Description

Sometimes deep value can be found in farts.  Or at least in fart control, that is.  And that noble olfactory endeavor is where a seemingly left-for-dead microcap busted-IPO comes in.  Say hello to lactose intolerance biotechnology company Ritter Pharmaceuticals (RTTR).     With a negative enterprise value, the market does not appear optimistic that its fully funded 350 patient Phase IIb/III study will be successful. While some may say that the company’s public company history smells like rotten eggs, we believe that the tiny market cap and relative obscurity of the company’s indication have created a very interesting investment dynamic.  Should the company’s drug, which is based upon a purified version of a consumer product that it previously sold, be successful, then there could be many turns of upside here upon a re-rating.  The company would potentially have a microbiome-attenuator that could be the first FDA approved drug for lactose intolerance. 

Business Description

Ritter Pharmaceuticals was founded in 2004 by a father-son team to develop a treatment for the son’s lactose intolerance.  Give them credit: the family does not have a medical background but they have hired a team that has identified a path to monetize their original work. Ritter began by selling a consumer product called “Lactogen”(see: https://en.wikipedia.org/wiki/Lactagen ) but the company shifted to pursue a higher-margin FDA-approved drug beginning in 2008.  The company raised venture capital and biotech crossover funding while conducting its early stage trials.  These trials showed sufficient efficacy to permit the company to raise public market financing to fund  its next later stage trial.  So in mid-2015 the company raised $20 million at $5.00 per share.  A year later, the company is closer to its data readout and the stock price sits below $1.50. 

The company’s investor presentation can be found here:  http://3s9driv455bkejnddzqa4795.wpengine.netdna-cdn.com/wp-content/uploads/2016/02/Ritter-Pharmaceuticals-Inc.-Presentation-Jan2016.pdf

Essentially, the company has a highly purified prebiotic (you get an A in nutrition if you know the difference between a prebiotic and a probiotic) called a galacto-oligosaccharide (commonly and unsurprisingly abbreviated as GOS).  You will see GOS in most infant formulas because it is a very healthy component of breast milk.  When ingested, the highly purified GOS activates certain strains of gut bacteria known to process lactose.  Thus someone who is lactose intolerant (which can cause abdominal pain and other discomforts) can colonize their gut with organisms that would allow him or her to consume lactose worry free.  Unlike Lactose supplements which must be taken with each meal and don’t always work, RTTR’s GOS is taken as a powder dissolved in water for 30 straight days after which a subjects lactose intolerance should cease. 

For the technically inclined, the Phase 2a data is in the above referenced investor presentation.  To summarize, in a 62 subject randomized double-blind placebo-controlled study (the gold standard), the GOS worked and was especially good at reducing abdominal pain.  Informed by the Phase 2a, the current larger study uses reduction of abdominal pain as the primary endpoint.  Data is expected towards the end of 2017. 

So is lactose intolerance a big problem?  After all, there are lactose supplements and lactose-free products that are commonly available.  Indeed, this could be an explanation for the company’s valuation: some may believe there is no market for its product.  According to the company, there are 40 million people with lactose intolerance in the US and 9 million who describe their situation as moderate/severe.  I believe there is some portion of this sub-population who feels they have no alternative except avoidance of all dairy (because of the ineffectiveness of over-the-counter treatments for them).  If even a small fraction of these patients try the 30-day regimen, then Ritter has a business.   And if the product is approved then it will mean it showed a medical benefit which would lead to productive reimbursement discussions.        

Because lactose intolerance is a large opportunity with no FDA-approved treatment, there is ambiguity around whether or not this study will be sufficient to warrant an approval.  If more trials are required, which is certainly possible, then either the company would have to raise more capital or find a partner.  In addition, the timeframe to commercialization would be pushed out.  As will be discussed below, investors today are not paying a premium for a short path to revenue so anything positive should help re-rate the stock higher. 

Valuation

RTTR’s current cash balance exceeds its market cap.  Typically, this sort of valuation would indicate either: 1) a substantial funding gap to reach pivotal data; or 2) a zombie company hopelessly pursuing a clinical program that has already blown-up due to lack of efficacy.  In this case: 1) the company has told the market that its funding will carry it through to the conclusion of its Phase IIb/III study; and 2) there has been no blow-up. Rather the collective experience of first-generation Lactogen consumers and statistically significant data in a 62 patient Phase II trial upon which the company went public suggest a de-risked opportunity. 

Obviously if the trial works then the returns look great.  Let’s be very conservative in our assumptions:

·         Let’s give the company a 66% margin on the drug – low for a pharmaceutical – so 90,000 people paying $300 for a treatment with a 66% contribution margin (implies $100 cost per dose which makes sense as this is a purification of a much lower priced previous consumer product ) is $17.8m pre-tax or $10.7m after tax.   By this math RTTR is trading at roughly 1x future earnings. For simplicity, let’s think of this as cash earnings and thus free cash flow. 

·         Only 1% of the 9m people in the U.S. with moderate/severe decide to take RTTR’s drug every year.  That’s 90,000 people. 

·         Now let’s assume the price per regimen is $300.  We don’t know what the ultimate price will be but an analyst report guided to $1,500.  If you bought 40 Lactaid packets for $12 on Amazon and used the recommended number of tablets then if you used them at every meal you would spend more than $300.  I bet 1% of people in a population for whom Lactaid doesn’t always work would be willing to give this drug a try for the same price.

·         At a modest 10x FCF multiple, the market cap would be $107 million.  There are 8.5m shares outstanding (excluding out-of-the-money options of approx. 2m and  warrants of 600k) but let’s assume they have to do another trial and no one will fund them (and that the trial costs around $16m).  In that case, the ultimate shares outstanding could be 20m: the company would be worth approximately $5.25 per share.  That would be a nearly a 4-bagger from here.  If this takes until mid-2020 to play out that would be a 40% IRR.   One could also use less conservative assumptions.       

So what happens if the trial doesn’t work?  Of course, this would imply the first target of RTTR’s purified GOS failed and that would not bode well for the value of the company’s assets.   However, this is where the current low equity value helps us because the numbers are small to begin with.  I believe that from the current $12 million market cap the company’s value would not go all of the way to zero. While it is impossible to predict with precision, I will offer that the company will be worth more than $5 million based upon the following:

1)       There would be the option value of other indications for which a microbiome attenuator may be relevant: RTTR list three potential orphan diseases as well as several large GI conditions such as Crohn’s and IBS. 

2)       The company has five issued patents in the U.S. as well as in the UK, EU and significantly China (very hard to get in my experience).  It also has 14 pending patents filed in the U.S. and globally. 

3)      The company will have $12 million of after-tax NOLs which could be worth several million dollars on a present-value basis and potentially more if a clear path to monetize them without triggering a Section 382 annual limitation could be developed (admittedly easier said than done).

Thus the risk skew is interesting to us as there is multi-bagger potential without risking an absolute capital loss within the next few years.   Based on all of the publically available information, there is a reasonable chance that a drug, which is currently ascribed negative value, will work.  Even if the ultimate market is smaller than the company’s management team believes, not a lot has to happen for this to be a successful investment.

Disclosure

We make no claims, promises or guarantees about the accuracy, completeness or adequacy of the contents of this document and expressly disclaim liability for errors and omissions in the document.  We have no obligation to update this document.  We may change our position at any time without posting an update.  The views expressed here are merely the opinion of the author.  Readers should do their own research.

Catalyst

Data readout from Phase IIb/III trial in lactose intolerance.  Evidence of progress in other indications.