PCRX - a rather decent lottery ticket with take-out potential

Stumbled upon this name from a friend just now. Clearly a different mandate than our usual special situation. But the thesis is straight-forward: really good product, clear take-out target for any spec-pharma (like MNK and ENDP), temporary hiccups. Speculative lottery ticket in case you are bored

Target:

$120.00 / share vs. $89.00 as of March 31, 2015

- Bull-case: $135-145, Nerve Block issues resolved and volume ramps in FY15, ~1.8 mm vials by FY16
- Base-case: $115-120, Nerve Block ramp pushed to FY16, ~1.5 mm vials by FY16
- Bear-case: $75-80, Nerve Block ramp pushed to FY17, Infiltration <5% share, ~1.2 mm vials by FY16
- 2 - 4 to 1 risk-reward
- Time Horizon: 9-18 months
- Key Catalyst:
   - May 1st, 2015 1Q15 Earnings Call
   - Pending disclosure on FDA’s Complete Response Letter
   - Potential bid / rumor by companies in the pain space (MNK, ENDP, etc)



Overview:

PCRX is a US specialty pharmaceuticals company founded in 2006 that is focused on development and commercialization of products based on the proprietary DepoFoam extended release drug delivery technology. DepoFoam uses a multivesicular liposomal product delivery technology that encapsulates drugs and allows for extended release. The company’s lead (and so far only) product is Exparel, a formulation of bupivacaine that uses DepoFoam technology and can provide post-surgical pain-relief for up to 72 hours. Through its extended-release formulation Exparel is able to reduce the amount of opioids that are need by the patient as well as cut down on hospital stays. Exparel was approved by the FDA in October 2011 and launched successfully in April 2012

Exparel Details
- The WACC cost per vial is $299.95
- Current utilization rates in different procedure types are about half in soft tissue (Hernia, colon, etc), and half in orthopedic (knee, hip, spin, shoulder, ankle, etc)
- One of the problems that Pacira has (a high quality one) is that when a surgeon uses Exparel once in its intended indication, he or she then will often want to use it in other areas where Pacira has no data and therefore is unable to guide the physician in proper dosing/technique/etc. The majority of its use is still in the soft tissue setting with general and colorectal surgeons, but two of the fastest growing surgeon types are cardiothoracic surgeons and, most importantly, the orthopedists.

Value / Supply Chain

• Manufacturing: 2 manufacturing facilities in San Diego, California + Pantheon outsourced facility in UK (capacity to commence in 2016/17; Pantheon, a Canadian private company with >$700 mm in sales, provides contract development and manufacturing services of prescription and over-the-counter pharmaceutical products for approximately 300 pharmaceutical and biotechnology companies). The total capacity for the batch process is expected to be $1.6bn by 2019
• Distribution: Appointed CrossLink BioScience as exclusive 3rd party distributor until September 30, 2018. Distribution of the DepoFoam products requires cold-chain distribution. Based in Atlanta, GA, CrossLink is the largest Distributor of Orthopaedic Implants in the U.S. with 35+ years in Orthopaedic & Spine Distribution and 500+ Orthopaedic & Spine Representatives in National Network
• Wholesaler: As of 2014, AmerisourceBergen Health Corporation (ABC), Cardinal Health, Inc. (CAH) and McKesson Drug Company (MCK), accounted for 33%, 29% and 24% of PCRX revenues. These customers are wholesalers that process orders for EXPAREL under a drop-ship program to hospitals. The company claims that there is very little inventory in the channel – i.e. they ship when ordered
• Note that in PCRX’s case, due to the cost of handling (specialty gel vs. regular pills) and relatively small volume, there is little economic incentive for middlemen to stock-pile the product in the channel (vs. what happened to SLXP). Typically hospitals have good visibility on # of surgeries ahead and order just-in-time. Thus the whole supply-chain for PCRX is quite tight, inventory sits at PCRX front, and gives the company good visibility to end demand
• Hospitals: The primary target audiences for Exparel are 2 groups within the hospital, 1 is the healthcare practitioner that applies the drug (surgeons and anesthesiologists), 2 is C-suite executives that run the hospital.
• The practitioners care about efficacy of the drug, and the volume benefits that brought about by improved conditions of the patient, faster turnarounds, lower readmissions. Exparel scores well here and the practitioners’ push had been key to driving adoption
• The procurers (C-suite) currently are the bottleneck to adoption: aside from incumbency and bureaucracy, since hospitals receive reimbursements based on relatively-fixed, diagnosis-related-group driven metrics (while their costs are variant and can be controlled) while Exparel was not factored into the negotiation process due to its recency, every dollar spent on Exparel will directly hit a hospital’s bottom-line up-front
• Thus, the key argument (a well-founded one in our view) for Exparel is that it lowers length-of-stay (thanks to lack of side-effect, unlike opioids) and reduces readmission (thanks to prolonged pain reduction). Both of which should materially boost a hospital’s turnover and consequently profitability
• New healthcare reform legislations reduce payments to hospitals for excessive unplanned patient readmissions post discharge. Pain was found to be the single most common reason for re-admissions after same-day surgery, and the mean cost of follow-up care was $13,900 per re-admitted patient (Coley KC, et al. J. Clin. Anesth. 2002; 14:349-53)
• Once the C-suite approves, Exparel will go on a hospital’s formulary available for practitioner’s request (and consequently orders to PCRX).Insurer: Could be private insurers (Aetna, Cigna, etc), Mediaid (government program for disadvantaged), or Medicare (government program for the elders). They would pay the hospital a calculated rate based on conditions, length of stay, and venue of care. For example, the inpatient rate for knee procedures with Pdx of Infection with MCC with 10 days of stay will cost a rather tight range subject to negotiation

Investment Thesis / Highlights

Effective, fast-growing product in a large market that will drive significant profitability

• The bull thesis is fairly straight-forward: Pacira makes a superior product in a big market that solves a problem, no competition, high reimbursement, proven cost-effectiveness, no generics, a built-in pipeline of new indications coming for low cost/low risk, and most importantly, low fixed costs such that every incremental revenue dollar now drops straight to net income.
• Exparel currently competes against two different standards of care. Because IR bupivacaine last only 8 hours and post-surgical pain lasts much longer, additional pain treatment has been needed and exists in two primary forms: (1) elastomeric pump which costs $450, is difficult to use, requires substantial time for appropriate installation and removal, and may introduce catheter-related issues, including infections, (2) Opioids delivered by IV Patient-Controlled Analgesia (PCA) device – which cost up to $500 per patient usage and comes with substantial adverse events (which leads to substantially longer hospital stays and additional hospital resources)
• There are 70 million surgical procedures annually in the US, 40 million of which are appropriate for Exparel (although we use an even more conservative number of 24 million procedures in our modeling). Therefore at $300 per procedure, about a 15% share of these 24 million procedures can make Exparel a $1 billion drug. If this becomes a reality, at the standard 80% gross margin / 55%+ operating margin, PCRX can do $9.50+ in EPS, or <10x P/E on a the current stock price
• Ball-parking a 14-15x PE and 6x EV/Sales will get us $145-150 / share (+65%)

High barrier of entry allows for considerable runway of profitability

• While the patent for Exparel is set to expire in 2018, what makes it so unique is its delivery formulation that took years to perfect and is a closely guarded manufacturing secret.
• The manufacturing process knowledge and complexity is key to the long-term barrier to generics.
• Exparel is difficult to make, and PCRX spent ~$100mm building a dedicated manufacturing site.
• A generic would have to make a considerable capital investment into a discrete manufacturing facility, which typically generics would not do for a drug Exparel’s size.
• PCRX also has key manufacturing and process knowledge that it views as proprietary and difficult to obtain, while also being critical to producing a therapeutically equivalent product, which the FDA would require from any company seeking approval of a generic Exparel.
• In short, there are high barriers to generic competition beyond the usual patent life. This is a product that should have a long lifecycle and has lots of runway left. Low odds of generic competition enhance duration, making Exparel more Botox-like in terms of how the market would value (low risk of an imminent cliff from generic competition)

Upside optionality not adequately priced in

• Aside from Experal’s current indications, the upside case should incorporate Exparel getting into other types of surgeries as well – dental, cancer, and even aesthetic. Those are farther down the road, but part of the bull case
• Additionally, Depofoam as a delivery mechanism may embody sizable opportunity in other medical tangents that require sustained, extended drug release
• The consolidation theme is also important. PCRX would fit well with many potential acquirers in a space that is rapidly consolidating – ACT, ENDP, MNK, VRX are the most obvious buyers. All of those companies sell products to hospitals. Acquiring PCRX would enable those companies to simply put Exparel in their existing sales reps’ bags, and cut/consolidate much of PCRX’s cost structure, leading to significant accretion and the ability to pay a very large acquisition premium
• As it stands today, the market is only giving credit to the approved indication, little for the accelerated approval for Nerve Block, and very little for future potential indications + M&A optionality

Investment Risks and Considerations

New nerve block indication could be substantially delayed

• While the request is unknown, the letter likely asked for something serious like another confirmatory P3 study -- either a second in femoral nerve block or in another nerve of similar size (e.g. sciatic). Although more clarity awaits on its April 30 earnings call, after an FDA meeting within 30 days, there is an inevitable delay. However, there is little doubt that Exparel works in nerve block so it will eventually be approved.

Slowing sales.

• Obviously if sales growth were to start to slow, it would present meaningful downside to our bullish scenario. We feel this is unlikely based on anecdotal evidence of the drug and the last several quarters of sales ramp, and the number of new accounts the company reports each quarter.

Formulary adoption

• The key to Exparel's early success has been the company's cost-effective argument that Exparel reduces opioid usage and hence lowers side effects and gets patients out of the hospital faster. However, the company needs to continue to gain formulary wins as the product becomes a bigger line item at some of the larger hospitals and the cost-effective argument needs to hold true to maintain its status and to gain much needed new wins. Setbacks here could materially slow growth and adversely affect the stock.

Competitor entry

• Recently, Heron Therapeutics showed its Phase 1 results for HTX-011, a long-acting formulation of bupivacaine combined with meloxicam. We don't see this as much of a threat for multiple reasons: 1) it's still years away, 2) FDA's combination drug rules make its pivotal program a bear to conduct, and 3) the lack of an early effect is baffling since i a post-surgical setting, early onset is what one would want, not avoid

Key Developments

March 3rd, 2015

• The one catalyst that the investment community had been looking forward to was the approval of indication for “nerve block” on or before March 5th, 2015. As opposed to the current “infiltration” indication, where the drug is injected into the surgical site, with nerve block a long needle is used under ultrasound-guided technology to “bathe” a large nerve such as the femoral so that, for example, the entire lower leg is anesthetized prior to something like a knee replacement surgery
• On March 2nd 2015, a Complete Response Letter from FDA for PCRX’s Nerve Block indication was issued by the FDA, whereby significantly more clinical work may be needed and may push out the nerve block indication for some time (could be well into 2016/17). A range of outcomes is still on the table, but it is possible the FDA had a question on the data (perhaps more safety than efficacy related due to the long acting nature)
• This is a negative surprise: while current surgeon adoption rate is high and favorable. The indication is important not only due to an additional market, but it also allows PCRX to market to the anesthesiologists – and the recommendation from these 2 parties combined (as opposed to just the surgeon) could really drive more rapid adoption from the hospitals, pulling the NPV forward
• This occurrence reinforces the idea that the bull thesis is contingent on (1) rapid adoption amongst hospitals (which drives EPS) and (2) absence of the rapid emergence of a strong competitor (which helps DCF and multiples). If PCRX can sail forward relatively smoothly, even with a delayed Nerve Block launch, the stock is still worth $115-120 quickly.
• Note that Exparel’s 2015 guidance of $310-330 mm has 10% reflecting contribution in nerve block, and the Street generally expects the nerve block indication to account for 20-30% of the $1 Bn revenue 4-5 years down the road. However, PCRX would essentially be targeting the roughly 6M-7M U.S. procedures annually where perineural catheters are used. In contrast, wound infiltration addresses a far wider range of procedures annually (PCRX has cited up to 40M annually)
• The realization of the bull case is contingent on (1) rapid adoption amongst hospitals (which drives EPS), (2) absence of the rapid emergence of a strong competitor (which helps DCF and multiples), and (3) Exparel getting into other types of surgeries

April 2nd, 2015

• Meeting with management suggest that scripts may be weak for 1Q due to sluggishness in surgery volumes induced by cold weather. Additionally, Kentucky highway shutdown around early March 2015 (recall that PCRX’s distribution facility is located there) may have further exacerbated this issue
• This may have led to the recent weakness – the longs are hesitant to take a potentially bad mark, and the shorts are reluctant to face potential FDA surprises on Nerve Block ahead of earnings