all medically eligible pregnant women, and we will step away from our longstanding and productive corporate relationship with Ther-RX. Thank you for your consideration of this critical matter. 

Sincerely, 

Jennifer L. Howse, PhD 

President

Pasted from <http://www.marchofdimes.com/news/mar23_2011.html>

Aetna wrote a letter in the New England Journal of Medicine arguing that society couldn't afford to pay for this drug at this price. 

Senator Sherrod Brown from Ohio wrote an editorial in USA Today denouncing the price. 

http://www.usatoday.com/news/opinion/forum/2011-03-21-column21_ST1_N.htm

Thus with all this pressure going on, the FDA took the highly unusual step of putting out a press release saying that they would issue discretion on the prosecution of compounding pharmacies for 17p and not prosecute unless there was a true problem with the quality of the drug.  

FDA STATEMENT

For Immediate Release: March 30, 2011

Media Inquiries: Beth Martino, 301.796.7603, [email protected]  

Consumer Inquiries: 888-INFO-FDA

FDA Statement on Makena

On February 3, 2011, the U.S. Food and Drug Administration approved the drug Makena (hydroxyprogesterone caproate) for the reduction of the risk of certain preterm births in women who have had at least one prior preterm birth. KV Pharmaceuticals, the drug’s owner, received considerable assistance from the federal government in connection with the development of Makena by relying on research funded by the National Institutes of Health to demonstrate the drug’s effectiveness. It also obtained seven years of exclusivity under the Orphan Drug Act, obtained approval under FDA’s accelerated approval program, and received expedited review.

For many years, a version of the active ingredient of Makena, which is a synthetic progestin, has been available to patients whose physicians requested the drug from a pharmacist who compounded the drug. Generally, FDA has exercised enforcement discretion with respect to most products made through traditional pharmacy compounding. This has included products made from the active ingredient in Makena, hydroxyprogesterone caproate.

Because Makena is a sterile injectable, where there is a risk of contamination, greater assurance of safety is provided by an approved product. However, under certain conditions, a licensed pharmacist may compound a drug product using ingredients that are components of FDA approved drugs if the compounding is for an identified individual patient based on a valid prescription for a compounded product that is necessary for that patient. FDA prioritizes enforcement actions related to compounded drugs using a risk-based approach, giving the highest enforcement priority to pharmacies that compound products that are causing harm or that amount to health fraud.

FDA understands that the manufacturer of Makena, KV Pharmaceuticals, has sent letters to pharmacists indicating that FDA will no longer exercise enforcement discretion with regard to compounded versions of Makena. This is not correct.

In order to support access to this important drug, at this time and under this unique situation, FDA does not intend to take enforcement action against pharmacies that compound hydroxyprogesterone caproate based on a valid prescription for an individually identified patient unless the compounded products are unsafe, of substandard quality, or are not being compounded in accordance with appropriate standards for compounding sterile products. As always, FDA may at any time revisit a decision to exercise enforcement discretion.

Pasted from <http://www.fda.gov/newsEvents/Newsroom/PressAnnouncements/ucm249025.htm>

Appendix B: KV Obligation Overview

2015 Notes:

• Placed on March 17, 2011
• Mature on March 15, 2015
• Payable semiannually on March 15 and September 15, starting September 15, 2011.  The first year of interest payments are held under restricted cash ($27M)

2.5% converts:

• Issued on May 2003
• Initial conversion price f $23.01
• Mature on May 16, 2033. 
• Interest payable on May 16 and Nov 16
• Holders may require the company to repurchase all or a portion of their Notes on May 16, 2013, 2018, 2023, or 238. 

Mortgage Debt:

• In March 2006, company entered into a $43M mortgage loan agreement. 
• Secured by 4 of the Company's buildings. 
• Bears interest at a rate of 5.91% and matures on April 1, 2021
• Company is current in all its financial payment obligations. 

DOJ Obligations:

• ETHEX (subsidiary of KV Pharmaceuticals) pleaded guilty to two felony counts, each stemming from the failure to make and submit a field alert report to the FDA in September 2008 regarding the discovery of certain undistributed tablets that failed to meet product specifications.
• Pursuant to the plea agreement, ETHEX agreed to pay a criminal fine in the amount of $23.4M (and total fine of $27.6M) in four installments. The first installment, in the amount of $2.3, was due and paid within 10 days of sentencing. Under the original payment schedule, the second and third installments, each in the amount of $5.9, were due on December 15, 2010 and July 11, 2011, respectively. The fourth and final installment, in the amount of $9.4, was due on July 11, 2012. On November 15, 2010, upon the motion of the Department of Justice, the court vacated the previous fine installment schedule and imposed a new fine installment schedule using the standard federal judgment rate of 0.22%, payable as follows (the Company has made all its required payments as of June 30, 2011):

DOJ False Claims Act Settlement:

•    On December 7, 2011, the Company issued a press release commenting on the Company’s settlement with the Department of Justice, the United States Attorney’s Office for the District of Massachusetts, the Office of Inspector General of the Department of Health and Human Services and the TRICARE Management Activity (collectively the “United States”).
•    The settled lawsuit was filed by Constance Conrad (“Relator”) on August 29, 2002 in the United States District Court for the District of Massachusetts styled United States ex rel. Constance Conrad, et al. v. Abbott Laboratories, Inc., et al., Civil No. 02-CV-11738-NG (D.Mass), pursuant to the qui tam provisions of the False Claims Act, 31 U.S.C § 3730(b), against multiple defendants, including the Company. Specifically, the Relator alleged that the Company failed to advise the Centers for Medicare and Medicaid Services (“CMS”) that certain products marketed by ETHEX Corporation, including Nitroglycerin Extended Release Capsules and Hyoscyamine Sulfate Extended Release Capsules, did not qualify for coverage under federal healthcare programs. On December 6, 2011 the parties entered into a Settlement Agreement to resolve this dispute. Pursuant to the Settlement Agreement, the Company agreed to pay the United States a total sum of $17.0 million, plus interest, in installments over five years as follows:

Catalyst