Expert Financial Analysis and Reporting

Investment Thesis
Cadence (CADX) reported another strong quarter for Ofirmev and in my mind the only question about the launch is the magnitude of success. In this report, I go through arguments that suggest that Ofirmev sales in a conservative case could reach $350 million in 2018 and in an optimistic case could reach $730 million. For perspective, Ofirmev was launched in January of 2011 and I am estimating sales of $106 million in 2013. Of course, these estimates assume no generic competition in that time frame

In my investment thinking, Ofirmev is only one component of what Cadence will be in 2018. Products come and go in the pharmaceutical business and it is the sales and marketing infrastructure in the hospital market,whichOfirmev has enabled, that is the greatest strength of Cadence. I think that the Company will be seen as a very attractive partner for smaller companies with hospital products but who lack infrastructure. I expect a number of new products will come to the Company through licensing, co-marketing or outright acquisition of small companies that will broaden the product offering significantly. With the marketing overhead in place and absorbed, these can be sold through the current sales force and gross profits can flow straight to pretax.

The great uncertainty in investors’ minds that has held the stock back and continues to be the major investment concern is a patent challenge to Ofirmev from a small privately owned company called Exela. Perrigo (PRGO) and Exela both challenged the Ofirmev patents, but Perrigo reached a settlement that would allow them to enter the US market with a generic in 2020. Perrigo is a much larger, more sophisticated and financially stronger company than Exela. It has a market capitalization of $12 billion and has recently made an offer to buy Elan. I don’t think that Perrigo decided to settle for financial reasons, but used some calculus that suggested the odds of their prevailing in patent litigation were not good.

To the surprise on many observers, including me, tiny, privately held Exela has decided to soldier on. The Markman hearing on claims structure prior to the patent trial was positive for Cadence in the minds of some knowledgeable observers as was the trial itself. Cadence has been willing to settle on reasonable terms to settle the litigation, but Exela has so far refused to enter into any type of settlement.

My best judgment based on the decision of Perrigo and the Markman hearing and the patent trial is that there is a very good chance that Cadence will prevail. However, it will ultimately be the decision of one trial judge and there is always a chance that Cadence could lose. The trial concluded on July 10 and my best guess is that the final decision will be rendered in the October to December time frame, but it could be longer. If Cadence loses, I think that the stock plunges to $2.00 and if it wins it probably goes up to $9.00 or more. At first glance relative to the current price of $6.80 there appears to be more downside than upside. However, I place the probability for the downside risk as being much lower than the upside. This is why I continue with my Buy recommendation.

No Doubt That the Ofirmev Launch Has Been Successful
The initial launch of Ofirmev following its introduction in January of 2011 was written off by many investors as being slow and disappointing. Gaining formulary acceptance and pricing approval was indeed an initial challenge. Perceptions began to change a year ago as I noted in my report “Confidence for Success of Ofirmev Launch is Bolstered by Very Strong August Results; Buy is Reiterated (CADX; $4.07)”. Now sitting here one year later I would not term the launch as good and probably not as excellent, but as spectacular.

The metrics in the second quarter of 2013 speak for themselves as compared to last year’s second quarter:
• Sales increased year over year by 223% to $24.7 million.
• The number of vials sold doubled to 2.2 million from last year’s 1.1 million. Since its launch in January of 2011 approximately 10.3 million vials of Ofirmev have been sold and used by 4.1 million to 5.1 million patients.
• Ofirmev's quarterly IV analgesic unit market share increased to 3.41% as compared to 1.93%.
• Over 4,350 unique customers ordered Ofirmev in the 2Q, 2013, a 37% increase.
• Average order size increased by 27%.
• Nearly 3,700 accounts or approximately 85% of customers placed multi le orders for OFIRMEV, a 49% increase.
• The average number of orders per customer increased 10%.
• For surgical in-patients, the average number of vials used increased by 12% to 2.7 vials.

Sequential sales performance for 2Q, 2013 versus 1Q, 2013 was also strong. There was an increase of $1.1 million or 5%. However, there was an unusual and non-recurring increase of $2.6 million in 1Q, 2013 from the recognition of non-recurring deferred revenue. Taking this into account the sequential sales increase was 18%. Some other sequential metrics were:
• The average order size was about 100 vials, an increase of just under 5%
• The order frequency, which is defined as the number of weeks during the quarter, that accounts order was 4.9, a 3.5% increase.

My estimate for the second quarter was $23.3 million and the Company actually reported $24.7 million.

Management Sales Guidance for 2013 Raised
Management increased its guidance for Ofirmev sales once again. At the end of 4Q, 2012 management issued guidance for 2013 sales for the first time of $94 million to $100 million. At the end of 1Q, 2013 the guidance range was increased to $97 million to $103 million. Now at the end of 2Q, 2013 the new guidance range is $103 million to $105 million. My 2013 sales estimate is $106 million.

What Could Peak Sales of Ofirmev Be?
Ofirmev in the period of two and one-half years has garnered roughly 3.41% of the hospital analgesic market. This market is estimated to be about 200 to 225 million units per year; for the sake of argument let’s call it 200 million. This market is essentially showing no overall growth. Clearly Ofirmev has a ways to go in increasing market share.

I think that we can look at the current marketshare of the non-steroidal analgesic ketorolac as a proxy for Ofirmev’s potential. It is the only other significant alternative to opiates in the marketplace and has a 15% market share. However, it has the very serious side effect issue (actually a black box warning) that it increases bleeding. This is obviously a major drawback for use in surgery patients. Ofirmev and ketorolac are used in combination to further reduce opioid use and there are many situations in which Ofirmev would be preferred over ketorolac. I think that it is reasonable to look for Ofirmev to capture 10% to 20% of the market. This would suggest peak unit sales of 20 to 30 million.

Ofirmev was introduced at a very attractive price in order to help it gain initial market acceptance and is currently price at a wholesale acquisition price of $13.18 versus $10.75 when it was launched; the net or actual price after discounts and rebates is probably 10% lower. They initiated the first price increase in July of 2012 and raised the price again in January of 2013 and July of 2013 so that the price relative to one year ago is up 23%. This magnitude of price increase is insignificant to the hospital in most situations. Assuming the use of four vials per patient (current average is 2.7), the cost of Ofirmev in a surgical procedure is $47.00 and the price increase over the last half year has been about $8.00. The surgical DRGs that Ofirmev is involved in can be anywhere from $10,000, $20,000 and up. Ofirmev’s cost is not even a rounding error for hospitals. I think that this gives Ofirmev good, but not unlimited pricing flexibility. Assuming 6% annual increases in price the WAC price in 2018 would be $17.65.

All of this thinking enables a back of the envelope estimate of peak sales which I will arbitrarily take to be 2018. The assumption of a 10% market share in 2018 of a 200 million unit vial market would result in sales of 20 million vials. The assumption of a WAC price of $17.65 and a net price of $15.89 results in a peak sales estimate in 2018 of $350 million. I think this is a conservative case.

I think that an optimistic case would be that unit sales reach 20% of the market and that annual price increases are 9% per year. This would produce 40 million units at a WAC price of $20.28 and a net price of $18.25. This would result in 2018 sales of $730 million.

I would lean more to the optimistic than the conservative case. My current annual sales assumptions for Ofirmev are 2013 ($107 million), 2014 ($158 million), 2015 ($224 million), 2016 ($315 million), 2017 ($378 million) and 2018 ($435 million).

Notes on the Patent Litigation
I believe that the only question about the Ofirmev launch is the magnitude of its success. I discount bearish arguments on the launch. However, the bears still can claim that these sales estimates are just an exercise in futility as Ofirmev will lose the patent trial with Exela and this will result in generic competition in 2014 or 2015 that will devastate the price and sales of Ofirmev.

The last day of the Exela trial was on July 10, 2013. Cadence continues to say that they would settle on reasonable terms which presumably are in line with what recent settlements have been and that would pass Justice Department scrutiny. This might be slightly better terms than the Perrigo settlement that would allow generic entry in 2020. However, Exela hasn’t been willing to do this. They have spent a lot of money for such a small company and seem inclined to see this through to the judge’s ruling.

The judge assigned to the case has a reputation for moving expeditiously and his announcement is expected in the October to December time frame although in some past cases the decision has taken nine months or longer to render. Cadence remains willing to settle on reasonable terms. While they are confident of their patent position, anything can happen in the judicial process because it ultimately comes down to the opinion of one man. Like any good businessmen they would prefer certainty on outcome.

If Exela loses in the trial and the validity of the patents are upheld, it would obviously give other potential ANDA filers pause. They would probably have to show that their manufacturing process does not infringe on the Cadence process and that is a hard thing to accomplish in management’s opinion. I think that investor concern about generics would nearly disappear.

If Exela prevails, Cadence would immediately appeal and try to get an injunction against Exela. If there were no injunction, Exela would be legally allowed to launch in January of 2014. However, they would have to find a manufacturing. This would take some time and then that manufacturer then would have to build the plant and gain FDA approval. Building the plant from scratch would be a one to two year project and management is not aware of any company making Ofirmev in quantity in countries where it is made in sufficient quantities to supply the US market. Exela will have to find a third party manufacturer as it does not have the money or expertise to build a plant on its own. Perhaps the best case for a generic entering the market is 2016 and it might be longer. Unlike with an oral generic in which sales often plummet 90% in the first year, I would expect that the Exela/ undetermined partner could only supply a small part of the market and I would expect other potential generic producers some time to build or gain access to supply. This would results in an oligopoly of Cadence and Exela/ undetermined partner. Prices would likely only be 25% lower than Ofirmev. This is not a good scenario, but it is not a catastrophe.

If Exela and its potential partner got to the point where they are prepared to launch, Cadence through its agreement with Perrigo could launch an authorized generic. This would take away all of the incentives that accrue to a company that is first to file an ANDA. Perrigo would be the dominant generic supplier and the second company coming in would have to compete on price to gain market share. And of course, Exela and the potential partner would have to share economics. It may not be a particularly attractive opportunity for a potential partner with Exela.