Description

Neose is a 15 year old speculative biotech firm with cumulative losses in excess of $200 million that is close to an inflection point. They have a valuable process with extensive patent protection that is applicable to most therapeutic protein drugs, a $50+ billion rapidly growing market. Stated simply, Neose owns a process that modifies protein drugs so that efficacy is improved resulting in smaller and less frequent dosing. As a side benefit, the manufacturing process is cheaper than some existing techniques and produces more uniform products in greater volume. More importantly, the Company has the ability to switch between different expression systems which could be a valuable way to get around existing patents. I have followed this Company for six years and would readily admit that this is not a “value” idea. The basic premise is that there is limited downside risk because the stock market has given up on the technology and has assumed the worst in the face of a lack of news. The upside in 2 – 3 years is ten times today’s price. The stock is actively traded, is covered by Value Line, was recommended in October by UBS at $2.45 and has recently bounced up from $1.75 on the anticipation of a filing with the FDA by the end of this year (see below).

Technology
Many new protein based drugs are manufactured using recombinant expression systems (a gene is spliced into a simple organism which then churns out the desired protein in volume). Neose owns enzyme processes that complete the sugar (carbohydrate) chains on proteins and add polyethylene glycol (PEG) to those sugar structures. The technology works with a host of recombinant expression systems from Chinese hamster ovary (CHO) cells (the standard for replication of mammalian proteins), to insect to yeast to bacterial cell cultures. Completing and capping the sugar chains is a key issue with protein drugs and is required to make them more human like to avoid rejection, increase efficacy and increase half life. All recombinant approaches result in incompletely or inconsistently glycosylated (sugared) proteins which can result in a rejection reaction and/or the drug being quickly cleared from the body. The addition of PEG to proteins is a well established process undertaken by a number of companies to improve protein drugs’ solubility, stability, half-life and to decrease the body’s immune response. Neose’s process attaches the PEG to the sugar molecule rather than the protein backbone, and by virtue of being farther away from the protein’s active site, better preserves the drug’s effectiveness and extends its half life. Using these two processes, Neose has taken protein drugs now on the market and re-engineered them so as to increase their efficacy over a longer period. Longer acting drugs that must be injected or applied intravenously offer substantial advantages in terms of reduced cost and reduced inconvenience to the patient.

History
Neose’s enzymatic technology was developed at the University of Pennsylvania, spun off as an independent company in 1990 and run until 2002 by its chief scientist and creator. After going public in 1996 at $12.50/share, management pursued a broad platform approach, including potential applications of the technology as a bulking agent for use with artificial sweeteners, as a nutritional supplement in infant formulas and as a method to improve the efficacy of protein drugs in development with an eye to the myriad drugs likely to be developed as a result of the human genome project. At various points, Neose had collaborations with a number of leading pharmaceutical companies and applied its process to 23 different drugs (existing and under development), a time consuming and expensive undertaking that produced no future earnings stream. The basic problem appears to have been big pharma’s unwillingness to bet an entire product on an upstart’s new technology. The pharmaceutical companies presented Neose with their most intractable and lowest priority items, and many of the drugs didn’t make it to Phase I or Phase II trials because the drugs themselves didn’t work.

Recognizing that the science worked but that a marketing approach was needed, the founder was replaced in March 2002 with a seasoned biotech executive, Boyd Clark. Clark’s strategy has been to apply Neose’s technology to existing drugs with substantial sales, and partner the revised versions with established drug companies or in one key case, develop a proprietary version. This product development approach has the advantage of targeting major drugs that have proven safety and efficacy – the same approach adopted by Sepracor. The journey has been longer and more difficult than originally envisioned and there are no Neose drugs yet in Phase I trials. Neose has had to repeatedly issue stock to avoid running out of cash and has substantially diluted its share count as a result. 8 million shares were sold in May of this year at less than $4, down from the $6 and $8 levels for shares sold in the previous 2 years. Share count is now just short of 33 million.

This summer the FDA delayed giving its approval for a Phase I trial for Neose’s blockbuster drug, a long lasting substitute for erythropoietin (EPO) despite numerous Neose studies that show the drug to be safe and virtually identical to Amgen’s Aranesp already on the market in Europe and the U.S. The delay tanked Neose’s stock, but they expect to submit additional materials to the FDA by the end of this year so as to start a Phase I trial in the first quarter of 2006. Most importantly, there is no indication that the FDA has concerns that the drug is manufactured using an insect expression system instead of CHO cells – there were no comments relating to that issue. The FDA is proceeding with considerable caution in the shadow of the Vioxx debacle and the fact that Johnson & Johnson’s EPO drug has been linked to adverse autoimmune reactions caused by its CHO cell manufacturing process.

Pipeline
1) NovoNordisk has licensed 3 drugs using Neose’s technology, 2 of which are marketed by other firms and one of which is sold by Novo itself. The three drugs combined had sales of $2 billion in 2002. Novo is paying for all costs of development and regulatory approval – Neose received a $4.3 million up front fee in 2002, stands to gain $51.3 million in milestone payments over the life of the deal and is covered for all R&D and out of pocket costs. Once approved for sale, Neose will receive royalties of approximately 10% of revenue. Neose’s technology will extend the half life of the drugs and provide Novo with a product that is superior to the ones currently being marketed.

There is a lack of information about the Novo nominated drugs, and the lack of news about a starting date for clinical trials has sown uncertainty in the market. Recently, Novo made a milestone payment to Neose, but the reason and the amount were not disclosed. It seems logical that one of the 3 drugs might be NovoSeven, which is administered to hemophiliacs, comes off patent in 2006 and has sales in excess of $500 million. Novo has indicated that they have proof of concept applying recombinant Factor VIIa (NovoSeven) for use against trauma and intracerebral hemorrhage – a use which would expand the market considerably. It’s difficult to identify the other two non-Novo drugs, but what little has been written is that Novo may apply Neose’s technology to cancer (blood cancers?) or inflammatory diseases. The original Novo collaboration began in 2002, was turned into a licensing agreement in November 2003 and was amended in November 2004. The amended agreement contemplates a 6 year development and approval period, which would mean that there are 4 years left to run clinical trials and get FDA approvals. In other words, assuming that a normal Phase I – III approval period for an established drug is 3 years, the timetable for the Novo related drugs are within the revised schedule.

Not licensed at this point, but obviously under discussion, is a Neose developed drug for human growth hormone deficiency which has a superior profile to Novo’s own Norditropin.

2) Neose has a licensing agreement for another unidentified therapeutic protein with BioGeneriX AG, a company that is part of the ratiopharm Group – the 5th largest European drug company and the largest generic firm in Europe. The agreement was signed earlier this year and calls for milestone payments of up to $61.5 million during the development stages and royalties on sales, which I again assume are in the 10% range. BioGenriX is responsible for R&D and clinical trial expenses and will decide by May of next year if it wants to proceed with full development.

The unidentified protein agreement with BioGeneriX grew out of a much more significant agreement with them for the development of a G-CSF (granulocyte colony stimulating factor) drug. G-CSF is used to stimulate the production of white blood cells in patients undergoing certain types of chemotherapy and is a $1.1 billion drug outside of the US where patents expire next year and a $2.3 billion drug in the US. The long acting BioGeneriX / Neose version of G-CSF will initially marketed in Europe and won’t be available in the U.S. until 2013. Tests on monkeys have shown that BioGeneriX / Neose’s G-CSF is virtually identical to Amgen’s Neulasta, but because Neulasta is manufactured using a non-mammalian system (e-coli) which is similar to Neose’s process, there is no way around the patents in the United States. Amgen’s Neupogen (1x/week) and Neulasta (1x/month) are the only G-CSF drugs presently on the market and Neose’s long acting version is the only competitor presently in pre-clinical development. Preliminary costs have been shared equally, but beginning in the first half of next year when human clinical trials will begin, all costs will be borne by BioGeneriX. The amount of savings is not clear, but it means that Neose’s cash burn should be considerably less by June 2006, compared to the present burn of $8 million/quarter. Once marketed in Europe, Neose will receive a royalty on sales of approximately 10%. Neose will own marketing rights to the drug in the U.S (after 2013) and will pay BioGenerix a similar royalty.

To summarize: Neose has 2 drugs in development with BioGeneriX and 3 licensed to Novo Nordisk. Total milestone payments to be received over the next 3-4 years should total $113 million, with significant royalties to follow once the drugs are marketed. Neose’s technology and that stream of payments, even discounted at a high interest rate, are worth more than the present stock market value of the whole company. But Neose’s more immediate and real value lies in its NE-180 EPO drug.

3)Erythropoetin (EPO) with worldwide sales of more than $10 billion, is the largest selling therapeutic protein drug by a large margin. EPO drugs are used to treat chronic kidney disease and anemia caused by cancer. Neose’s EPO strategy has been to take an existing drug, make an improved version (long acting), and spend the money to conduct clinical trials rather than bring in a partner. Neose’s NE-180 EPO look-alike would be administered once a week versus three times a week for the normal EPO. Amgen’s Aranesp, which to date is the only long lasting EPO approved in Europe and the U.S., has grown rapidly and now outsells regular EPO (Epogen) with a trend that clearly favors the longer acting drug. Patents have already expired on Amgen’s Epogen and Aranesp in Europe, a $2 billion market all by itself, but don’t expire in the U.S. until 2013 – 2015. Neose will conduct clinical trials in the U.S. with the idea of porting the results to Europe where they will seek to sell NE-180. Since a Phase III trial would break the bank, Neose will fund Phases I & II themselves, and then find a deep pocketed partner who would foot the remaining bill and pay them accordingly. The goal is to get successfully through Phase II so as to be in a strong negotiating position with a future partner. Since Neose uses a non-mammalian (insect) expression system to manufacture NE-180, it is likely that their approach does not violate Amgen’s U.S. patents. The prospect of having a long acting EPO drug in the U.S. well before 2015 to compete against Aranesp could be extremely valuable but would require deep pockets to deal with Amgen’s legal reaction.

There are at least 10 companies working on an EPO drug, but only Roche (CERA - Phase III) , Affymax (Hematide - Phase II), Shire (Dynepo - 2006 introduction) and Neose (NE-180) have longer acting versions that could compete with Aranesp. In the next few years, the overall EPO market should grow to $3 billion in Europe and Aranesp, CERA and Dynepo should have the leading market positions. Obviously, Neose’s long acting EPO will be an also-ran in Europe once it arrives even if it has marketing support from a big name company – Europe is a large market, but by 2009 when Neose should have an FDA approval in hand, the three front runners will be well entrenched. So where’s the value?

NE-180’s potential can be demonstrated by Shire’s $1.6 billion purchase earlier this year of Transkaryotic (TKT). Transkaryotic had unprofitable sales of $77 million in 2004, all from one drug, and has 2 drugs in the pipeline for rare conditions, both of which will be modest sellers, at best. The prize was TKT’s Dynepo, an EPO drug which will go on sale in Europe in 2006 for treating chronic kidney disease, but has not yet been approved for the larger market of cancer related anemia (in Phase III trials). In effect, Shire paid at least $800 million (my guess) for Dynepo, a drug with a similar profile to NE-180. Dynepo will undercut Amgen’s Aranesp in price, but even after substantial marketing costs, should be extremely profitable. Neose’s NE-180 doesn’t have the same potential in Europe, but because it is manufactured with an insect expression system, it is the only EPO drug that could compete with Aranesp in the U.S. before 2015. So here’s what investors in Neose have been salivating over for many years: 1) FDA approval of NE-180 in 2009 followed by sale of the drug in Europe; 2) an announcement after completion of Phase II of a collaboration with a major partner to sell NE-180 in the U.S., presently a $7.5 billion and growing EPO market. If legal skirmishes can be resolved by 2010, NE-180 and Aranesp would have the U.S. market to themselves for 5 years. In other words, if Dynepo was worth $800 million to Shire in a smaller more competitive marketplace, NE-180 is worth billions. Discount that back to the present to account for hypotheticals and unknowns, and the risk /reward looks pretty good.

Finances
Neose has received periodic progress payments, but has never made money since it writes off its R&D and none of its drugs have made it to market. Recently, management closed the San Diego research office, laid off some personnel at headquarters, wrote down the value of its plant and indicated that they may sell the plant, all as a means of getting the cash burn down to approximately $8 million/quarter. Future capex requirements are de minimis. At the end of the September quarter, Neose had $45 million of cash and $20 million of debt. Rather than centering in on an EV of approximately $51 million, I think that it’s more meaningful to assume that they sell their plant (which might reduce cash burn to $5 million/quarter) to retire all the debt and use the remaining cash to develop the drugs in the pipeline. The question then becomes whether the pipeline of 6 potential drugs (+ 2 others being worked on) is worth $76 million, or roughly $2.30 * 33 million shares.

An NE-180 Phase I trial of 50 healthy volunteers should take 6 months and might have a direct cost of only $1.5 million. Phase IIa and IIb cancer patient trials might take a year and a half for 500 individuals and have a direct cost of $25 million. During the next 2 years, Neose will be in a race to complete Phase II for NE-180 and not run out of cash. Against an ongoing cash burn of $5 million/quarter (once the main plant has been sold) plus the direct costs of clinical trials, there should be incoming milestone payments. But I assume that the underlying agreements weight the amounts towards the back end – in other words, there won’t be that much inflow from milestones. Neose does have 2 significant improved drugs that they can partner or maybe sell (interferon alpha and human growth factor), but it’s a good bet that they will need to issue additional shares. That would create terrible dilution at today’s price, but a year form now with a successful Phase I trial behind them and a much more visible path to profitability than is the case today, there should be a much more positive reception in the market. If the price is still depressed, the board would then be faced with selling the entire company for a bargain price (but still higher than today’s price).

Ownership
Neose’s major shareholders are impressive institutional investors who have purchased the stock at much higher prices – they obviously saw some of the upside discussed above. But Lindsay Rosenwald of Paramount Capital, an early backer of Neose and known as a savvy biotech venture capital investor, has been selling. At one point Rosenwald owned 1.2 million shares. In February of this year, he filed a 13D indicating that he was down to 257K shares. I assume that he has cleared out his position by now.

The largest shareholder with about 14% of the stock (4.6 million shares) is Eastbourne Capital / Black Bear (a hedge fund spun off from Robertson Stephens in 1999 and run by Rick Barry) which manages $2 billion. They started buying Neose at $32 and have added at various times, most recently at $4. Their cumulative investment is around $65 million, about the present market cap of the entire company.

Other major shareholders are as follows:
George Haywood, a NY investor supposedly close to Eastbourne, 3.1 million shares. It appears that Haywood’s initial investment was at $6/share and that he purchased 950,000 shares in February of this year at $4.

Kopp Investment Advisors, $1.4 billion under management, 3.8 million shares. They added 700,000 shares to their position from March to October at prices generally well under $4/share.

Domain Associates, a well regarded life sciences venture capital firm, with $1.4 billion under management; 950,000 shares (purchased at $6/share). Brian Dovey, a Domain partner and former president of Rorer Group (now Aventis), is on Neose’s board.

Dr. Mark Rachesky, head of various MHR Funds, has been on Neose’s board since 1999 and owns 828,000 shares. Rachesky worked for Carl Icahn for 6 years, the last three as acting chief investment advisor of Icahn Holding Corporation. 90% of Rachesky’s shares were purchased in 1999 or earlier at an average price of $9.50.

Summary
The FDA approval of Phase I studies of NE-180 is not in jeopardy although timing is an issue. Neose is in a race against the cash flow clock over the next 2 years and will probably suffer additional dilution. But the stock should rise as it becomes clearer that they are having clinical success and that the various drugs will be brought to market. If the stock stays depressed, I can imagine Amgen buying Neose to eliminate a threat to its EPO and G-CSF franchises, particularly the threat of an early EPO competitor in the U.S. Alternatively, Novo or BioGeneriX might be interested in all of Neose to avoid significant milestone and royalty payments. If they get through the NE-180 Phase II trials relatively intact, there is the possibility of a Transkaryotic type home run sale because Neose’s unique technology would allow them to get around Amgen’s patents in the U.S.

Catalyst

Revised FDA submission (by the end of this year)
FDA approval or lack of disapproval for Phase I trials (30 days later)
Commencement of Phase I trials by BioGeneriX and/or Novo Nordisk