Description

Long: HLS Therapeutics ($25 target price)

“Hope deferred maketh the heart sick: but when the desire cometh, it is a tree of life”

HLS Therapeutics (HLS) is a small cap Canadian pharmaceutical company. The company’s history is one of great promise and initial success, followed by years of repeated disappointment and investor fatigue. This disappointment was not a function of economic setbacks or management failure, but rather a function of the difficulties of new drug commercialization (sales) during Canada’s lengthy Covid lockdown. It turns out that it is much easier for pharma sales reps to educate doctors and sell new drugs in person than via Zoom; it also turns out that the wheels of Canadian state healthcare bureaucracy move at a glacial pace. We assert that as of late 2022 the main issues facing the company have been resolved, placing HLS in a position to realize the promise that the market glimpsed in late 2019. Vascepa sales are rising rapidly in Canada (October is 39% higher than Q3 average levels) and are finally reaching sufficient scale to move the needle on the consolidated income statement. However, after 3 years of delay and stock price declines no one seems to be paying attention. Furthermore, the stock has faced forced selling pressure leading up to its expulsion from the MSCI small cap index on Nov 30th. With the shares near an all-time low and the business fundamentals finally inflecting to the positive, we think the stock presents an extremely interesting opportunity.

Rough, back of the envelope numbers for a choose-your-own adventure:  

• Clozaril as-is and zero credit for Vascepa = $13 per share
• Clozaril as-is and moderately successful Vascepa (10% in label penetration) = ~low $20s per share
• Clozaril as-is and moderately successful Vascepa with successful patent portfolio defense (longer timeline to Canadian genericization) = ~$30 per share
• Clozaril as-is and Vascepa with statin-levels of patient penetration (4x company target) = ~$55 per share, which incidentally seems to be what people were hoping for in 2019 post approval.
• We picked $25 as a reasonable target price since we think the Vascepa rollout will be successful, but struggle with strong assertions on any genericization timeline.

HLS was written up previously in January 2021 by ahnuld, which we believe is a great writeup. In brief recap, the company has two main assets:

1) Clozaril: an antipsychotic used in treatment-resistant schizophrenia. The drug was genericized in 2004 in the US and Canada but retains a 55-60% market share in Canada due to the infrastructure HLS established around blood testing. In the US the drug is a pure “tail product” with 1% market share. Clozaril is a product of last recourse but comes with a potentially life-threatening side effect for 1% of patients relating to a drop in white blood cell counts. Consequently there is a mandatory patient registry that requires patients to have documented white blood cell counts 39x in the first year and once per month thereafter.  HLS operates (e.g. staffs) a patient care portal to facilitate data entry on the blood tests into the national registry, simplifying life for the prescribers and allowing the drug to hold market share. The main point regarding Clozaril is that revenues and cash flow have been very steady in the last 7 years, and are likely to remain flat or even grow decently if the company’s initiatives on CSAN pronto are successful.

2) Vascepa: icosapent ethyl capsules used to reduce the incidence of adverse cardiovascular events in statin-treated patients with established cardiovascular disease and elevated triglycerides. Three major phase 3 trials have shown that the use of Vascepa results in a significant reduction in adverse cardiac events in at risk patients (JELIS 2005, REDUCE-IT 2018, RESPECT-EPA 2022). The data is compelling enough that the Canadian Cardiovascular Society included icosapent ethyl in its official treatment guidelines under “strong recommendation: high quality evidence” and the Canadian healthcare authorities formally recommended that the drug be reimbursed under state healthcare plans. The commercial potential of the drug is massive with a target market of ~1.55mm patients (C$ 2.5bn-3.0bn revenue per year)

Financially, the value of Clozaril alone supports the current share price including the net debt, implying less than zero value for Vascepa. Vascepa to date has been a drag on the income statement, as HLS built out a national sales force but is only now reaching sufficient prescription levels to break even on that drug – in Q4’22 by our estimate – which is seemingly 18 months behind the company’s original plan. The setback in Vascepa’s commercialization timeline has been due almost entirely to delays created by Canada’s strict Covid lockdown. The main barriers to Vascepa’s adoption to date in Canada have been twofold:  a general lack of awareness about the product among prescribing physicians and a lack of reimbursement coverage by provincial government health plans.

During lockdown Vascepa’s sales force was unable to visit doctors in person to educate them on the drug’s trial results and clinical benefits, which significantly elongated the sales cycle. In Q1 2020 HLS built out a sales team of 30 people to call on 2500 cardiologists and endocrinologists, albeit remotely. To accelerate the sales process, in August 2021 Vascepa entered into a sales agreement with Pfizer Canada to call on 7500 general practitioners across the country. Since the drug is indicated for statin-treated patients, HLS and Pfizer are initially focusing efforts on the highest-volume statin prescribers in the country and then broadening awareness from there. The company estimates that it takes a salesperson around 5-6 visits and ~12 months on average to fully answer a physician’s questions around a new treatment before they start prescribing. Once a physician starts prescribing Vascepa, they tend to prescribe it for all their patients. Canada removed in-person restrictions late in March 2022, implying an acceleration in prescriptions in Q4’22 into Q1’23.

Furthermore, staffing shortages in the Canadian state healthcare system lengthened the negotiation process on state healthcare reimbursement beyond the company’s original anticipated timeline. While HLS quickly achieved 90%+ reimbursement coverage in private healthcare plans, reimbursement under provincial healthcare plans only started in May 2022 (in Quebec) after HLS reached agreement with the pan-Canadian Pharmaceutical Alliance, which is the entity that negotiates on behalf of provincial healthcare systems. As a rough generalization, doctors in Canada tend not to prescribe drugs unless they are covered under both public and private insurance plans to ensure certainty of reimbursement; the lack of dual coverage has significantly limited volumes. As of August 2022 HLS achieved 70% public sector coverage, while negotiations with the provinces of Alberta and British Columbia remain ongoing.

HLS believes that Vascepa can generate a run rate of 250-300mm in revenue in 2026 at a 10% patient penetration level, versus the 10mm annualized revenue run rate recognized in Q3’22. Now that the barriers for adoption have been removed, we would expect to see very rapid revenue growth from the product into 2023. Indeed, revenue growth is already accelerating, with October 2022 factory shipments 19% higher month-month and 39% higher than the monthly average in Q3.  In our opinion, the long-awaited bull case for HLS appears to be finally manifesting itself, but the stock remains languishing near all-time lows, providing a very interesting entry point.

Source: IQVIA, Stifel Canada 11-10-22

Why only 10% market penetration?

A priori, the company’s assumption of 10% market penetration with Vascepa for in-label patients in Canada looks quite conservative. Vascepa’s indication is to reduce cardiovascular events in high-risk patients that are already treated with statins. The 25% reduction in adverse events seen in Vascepa’s clinical trials is similar to the 25-30% reduction in adverse events seen in the clinical data supporting statin use, and statins have achieved a market penetration of 40%. Considering that the relevant patient population already has established cardiovascular disease, medically speaking it would seem compelling to offer Vascepa to everyone who’s already on a statin since the risk reduction is additive and the need is obvious. Furthermore, the safety profile of Vascepa is extremely benign, the drug is very easy to administer, the drug’s cost to the system is low, and insurance reimbursement is widespread and growing (AB and BC provincial plans are expected to provide reimbursement over time). The main problem for Vascepa’s adoption has simply been a lack of physician awareness. To that end, HLS’ partnership with Pfizer expanded coverage to physicians responsible for 70-80% of nationwide cardiovascular prescriptions. The same Pfizer Canada sales team was also behind the launch of Eliquis, a different cardiovascular drug that achieved 30-33% market penetration. Essentially all logic would point towards a market penetration rate significantly higher than what management has guided towards. The primary reason for why HLS has chosen a much lower number appears to be that they just don’t want to disappoint the market (again).

What about generics given the history of Amarin?

Amarin (AMRN) is the company from whom HLS purchased the Canadian rights for Vascepa. Amarin’s original patent relating to Vascepa was that the drug lowered triglyceride levels, and in 2020 Amarin lost a legal challenge to this patent allowing generic versions of Vascepa to proliferate in the US on that basis. Investors appear to have lingering concerns that something similar will happen to HLS, although there are some very important distinctions between the two markets as well as the two companies’ patent portfolios. HLS’ exclusivity in Canada through the end of 2027 is based on the specific results from the REDUCE-IT trial results (e.g. the drug lowers adverse cardiac events), rather than a claim to lower triglycerides. With the benefit of having witnessed Amarin’s legal challenges, HLS also hired patent attorneys to implement a ‘picket fence’ strategy of 11 patents covering various topics from method of use, formulation, biochemical/microbiological activity, etc beyond the data exclusivity period. The patent portfolio extends through 2039 and if any of the 11 patents are upheld, no generic competition can enter the Canadian market.

Historically, generic drug manufacturers have utilized the same regulatory pathways to enter the US and Canadian markets simultaneously. In the case of Vascepa, the US pathway (claim to lower triglycerides) is not available in Canada. Therefore, a new entrant would need to consider the economics of Canadian market entry – specifically the legal cost of challenging HLS’ patent portfolio or the cost of a new trial  – versus the rewards of Canada-only generic revenue. In all honesty, we have not been able to find examples of generic manufacturers pursuing Canada-only market entry although it’s certainly possible that precedents exist. Ironically, this means that genericization of Vascepa in Canada is primarily a threat in the event that HLS’ estimates of market penetration turn out to be wildly conservative (in which case the stock would have more than worked in the interim). The market’s base case assumption of a somewhat successful Vascepa launch followed by aggressive generic market entry at the earliest possible moment simply appears unlikely.

Valuation:

The sellside appears to use a mix of DCF and EBITDA multiples to value HLS. Given that there is no capex to speak of, EBITDA effectively represents unlevered pre-tax free cash flow after the Canadian NOLs are exhausted. We use DCF ourselves given that Canadian genericization of Vascepa will likely be a reality at some point in the future, albeit possibly 15 years from now. However, the main issue with DCF as a methodology is that people tend to effectively assume a wind-down for the company at the point of genericization. In all likelihood, management will take advantage of the next 13-15 years to reinvest Vascepa cash flow into new pharmaceutical assets, turning the key question into one’s estimation of management’s skill at capital allocation rather than the date of a future hypothetical liquidation. Basically DCF does not give credit for management’s skill at reinvestment, or the ‘platform value’ that could be created by accumulating a portfolio of cash-flowing pharma assets. In our view the most likely outcome is that HLS will continue to invest in new pharma assets, grow EBITDA, and eventually pursue a US listing, a scenario which lends itself to traditional short-hand metrics like EBITDA or earnings multiples and a much higher valuation in general. Of course, the key is that the Vascepa commercialization process actually works to deliver the cash flow used in reinvestment.

Catalyst

earnings growth from Vascepa commercialization