Description

Summary

I believe Recro Pharmaceuticals (REPH) (Recro or the “Company”) is a compelling long investment, with several catalysts over the coming years that should unlock substantially greater value.  Unlike many other pharmaceutical investments, Recro benefits from a highly attractive contract manufacturing asset that provides excellent downside protection for the stock and is arguably undervalued on a standalone basis.  However, the true gem for Recro is likely to be its intravenous version of Meloxicam (IVM), a non-opioid pain medication to be used in the hospital/ASC setting and which is expected to be approved in the coming weeks.  Given the abundance of issues with opioids and opioid addiction in the US, the market for non-opioid alternatives is growing significantly and provides a strong tailwind for Recro’s commercial launch of IVM.  Importantly, I do not believe any value is currently being ascribed for IVM, despite a near-term launch, a management team with a history of successful product launches, a shareholder base that is likely waiting for a sale of the company in the next 24 months after approval, and market M&A and revenue precedents for similar drugs.  REPH stock today is in a sweet spot with significant positive news flow expected in the near-term and a tremendous risk/reward.  I believe Recro has upside of 300%+ in the next few years, with limited downside of 20% because of the Company’s cash-flow generating CDMO asset.

Mispricing

In my opinion, Recro is mispriced for the following key reasons:

• ·         “This is a biotech, and I don’t do biotech.”  This seems to be the mentality of many investors who analyze Recro, despite the fact that the CDMO asset supports potentially the entire enterprise value.

• ·         The long history of Meloxicam as an approved compound (detailed later) minimizes regulatory risk.  The Company has already filed its NDA for a new form of this drug which has mountains of clinical data through its phase III trials supporting approval.  IV Meloxicam is not your typical developmental pharmaceutical given the much reduced downside risk with an oral formulation already on the market.  The May 26^th PDUFA date in particular is an obvious catalyst that should drive shares meaningfully higher.

• ·         Recro’s current market capitalization is less than $250mm, which makes the universe of available investors much smaller.  Over time, if my analysis is correct, I believe Recro will be worth well north of $1bn, and potentially multiples of that number if other pipeline opportunities materialize.

• ·         Because of legacy R&D costs related to its trials and ramping expenses in anticipation of a commercial launch, Recro screens very poorly, despite a captive asset that is currently generating over $30mm annually in EBITDA.

Company Background

Recro was founded by CEO Gerri Henwood, an experienced pharma executive who has a history of taking pharmaceutical assets from development stages through commercialization, most notably at Auxilium pharmaceuticals.  Gerri took Recro public in 2014 and in 2015 negotiated the transaction which formed the basis for today’s Recro Pharmaceuticals.  Gerri had been serving on the board of Irish pharma company Alkermes which was seeking to shed non-core assets and narrow its focus.  Among these non-core assets were the rights to intravenous meloxicam (IVM), a powerful non-steroidal anti-inflammatory drug (NSAID), and a contract drug manufacturing facility in Gainesville, Georgia, USA.  Gerri resigned from the board in order to bid for these assets on behalf of Recro.  Recro initially lost to another, higher bid before that buyer fell through because of financing issues, at which point Recro purchased the assets for approximately $54mm cash plus milestone-based contingent consideration and a royalty on IVM sales.  The contingent consideration includes $45mm to be paid upon FDA approval of IVM, unspecified milestone payments up to a total amount of $80mm additional, and 350,000 warrants struck at $19.46 per Recro share.  The Gainesville facility became the sole asset of the contract development and manufacturing operation (CDMO) and IVM has been developed by the Acute Care business, detailed below.  The management team of Recro has a strong history of finding gems in the developmental pharmaceutical space, and in selling businesses for attractive premiums; I believe both are likely here as well.

Business Segments

Recro has two primary business segments, its CDMO segment, which focuses on contract manufacturing of controlled drugs for third-party pharmaceutical customers, and its Acute Care segment, which focuses on the development of pharmaceutical assets with the hope of proceeding to commercialization.

CDMO

The CDMO segment consists of a large manufacturing facility in Gainesville, GA and provides good downside protection for Recro given its low capital intensity, strong and growing EBITDA, and strong competitive position due to its license with the DEA to produce controlled drugs.  As you might imagine, not every contract manufacturer can obtain a DEA license, and it does help insulate Recro from competitors and the already-low threat of customer switching.  This is a high quality business in which customers are disincentivized to switch from a reliable, approved manufacturer due to the costs of validating a new supplier and the risk to supply chain reliability.

Although many of Recro’s core drugs are flat or even declining slightly, they do have exclusivity on several compounds, suggesting the tail could be quite long.  Additionally, for the first time since the asset was acquired from Alkermes, Recro has begun to focus on business development.  There were zero business development staff supporting the Gainesville operation at the time of acquisition.  As the Company is currently operating at approximately 65% utilization on one shift (with the ability to go to two shifts), there is tremendous upside because incremental margins are extremely high as they continue to fill the facility. 

Over time, the Company’s goal is to diversify the customer base further and grow EBITDA to north of $40mm, from approximately $31mm today.  At those levels, the CDMO business could demand at least a market multiple, which is nearly 12x EBITDA based on comparable companies today.  For reference, a 12x EBITDA multiple on 2020 earnings of $40mm EBITDA might represent $480mm in enterprise value.  The company’s current, total enterprise value is less than $240mm. 

The CDMO segment is also beneficial as a source of lower cost equity capital for the early Meloxicam commercialization phase, during which the Acute Care segment will initially continue to consume cash.  Because the implied cost of equity for developmental pharma companies tends to be very high, I think the combination of these assets makes sense for the immediate future.  However, longer term there appears to be an excellent opportunity to monetize this asset.  The Company is very transparent in their view that they believe they can grow EBITDA meaningfully, and eventually potentially sell the asset at an attractive price so they will “never have to touch the capital markets again.”  The CDMO segment has developed a decent track record as a “beat and raise” segment over the past several quarters, and I believe this year will be no different.  The first quarter started off strongly, and importantly, new business development efforts are NOT included in guidance despite what sounds like meaningful progress on that front.  A snapshot of the CDMO segment financials is below:

Acute Care

This segment is the drug development and commercialization business which is responsible for IVM’s upcoming launch.  The company also owns the rights to develop two novel Neuromuscular Blockers (NMBs) and their reversal agents, as well as a new version of existing drug dexmedetomidine.  The NMBs appear to have strong potential with a large end-market, but due to their early stage of development and our lack of expertise in this area, I ascribe no value to them.

The company’s commercial stage asset is an IV form of Meloxicam, as noted above.  Recro submitted a new drug application (NDA) to the FDA in July of 2017 and the PDUFA date (the FDA’s deadline for response) for IVM is May 26, 2018.  Given the drug has had a nearly two-decade long history of safety and efficacy in oral form, and excellent trial data in IV form, I believe the probability of approval is very high.  As it is, drugs that successfully file an NDA have over a 90% approval rate.  I believe the chances for IVM are incrementally higher considering the long history of the oral formulation on the market.

So, what is the commercial opportunity?  In the current policy climate, framed by a nationwide opioid crisis, the focus on finding non-opioid alternatives is reaching fever pitch.  Unusually, this goal is shared by regulators, providers, patients, and much of the pharma industry.  IVM will be the first non-opioid systemic pain reliever to offer pain relief for up to 24 hours and is envisioned as a peri or post-surgical application.  Current non-opioid competitors include Mallinckrodt’s Ofirmev and generic drug Ketorolac.  Both are short-lasting and provide relief for no more than 6 hours without additional dosing. The opioid penetration rate today is still very high, suggesting a large market opportunity for non-opioid alternatives.

This is an important distinction because IVM will provide pain relief for the critical first 24 hours post-surgery during which patients are most likely to resort to opioid pain relievers.  Data indicates that 6 to 10% of post-surgical patients prescribed opioids will become habitual users thereafter.

To be clear, IVM will be a tool in the tool chest of healthcare providers that will be used in conjunction with other drugs, as is generally the case today.  “Multi-modal pain medicine” is the standard in modern peri and post-surgical care and the use case for IVM will include combinations with local agents like bupivacaine and Exparel, for example.  A specific use case might be for a knee replacement surgery.  The patient would be under general anesthesia for the surgery and likely receive bupivacaine or Exparel at the site of operation, while also receiving IV Meloxicam immediately post-operation.  This dose should allow the patient to return home and begin recovery in relative comfort for the first 18 to 24 hours, thus delaying and reducing, or perhaps eliminating the need for any supplementary opioid pain medication.  The Company has many slide presentations, including some with blind survey data, suggesting doctors see strong potential in a product like IVM.

While there are many inputs into how the commercialization plays out, and these inputs affect the value of IVM, we have a reasonable analog in Ofirmev.  Ofirmev, which was acquired as part of Mallinckrodt’s acquisition of Cadence Pharmaceuticals in 2014, currently has run-rate sales of around $320mm.  The acquisition was for consideration of approximately $1.3 billion, at a time when Ofirmev was doing approximately $100mm of sales.  I think IVM has a similar or better market opportunity as it is effective, and yet longer lasting and cheaper than Ofirmev (based on the $80 to $100 per day/dose the company is targeting).  I expect IVM will compensate for a lower price point with higher volumes and share gains from Ofirmev, Ketorolac and post-surgical opioid prescriptions.  While a $1.3 billion price tag for Ofirmev might have been high, just a fraction of that value could cause Recro’s stock to appreciate by multiples.  My base case value for IVM is in the $500mm range, with the potential for materially higher values if sales eventually reach $300mm.  Anecdotally, Pacira’s Exparel, which is generally hated by doctors because of its price point and difficultly in administering, is still growing and is expected to eclipse $300mm of revenue.  I believe this shows just how strong the anti-opioid trend is, and there seems to be a very good chance for IVM to eventually reach sales levels in this range.  Although Ofirmev’s sales multiple was likely too high, most comparable transactions I have seen suggest fair sales multiples in the 5x range, a value that would yield multiples of money for IVM assuming a similar sales trajectory.

The company intends to launch with 50 sales reps by the end of 2018, and to reach 100 in 2019.  Each rep should cost in the $250k per year range.  All indications thus far are that hospitals and ambulatory surgical centers (ASCs) are receptive to a new IV product with Meloxicam’s profile.  While the company is not permitted to market IVM pre-approval, they have presented study data in journals and at conferences in order to begin “building the buzz”.  Based on studying analogous launches, I estimate breakeven sales of around $75mm will be surpassed in 2020, and the Company has publicly stated they expect to be cash flow breakeven or better in 2020.  In terms of gross margins, the Company is anticipating approximately 75% gross margins, which includes the negative impact of royalties paid to Alkermes.

While I am no expert on patent law, my consultations with those who are indicate Recro has iron clad protection through the end of 2022, meaning a generic could enter sometime in 2023 earliest.  Recro has additional patent protection which covers method of production through 2030.  Further, the company just received coverage of three more patents in May 2018, one of which is Orange Book listable and should give them an additional layer of coverage through 2030.  I have no idea whether another company might be able to engineer a production method around these patents post-2022, but the company claims the drug is very difficult to make due to a tendency to precipitate solid flakes out of solution. The patent is licensed from Alkermes and has already been approved on multiple other compounds.

On that point about production, Alkermes noted it had received pre-approval from the FDA to produce IVM for Recro in February this year.  Recro confirmed this in its May quarterly report.  Alkermes has been the producer of clinical development batches for Recro and will scale up production and remain the commercial producer for the foreseeable future.  It seems unlikely the FDA would conduct pre-approval inspections, and approve IVM, if rejection was imminent.  Additionally, there has been an increasing amount of chatter in both Congress and specifically at the FDA regarding new incentives for non-opioid painkillers and efforts to reduce the need for opioids.  It seems unlikely the FDA would reject a proven safe and effective alternative in IVM when it is actively trying to help this exact issue.

Capitalization

Recro will likely have to issue equity at some point in the next 12 months.  While Recro currently sits in a net cash position, the company must make a $45mm milestone payment to Alkermes within one month of FDA approval of IVM.  Management has been intelligent in lining up additional sources of capital at relatively reasonable cost.  Recro has at its disposal a $100mm credit facility with investment firm Athyrium which was put in place in November 2017, and of which $60mm is currently drawn.  The additional capital is accessible in $20mm increments initially upon reaching FDA approval and another tranche upon reaching certain early sales milestones.

Recro has also put in place two equity facilities.  The first is an at-the-market sales agreement with Cowen and Company which allows Recro to sell up to $40mm in equity.  Management views this as an opportunistic vehicle for the company to sell equity without the fees associated with an underwritten offering as market conditions allow (i.e., incoming interest from an investor that wants shares).  The second is a purchase agreement with Aspire Capital which allows Recro, at its sole option, to sell up to $20mm of stock to Aspire within the course of the two and a half-year agreement.  This purchase agreement was put in place in March of 2018 and, while the purchase price per share is based upon a formula (explained in filings), it is essentially an at-the-market facility as well.

Depending on various scenarios, I anticipate that Recro will need to raise an additional .~$50mm in equity capital, which includes a $25mm minimum cash balance, milestone payments to Alkermes, and cash burn associated with commercial launch.  Importantly, this estimate does not include potentially selling the non-US IVM rights, which the Company is actively trying to sell, or upside from the CDMO business cash flows.

Valuation

Valuation here is admittedly more an art than a science.  What I would stress here is that even under very conservative scenarios, I do not believe much or any value is being ascribed to IVM, despite its very strong potential.  One can even argue that the current enterprise value does not even fully value the company’s CDMO asset.  Finally, none of these valuation cases assume anywhere close to market sales levels of similar drugs, or an acquisition, which I believe to be the most likely path for the company in the next several years.  I have also ascribed no value for the NMBs, despite what the Company thinks could be a multi-hundred million opportunity, and which they say other companies are very interested in.  In short, I believe I’m being very conservative here in almost every respect, and there is still tremendous upside in the stock.  If comparable multiples are used for the CDMO segment, Meloxicam does market-comparable sales levels, and the NMBs have incremental value, Recro could be worth multiple billions in a few years.  None of that is required to justify an investment today.  The real point is that today’s enterprise value of about $235mm doesn’t come very close to fully valuing the combination of assets at REPH. 

Key assumptions:

·

Depending on the scenario, anywhere from 3mm to 5mm more shares issued.  Coupled with the warrants, ongoing equity grants, and options outstanding, I’m using a fully diluted share count which is nearly 40% higher than today’s figure.  My dilution already factors in cash burn, milestone payments, etc.  Essentially, this valuation is for what the Company might look like at the end of 2019.  I assumed equity issuance price of $11/share

·No value assumed for NMBs or ex-US rights.Interestingly, I believe they will try to sell at least China development rights, though maybe not the rest of the world because the rest of the world might be attractive to a buyer of the whole Company.

·Assumed a $25mm minimum cash balance and a full draw of the credit facility.Thus, net debt is $75mm.

·         Assumed another $30mm of undiscounted milestone payments, assuming the trigger is $100mm of sales.

·

Risks

While I think Recro is the rare high probability bet within the developmental pharma space, there are still risks.

FDA rejection – As noted above, May 26^th is the PDUFA date.  Should this go against the company, this would be a painful event from a mark-to-market standpoint.  A negative event here could take several forms – an outright rejection or what is essentially a request for more information and discussion.  I think the former case has a probability approaching zero given Meloxicam’s long history of safety, efficacy, and commercial presence in oral form.  Should the latter event happen, it could be a tremendous buying opportunity especially given the CDMO value.  All indications are that IVM will be approved, but the government is impossible to predict with certainty.  The FDA has indicated to the Company that it will be “on time” with its decision, and aside from some basic questions about where to find data early on after the NDA filing, there has been very little from the FDA.  Generally, no news is good news in these types of situations.

Failed Commercial Launch – Poor traction with providers and formularies could create a situation where the drug’s financial value, in the hands of Recro, is marginal.  Possible outcomes here include a repricing to meet market demand or a sale of the drug at a suboptimal price.  All indications thus far are that IVM will be welcomed as a less expensive and longer acting solution vs Ofirmev (its closest analog).  I again note that Ofirmev has run-rate sales of around $320 million.

Competition From Other Drugs – I examined Pacira’s Exparel, Heron’s developmental drug HTX-011, Cumberland Pharma’s Caldalor, Ketorolac, and a host of other potential competitors.  There does not appear to be anything that is currently on, or imminently coming to market that could compete on all metrics, and it is unclear if any of the developmental drugs will have a comparable profile.  Generally, IVM should be compared to other systemic, non-opioid pain drugs on measures of efficacy, duration of action, and safety.  IVM stands up well to comparisons on those measures. 

Major Customer Loss at CDMO – The CDMO segment is a fantastic business that has a high degree of customer captivity.  Even so, it has a high degree of customer concentration with four customers representing substantially all of revenues.  Since acquiring the asset from Alkermes, management has launched a business development effort to diversify the customer base as well as grow revenues.  I expect we will see new customer acquisitions this year.

Catalyst

Meloxicam Approval – May 26^th is the PDUFA date.  Since it is a Saturday, look for news either May 25^th or May 29^th.  As a general rule, approval tends to cause the equity to rally in analogous situations.  Approval brings a whole new investor base into the name as some investors just will not get involved in a pre-approval, single drug company. 

Early Commercial Launch Traction – Good early sales numbers would indicate an appetite for the drug at this price point.  That could bring in a buyer of the whole company as my understanding is larger pharma companies wait for signs of market traction before considering an acquisition.

Ex-US Licensing – The company has been in talks with potential counterparties for ex-US licensing rights.  This could provide a source of relatively lower cost capital for the US commercialization. 

Potential Unbundling of Pain Medicine from DRG codes – There is some talk about removing pain drugs from the DRG codes for common procedures.  If this was done, it might eliminate one of opioids main advantages, which is that they are very cheap.  By allowing separate reimbursement for medicine, hospitals can do what’s best for the patient and the opioid epidemic, without feeling the pressure to squeeze on cost.

Sale of the Company – I think it makes tremendous sense for a larger pharma company to buy Recro, and the management team of the Company knows this is the best exit which will yield the best results for shareholders.  I suggest googling for various quotes from the Company’s CEO about how an acquisition of the Company is more or less inevitable, though here is one:  https://www.benzinga.com/general/biotech/17/01/8918579/exclusive-recro-pharma-ceo-talks-meloxicam-alleviating-investor-concer

Going down the path of a commercial launch helps to increase the Company’s negotiating leverage and credibility.  The drug could be simply plugged into an existing sales force and eliminate essentially all SG&A.  This would create a great deal of value that will otherwise be lost if Recro must develop its sales force and commercialize the drug independently.  Even so, none of my valuation cases assume a sale, and the investment is compelling as a stand-alone company.  Based on other transactions, smaller pharmaceutical companies can receive large premiums because the synergies can be quite high for an acquiror.  The largest shareholder of the Company owns shares through a healthcare VC fund that is getting long in the tooth.  At some point, I’d expect them to seek liquidity and it seems logical that they would want a sale to maximize value.  This management team has sold companies before.