Description

This will be a quick and dirty analysis. I’ve followed Depomed for quite a while and was starting to write it up in early September at around $5.10 per share. Of course, it immediately took off to a peak of $6.70 and I was kicking myself for missing the opportunity to look like a hero to my fellow VIC’ers. So, now, with the stock back at $5.30, I won’t miss this chance – even if it means scrimping on the details.

When I look at small pharmaceutical and biotech companies, I do a bottoms-up analysis that evaluates each product or product candidate. I try to buy when the company is valued significantly below my estimate of the value of the products plus the cash on hand. I haven’t been infallible, of course, but this approach has generally served me well.

In the case of Depomed, I believe the cash plus the value of one approved drug may exceed the current market cap, meaning the market may be missing the value of a second approved product plus the development pipeline. Here are some basics:

a. With nearly 40 million shares outstanding, the equity market cap is around $212 million with the stock at $5.30.

b. Cash at June 30 was $17 million, but this was offset by a nearly identical liquidation value of preferred stock. Depomed has no debt.

c. In the third quarter, Depomed received a $25 million license fee from Biovail and $30 million in license fees from Esprit Pharma.

d. Assuming a cash burn in the third quarter of $7 million, cash at September 30 would be around $48 million and the enterprise value, net of cash, would be $164 million.

Depomed’s first product, Proquin, is expected to launch in the U.S. in November. Esprit is the marketing partner for this product and Esprit agreed to royalty arrangements that appear to be very favorable to Depomed. In addition to the $30 million up-front license fee, Esprit has agreed to pay $10 million in license fees in each of the next two years plus royalties starting at 15% of sales and ramping fairly rapidly to 25% (above $80 million in annual sales). Minimum royalties are $4.5 million in 2006 and $5 million per year thereafter. I believe the agreement will run at least until 2020 when one of Depomed’s key patents expires.

Using a 10% discount rate on minimum royalties and license fees from 2006 through 2020, I get a pretax value of $55 million. However, the value is substantially higher if Proquin achieves expectations of becoming a $200-300 million drug.

Using a 15% discount rate (these cash flows are more risky), I estimate the pretax value of the stream of payments at $130 million, $276 million, and $423 million at annual revenue levels of $100 million, $200 million, and $300 million, respectively. At sales of $100 million, annual royalties would be $19.5 million. Incremental sales yield royalties at a rate of 25%.

For now, I’m ignoring pesky issues such as taxes (Depomed does have an NOL exceeding $100 million), quarterly burn rates, competition, and dilution. I’ll be happy to get into more details over time if there’s sufficient interest. For now, my goal has been to show it’s possible that the current market cap is justified solely by the cash and the value of Proquin.

Moving further into the situation, Depomed has a second recently-approved product, Glumetza, which is licensed by Biovail. The agreement with Biovail was struck in 2002 and Biovail has subsequently undergone significant corporate changes. So, while Biovail is preparing to launch Glumetza in Canada and recently paid Depomed the $25 million license fee that was due under the agreement, Biovail is looking for a sublicensee to launch the product in the U.S. Delays in concluding this search have contributed to the recent weakness in Depomed’s stock price.

I suspect the delay has more to do with Biovail’s motivations than it does with the attractiveness of Glumetza. Biovail has made a significant investment in Glumetza and now, after changing direction, it’s trying to negotiate terms that will protect its investment and also work for a sublicensee. That may not be an easy task.

As for valuation, I don’t attribute the same value to Glumetza that I do to Proquin. However, I believe there’s a reasonable chance that Glumetza is worth at least $100 million to Depomed – and potentially much more. The royalty agreement with Biovail is not public but it has been described as starting at rates in the double-digits, plus escalators. After a $35 million optional buydown payment, royalties would be in the “high single digits” with escalators moving into the “low double digits.” If Glumetza can achieve sales of $100-200 million, the value to Depomed is likely to exceed $100 million.

Depomed has other products in the pipeline, including Gabapentin which management believes could be Depomed’s biggest product. Rather than spend time here, though, I’m going to refer you to the SEC filings and company publications for descriptions of Proquin, Glumetza, and the pipeline drugs.

If things go well for Depomed, I could see the stock price getting to $10 or more in the next year or two. This could occur if the two approved drugs have a combined value of $400 million and/or if Gabapentin continues to succeed in trials. Again, I’m giving you a very rough analysis and I trust each investor will conduct his or her own research. I will be glad, though, to answer questions and delve into issues that may be of interest.

Catalyst

1. Successful launch of Proquin in U.S.
2. Agreement to launch Glumetza in U.S.
3. Development progress with Gabapentin