Description

Short American Pharmaceutical Partners (APPX)

Business Description:
American Pharmaceutical Partners, Inc. is a specialty pharmaceutical company that develops, manufactures and markets over 130 generic injectable pharmaceutical that it primarily sells through group purchasing organizations (GPOs) to hospitals. APPX has grown by offering complex generic injectables that face less competition and have higher margins. The base business appears quite strong but recent enthusiasm surrounding the stock is due to a proprietary cancer drug, Abraxane, which was accepted for normal status review by the FDA on May 10th 2004 is awaiting rejection/approval.

My original thesis on APPX was for the Abraxane application to be rejected all together by the FDA. However, the FDA decided to accept the application for normal review. APPX had been applying for fast track status, which means the FDA would have given the thumbs up or down within six months. The acceptance under normal review sent a shock to the stock price because it will take at least twice as long for an FDA ruling and it shows that the FDA does not think Abraxane is worth fast track status, possibly given the loops holes in the studies detailed below.

Investment Summary:
APPX is a short because there is a strong likelihood that Abraxane will be rejected by the FDA contrary to consensus, there are questionable accounting practices, and management is slimy.

• Abraxane might be rejected by the FDA contrary to consensus opinion

• Corporate structure of APPX with parent company ABI seems skewed in favor of ABI’s success

• CEO has a spotty track record

• Agreements with GPO’s create conflicts of interest and opportunities for shady accounting




Abraxane might be rejected by the FDA contrary to consensus opinion
o Removal of the Cremophor solvent may not significantly reduce toxicity of Paclitaxel
o Press releases have undergone material changes in wording and contain optimistic language
o The clinical trials may not be large enough to achieve statistical significance
o Conflicting feedback from experts makes prediction difficult

Abraxane is a Nanoparticle Albumin-bound Paclitaxel for the treatment of various cancers. Albumin-bound means that it is delivered through a human protein cell. The current leading Paclitaxel based cancer drug is Bristol-Myer’s Taxol. APPX claims the nanoparticle technology allows Abraxane to be delivered without the toxic solvent, Cremophor, needed to deliver Taxol. The toxicity of Cremophor limits the dosage of Paclitaxel that can be administered. The absence of Cremophor and the ability to deliver higher doses of Paclitaxel to the tumor site in thirty minutes rather than three hours needed for Taxol is Abraxane’s claim to fame.

In order to be approved by the FDA non-inferiority to Taxol must be proven. However, there are many red flags that raise concern. One alarming point is that the wording between phase II and phase III trial results has undergone material changes. The phase II results press release said that patients did not need any steroid pre-treatment, but the phase III trials press release commented that the patients did not need any routine steroid pre-treatment. Management has defended this change, after questions were raised, by explaining that it is unethical to prevent a doctor from treating a patient with certain drugs if he/she thinks the patient’s health is at risk. According to Dr. Soon-Shiong, 90% of the Abraxane patients were steroid free. These facts suggests that some Abraxane patients did require steroid pre-treatment and that the absence of Cremophor does not reduce toxicity to a level every patient can handle unassisted. In fact, patients treated with Abraxane experienced more cases of Neuropathy, a nervous system reaction that can be serious. If indeed the patients did receive steroid pre-treatment and Neuropathy increased in the Abraxane patients then the higher dosage is most likely to blame. It is important to note that Patrick Soon-Shiong is now the target of a class action lawsuit because of his overly optimistic claims about Abraxane.

The structure of the clinical trials also raises concern. Only 230 patients of the 460 in the study are actually receiving Abraxane. 230 patients does not seem like enough data to prove statistically significant results. With the potential market value for Abraxane estimated at 500 million in the first year it is strange that APPX is willing to take the risk of postponing FDA approval, especially given the fact that competitors are developing similar Cremophor free versions of Paclitaxel. The fact that clinical trials have been carried out in Russia adds to the mystery and to the likelihood that the FDA will reject the drug.

A conversation with a chemistry professor who was the first to develop Paclitaxel, the active ingredient in Abraxane, raised even more concern surrounding the trials. He said that Paclitaxel is itself a poison designed to kill cells. Never has he seen studies that prove higher doses of Paclitaxel provide enough benefit to offset the risk. He did not believe anyone understood Paclitaxel enough to break down its components and remove the elements that added toxicity. Furthermore, he said that the nanoparticle technology used to create the Albumin-bound Paclitaxel was stolen from the University of Illinois. He also mentioned that other Paclitaxel treatments from companies such as Sonus were going through clinical trials and looked promising.

Another red flag is that the trials for Abraxane were not double-blinded and the different stages of dosing. A doctor I spoke with explained that double-blinded trials are very important because they are better indicators of the actual efficacy of the underlying drug, rather than possible placebo effects and or physical tampering of the results. The differences in Taxol dosing also make direct comparisons for efficacy and safety difficult.

However, A medical professor and leading expert in Oncology, bravely defended the Abraxane trials. He believes that if 230 patients were not enough to prove statistical significance then the FDA would have instructed APPX otherwise. The data that has been released thus far shows that Abraxane is superior to Taxol and has a higher response rate with longer time to progression in the trials, he quoted. The fact that the trials were performed in various countries did not bother him since this is a phenomenon that has become more common in the past five years. He thinks Doctors in Russia can measure a tumor before and after treatment just as well as a US scientist. He went on to explain that the small increase in Neuropathy was expected given the higher dosage of Paclitaxel and that many drugs currently on the market have a much higher incidence of Neuropathy. He was the only supporter I encountered during my research.

The Chief Medical Officer of a competitor said he had a great deal of respect for the CMO of APPX, Dr. Hawkins, but has questions regarding the Abraxane trials. The contact is a leading expert in Oncology and has held numerous distinguished positions including many years in management at Bristol Myers Squibb. He was very curious about Abraxane because he believes what APPX is doing with Abraxane does not fit regulatory practices.

Abraxane might be rejected because it appears to be a new molecular entity. APPX has switched it’s filing application in the past between a 505 2b application and an NDA application. A 505 2b requires the drug to be the same molecular entity as the innovator. After consulting with numerous chemists, the Doctor I spoke with is convinced that Abraxane is indeed a new molecular entity. The chemists he spoke with said that it was near impossible to create the albumin particle bound Paclitaxel synthetically without modifying the compound. Assuming Abraxane is a new molecular entity APPX should be applying for a NDA, which would require vast amounts of additional testing. In other words, APPX was originally not using the correct application, but changed has changed their stance to the NDA without adding more patients to the trials.

The abstract for the Dec. 5th 2003 ASCO presentation in San Antonio raised concern because it had the data for both first and second-line metastatic cancer patients being reported together. These patients respond differently to treatments and should be reported separately. Just as strange, the date from the abstract was different from the data in the presentation. Response rates improved from 31% for Abraxane and 16% for Taxol to 33% and 19% response rates, respectively. Similar to the change in response rate for the ASCO conference is the change that has occurred in phase II date response rates.

Abraxane trials show an abnormally low response for Taxol contrary to over 10 years of studies. Abraxane is being praised for beating Taxol response rates in the APPX trials. However, over the past 10 years Taxol has shown a response rate ranging between 30-50% while the Abraxane trials only had a 16% response rate for Taxol. When compared to past Taxol data Abraxane doesn’t look so hot. Why is Taxol behaving differently in these studies is a mystery to many professionals who are familiar with Taxol treatments. One interesting twist uncovered in my research is the possibility of the Taxol used in the APPX studies may have been sourced from a generic pharmaceutical company in China. This may explain the lower response rates for Taxol. The significance here is the manner in which Paclitaxel was derived. In the US, the synthetic version is the only version approved for use. Paclitaxel sourced from a Chinese generic manufacturer might be plant derived, which would cause the FDA to reject the study.

FDA will want to know how much Paclitaxel actually reaches the tumor site in humans and APPX has only studied this figure in animals. APPX says Abraxane allows Paclitaxel to be administered in higher doses but has not studied the relationship between higher doses and increased Paclitaxel at the actual cancer site in humans. The Paclitaxel that actually reaches the site is an important figure that should not be overlooked. A high does may not translate into a higher dose at the site. The CMO of APPX, Dr. Hawkins, said that in animals the amount of Paclitaxel at the cancer site was significant and he expects the same is true in humans. This comparison is not factual but only opinionated. My contact believes this is one aspect of the trials the FDA will criticize.

Radiologists’ opinion is not material because they did not examine x-rays. APPX continues to refer to the Radiologists’ analysis of the Phase III data as a point of confidence in their results. A doctor I spoke with said that it is odd for a Radiologist to not use x-rays when examining the effectiveness of a cancer treatment, and can not place much faith in the Radiologists’ opinion if this is the case.

Corporate structure of APPX with parent company ABI seems skewed in favor of ABI’s success
o Patrick Soon-Shiong is the CEO of both APPX and the private parent company American Bioscience (ABI)
o ABI receives a substantial amount of income for each step of Abraxane’s development
o APPX shareholders bear the most risk in the event of FDA rejection

Patrick Soon-Shiong is the CEO of both APPX and the private parent company American Bioscience (ABI), formerly known as VivoRx Pharmaceuticals. ABI was started in 1994 to pursue cancer research. In 1994, Dr. Soon-Shiong was also the head of VivoRx, a company focused on diabetes research that his brother Terrence and Mylan Laboratories helped establish.

The agreement between ABI and APPX for the licensing of Abraxane shifts the risk of failure on APPX’s shareholders. With each FDA regulatory milestone APPX must pay ABI between 10 and 15 million dollars. If Abraxane is approved ABI will claim 50% of the future profits.

The CEO of a onetime rival to VivoRx told me he would never create a corporate structure like Dr. Soon-Shiong has and that the structure guarantees success for Patrick Soon-Shiong while shifting risks to the shareholders. Furthermore, the board structure lacks corporate governance.


CEO has a spotty track record in both his business and personal life
o Has made bogus claims in the past regarding a cure for Diabetes
o Shifted wealth from one company he managed to his personal company
o Has been sued by his own brother

Patrick Soon-Shiong, CEO, started ABI after he made a public name for himself with his late 80’s work on diabetes at VivoRx. He starred in numerous talk shows and bragged he was close to a cure for diabetes. However, he was reluctant to release the data behind his research. The result of these claims is a company that has had zero success and has been a crutch for Dr. Soon-Shiong’s cancer research at ABI. Now, Dr. Soon-Shiong is creating similar hype for the cancer drug Abraxane. Dr. Soon-Shiong was even sued by his own brother, Terrence Soon-Shiong. Terrence accused Dr. Soon Shiong of using money Terrence had invested into VivoRx for his personal interests at VivoRx Pharmaceuticals, the cancer research company that is now ABI.

An Chemistry Professor who has followed Patrick Soon-Shiong’s work said that he was a fraud who had offshore accounts used to funnel money out of his companies. APPX seems as if it could be a repeat of VivoRx, a company being used for his personal gain.


Agreements with GPO’s create conflicts of interest and opportunities for shady accounting:
o GPOs represented 93% of APPX sales and 88% of accounts receivables in 2002

o GPO Premier has offered a hidden track of profits to a Healthcare Supplier

o Premier and Novation have been known to force Hospitals to buy products from select manufacturers

The first question raised is what could APPX be trying to hide through shady accounting. With GPOs representing 93% of sales and 88% of accounts receivable in 2002, there is ample room to make the underlying business appear stronger than reality.

Premier, the GPO that has played a large role in APPX’s success, has used unethical business practice to secure business in the past. Conversations with a Manager at a Healthcare Supplier explained his past with Premier. Years ago Premier wanted to buy the company and offered a “hidden track of profits” as the incentive. Through a distributor Premier had recently started, Hawkeye Medical, Premier explained to him how they could negotiate with end users and manufacturers in a manner that would hide what the end user paid for the product. Essentially, Hawkeye Medical helped Premier collect chargebacks in excess of the actual difference between the list price from the manufacturer and the selling price to the end user. The Healthcare Supplier turned down the offer and has kept an eye on Premier ever since. They explained that Novation and Premier were the worst offenders and that AmeriNet was the most ethical among GPOs.

After talking with some Medical Center Pharmacy directors about GPO’s and purchasing decisions I learned that Premier and Novation, GPO’s that APPX uses, engage in “sole source” practices. The Pharmacy director explained that GPOs steer customers towards certain manufacturers by only offering specific manufacturer’s products. He said flexibility was very important when choosing products and that his hospital uses MedAssets because they provide at least two product choices in most cases. Without product flexibility his staff could undergo expensive training to become familiar with new equipment. The interesting thing was that he quoted Premier and Novation as being cheaper for some supplies, but that in the long run product flexibility is what keeps costs down.


Actual reserves for chargebacks do not match figures from my research.
oPricing data from hospitals suggests the end user price averages 42% below the list price

o The reserve set aside to account for the difference between list and end user price has varied greatly overtime

oLack of transparent accounting allows this reserve to conceal true business transactions

o Conversation with CFO, Nicole S. Williams added strength to my conviction

o The difference between list price and end user price varies greatly for each drug

o Inventory levels and other balance sheet concerns




After comparing wholesaler acquisition costs (WAC) to the actual end user purchasing data from two major hospitals, the hospital purchasing price averaged 42% below WAC. The survey was based on 29 data points of the newer best selling APPX products and a random sample.

A chargeback is the amount that APPX estimates will be charged to them by the GPO. Since sales and the resulting receivable are recorded at the WAC, a contra asset is created at the time of sale to account for the difference between WAC and the end user selling price, known as a chargeback. Furthermore, the notes point out that this end user price is “previously contractually established between APPX and the end user,” meaning this estimate should be accurate. However, the actual reserve for chargebacks has varied significantly from my research figure of 42%. In 2000, 2001, 2002, and 2003 the ending reserve set aside for chargebacks was 55%, 56%, 69%, and 64% of receivables.

The chargeback varies greatly for each drug. Ifosamide, a chemotherapy drug launched in July 2002 with 180-day exclusivity, had an average discount of 67% from the list price. Heparin, an injectable blood thinner had an average discount of 77%. Doxycycline and Cefotaxime, two products that make up a lower portion of sales when compared to Ifosamide and Heparin, had a discount of 17% and 21% respectively. The substantial difference between the discounts of certain drugs raises concern. Matched to the fact that Premier and Novation are known to have very low relative prices for some drugs adds to the mystery.

When compared to Sicor, another generic injectable business that was recently acquired by Teva Pharmaceuticals, American Pharmaceutical Partners appears to have vastly different balance sheet ratios. The day’s sales inventory for APPX is almost double that of what Sicor’s used to be and has fluctuated greatly over the years. When questioned on the “stockpile levels” of inventory Nicole S. Williams, CFO APPX, explained that they use batch processing and frequently overproduce to better utilize their manufacturing equipment. In conference calls the CEO said that the higher levels of inventory were in response to expected future shortages. This discrepancy raises concern.

DSI
Year 2000 2001 2002 2003
APPX 119 152 199 248
Sicor 105 107 132 na

The days sales outstanding (DSO) based on net receivables is less than half that of Sicor’s old figures. Conversations with the Senior Director of Investor Relations at Sicor explained that the DSOs might be different because Sicor conducts a material amount of business in Latin America where timely payments are not as popular. She did not know why inventory levels would be so much higher at APPX.

DSO (net receivables)
Year 2000 2001 2002 2003
APPX 34 30 28 32
Sicor 81 69 67 na

Other:
Teva decided to acquire Sicor for 3.25 billion at $27.50 per share. To help evaluate upside risk, Teva paid 4.5-5.5 times sales when it bought Sicor. APPX is currently trading at 6 times sales.

Reported sales growth conflicts with VAR:
oWholesalers reported declining to varying sales growth with injectables
oAn APPX employee said they are encouraged to “push sales through”

I spoke with an inventory manager at a Pharmaceutical Wholesaler who said they no longer carried injectables because of low demand. About two years ago demand had slumped and the high costs of storing and packaging injectables no longer made it profitable. To back up this information I called another Healthcare Supplier to ask a sales person what they had seen over the past few years in the injectable market. The representative I spoke with said that injectable sales had varied and he could not make any estimates. I then spoke with people at the APPX distribution warehouse in Illinois to confirm what I was hearing from wholesalers. One woman explained that it would be hard to comment on issues related to sales but that sales are notably higher before quarterly reports. She said they were encouraged “to push sales through” during these times.


Risks
o Apparently strong base business: APPX maintains a strong pipeline with over 50 generic injectables in development and an average of 12-13 ANDAs per year with many more important drugs coming off patents

o Abraxane might get approved and would trigger a major short squeeze at 63% short interest

o High barriers to entry protect APPX from severe competition

o Teva Pharmaceutical’s purchase of Sicor signals that the generic injectable market looks promising

o Questionable accounting practices might not lead to a smoking gun if APPX can resolve the issue chargebacks might be hiding

o FDA not as stringent as in past

Valuation:
It’s tough to value this company given the low faith I have in the reported numbers. I think anywhere from 15-25 dollars a share could be a good ballpark. My DCF yielded a high teen share value and multiples the industry carries yields a 20-25 share value. I’m short at 41 but recently covered half of my position and will get back in closer to the approval date. I suggest keeping an eye on the stock and shorting it if the hype returns. APPX does a pretty good job of doing that with press releases.

Catalyst

Stock my regain steam in near future as Abraxane rejection/approval date is in sight
Middle 2005 rejection of Abraxane
Earnings shock as a result of shady accounting