Description

It’s a difficult market in which to find attractive investments.  Most investment candidates are correlated to market beta and if you feel the market as a whole is overvalued or expensive, it’s best to look in the road less traveled by value investors to the more arcane corners of the market. This investment represents mostly idiosyncratic risk, or to be more precise, binary risk, with 3 very near term catalysts -- 2 in July/August and 1 in September.  Obviously, with all early stage pharma/biotech investments, there is the risk of large capital loss when the binary risk goes against you, so we recommend sizing it appropriately within the context of a larger portfolio.  The recommendation is to purchase ZYNE in advance of the upcoming catalysts.

If you’re searching around in the marijuana/cannabis space for potential investment candidates, you may have come across Zynerba (ZYNE), along with GW Pharmaceuticals (GWPH) and a few other companies of that ilk. These pharmaceutical companies that are swept up into the cannabis bucket are not really in the cannabis space per se as they are using the two main active ingredients found in marijuana and hemp plants, THC (the psychoactive chemical) and CBD (the non psychoactive chemical), to treat patients across a variety of medical conditions.  The main risk associated with these pharmaceutical companies is scientific and FDA risk and not the consumer preference or DEA regulatory risk associated with most of the other cannabis stocks.  As such, Zynerba is not really a cannabis play and is not particularly levered to the changing regulatory landscape of medical and recreational cannabis, although it is benefiting from the increasing awareness of the use of cannabis and its active components for medical purposes.

Zynerba has 3 candidates in the pipeline for its synthetically manufactured CBD using a transdermal delivery mechanism (ZYN002).  In a nutshell, because CBD is not patentable, the company developed a proprietary (patentable) method of delivering CBD through the skin using a gel formulation. Its delivery mechanism allows CBD to penetrate the skin and deliver CBD into the blood stream.  Because CBD is a large molecule, if it were simply just applied to the skin, the amount of CBD that penetrates the skin and reaches the blood stream would be relatively modest compared to what’s achievable with the company’s formulation.  Zynerba also has 2 programs using a patented THC pro-drug patch (ZYN001).

The first trial, STAR 1 for epilepsy in adults with focal seizures, is the most critical to the investment thesis and currently represents most of the near term value of the company. Hence, to keep the writeup succinct, we will mainly focus on this trial.

The market for adult epilepsy with focal seizures is a large market with a large unmet need. There are 2.4 mil US adults with epilepsy. Of these 1.5 mil have focal seizures. The current anti-epileptic drug regimen of more than 12 drugs fail to control seizures in about â…“ of patients.  There is a large unmet need for new treatment options to improve the quality of life for these patients.

CBD has been shown to be effective in treating different forms of epilepsy. What’s gotten a lot of recent publicity and generated excitement among investors were the two Phase III CBD trials by GW Pharmaceuticals (GWPH), which demonstrated that CBD was effective in reducing seizures in children with Dravet syndrome and Lennox-Gastaut syndrome.  GWPH is now a $2.8bil company on the back of these two successful Phase III trials. GWPH used a non-proprietary oral formulation of CBD derived from plants for these two orphan epilepsy indications.  We believe that the transdermal delivery mechanism is superior to the oral formulation used by GWPH.  Whereas GWPH use a plant derived CBD formulation, Zynerba uses a synthetic CBD, which is produced through a synthetic chemical process in a manufacturing facility rather than derived from cannabis plants. This allows the company to manufacture pure CBD and allows for higher quality, consistency and scalability in manufacturing and not be subject to the vagaries of agriculture. Zynerba’s transdermal delivery (1) provides a more consistent, controlled and sustained plasma level of CBD, (2) avoids first-pass metabolism in the liver, (3) reduces the potential for drug-drug interactions, (4) avoids the GI tract, which lowers the incidence of gastrointestinal events and the potential for CBD to degrade into THC and cause adverse psychoactive side effects.

Here is a summary of third party CBD trials for epilepsy:

The Star 1 trial design is summarized below:

The median baseline seizure frequency is 11, with patients using a median of 3 anti-epileptic drugs (AEDs), which we see as fairly representative of the population. See the company slide below:

The top-line data is expected to come out late July / early August, starting as early as 7/20/17. We believe STAR 1 could demonstrate efficacy in adult focal seizures with a safety profile that is better than what GWPH achieved with its oral CBD.

This is a summary of the key investment considerations:

• CBD has been shown to be effective in treating different forms of epilepsy. See GWPH’s recent successful Phase III trials results in reducing seizures in children with Dravet syndrome and Lennox-Gastaut syndrome with an oral CBD formulation. Given the high unmet need for this population, we believe the FDA, especially under the current FDA commissioner Scott Gottlieb, will look favorably on therapies addressing this need.

• The transdermal delivery provide patent protection for ZYNE’s CBD and is better than the unpatented oral CBD formulation used by GWPH.  The transdermal delivery (1) provides a more consistent, controlled and sustained plasma level of CBD, (2) avoids first-pass metabolism in the liver, (3) reduces the potential for drug-drug interactions, (4) avoids the GI tract, which lowers the incidence of gastrointestinal events and the potential for CBD to degrade into THC and cause adverse psychoactive side effects.

• Phase I demonstrated safety (low incidence of GI events, no somnolence/ fatigue) and favorable dose dependent PK with no THC detected in plasma or urine (vs oral CBD).

• 158 out of 162 patients (which is a pretty high percentage) who completed Star 1 have enrolled into the Star 2 extension study, which as least is an encouraging sign for tolerability/safety.

• One of the key risks underpinning failures in epilepsy trials has been the high placebo response. Zynerba seems to have prudently designed the STAR-1 trial with the assumption that the placebo response would be around 20% and treatment response would be 40%, which would lead to a treatment effect of 20%. Other drug trials with similar designs suggest this is likely an optimal design for achieving success: e.g. Briviact, which was approved early last year, demonstrated 18-21% improvement over placebo, with the placebo response at 17%; in 3 clinical trials for Vimpat, the placebo response was 21% across two of the studies and 10% in a third trial, with the treatment effect ranging from 14% to 30%.

We envision 3 possible scenarios for the outcome of the Star 1 trial in July/Aug:

1. Clear efficacy/safety. In this scenario, the trial is successful: a greater than 15-20% reduction in seizure frequency from baseline for either one or both doses of ZYN002 in a statistically significant manner with a good safety profile would be a make this a compelling treatment option for the target patient population.  We are assuming a 35% chance of this outcome. This would result in a stock price of $75.

To get to the $75 stock price, we used the following assumptions. We estimate peak US sales of roughly $2 billion in about 10 years for the refractory epilepsy market only.  This is assuming pricing in the range of $10k-$15k/patient.  Based on a multiple of 0.5x peak sales for a early Phase III assets, we get a valuation of $1bil or $75/share in this scenario.  We estimate that a Phase III trial will begin sometime in 2017, and assuming positive data, filing in 2018, and FDA approval/launch sometime in 2019. For conservatism, we did not include ex-US sales, additional indications for ZYN002 such as Fragile X syndrome or osteoarthritis or any ZYN001 sales. These all represent upside.  

2. Positive trends but not meeting endpoint. In this scenario, there are a range of possibilities but it would entail the company not meeting the statistically significant endpoint but producing positive efficacy and safety signals in certain subset of patients, such as in patients on certain drug regimens or with certain baseline characteristics. The positive signals could be analyzed and could be the basis of another trial. We are assuming a 55% chance of this outcome. This would result in a stock price in the range of $10-$14 depending on what the data shows.

3. Doesn’t work.  The trial fails and the ZYN002 doesn’t show any efficacy or there are clear safety concerns that warrant no further studies.  We are assuming a 10% chance of this outcome.  This would result in a near-term stock price in the range of $4-$6 based on investors holding for the event dumping the stock. Based on cash of $5.85/share and the pipeline of ZYN002 for other indications and the ZYN001 program, we feel that this is a reasonably conservative assumption.

Based on the above 3 scenarios, we calculated a probably weighted expected value:

35% chance of $75/share = $26.25

55% chance of $12/share = $6.60

10% chance of $5/share = $0.50

= $33.35/share

To this we add $5-$10/share for the rest of the pipeline (this is not unreasonable since we are not counting the $5.85/share in cash and the programs are in Phase II)

= $38.35 to $43.35/share estimate of fair value

The other two ZYN002 trials have a lower probability of success and provide additional optionality. We believe the osteoarthritis trial has a chance of success but a lower probability than for focal seizures. This indication also addresses a very large multibillion dollar market.  The trial for Fragile X is a bit more speculative. This would be an orphan indication and would also be a lucrative market for the company. If the company demonstrates some positive signals in the Fragile X trial, we feel that would be still be an acceptable outcome and allow the company to run a second study. If CBD works in Fragile X, the company could potentially pursue much larger indications like autism and autism spectrum disorders that afflict millions of patients.  The two XYN001 programs provide additional optionality, but we won’t go into details for the sake of simplicity other than to note that the pipeline for the company is robust.

With a fair value estimate in the range of $38.35 to $43.35, we think this is a good risk reward and well worth having in a portfolio of risk assets if sized appropriately. While the valuation exercise is relatively imprecise, we think adding any additional level of precision to the analysis wouldn’t add much in making the investment decision.

Risks

All the typical risk factors of an early stage pharma/biotech company facing binary risk.  However, the company has multiple shots on goal with 5 programs in the pipeline and $77.2mil in cash, which funds them into 2019.  

Catalyst

- ZYN001 trial results for focal seizures July/Aug 2017

- ZYN001 trial results for osteoarthritis July/Aug 2017

- ZYN001 trial results for Fragile X Sep 2017