Expert Financial Analysis and Reporting

Investment Opinion and Background

I initiated coverage of A.P. Pharma (APPA.OB) in April of 2012 with a Buy. I am anticipating approval of its lead drug, APF530 at the March 27, 2013 PDUFA date. I believe that the company has successfully answered the CMC issues that resulted in a Complete Response Letter to its earlier NDA application. I project that in stark contrast to almost all recent biotechnology product launches that APF530 will have a rapid takeoff following a potential 2013 launch. Please refer to reports on my website for a more in-depth analysis of the company.

The stock has been strong recently based on a trading game that goes on in many cases prior to a PDUFA date. Some short term traders buy the stock in the days leading up to the PDUFA date and then sell it just before the PDUFA date. This has nothing to do with the timing of this report. I am not good at short term trading ideas like this and my investment time frame is much longer, often years. Warren Buffett in a way that only he can do summarized my disdain for short term trading when he said that “Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, ‘I can calculate the movement of the stars, but not the madness of men.’ If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.”

I am estimating peak sales of $200 million for APF530 in 2014 and EPS of $0.22. My price target for late 2013 is arrived at by applying a P/E ratio of 20 to projected 2014 EPS of $0.22 and results in a price target of $4.40. Please note that in my models, I have assumed that the product will be launched in mid-2013. The company is only giving guidance that the launch will be in 2H, 2013. If the launch were to occur much later in the year, it might push peak sales into 2015; a somewhat later launch would not appreciably alter my thinking on the stock.

APF530, is being developed for the prevention of chemotherapy induced nausea and vomiting or CINV. It is an injectable drug that uses the company’s Biochronomer™ polymer-based, sustained-release delivery technology to deliver the widely used generic drug granisetron. It increases the time of effectiveness for granisetron from one to five days, which provides important therapeutic advantages.

There is a compelling clinical reason to use APF530 when the only other approved drug for treating delayed onset vomiting, Aloxi, fails to completely halt vomiting, which is about 30% to 60% of the time. A 1,341 patient Phase III trial showed that APF530 is as effective as Aloxi and thus offers the physician an alternative when Aloxi fails to establish complete control. Importantly, there is also a compelling economic reason to use APF530, which I discuss in detail shortly.

Very importantly and in contrast to most recent new biotech product launches, I am projecting a rapid takeoff. This projections stems from a pricing peculiarity under Medicare part B that creates an economic incentive in the early stages of a launch for many providors/physicians to use a new drug.

It is imperative that A.P. Pharma stages an aggressive launch for APF530 to maximize its market position during the economic window of opportunity in the early launch period. It raised $54 million in 3Q, 2012 which gives it the option of building its own small sales force to market the product. The CINV market is relatively small and can be covered with about 40 reps. I estimate that putting a sales force in place and then launching APF530 would cost about $15 to $20 million and this is within APPA’s reach. This strong cash position also puts the company in a strong negotiating position if it opts to license APF530 or sell the company outright after product approval.

Medicare Part B Reimbursement is Very Favorable to APF530

Clinical benefits alone could allow APF530 to gain a meaningful share of the CINV market. However, there are also strong economic incentives for doctors to prescribe APF530. The reimbursement of injectable 5-HT3 drugs, the class to which APF530 belongs, is covered under Medicare part B regulations which set the pricing for Medicare and the Medicare price is then closely followed by private insurers. Aspects of the reimbursement regulations create economic incentives which favor newly introduced drugs over older ones.

Let me show how this Medicare pricing works in the case of Aloxi. The wholesale acquisition price or WAC for Aloxi is about $380, but it is sharply discounted so that I estimate that its actual average selling price or ASP that providors actually pay is about $175. The manufacturer is required by Medicare regulations to gather and submit actual billing information from accounts which is used to calculate the ASP. Physicians are then reimbursed for the ASP plus a 6% markup. In the case of Aloxi, the drug is purchased by providors for about $175 and reimbursed at $186 due to the 6% markup; this results in about an $11 profit from this factor. In addition, physicians also bill for an administration fee that is roughly $20 per injection. Hence the physician receives $11 plus $20 or roughly $31 per injection of Aloxi.

Medicare part B regulations create a unique situation that is very much to the advantage of new drugs. The pricing regulations are based on historical ASP, but new drugs have no pricing history. Instead, new drugs are reimbursed at markup over WAC prices for roughly two full quarters following introduction. For example, if a drug were introduced on July 1, 2013, it would probably be reimbursed at a markup of 6% over WAC until December 31, 2013. Reimbursement would then shift to a markup over ASP.

Let me illustrate how APF530 could benefit from this. Let us assume that it is introduced at a WAC of $380, the same as Aloxi. For 6+ months, physicians would be reimbursed at a 6% markup over WAC or $403. APPA during this time could elect to discount APF530 and sell it to doctors at perhaps $260 so that the difference between $380 and $260 or $120 would be profit for the physician. The total profit for physicians would be $120 plus the markup of $11 and the administration fee of $20 for a total profit of $151 on APF530; this compares to $31 for Aloxi per my previous example. Past experience suggests that a $30 difference in price can induce physician prescribing behavior and the difference in this case would $151. Please note that the $380 price on APF530 and the possible approach to discounting is pure speculation on my part as the company has made no comment on pricing plans.

This initial discount incentive lasts for six and possibly as long as nine months past the launch, the period during which Medicare determines the actual selling price of ASP. What happens next? Over this time, APPA gives Medicare the necessary data to calculate an ASP. Physicians then begin to bill at a markup over the newly established ASP; Medicare is continually recalculating ASP. However, this doesn’t immediately eliminate the incentive enjoyed by APF530. For example, if we assume that during the first six month introduction period for APF530 that the physician is actually paying $260 per injection, this then becomes the new ASP on which reimbursement is calculated. Remember that the ASP for Aloxi is $175 so that APF530 can still provide a meaningful discount. If the ASP is $260 and APF530 is discounted to $220 per injection, the physician could still realize a profit of $76 per injection versus $31 for Aloxi. Hence, this economic incentive can probably be maintained for some period past the first six plus months following introduction.

The market for Aloxi usage according to data presented by A.P. Pharma in its latest presentation indicates that about 2.8 million units of Aloxi are sold annually. Of this, about 2.2 million goes to cancer clinics and 0.5 million to hospitals. The clinics are generally profit making institutions that will respond to an economic incentive. This powerful economic incentive along with the substantial unmet medical need is the basis for my projecting a rapid uptake following the launch of APF530.