Transcept (TSPT) is a net-net specialty pharmaceutical company trading with a market cap of $95M. This is below the company’s $98M cash balance. We view TSPT similar to a blank check company trading a slight discount to cash but this one also has ownership of a potentially blockbuster drug that has already been approved by the FDA. Rarely does a biotech or specialty pharmaceutical company trade below cash unless they have no revenue stream, a shallow pipeline, and a rejection or complete response letter in hand from the FDA for their chief new drug candidate. Ending up in this unfortunate boat leaves companies with little to no option but to dividend out their remaining cash or find something new to buy, which places the cash balance at risk. In some situations, it might also mean spending whatever cash is left on expensive clinical trials to satisfy the FDA criteria in order to resubmit for approval.

TSPT was in this boat a year ago when they received a CRL from the FDA for their one and only drug Intermezzo, a sleep aid. The core ingredient in this drug is Zolpidem, better known to the public as Ambien. TSPT created a product that targets ‘middle of the night’ awakening (www.myintermezzo.com). Large chunks of people with sleeping problems don’t actually have any issues falling asleep. Rather, they have a problem staying asleep and falling back asleep after waking up. These people over medicate on Ambien or other sleeping aids (Lunesta, etc…) because they don’t know which nights they will sleep through and which nights they will wake up. As a result, they take a sleep aid every night or way too frequently. 

After receiving a CRL from the FDA, the stock traded well below cash for a period of time and the company was forced to spend millions of dollars on a driving study to ensure patients who took the drug didn’t crash their cars driving to work – a key concern of the FDA for patients who might take the drug at 4 AM only to be on the road just 3 hours later. After resubmitting and gaining approval, a slow initial launch has caused the stock to linger below cash. We believe this is highly unwarranted given that TSPT has a strong and committed partner in pharmaceutical giant Purdue who believes strongly in this drug. In fact, the company signed on to a $100M initial 12-month rollout budget and recently committed $19M to a direct to consumer ad campaign beginning this month. They are also more than doubling the size of the original sales force from 275 people to 615. Such a large launch budget is rare (FiercePharma: “Last week, Advertising Age celebrated a big direct-to-consumer ad campaign that's in the works for Purdue Pharma's new sleep drug. The planned spending: $100 million. It's among the few recent drug launches with significant DTC support, Ad Age pointed out. And some numbers from Pharma Marketing Blog illustrate just how unusual that sort of spending is these days.”)

We believe the chief problem behind this launch has been awareness of the drug which is why Purdue is putting such a large budget behind it. In our primary research with doctors, pharmacists and patients, we have found there to be little to absolutely no awareness at all that such a product even exists. In our opinion, this is the best problem to have in a drug launch. Some drugs fail because patients don’t want the drug or competing drugs are more efficacious or they have too many side affects or they are too expensive, or insurance coverage is weak. Nothing points to any of these issues being the chief driver behind the weakness.

• Safety: Both Intermezzo and Ambien rely on the same underlying ingredient – Zolpidem. We know that Ambien was and is a blockbuster drug and has been an approved substance since 1992. It has been used safely ever since without major incidence.
• Insurance: 81% of patients are on the formulary coverage. Additional managed care coverage is expected and Purdue is also offering coupons which lowers the tier 3 patient co-pay to just $15 from $50.
• Competition: There is no drug on the market that acts like Intermezzo. Ambien and Lunesta are the closest comps. The difference between these drugs and Intermezzo is dose size (50% less for Intermezzo) and method of digestion. Ambien is an 8 hour pill which takes 40-minutes to digest whereas Intermezzo lasts 4-hours and dissolves through the cheek enabling rapid onset in just 15 minutes. When a person awakens in the middle of the night, taking a pill with a 40-minute onset and an 8 hour sleep response does not make sense.

Variant Perception: Doctors and pharmacists who deal with sleep issues day in and day out are unaware of Intermezzo. All the more so, we find investors are unaware of the importance of this product and why it differs from generic Ambien. The primary questions that tend to surface frequently when we discuss this product with other investors center around why Intermezzo is any better than generic Ambien. There are clear benefits to Intermezzo in terms of its rapid onset and lower dosing. Even if one were to cut an Ambien in half, it would still take nearly 40 minutes to digest into the bloodstream. Awakening at 3AM and taking half an Ambien is dangerous if one then needs to awaken at 7AM. Additionally, at 3AM no one wants to lie in bed waiting 40 minutes for onset. We also believe many patients don’t even bother cutting the pill at all which is even more problematic. Finally, for people who don’t have any trouble falling asleep but tend to awaken during some nights, taking Ambien every night is overkill because one never knows which nights will be restless. A solution created specifically for this problem should be welcomed by anyone who has experienced this specific issue.

Although investors have yet to understand and patients have yet to be informed, the FDA itself recognizes just how important this drug is. The acting deputy director of the FDA Dr. Robert Temple, commented: “For people whose insomnia causes them to wake in middle of the night with difficulty returning to sleep, this new medication offers a safer choice than taking a higher dose of zolpidem upon waking. With this lower dose there is less risk of a person having too much drug in the body upon waking, which can cause dangerous drowsiness and impair driving.”

Given strong insurance coverage coupled with coupons, we don’t think price is a deterring factor. Safety certainly isn’t and neither is insurance coverage. Our aforementioned channel checks confirm this perspective. As with any product, there is always some level of risk; but, according to the FDA and based on market research, Intermezzo serves a clear and present need. Educating physicians and patients is the key to achieving success.

DTC Campaign: As mentioned, although Purdue had originally committed 275 salespeople and $100M in first year advertising, this has been a difficult sell. The primary factor impeding sales is consumer and physician awareness and understanding. At the consumer level, patients are used to the sleep medications they have been using for some time. At the physician level, doctors have not been trained to ask if their patient is having trouble sleeping vs. having trouble falling asleep. There was no reason to ask this question because there was no difference in treatment. In order to solve these problems and grow scripts (which have been trending near 1,000 per week) Purdue and TSPT have committed to a national, 6-month, DTC advertising campaign. Purdue has committed $19M while TSPT has committed $10M. Because a DTC campaign takes $10M out of TSPT pocket, this has added pressure to the stock. While it is unfortunate that TSPT has to lay out some additional cash, it will hardly bankrupt them. This campaign will be executed during the first six months of 2013. For some context, in terms of size, Viagra was the largest DTC campaign over the six-month period of Q2/Q3 2012 at $36m. The $29M committed by TSPT and Purdue would have placed the Intermezzo campaign in the top 20 campaigns during that time period. Notably, because this condition affects people who wake up in the middle of the night and often turn on their TV, the campaign can take advantage of lower cost middle of the night advertising. In addition to the additional advertising, Purdue plans to utilize is analgesic sales force, which consists of 525 representatives, to promote the drug to primary care providers and doctors. In addition, the company will market the drug to psychiatrists with a sales force of 90 people devoted exclusively to Intermezzo.

Burn w/no acquisition: The stock recently lost 15% of its value because the company’s OCD drug failed in Phase 2 trials. While this was a clear negative, it also means the company will no longer be spending any additional cash on this drug which should severely reduce R&D from its $2M - $3M per quarter run rate. We believe this lowers the overall risk profile of the story. With a burn of $10M on G&A, reduced R&D expenses, and $10M going out the door for the DTC campaign, we estimate TSPT ends 2013 with $75M - $80 in cash vs. the current market cap of $95M. Cash burn would increase if TSPT opted-in to the co-promote program in April (see next paragraph). Given that Purdue is utilizing a sales force of 90 people to promote to psychiatrists it would likely cost TSPT around $9M annually ($200K per sales person). We estimate an additional burn of $7M over the course of 2013 on top of the $20M if they choose the co-promote option. This would bring cash down to $65M to $70M by year-end 2013. Another wildcard: should the DTC campaign prove successful, it is likely there would be an additional $10M outlay in the back half of the year which would bring the cash balance closer to $55M - $60M.

Upside: TSPT is eligible to receive royalties between 15% and 25% on sales of Intermezzo. They also retain the right to co-promote the drug to psychiatrists. If they choose to do so in the first month following the one-year anniversary of Intermezzo’s launch (April 2013), they will be eligible to receive a 40% royalty. TSPT can opt-in to this program for a period of up to 4.5 years post launch; however, the royalty rate begins to fall down to a low of 22%. For clarity, if TSPT opted-in this coming April, they would always be eligible to receive the 40% royalty.

Competing drug Lunesta is a $1B drug but Sepracor had been pumping in several hundred million dollars in advertising per year (this has been reduced to almost nothing recently). Also, as mentioned, people take current sleep aids more often than necessary. Presumably, Intermezzo would need to be used less often. However, while Lunesta benefited from a larger advertising spend, it also competes directly against Ambien and other sleeps aids which offer the exact same benefit. Intermezzo is in a class by itself.

If Intermezzo could achieve annual sales of $275M, we believe TSPT could earn in excess of $1 a share or close to $50M in annual royalties. At $5 a pill, this represents 55M annual doses. Assuming 3X dosing per week, the average patient would need 156 pills a year. The math suggests TSPT needs 350,000 patients whereas there are an estimated 30M people in the US that suffer from some sort of sleeping problem. This works out to approximately 570 scripts per year by each of the 615 sales people devoted to Intermezzo – hardly an unachievable feat.

In the last week Ambien was under patent protection, the drug did $55M in weekly sales – or a $2.8B annual run rate. Coupled with Lunesta, these two drugs alone suggest a market size of nearly $4B at branded prices. Our research suggest that up to half of these patients are having issues not with falling asleep but with middle of the night awakening. Based on the absolute size of the sleep market, we believe $300M is a fair target for peak sales.

Earnings Matrix:

Year     Sales                Royalty           G&A    R&D      Tax      Shares  EPS     

2014    $100M             $15M (15%)     $10M   0          40%     18.5M  $.16

2015    $150M             $22.5M (15%)  $12M   0          40%     18.5M  $.32

2016    $300M             $60M (20%)     $15M   0          40%     18.5M  $1.49

Opting in to the co-promote would obviously complicate the G&A picture as would an acquisition. We view each of these as likely events so the above model is meant as a basic illustration of the upside from sales of Intermezzo. Also note that there are an additional 4.5M shares (options) which come back into the picture at higher prices (average price $6.15).

Valuation: We value TSPT as 10X peak EPS of $1.49 or $14.90 and we believe it will take the company at least three or four years to get there. We discount the value of the cash to $25M ($1.35 p/s) assuming the company blows most of it on advertising and an acquisition. If TSPT can achieve even a more moderate $150M or .32 a share, this would suggest very little downside based on a 10X multiple and the $1.35 in remaining cash.

As mentioned in the introductory paragraph, TSPT is like a blank check company with nearly $100M to spend. But there is a key difference because TSPT also has an approved drug and a strong partner pumping their own $100M into advertising. Why should the market assign TSPT the same valuation it generally assigns to blank check companies with nothing to brag about except management reputation? Not only does TSPT have management that has executed in the past (see below), not only do they have the cash, but they also have a potentially valuable product in hand. While we can compare TSPT to other specialty pharmaceutical valuations, we think a comparison to SPACs is telling and highlights the undervaluation in TSPT shares. Of the 15 SPACs currently seeking an acquisition, the annualized return on average has been .7%. This suggests they are all trading at or near cash (www.spacanalytics.com/) and with a couple of exceptions, they don’t come with the inherent optionality you also have with TSPT.

Risks:

Acquisition: Management did a secondary offering and sold 4.5M shares at $9 when the stock was at $11. The company was flush with close to $60M in cash and there was no near term funding needs. They have made it clear that they intend to make an acquisition. This has the potential to destroy some shareholder value. In the valuation section we assumed the cash was worth $25M but in reality we doubt management would actually destroy that much value and could possibly even be ultimately accretive.

Insider Ownership: Management owns very little stock. We don’t believe the company would have committed to the above secondary offering if they were more invested in the story. Having said that, we have high regard for the management team. Glenn Oclassen, the CEO, successfully sold his last two companies. Glenn was CEO of NextDerm which was sold to Procyte in 1999 and he was the founder and CEO of Oclassen Pharmaceuticals which was sold to Watson in 1997. They are very responsive to shareholder inquiries.

DTC Campaign: The advertising may not resonate with consumers or more money may need to be pumped into generating awareness.

While these are important risks which cannot be ignored, the bottom line is that there is enormous upside from success of Intermezzo and one’s downside is buffeted by $98M in current cash. The stock is trading like a SPAC and is completely discounting Intermezzo. Although there is acquisition risk and some of this cash will be spent on advertising/operating expenses, we believe the market underappreciates the potential demand for this drug as people learn about their new option, Intermezzo, which is a more sensible way to treat their problem. The FDA seems to agree that there is a real need for a drug like Intermezzo and it faces absolutely no direct competition. The large DTC campaign will act as a near term catalyst.

-       $29M DTC campaign ($7M shy of Viagra spend over Q2/Q3 time period)