Description

ZILA is an opportunity to buy a stable, cash-cow business with a solid balance sheet (providing an attractive valuation floor near current levels) and also receive an extremely cheap option on what is likely to soon become the only oral cancer screening test in existence (a potential $1.1B market opportunity). The market has failed to correctly value this tremendous option (which we think is worth more than $12 per share on its own) due to near-term confusion over the likelihood of FDA approval (which we argue below, in detail, is extremely high) coupled with shareholder fatigue as a result of PRIOR management’s history of miscommunication and regulatory missteps.

Not only is ZILA not trading anywhere near its intrinsic value, its shares have also suffered in recent months as the entire sector (small cap. nutraceuticals) has been out of favor with investors, making this the perfect time to build a position at a depressed multiple of core earnings before even considering the huge upside of OraTest and other promising developments. This upside consists primarily of:

(1) OraTest. Depending on the market penetration achieved, we see the product adding anywhere from $2- $35 to ZILA’s stock price, with the most likely outcome a conservative $12 of value. While FDA approval is approximately 18 months away, our sources tell us that the company may announce a marketing partnership within the next couple of months, which we believe will be a key catalyst for the shares.

(2) Additional cancer types. ZILA plans to expand applications to include skin, esophageal and cervical cancer. Currently, no product is on the market to assist with visual identification and biopsy for skin and esophageal cancer and ZILA’s approach would be a meaningful complement to the Pap test for cervical cancer (addressing some of the Pap test’s weaknesses, including a 24-36 hour delay in results and a higher rate of false positives). These three cancer areas pose an estimated opportunity for ZILA at least in the $300-$400MM range. At that level, we project that these additional applications could add $25 to ZILA’s share price.

(3) Ester-E. When the Vitamin E market recovers from its current slump and if Ester-E is able to match the success of Ester-C in terms of market penetration (highly likely given the 87% of Ester-C customers who also take Vitamin E), Ester-E could add an additional $2-$3 to ZILA’s stock price.

(4) Multivitamin opportunity. Sales of Ester-C and Ester-E to multivitamin manufacturers as an additional distribution channel (currently in discussions) could add another $1-$2 to ZILA’s shares.

In short, ZILA offers an extremely attractive risk-reward structure, with a downside floor (based on current cash and a reasonable multiple on the stable core earnings) of $2.37, which is just 30% below current levels. Furthermore, the upside optionality is staggering (and virtually free) and shares are likely to reach $12-15 in the next 6-to-18 months, with the prospect of reaching as high as $65-70 in the long-term as the story begins playing out and the rich multiples characteristic of biotechnology companies are appropriately ascribed to the business.

A more detailed company description and our analysis of the primary risks and issues involved with ZILA appear in a following posting due to space constraints.


INVESTMENT THESIS PART I: NUTRACEUTICALS-------

Nutraceuticals is a patent-protected, cash-cow business with good growth prospects, providing a solid $2.37 (including current cash) floor to the stock price.

* Ester-C is a solid cash flow business, with continued market penetration and growth opportunities.

The company’s flagship Ester-C franchise has built a strong position over several years, and is widely recognized as the most efficacious form of Vitamin C available. Estimates indicate that Ester-C currently has approximately 5% share of the ~$700MM Vitamin C market, and is a key part of the product lineup at leading vitamin manufacturers including Nature’s Bounty, Nutraceuticals Int’l, and Natrol. A visit to the local GNC store shows the large number of Ester-C SKUs available, the 100% to 200% price premium they command, and the endorsement they receive from store staff. The company has recently initiated discussions to supply Ester-C for multi-vitamin formulations, which should significantly expand the product’s addressable market.

* Ester-E growth has suffered due to the market downturn, but will bounce back and drive growth.

ZILA’s “Intel Inside” approach to marketing Ester-C has built a strong core customer following for the Ester brand; the first extension of this brand is Ester-E, a patented form of Vitamin E with vastly improved absorption characteristics. Growth in Ester-E has been slow due to the unfortunate coincidence of the product launch with a widely-publicized study (Miller, Annals of Internal Medicine) that questioned the health benefits of excessive Vitamin E supplementation for older people suffering from diabetes and heart disease. The subsequent market downturn (~20-40%, depending on the channel) was driven by consumer over-reaction to the findings of the Miller study, which beyond being very specific to the particular population being studied (a fact that the broader media failed to clarify and many consumers failed to appreciate) has also been widely criticized for its flawed statistical approach and ambiguous results.
Approximately 87% of Ester-C customers also consume Vitamin E, providing a readily accessible potential core customer base for the Ester-E line as the market bounces back. The constraint on the line’s growth to date has been uptake from vitamin manufacturers rather than consumer uptake (conversations with customers have indicated that the Ester-E products that are available in retail have in fact held up much better than the overall Vitamin E market): the result has been a small number of SKUs as manufacturers have postponed the introduction of new Vitamin E products during the market downturn. When the Vitamin E market recovery becomes more certain (and when the findings from the current University of Michigan clinical trial of Ester-E are released later this year, demonstrating the product’s uniquely beneficial impact on cholesterol levels), one can expect Ester-E to begin penetrating vitamin manufacturers at a faster pace. As the number of SKUs available to consumers then grows, ZILA will grow market share within the category even if the overall market remains flat or sluggish.

* Other brand extensions.

The company has the opportunity to extend the Ester brand into additional major vitamin categories, including calcium and glucosamine, again with significant overlap with the Ester-C customer base.

* Valuation assumptions

Revenue growth of 12% in 2006 (down from 17% growth in 2005) reflects continued penetration of Ester-C in the Vitamin C market (current penetration ~5%) as well as an initial entry into the multivitamin market. These growth numbers do not account for any significant pick-up in Ester-E growth. Improvement in EBT margin reflects sustained higher gross margins as of Q3 05 from locking in long-term supply of ascorbic acid at an attractive price (2005 gross margin was dragged down by spike in ascorbic acid price late 2004). 15x earnings multiple is a slight premium to 13x multiple at which leading nutraceutical companies (NTY, NUTR) are currently trading (note that valuations for these companies are currently depressed). This premium is justified by the company’s strong brand and patent protection, potential to expand into adjacent vitamin categories, and lack of retail exposure.


INVESTMENT THESIS PART II: ORATEST-------------------

Purchasing ZILA stock at current levels provides a cheap option on OraTest, which is in Phase III clinical trials and, in the likely event of its FDA approval (note that the solution has already been approved as a swab adjunct to Vizilite, Zila’s oral-examination light), could drive the stock as high as $40.

* What is OraTest?

Generic toluidine blue has been known for decades to stain cancerous cells, and its reagent-grade version (which is highly unstable) has been used occasionally by dentists and cancer specialists to stain lesions prior to biopsy. ZILA has been developing Zila Tolonium Chloride (ZTC) (branded and packaged as OraTest) since 1993 as a stable, pharmaceutical-grade toluidine blue solution formulated to enhance its specificity and sensitivity to cancerous and pre-cancerous lesions (conversations with cancer experts indicate that OraTest is significantly more effective than off-the-shelf toluidine blue). The product will be used as an oral rinse to mark cancerous and pre-cancerous lesions prior to a visual check-up. The company holds eleven US patents (expiration from 2011 through 2020) and 59 corresponding foreign patents on its formulation and on the use of toluidine blue as a cancer screening tool.

* Market size and position.

Oral cancer afflicts 30,000 people each year (out of a high-risk population of more than 28MM that would need to be screened annually). The sixth-most common cancer among men, it has a five-year mortality rate of ~44%, higher than most other common cancers. The only screening method available today is visual identification (now with the assistance of ZILA’s Vizilite product, which uses light-absorption to identify oral abnormalities); once a lesion is visually identified, a brush or surgical biopsy is taken and sent to the lab for diagnosis. Because earlier-stage lesions are difficult to visually identify, 67% of oral cancers are not diagnosed until Stages 3 and 4, at which point the mortality rate is greater than 50%.
OraTest has a significant statistical advantage over visual identification in identifying oral cancer at Stages 1 and 2 (where mortality rates are markedly lower than in Stages 3 and 4), while it is practically impossible to visually identify the pre-cancerous cells that OraTest is able to highlight. Early identification of oral cancer lesions dramatically reduces the mortality rate; consequently, the introduction of OraTest would serve a tremendous unmet market need and significantly decrease the mortality rate from oral cancer. According to conversations with oncologists and dentists, OraTest would become the standard of care, and its use would be driven by the imperative to cut downstream healthcare costs through early diagnosis and treatment and by malpractice liability concerns on the part of physicians and dentists. It should be noted that by reducing the mortality rate from oral cancer, OraTest would have the added impact of increasing the size of the addressable market (more high-risk patients living longer and needing to be screened in additional years). OraTest has been likened to the Pap test (the standard screening test for cervical cancer, recommended at least once every three years for sexually active women younger than 65 years) in its anticipated impact on oral cancer.

* Valuation assumptions.

There are 28MM high-risk (>45 years, smoker/drinker) patient visits to dentists annually in the US; this is the target population for oral cancer screening. We view it as highly possible that OraTest becomes, like the Pap test is for cervical cancer, a ubiquitous annual test for patients at risk for oral cancer. Note that 55MM Pap tests are administered annually, implying 60% penetration among ALL women between the ages of 18-65; the penetration rate among women considered high-risk for cervical cancer—e.g., smokers, multiple sexual partners, STDs—is significantly higher. OraTest would also benefit from the conspicuous absence of any genuine competitors (see Risks section). We consequently see a realistic upside scenario in which OraTest achieves market penetration of 40%. In the downside scenario, we see the product achieving at minimum a 5% penetration rate, focusing on patients who are at especially high risk. In our modest “expected” scenario, we see OraTest achieving a 20% penetration rate. The company plans to price the product between $30-40 (*28MM=$0.8-$1.1B market size) with EBITDA margins between 25-27%, which translates to a net margin of 10-15% (assuming minimal depreciation). We apply a 25x multiple of earnings, which is on the lower end of the biotechnology range, to arrive at our valuation of the OraTest opportunity.
OraTest would also have a significant market abroad (e.g., oral cancer is the most common cancer in Asia). In addition, the ZTC technology underlying OraTest—once validated by the FDA for oral cancer—can quickly be extended to the diagnosis of esophageal, cervical, and skin cancer, dramatically enlarging the addressable market.

* Why is the option on OraTest so cheap?

Investors are applying an unjustifiably high discount rate to OraTest due to uncertainty around the current FDA process; this is due in large part to investor fatigue and the company’s prior unsuccessful application. However, several factors distinguish the current effort from the prior attempt; these include, to summarize the subsequent discussion:
- The newly positive relationship with the FDA, reflecting lessons learned from past interactions.
- The involvement of a world-class Medical Advisory Board (whose financial incentives are limited to “a couple of thousand dollars a year and a few stock options” and who appear to be motivated more by the potential impact of OraTest on a significant public health problem) and the support of the academic community.
- The positive indication from the FDA’s February 2005 approval of a ZTC swab as an adjunct to Vizilite.
- The involvement of Quintiles, a top-class CRO (which has invested $500K in OraTest);
- the inclusion of severe dysplasia as a positive endpoint, which makes the statistical evidence in favor of OraTest extremely compelling (and an order of magnitude better than the evidence in favor existing cancer screening tools like the Pap test).
- A clearer understanding of the mechanism by which OraTest identifies cancerous and pre-cancerous lesions.
- The involvement of the FDA’s Dental division, which is easier to deal with than the Oncology department and provides, to some extent, a clean slate for OraTest untainted by the prior application.
- The involvement of statistical experts to ensure a well-structured clinical trial that meets FDA standards.

* OraTest’s history with the FDA.

OraTest had an unsuccessful first experience with the FDA in 1997-1999, when it was first submitted by the previous management team for regulatory approval. The team’s lack of familiarity with the ins-and-outs of the regulatory process resulted in a bungled Phase III clinical trial. The main fault lay in management’s definition of the “positive endpoints” for the clinical trials—the definition was limited to cancerous cells and excluded pre-cancerous cells (in particular, the final stage of pre-cancer known as severe dysplasia), which OraTest also marks. Consequently, when OraTest “lit up” precancerous lesions in the clinical trial, these datapoints were counted as “false positives”, resulting in an unacceptably high false positive rate.
The FDA was unimpressed by the management team’s efforts and structure of the clinical trials, and rejected the application in 1999; the potential of the product itself, however, received positive comments from FDA panelists. There were also some unanswered questions as to the exact mechanism by which OraTest attached itself to cancerous lesions (exacerbating the concerns about the false positive rate). During this first FDA experience, the previous management team made several overly optimistic public statements, which strained the relationship with the FDA and led investors to lose faith in management when their rosy picture failed to materialize.

* The current FDA process.

OraTest’s return trip to the FDA was bolstered significantly by the 2001 publication of research by Dr. David Sidransky (Professor of Oncology and Director of Head and Neck Cancer Research Division at Johns Hopkins, recently cited by Time magazine as America’s Best Oncologist, and current Chair of ZILA’s extremely impressive Medical Advisory Board) demonstrating that the vast majority of the “false positives” from the original OraTest clinical trials were in fact precancerous cells—by accounting for those precancerous cells as positive endpoints, Dr. Sidransky was able to show that OraTest’s false positive rate was well below benchmark levels (“if you get a positive reading with OraTest, there is a better than 80% chance that the lesion is cancerous or pre-cancerous”) and that its hit-rate in identifying cancerous lesions was ten times better than that of the Pap test. The study also made advances in terms of clarifying the mechanism by which toluidine blue identifies cancerous and pre-cancerous lesions, potentially allaying some of the FDA’s concerns with ZILA’s first application.
The old management team was replaced in 2002: David Burkett, formerly head of the OraTest project, assumed the position of CEO. The new management team hired Quintiles to oversee the clinical trial process, employed a former FDA staff-member to advise on the intricacies of the regulatory process, and spent a great deal of time educating the FDA about the effectiveness of OraTest as an oral cancer screening product (in particular trying to get the FDA on board with treating dysplasia—technically a pre-disease state—as a disease state). The company’s relationship with the FDA is significantly better than it was during the 1997-1999 application discussions (“Our relationship wit the FDA has suddenly and dramatically improved…We have the FDA’s attention, the tone of conversation has changed…it seems like we’ve suddenly gotten to the top of somebody’s pile and things are beginning to move.”). This improved relationship is due in part to the company’s success in having its application transferred from the Oncology division of the FDA to the Dental division, where its story has received more attention.
The proposed Phase III clinical trial program submitted to the FDA last year had two key elements that significantly reduce the cost and duration of the program while ensuring the broadest product labeling post-approval (and hence broadest addressable market): (a) the inclusion of severe dysplasia as a positive endpoint in this run of the clinical trial, allowing the approved product to be marketed as a test for the entire high-risk population of 28MM; (b) reducing the requisite trial patient population by a factor of 10 (enabled by the inclusion of severe dysplasia, which reduces the sample size required to achieve a statistically significant result), dramatically reducing the cost (by a factor of 10) and duration (to less than one year) of the clinical trial program.
In February 2005, the Devices division of the FDA informed ZILA that it had approved the use of ZTC as a swab application to be used as an adjunct to the company’s Vizilite device. This was extremely positive news for the ongoing effort to have OraTest approved as a standalone screening product, especially in light of the three main criteria on which FDA approval rests: (1) Safety – clearly the product is safe, if it has been approved as an adjunct; (2) Market need – clearly oral cancer is a significant and underserved problem, and an early-stage screening tool like OraTest would be a valuable addition to the tools healthcare providers have at their disposal and, recognizing that the FDA is a political entity, would help ease the burden of government healthcare expenses; and (3) Efficacy – the efficacy of ZTC has been established as an adjunct and, while there is a greater burden of proof for the solution to be approved as a standalone screening tool with general labeling, the statistics discussed above, the favorable comparisons to the Pap test, and the endorsement of the country’s leading oral cancer specialists all give good reason to believe that the FDA should be satisfied on this third criterion as well. While management and their medical advisors have stopped short of making any statements about OraTest’s current status at the FDA, they have guardedly expressed optimism as to its approval.
In March 2005, the FDA provided preliminary comments on ZILA’s proposed clinical trial program. The comments focused on a handful of relatively minor methodological/statistical issues (e.g., whether one investigator or two investigators should administer the visual exam and the OraTest to trial patients) and did not indicate any criticisms of the key aspects of the proposal as listed above. Even if the company accedes to these recent comments, management indicates that current cash resources of $14MM are more than adequate to cover the projected costs of the OraTest clinical trial program. Note that in addition to this cash, the company has $9.7MM available on its $10MM line of credit, and the bulk of ZILA’s $4MM of long-term debt is due after 2010.

* Timeline to commercialization.

OraTest is expected to launch commercially within two years. Management has already laid the foundations for the clinical trial (submitted protocols to review boards at testing sites) and will initiate patient enrollment by the end of this summer. The trial will take less than a year (according to management), at which point a full New Drug Application (NDA) will be submitted to the FDA for consideration. The FDA should respond within 6 months with (hopefully) minor revisions/comments; a subsequent turn of the NDA should take another 60 to 90 days, at which point OraTest would be ready for commercialization.

* Distribution/marketing strategy.

ZILA intends to use its ongoing Vizilite marketing and distribution activities as a foundation for the bigger and broader marketing push to be exerted behind OraTest once it is ready for commercialization. At present, ZILA is selling Vizilite through dental distributors; once the product achieves critical mass, the company intends to move more towards partners that specialize in selling pharmaceuticals (as opposed to the supplies and equipment that are the focus for traditional dental distributors like Patterson) to dental offices. The goal is to have the internal/external sales and marketing structure fully developed by the time OraTest is launched. There is also a possibility that the company might pursue a marketing partnership with a major pharmaco or consumer products company.
The government has issued a reimbursement code for Vizilite, and the company is working with private payors to designate Vizilite as a reimbursable expense; management expects these efforts to bear fruit by the end of next summer (2006). In the meantime, they are focusing on growing Vizilite in wealthier locales where dental costs are borne primarily by the patient and the patient has the ability to pay for the screening. Regarding OraTest, conversations with dentists suggest that achieving significant market penetration at the expected $40 price point would not necessarily require insurance coverage (noting that most people do not have dental coverage in the first place); however, it appears likely (given the magnitude and severity of oral cancer) that OraTest will quickly gain approval as a reimbursable expense by both private and public payors as a means of minimizing the much more costly treatments for advanced oral cancer.
Note that OraTest has already been approved in eight countries outside of the US, but the company has held off on investing in the marketing and distribution abroad until it has launched the product in the US—this presents significant hidden upside to the investment thesis (e.g., oral cancer is the most common cancer in Asia).


DISCLOSURE: We own ZILA shares at current market levels.

Catalyst

* Distribution partnership/licensing agreement for OraTest (rumors suggest that an announcement is imminent).
* Announcements re FDA approval process/clinical trials for OraTest.
* Management stock purchases.
* Acquisition of OraTest by major pharmaco.
* Activist shareholders.
* Upturn in Vitamin E market/release of University of Michigan Ester-E study.
* Ester-C multivitamin deals.
* Expanded analyst coverage/investor community awareness.
* Sale of IST, adding further cash to the balance sheet.