Catalyst Pharmaceuticals (Ticker: CPRX)

Price p/s: $3.69 | Mkt cap: $371m | EV: $231m | FCF (adj.): $30m | EV / FCF (adj.): 7.7x

Introduction – a small bio-tech company with healthy cash generation

Catalyst Pharmaceuticals (“CPRX”) is a small bio-technology company with a focus on the treatment of rare diseases. Unlike other bio-tech firms whose value lies (at least in part) in future uncertain FDA approvals, CPRX has an approved and free cashflow generating drug called Firdapse. The drug has Orphan Drug Designation (ODD) from the FDA, giving it 7 years of marketing exclusivity in adults, of which about 5 years remain.

Firdapse is the only FDA-approved treatment in adults for Lambert-Eaton myasthenic syndrome (“LEMS”) which affects about 3,000 people in the US. LEMS is a rare and debilitating neuromuscular disease which is characterized by severe muscle weakness in the legs, arms and shoulders rendering patients unable to walk or care for themselves. In extreme cases, patients are also rendered unable to chew, talk or swallow properly. Needless to say it dramatically affects a patient’s life. LEMS broadly affects people in two categories: 1) in about half of cases it is associated with small cell lung cancer with an older age of onset (averaging 60 years), and 2) in the other half of cases it is believed to be genetic with a younger age of onset (averaging 35 years).

As with many orphan drugs (drugs that treat diseases affecting a small proportion of the population), Firdapse is very expensive with a list price of $375,000 per year. Payers (insurers, Medicaid, etc.) cover this cost with a small co-pay (typically less than $10 per month) and for those who are not insured and qualify, CPRX gives the drug away for free. CPRX has exclusive rights to Firdapse from BioMarin Pharmaceuticals (who earn a royalty on sales) for the US, Canada and Japan. It is currently distributing the drug to about 600 patients in the US after its launch in January 2019.

Investment thesis – a discount on expected cashflows with many additional upside levers

The investment thesis is one of low risk (at the current price) and high uncertainty with respect to the upside. Not only does the current stock price undervalue (by 31%) the cashflows that CPRX is likely to generate in the US for the treatment of LEMS patients (giving a healthy margin of safety), but it ignores a range of further potential growth catalysts, namely:

·  Sales of Firdapse in Canada to LEMS patients, having recently received marketing authorization for Firdapse from Health Canada. Canada has about 10% of the LEMS patients (estimated at 300) that the US has.

·  Sales of Firdapse in Japan to LEMS patients which has about 40% of the US population (estimated at 1,200 LEMS patients). CPRX has “…reached a tentative agreement on a regulatory pathway to seek approval of Firdapse in Japan” after the Japanese Ministry of Health, Labor and Welfare designated the underlying drug (amifampridine) as a priority and have been soliciting companies to file for approval. Such approval would give Firdapse 10 years of exclusivity under the Japanese orphan drugs act. Achievement of certain milestones in Japan will unlock further territories in most of Asia, Central and South America.

·  Gaining approval of Firdapse for the treatment of other rare neuromuscular diseases through clinical trials. CPRX spends about $16m per year on R&D. The company is currently conducting trials of Firdapse (at various stages) on Spinal Muscular Atrophy (SMA) Type 3 which affects between 2,900 and 3,600 people in the US. They are also exploring the application of Firdapse to Kennedy’s disease and HnPP. Admittedly, their trials were unsuccessful for approval for Firdapse to treat MuSK Myasthenia Gravis (which management were quite bullish on) and CMS.

·  Using their significant cash balance ($140m) together with some debt capacity (currently no debt) to purchase other late stage drugs for rare diseases. This seeks to leverage their clinical expertise and the significant investment that CPRX have made into a rare disease sales force and advice platform for Firdapse.

All of these initiatives have varying probabilities of success (with higher probabilities on the Canadian and Japanese approval of Firdapse for LEMS treatment) with substantial payoffs if they come to fruition. Fortunately, the current stock price does not necessitate a reliance on these events coming to pass. Thus an investment gives one an opportunity to benefit from any one of these events if they occur, but a satisfactory return if they don’t.

Moat – defense during and after the exclusivity period

The moat around CPRX is obvious – they have an ODD which gives them exclusivity for 7 years from November 2018 and are the only adult-approved drug for a debilitating disease. This moat has been somewhat threatened by another drug called Ruzurgi (also amifampridine, although the base form) produced by Jacobus Pharma, which was strangely granted FDA-approval for children (6 – 17 years old). It is very rare (maybe one of the first times?) that the FDA has granted orphan-drug approval for the same chemical entity from two different drug makers. Ruzurgi costs between $175k and $292k per year so is cheaper than Firdapse. CPRX filed suit against the FDA, lost, and are appealing the ruling.

This risk to Firdapse from Ruzurgi should not be entirely discarded, but its likely that we’ve seen the worst of its effects. Some adults appear to have been given off-label prescriptions for Ruzurgi towards the end of 2019 / start of 2020, allowing them to switch away from Firdapse. Management are saying that this is largely the group of people that were part of the Ruzurgi investigational trial and that they’re now hearing very little about Ruzurgi. CPRX are much better funded so are able to get the word out on this rare disease and better support patients / doctors in the use of Firdapse. Additionally CPRX have the adult FDA-approvals where LEMS largely occurs (forcing doctors that want to prescribe Ruzurgi to do so off-label), and also have better (patented) treatment methods.

What happens after the orphan drug exclusivity is over?

The bigger question for me was what happens to the CPRX moat after year 7 of their exclusivity period ending in 2025. The standard theory is that generics will enter the market, pushing down the price and reducing the branded product’s profitability. But this is a rare disease which only affects 3,000 people in the US, making entry for a generic less appealing.

A 2019 paper by the National Bureau of Economic Research entitled “The Orphan Drug Act at 35: Observations and an Outlook for the Twenty-First Century” had this to say on the matter:

“…the small size of patient populations for orphan drugs, together with the increasing prevalence of biologics among orphan drugs, have created a set of natural monopoly‐like markets in which firms face little competition, even after the end of formal periods of patent protection and market exclusivity.”

Further on they discussed the topic in more detail:

“In the orphan drug space, a branded manufacturer (or in the case of biologics, reference product manufacturer) can sometimes exploit the link between high prices and low market contestability. Generic and biosimilar manufacturers will recognize that their entry into a small orphan drug market will prompt the branded manufacturer to drop its price to maintain market share. An already small market could therefore become even less profitable on a per‐patient basis, potentially eliminating the expected value of entering the market to a generic or biosimilar manufacturer. These manufacturers may thus choose not to enter, leaving branded manufacturers to behave as monopolists. Crucially, the test for contestability is not the actual number of generic manufacturers with the technical means to produce competitor drugs, or the existing number of competitors. Instead, markets are considered contestable based on the number of manufacturers that could rationally enter. If that number is small—whether due to small market size or high production costs that prevent manufacturers from achieving minimum efficient scale—the original manufacturer will remain a natural monopolist, allowing it to reap the gains of monopoly pricing well beyond the officially granted exclusivity period.”

For context, when referencing “small orphan drug market” they gave examples of diseases affecting 10,000 people – 3 times the size of the US LEMS market. The paper goes on to show that orphan drugs typically only face generic competition 27.3% of the time after their exclusivity period ends (having looked at 498 orphan drugs). The prevalence for generic competition is also lower when the peak number of patients treated by the branded drug is lower.

Additionally, CPRX have just been awarded a patent (expiring in June 2032) for its methods of administering its drug. In the words of the CEO, Patrick McEnany: “This patent will further strengthen and reinforce our exclusivity of the Firdapse brand in the United States.”

My view is that Firdapse is unlikely to face generic competition after 2025 because of its small market, the loyalty that it is building amongst its patients and possibly the protection provided by this new patent (although admittedly this patent protection is difficult to get a firm handle on right now). The more likely downside case is that Firdapse would need to reduce its pricing down to the Ruzurgi level (midpoint pricing of $233k) which would still offer healthy cashflows.

Valuation – 19 quarters of FCF plus a terminal value plus current cash

A DCF method was thought to be most appropriate given the limited period (19 quarters) before ODD exclusivity ends and the potential changes to the cashflows at that point. In summary, 5 years of cashflows plus the terminal value plus the current cash on hand gives a total value of $557m or $5.37 per share.

CPRX in its current form (sales of Firdapse in the US to treat LEMS) is not overly complex to value on a discounted cashflow basis, although some adjustments are required. The current quarterly revenues of about $30m are from about 600 patients (some paying, some not) at a gross profit margin of 86%. With $4m of R&D expenses, $10m of SGA expenses and minimal working capital investment, CPRX produces quarterly free cashflow of about $11.8m.

Two normalization adjustments are required. Firstly, the long-term gross profit margin is likely to be closer to 80% since the 2019 and 2020 margins benefitted from inventory that was manufactured and expensed prior to FDA approval. Secondly, CPRX have just entered into a tax-paying position and expect their tax rate to be in the range of 22% - 25%. These two adjustments give an adjusted quarterly FCF of about $7.5m. (Note that sales above $100m annually in the US attract a higher 10% royalty from CPRX to BioMarin up from the current 7%)

The crux of the projection lies in the forecasted growth in patient numbers. Before COVID struck and after the initial sign-up phase (where people from the trial were quickly converted to Firdapse), management mentioned signing up about 15 – 20 patients per month. Once COVID struck, general patient visits to doctors (mostly neurologists in this case) reduced by about 70% (LEMS patients being particularly fearful and even less likely to go out). So patient growth has slowed dramatically, despite CPRX hiring a number of additional rare-disease sales people just before COVID struck (a good sign of their view on the growth potential).

I’ve assumed that in 2021 only 5 patients will be added per month and thereafter (once vaccines take effect) 10 per month, with the total patients peaking at 1,110 by the time the exclusivity expires in Q3 of 2025. This is a conservative set of growth assumptions for three reasons: 1) there is significantly more runway for growth if the 3,000 LEMS patient number is to be believed – at a minimum the insurance data obtained by CPRX shows 1,500 diagnosed LEMS patients, 2) I’m using 10 patients per month which is below management’s range of 15 – 20, and 3) this is a debilitating disease for which Firdapse is the only adult-approved treatment – the moat here should spur growth. Critically, the growth in revenue ($1.5m per quarter from 2022 onwards) drops largely to the bottom line (adding $900k of FCF per quarter) after applying the 80% GP margin and 25% tax rate since the R&D and SGA expenses remain steady ie. they benefit from operating leverage. By September 2025 the business is forecast to make $81m in FCF p.a. on an TTM basis.

Using a 9.7% discount rate (long-term S&P 500 return) and a term ending in September 2025 (when the orphan drug designation expires) gives a DCF value of future cashflows of $204m. Add to that the current cash balance of $140m and a discounted terminal value (explained below) of $210m gives a total fair value today of $554m or $5.35 per share. At a current share price of $3.69 that’s a 31% discount to fair value or 45% upside from here.

Terminal value – there should be some value to CPRX after 2025

In coming to the terminal value after the ODD exclusivity period at the end of 2025, I assumed that the revenue drops to the Ruzurgi level (average of $233k per year). At that stage, I also assumed that R&D spend ends (having effectively delivered nothing for the total $70m of R&D work over the 19 quarters) and SGA expenses halve since the business is effectively ex-growth then and won’t need the same sales people. This gives an annual FCF at the end of 2025 (for the then 1,110 patients) of $65m to which I apply a 5.0x multiple giving a value of $325m ($210m when discounted). (Note that although the royalty payments to BioMarin and the sub-licensor are only for the first 7 years of Firdapse sales in the US, I’m not sure what happens thereafter so have left these in the cost of sales.)

Downside case – get 80% of your investment back in cash

It must be stressed that due to the rare nature of LEMS, a neurologist may never even see a LEMS patient in their careers and if so, they may not necessarily think about LEMS as a diagnosis. (There are undoubtedly people out there who suffer from LEMS and don’t know it, bouncing from diagnosis to diagnosis.) In addition, Firdapse is a new drug that needs to gain awareness. Much of the work that CPRX management have done is to increase awareness and improve diagnosis of LEMS, reaching out to neurologists of patients identified in insurance data, providing free LEMS test kits, running rare disease symposiums, etc. COVID has hampered these efforts.

The recent 4 quarters have not seen any revenue growth. Ruzurgi has played its part in pulling away some patients and COVID has made signing up new patients very difficult since they’re just not going to see their neurologists. But just before COVID struck, CPRX doubled its sales force (increasing quarterly SGA expenses by 25%+) indicating their view on the potential for growth. This growth may be slow to emerge as the world continues to recover from COVID in 2021, but I believe that a treatment for a disease that is as debilitating as LEMS certainly has a way of getting out there. That being said it may not, so what’s the downside?

If one assumes that the current revenue never grows again, that CPRX management continue spending on R&D at $4m per quarter (without any success) and that after having no growth for another 2 years they eventually cut back on sales spending (halving SGA expenses from then on), then CPRX will generate $1.72 per share in free cashflows (not discounted) over the next 19 quarters. At that point, lets assume that a generic enters the market and charges $1 per year for treatment, completely killing the current CPRX (and Ruzurgi) business and leaving no terminal value. Adding the $1.72 in future cashflow to the current $1.35 is cash per share gives a current downside value of $3.07 which is 30% below the current share price.

Other risks not yet discussed – media attention, insurers paying and asset allocation

1. Orphan drugs tend to get a lot of media attention because of their high price tags. My personal, simplistic view is that there needs to be an economic system to encourage development of drugs for rare diseases and the Orphan Drug Act has been in place since 1983 for this reason. But Firdapse has already suffered from its high price tag after CPRX was singled out by Senator Bernie Sanders who has a history of targeting the pharmaceutical industry. In the runup to the elections, this attack was likely spurred by political rather than purely ethical motives, but nonetheless the pressure probably contributed to Ruzurgi receiving FDA approval for treatment of children. It is not beyond the realm of possibility that more negative media attention spurs further action against orphan drugs.

Besides the argument for ODD encouraging rare disease research, this risk is mitigated partly by economic interest. There are far larger pharmaceutical companies charging far higher prices for orphan drugs that stand to lose from a permanent attack on orphan drug status. Firdapse, at $375k per year, is not near the top 10 most expensive orphan drugs at the moment, with number 10 coming in at $633k per year. The top 10 orphan drugs are produced by companies like Sanofi and Amgen which are far larger and likely have significant clout in Washington. Any change to orphan drug policy is also more palatable for new orphan drugs as opposed to existing drugs.

2. Another risk is that the insurers refuse to pay the high ticket price for these rare disease drugs. Thus far this has not been a problem for Firdapse. In the Q2 2019 earnings transcript, Dan Brennan (Chief Commercial Officer) stated: “About 95% of insured patients have received positive coverage determinations from their insurer and all uninsured patients or those denied coverage from their insurer have received free charitable patient assistance medication.” There has been no indication that this has since changed.

Additionally, in the previously-cited orphan drug paper they state [emphasis mine]: “… those afflicted with an orphan disease are sympathetic and supported by well‐organized patient advocacy organizations, including the National Organization for Rare Disorders in the United States (NORD) and the European Organization for Rare Diseases (EURORDIS) in the European Union. It may, as a result, be politically untenable or undesirable for a payer to refuse coverage for a promising new therapy on the grounds of cost.”

3. Management’s use of the cash balance that CPRX has accumulated over the last few years is the third major risk I can see. They’ve spoken about looking for other rare disease drugs that they can bolt onto their existing platform and leverage off of their rare disease sales force. In theory this sounds extremely sensible, but much will depend on the price they pay for such drugs and their stage of approvals. Management have expressed a desire to not go back to drugs in early-stage trials, but later stage approvals are not guaranteed either. More importantly, the price they pay may not be value-accretive to shareholders when considering what they’re getting – there are countless examples of management teams destroying shareholder value through acquisitions. Unless a truly great acquisition opportunity presents itself, I’d prefer to see management buy back CPRX shares at current prices (unfortunately nothing I’ve read seems to suggest that this is on the cards right now).

Management and incentives – are they appropriately aligned with the shareholders?

Management appears to have executed on their strategy quite well over the last few years before COVID hit. They are led by 72 year old Patrick McEnany who was the previous (apparently successful) CEO of Royce Laboratories. McEnany founded CPRX and is the current president, CEO and board chairman. Having read through the earnings transcripts, McEnany and Co have been honest with shareholders in my view - sharing the ups but not sugar-coating the downs.

As a collective, the top 6 management members have beneficial share ownership of just under 10% of CPRX. Of this, about 30% sits in unexercised share options that are in the money and an additional 10% of share options that are out of the money. A vested interested in the company’s shares is good, but I prefer that one-sided options are not given as rewards since it creates the wrong incentives (upside focus without due consideration for the downside). Unfortunately one-sided options are the main reward-mechanism of choice at CPRX.

McEnany does appear to have just under 5% pure share ownership (excluding options) to the value of just over $18.5m at today’s price. Considering his total remuneration package in 2018 and 2019 was about $3.4m in each year, his current shares are likely meaningful to his net worth and should drive the right view of risk-reward. The other management members have the majority of their beneficial share ownership in unexercised options although the COO (0.6%) and CFO (0.4%) do have some pure stock ownership.

All round, the total incentive packages of the top 3 remunerated individuals (CEO, COO and Chief Medical Officer) were $3.4m, $1.4m and $1.2m respectively in 2019. Relative to a total CPRX net income of $31.9m, this is high but not outrageous if one considers that about 80% of those packages were in the form of bonuses and stock (options) for good performance.

I would like to see the total remuneration for the main management members for the 2020 financial year (not yet published). This will give a view of how the board balances management incentives with shareholder value. Management was well rewarded in 2018 and 2019 when they launched Firdapse and started generating healthy cashflows – in these years they appear to have received a total package that was about 3 times that of 2017. 2020 was a tougher year for CPRX (admittedly for reasons that were not all in management’s control) and in my view this should be reflected in lower total remuneration.

Conclusion – a bet weighted in the investor’s favor

My view is that the potential reward justifies the risk and that CPRX provides investors with a bet that is nicely skewed in their favor at the current price. The current price undervalues (by 31%) the Firdapse opportunity for LEMS patients in the US under a cautious set of growth assumptions (although FCF does admittedly grow quite rapidly). There is a strong moat in place until 2025. I also think that Firdapse will continue to have value beyond 2025. The downside, if nothing pans out from any of the current sales force, significant R&D spend and other growth opportunities, is not enormous at about 20%.

This write-up has not spent much time considering the upside opportunities because they are difficult to quantify and my view is that you’re not paying for them. There is more upside in the US LEMS opportunity – the forecast peaks at 1,110 of the estimated 3,000 LEMS patients. I believe that Canada will result in sales (they have signed an agreement with a Canadian distributor) and Japan will likely result in sales (authorities are keen on an amifampridine product). Firdapse could also prove effective on other rare illnesses (a longer shot for sure but with big upside). And of course there is always the possibility of a buy-out from a large pharmaceutical company at a significant premium to the current valuation.

I am long CPRX.