Durect Corporation is a small cap specialty pharmaceutical company with proprietary drug delivery technology, specifically dealing with pain-killers. We believe that at today's market cap, you are getting Durect's most advanced drug program - tamper-resistant controlled-release oxycodone - for a discount, while also getting a decade's worth of optionality for free.

Remoxy

Remoxy is an oral, long-acting (i.e. "extended release") oxycodone gelatin capsule. The distinguishing characteristic of Remoxy is that it's tamper-proof, which is important given the pervasiveness of pain-killer drug abuse, especially oxycodone-based Oxycontin (to be elaborated upon in a bit). The tamper-proof technology of Remoxy is proprietary to Durect and is called ORADUR. In 2002, Durect licensed out worldwide development and commercialization rights of Remoxy to Pain Therapeutics (PTIE) in return for future milestone payments worth $9.3M (only $1.7M of which have been earned thus far), and a royalty rate that ranges from 6-11.5% of sales, depending on the sales volume. Durect also licensed to PTIE the rights to develop ORADUR-equipped drugs based on three other opioids - hydrocodone, hydromorphone, and oxymorphone.

The Remoxy development timeline, starting from its successful Phase 3 trial is as follows:

• December, 2007: Remoxy completed a successful Phase 3.

• June, 2008: PTIE submitted an NDA for Remoxy.

• December, 2008: the FDA sent back a complete response letter saying that additional non-clinical data was required in order to approve Remoxy.

• March, 2009: PTIE ended up sublicensing Remoxy to King Pharmaceuticals, which assumed responsibility of Remoxy development in March of 2009.

• July, 2009: King met with the FDA to discuss the response letter. King and PTIE have indicated that as a result of the meeting, they now had a very clear idea of what they needed to do in order to resubmit the NDA and address all the FDA comments.

• December, 2010: King resubmitted the NDA

• March, 2011: Pfizer completes acquisition of King so that Pfizer is now the party with the commercialization rights.

• June 23, 2011: PDUFA date for Remoxy.

Before getting into a valuation of Remoxy-based cashflow, a basic primer on the opioid-based painkiller market is in order. In 2010, approximately 26M prescriptions were filled for long-acting opioid-based drugs, for a total market of somewhere in the $10B range. The vast majority of these scripts - approximately 17M - were for generics, which include Fentanyl, Morphine, and Methadone, among others. Of the 9M non-generic prescriptions filled in the opioid category, ~8M of them were for Oxycontin, which is the most popular form of the opioid oxycodone.

Oxycontin, developed by Purdue Pharmaceuticals and introduced in 1996, is Purdue's patented extended-release formulation of oxycodone. Oxycontin has been the subject of a bunch of patent suits (which, to keep a long story short, have failed), as well as other controversy, mostly related to the fact that Oxycontin is the most seriously abused opioid-based drug. Purdue has been accused in the past of downplaying the addiction risk of Oxycontin and has in fact plead guilty to the charge, forking over ~$650M (including personal fines), as well as having a bunch of executives charged with felonies related to the matter. Beginning in 2010, Purdue started selling a slightly modified version of Oxycontin - Oxycontin OP - which is supposed to be tamper-proof. We can tell you, on pretty solid authority, that while it may be more tamper-proof than the original Oxycontin, it is still fairly abusable. Further, the OP version is also the subject of a newer controversy regarding its effectiveness, as both doctors and patients have complained that the new formulation is not as effective as the original version (this has not been proven, by the way).

This brief history of Oxycontin is important to the Remoxy story because Purdue's sleazy history has not won it any friends over at the FDA, which makes it more likely that the agency will look kindly upon any new competitors. In addition, abuse-resistance in the opioid-based drug world is now super-important for the following reasons:

• The FDA will not approve a new oxycodone-based drug that is not tamper-proof at this point.

• Abuse resistance is also significant because Remoxy is significantly better than Oxycontin from an abuse-resistance standpoint.

• Doctors are quite aware of the abuse potential of pain killers. Remoxy's tamper-proof characteristics make it an attractive sell - one that is now in the hands of the Pfizer salesforce. Thus, Remoxy should be able to gain significant market share. Additionally, it's possible that the availability of a true abuse-resistant version of Oxycontin will expand the entire market.

• The necessity of abuse resistance sets up a substantial barrier to entry for new formulations of oxycodone given that any tamper-proof technology will have to move through the clinical trial process at the FDA in order to prove efficacy. Remoxy, as mentioned above, has met its Phase 3 endpoint and the FDA response to its NDA was solely focused on non-clinical data (e.g., shelf-life), which King and Pfizer are confident they have taken care of.

People in the industry, as well as pharmaceutical consulting reports we've been reading, speak about Remoxy approval as if it is a done deal. Still, this is the FDA we're talking about so Remoxy approval is not a guarantee, but it's as close to a layup as possible when it comes to drug approval. Another data point you can use is that PTIE's CEO has for years had a systematic stock-sale program and suddenly stopped it last year. Additionally, he recently picked up his entire headquarters and shipped them from San Mateo, CA to Austin, TX. By the way, Texas has a zero rate for both capital gains and income taxes. Also, to see how much pressure there is on the FDA to deal with opioid-based drug abuse, check this out, posted on the FDA homepage yesterday: http://www.fda.gov/ForConsumers/ConsumerUpdates/ucm251830.htm

What is Remoxy worth to Durect, if approved? This is an exercise that obviously depends on a lot of assuming, but here is what we know for sure:

• The long-acting opioid market in the US is approximately $10B, and we have read consultant projections of growth in that market of anywhere between flattish to high-single digits over the next decade. We don't really know what to believe, but we assume the market grows low single digits (~3% CAGR) over the next 10 years.

• Even though there have been plenty of opioid-based generics available to prescribe, Oxycontin has still dominated the market with about 25% share in scripts filled and a bit over 30% of total revenue. The reasons, based on our conversations with physicians, include the efficacy and time-release properties of the Oxycontin formulation, as well as doctor familiarity with oxycodone.

• Oxycontin itself goes generic in 2013, which in theory means that similar extended-release versions of oxycodone will become available at that point. As we've discussed above, though, that is extremely unlikely given the increased abuse-potential of non-abuse-resistant extended-release oxycodone (remember that the extended release pill has a lot more drug than one you have to take every few hours, hence the increased abuse potential). Thus, the FDA would not approve a generic version of Oxycontin.

• Remoxy is not claiming to be a generic version of Oxycontin, but a new formulation of oxycodone, with similar (or better, depending on one's view of Oxycontin C) efficacy as Oxycontin, better abuse-resistance properties, and a comparable extended release profile. Additionally, Pfizer expects to be able to describe the ORADUR technology on the Remoxy label, as well as include data from abuse-resistance studies, even if it will not be able to unambiguously claim abuse deterrence. While we won't label Remoxy the holy grail of opioid-based pain-killers, it will probably be the best abuse-resistant, oxycodone-based, extended-release drug for the next decade.

Given the above, our DCF for Durect's Remoxy royalty present value assumes sales begin later this year, ramp up over five years to about a third of the Oxycontin market (i.e. a bit less than 10% of the total opioid-based prescription pain-killer market), and grow 3% thereafter until year 10 (i.e., 2021). We put a 5x multiple on year 10 royalties, and discount that back to the present. We use a 10% discount rate, and we assume a fairly conservative royalty rate profile based on our conversations with Durect management and the company's investor presentation (while Durect's royalty rate ranges from 6 to 11.5%, our royalty rate never goes above 8%).

Our PV for Durect's Remoxy royalties using the aforementioned assumptions yields a value of ~$400M. Properly diluting for options outstanding, accounting for the cash those would generate, and adding back two thirds of the net cash on the balance sheet plus the milestone cash Durect would receive upon Remoxy approval gets us to a ~$4.70/share valuation. Shares closed Thursday at $3.29 a piece, which you can say puts the chances of approval at ~70% (way too low in our opinion) and values the rest of the Durect pipeline at zero.

(By the way, for the sake of sensitivity analysis and because terminal valuations can make a big difference, if you assign a zero terminal value at year 10, our per share valuation falls to ~$3.40, and if you put a 10x multiple, as we've seen the sell side do, the per share valuation increases to ~$6.00. Obviously, the former assumption is ridiculous, but we view the latter as too speculative, so we just averaged them, which you can feel free to disagree with and/or suggest alternatives).

The Rest of the Pipeline

We're not valuing the rest of Durect's pipeline in the above valuation, but we are certain that, at least from a probabilitic perspective, it has plenty of value. The following is a list of the potential products that will generate revenue for Durect, in approximate order of most tangible/practicable to most speculative:

POSIDUR

Posidur is potentially more exciting than Remoxy, but we put it here because Phase 3 enrollment is happening as we speak and it will take a while until we get results. But here are the quick facts on Posidur:

• After surgery, the typical patient will get a bupivacaine injection at the site of the surgical wound in order to reduce pain. The pain-killing effect of the bupivacaine lasts for approximately 20 hours, and as it wears off, the patient moves to oral pain-killers. Posidur is based on a Durect technology which would allow the pain-killing effect of the injection to last for about 72 hours.

• Posidur has passed Phase 2 and is currently enrolling Phase 3 participants.

• The potential here is enormous because such a treatment would reduce the dependency the patient properly taking oral pain killers, and this would also eliminate many of the side effects currently experienced with oral pain killers such as constipation, drowsiness, etc. We've spoken to anesthesiologists about the product and they consider it a massive improvement on the tools they have right now.

• Durect has licensed Posidur to Hospira in the US and Canada, and Nycomed in Europe. Hospira already has significant sales contact with hospital anesthesiologists, and actually are the manufacturer for Posidur, so the partnership makes sense.

• Durect is in line to receive another $185M from Hospira and $181M from Nycomed if it hits additional milestones (i.e., approval of the drug, which is probably the event that triggers the vast majority of the milestone payments).

  • Durect will get a "double digit" royalty from Hospira and a 15-40% blended royalty rate from Nycomed.

• As you might have guessed, given the enormous milestone payments Durect can earn here, together with a pretty decent royalty rate (much higher than Remoxy), the market here is enormous - There are approximately 33M surgeries in the US each year that Posidur would target (and growing) and there is no competition in sight for this product. At a $250-400 target price per procedure and only 10% of the market, we're talking about $1B in sales and >$100M in US-based cashflow for Durect. Now add in Europe, and add in that the target share-of-surgeries is >30%, and the potential here is clearly enormous.

• Still, this is only starting Phase 3, and we have no clue how it will work out. If successful, the product is worth over $1B to Durect. Current enterprise value: $250M. We'd say that given the probabilities of success here are better than the average Phase 3 (bupivacaine has been used for post-operative injection for decades so there's no question the drug works - the issue is just how long), Posidur by itself may justify the current market value of Durect.

ELADUR

Eladur is a bupivacaine patch that lasts for 3 days vs. the current alternative of the 12-hour lidoderm patch. Durect developed this specifically for postherpetic neuralgia (PHN) and licensed it to Alpharma, which was acquired by King, which was acquired by Pfizer. King went for the grand slam by doing a Phase 2 with Eladur on lower back pain, which was unsuccessful (unsurprising given the placebo effect on lower back pain). Durect has already completed a successful Phase 2a with Eladur used on PHN patients, and Pfizer is currently reviewing the asset.

TRANSDUR

Using the same base technology as Eladur, the Transdur patch uses sufentanil as its primary ingredient, is targeted at chronic pain, and is supposed to last 7 days vs. the current 2-3 day period that fentanyl patches are effective for. The fentanyl patch market is currently ~$750M and Transdur-sufentanil is supposed to have significant advantages over fentanyl besides the longer-lasting effectiveness, including reduced cost of therapy, fewer patches used (so better odds of patient following the regiment), and potentially less use of oral pain killers. Transdur-sufentanil has successfully completed Phase 2 and Durect holds all the rights to commercialization and development. The company is currently looking for a partner.

Other ORADUR shots on goal

The Oradur tamper-resistant technology being used for Remoxy also has the potential to be used in other opioid-based oral drugs, as well as another enormous category of frequently abused drugs - stimulants. This is all early-stage stuff and is really just a twinkle in someone's eye at this point.

Other SABRE shots on goal

The Saber technology that is being used for Posidur, i.e. the "long-acting" injection can also be a huge boon for the delivery of proteins and peptides. So the potential in the potential in the area of biologics is significant. Again, this is very far off stuff.

The Market for Small Cap Pharma is Broken

We think that from a probabilistic standpoint, Durect is worth more than double the current market price. Of course, over time, those probabilities and resulting value will change depending on the results of clinical trials and/or FDA approval decisions. As for cash-burn, there is not much to worry about here given that Durect has only gone through ~$10M in cash per year over the last few years and has $50M in the bank. We're only starting to turn over the stones in small cap pharma land, but it's clear to us that the market is broken. Durect is one of the less-speculative, high-probability ways to play this game, with the Remoxy-based margin of safety.

Risks

Obviously, the biggest risk here is the non-approval of Remoxy over the next few months. We think the odds of approval are as good as you can get with the FDA. Additionally, if Remoxy does not get approved, and the stock tanks, we would view it as a very asymmetrically-positive bet on Posidur approval down the line.

The PDUFA date for Remoxy is 6/23/11