While I generally do not like investing in small cap biotech awaiting FDA approvals, an investment in Cardiome (CRME) offers the ability to buy a business that is misvalued for a few specific reasons with massive free optionality from a blockbuster new drug soon to be undergoing the next step in clinical trials.

CRME is a Canada based biotech company that is developing drugs for Cardiac Arrhythmia. Specifically, CRME's drugs convert atrial fibrillation into normal sinus rhythm in well under 90 minutes. I'll spare a more detailed description here since the company's MD&A is a very good and can be accessed below.

http://cardiome.com/documents/1008Cardiome2010Q2MDA.pdf

 The company has two forms of one major drug under development, Vernakalant, an IV and an oral form of the drug. IV Vernakalant has been approved for use in Europe in early September and is in the process of being approved in the US. Astellas is the company's US distribution partner for IV Vernakalant and Merck is the distribution partner for IV Vernakalant in Europe and oral throughout the world. CRME will receive 30% of revenues in royalty payments from Astellas and 25% from Merck. All development costs going forward for oral Vernakalant will be assumed by Merck.

What does Vernakalant do?

• Atrial fibrillation process
  • Generally when a patient comes into an ER with a fib, they are often simply given beta blockers to control the heart rate and anti-coagulation drugs to prevent a stroke and monitored for a short period of time to see if their heart beat returns to normal and then sent home
  • In some cases, where the heartbeat doesn't return to normal, the patient is sedated and given shock therapy through paddles or given a drug
    • Shock through the paddles is generally considered safe for older people, and a little less safe for active, younger people
  • Health issues
    • Toxicity issues are high in most of the current a fib drugs

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    • Generally, vs. paddles, drugs are much worse
  • Amiodorone, current a fib drug does not act very fast, hence the combination with shock therapy and also does not help with future maintenance, hence the anticoagulation drugs; there are also longer term toxicity side effects to Amiodorone
  • The current IV Vernakalent can treat atrial fibrillation in 90 min at the hospital and has tested well in terms of sustaining the conversion into sinus rhythm so as to limit future needs for beta blockers and anticoagulation
    • Studies done for EU approval show that Vernakalent converted 52% of patients in 90 min while Amiodorone converted 6% in the same timeframe
    • Ibutilide, another IV a fib drug has the highest conversion to normal sinus rhythm from a fib of any drug except Vernakalant (31-44% w/in 90 minutes vs. 52% for Vernakalant) but with massive toxicity risks
  • Initial conversion vs. maintenance conversion
    • When patients come to an ER with a fib, in situations where it's bad enough that it must be converted, there are two aspects to conversion, initial conversion and making sure that the patient stays converted in the future and doesn't end up in a fib again
    • Oral drugs are often much better at maintenance since the patient can take them at home
  • IV a fib drug market is a very small niche
    • Generally it's not a very big market, only 14% of patients who come in with a fib are actually given any sort of treatment
    • In most cases, patients are either just given beta blockers and anticoagulation and sent home or they are sedated and shocked
  • The real value is in the oral drug
    • Doctors really aren't looking for a new IV treatment since they don't really need anything new to use in the hospital since shocking works well
    • The real value here is in an oral drug-if there's an oral drug with as good success rates in maintenance and as low side effects as IV Vernakalant, then this will be a huge multi-billion dollar drug
    • There's nothing great in the form of a daily pill right now

Why the IV market is currently very small, the studies of IV Vernakalant show that it's much safer and more effective than current treatment.

IV Competition:

Ilbutilide-Does $10m/year in business so people look at it as a competitor, but it is fatal in 1 out of 20 patients.

IV Amiodarone-as discussed above, the success rates aren't nearly as high as Vernakalant

Electrocardioversion-this is likely the most proper comp as discussed above. However, in smaller hospitals which don't have E&P, anesthesiologists and cardiologists always on call to shock a patient (extremely expensive and time consuming), IV Vernakalant offers a much safer and more effective alternative to any other drug. It might be an uphill battle by the drug companies to educate doctors of the safety/effectiveness here, but it truly is the only drug replacement to shocking.

Oral Competition:

Flecainide-causes arrythmias and is really not used by the majority of practicing physicians today.

Dronedarone is brand new and got approval only a few months ago but really only works in a small segment of the population and is very expensive to produce. In fact, the UK government initially banned it because it just wasn't very effective but cost a lot of money (this was overturned by doctors who wanted to use a drug treatment for a fib, but this was the best alternative).

Oral Amiodarone is the only real comp for oral Vernakalant, but toxicity levels are high and many doctors will use anti-coagulation and beta-blockers simply because they don't like the side effects of Amiodarone

This would create a $2bln market for oral Vernakalant.

Why is the company misvalued?

(1) Stock dropped on August 11, 2010 after announcing that they were pushing back the timeframe for the next stage of clinical trials with Merck for oral Vernakalant.

The market reacted very negatively to this information, but our discussions show that it has nothing to do with the effectiveness of the drug but that Merck simply wanted to reassess the uses of the drug for a potentially wider mandate (i.e. test the drug on more uses so it could get approval for more uses). Also, the FDA likely came back with questions about dosage-asking MRK how they were planning on testing dosage and what was the intended level of dosage. As such, MRK is adding a titration study to the trial where they will test dosage for patients over the course of 1-2 weeks after the initial dosage is given; this should not extend the amount of time of the study but should help with any issues the FDA gives them in the future about dosage. We believe that Merck will announce the oral drug trial resumption before Christmas and it will likely begin in January.

(2) Since the postponement of the oral trial, 1-2 large long only funds who have been in the stock since the $4 range decided to take their profits rather than risking their gains on more negative data on the oral drug. I don't believe these funds have any edge here given our discussions with CRME, MRK and many physicians who believe there's value to this drug and all trials should resume imminently.

(3) The stock further dropped today after a single person who entered the IV study in South America with recent onset of a fib and an elevated heartbeat received the drug and went into shock. The Independent Review Board said that the study should continue but Astellas halted it pending a review by the FDA which wanted to see all information regarding the patient and the drug. According to the CEO of CRME, this was not a pro-rhythmic event and doesn't seem like there's any idiosyncratic risk to the drug in this sort of situation since there have been no issues like this in trials in the past. The argument here is that the patient likely had some sort of atherosclerosis or cardiac myopathy that would have reacted similarly under IV Vernakalant or any other therapy. We believe this was an overreaction and once the FDA sees the data, the trial should resume and the FDA should approve IV Vernakalant in the US.

From each of these issues, it's easy to see why the company is misvalued and why none of them are permanent issues.

Market Sizing/Valuation

Sales for Dronedarone and Flecainide were about $125m in the US and likely the same through the rest of the world and total sales of Ibutilide were about $20m in the US. So all in, Vernakalant has the ability to replace a potential $300mm in a fib drug sales.

Assuming IV is used in 7% of 1.5m US cases at $1000/case which would result in about a $105mm opportunity-assuming it's safer and used in more cases than Ibutilide since those on the fence about getting shocked through paddles might be more likely to use this option. We assume the worldwide IV opportunity is about the same size as the US. At a 27.5% blended royalty rate, CRME could do $57.75m in sales from the IV treatment alone based on very conservative assumptions.

In terms of cash, they have $60m in cash on the balance sheet but we think that R&D should be stepping down going forward. Q2 2010 was the last quarter in which they helped Merck with development costs for Vernakalent IV and oral. The biggest cost was the R&D expense for the AVRO study in the quarter. The only Vernakalant related development costs which they are still on the hook for is Act 5 IV with Astellas. As such, the $3.7m in R&D costs in the quarter should drop by $800k (cost for AVRO that Merck will now fully assume). G&A should stay constant, though 1/3 of it is stock comp (non-cash). So, the highest we should see burn is $6.3m/quarter. Also, they are attempting to set up a JV for their GED-APC product so we could potentially see a drop in R&D expense there ($300k total in the quarter).

Based on $6.3m/quarter in cash burn, CRME could do $32.55m in earnings or 8.6x its current enterprise value assuming no value to the oral drug. Even assuming the US drug is not approved (99% chance that it is), the stock is trading at 17.2x, which is not cheap, but fair for a royalty stream that does not expire until 2023 and in a company that will return cash to shareholders before any other R&D expenses.

However, assuming a $2bln revenue opportunity from the oral drug, based on similar assumptions, the stock is trading at 1x earning!

Aside from the valuation argument, the CEO of the company is very transparent and has openly expressed his interests in potentially selling the company to Merck or anyone else in the future. Why hasn't it happened yet? In 2008 (long before the IV/oral drugs were at their current advanced stages of testing), the company shopped itself to Glaxo, Pfizer and others but couldn't come to an agreement on price. As this point, Merck said they didn't want to buy them yet but would partner on IV Vernakalant in Europe and oral Vernakalant worldwide and also put in place an agreement that no one above a $14bln market cap could acquire the company-this agreement is in place until 2012. So, there is no reason to see an acquisition by anyone before then, unless Merck believes the stock price is stupidly cheap and worth the acquisition to cover the royalty streams to CRME. That said, there is much more value here if Merck acquires Astellas's rights to the US IV opportunity since Merck has a much better network so while I'm not basing my thesis on an acquisition, there's a chance it happens.

Generally, I think this is a situation where the royalty stream justifies the current valuation, it's a product that is proven to be much better than the competition, is cheap for understandable reasons and offers a good risk/reward for a biotechnology investment. I'm not advocating putting on a giant position, but I believe that there's enough upside to justify the risk here.