Expert Financial Analysis and Reporting

Investment Thesis

I published an extensive report on Derma Sciences (DSCI) on January 31, 2014 in which I recommended purchase. I argued in that report that DSCI presents an unusual and attractive biotechnology investment situation. We are all aware of the binary outcomes of critical phase 3 trials in which a successful outcome usually leads to a dramatic increase in stock price (perhaps several fold), but failure can lead to a 50% or greater decrease in price. As there tend to be more failures than successes, it is always difficult to make a risk adjusted decision to buy a stock facing a binary outcome.

DSCI will report critical phase 3 results for its wound healing drug DSC-127 in mid-2015 or early 2016. The upside potential is substantial in the event of success, but the downside risk if it fails is enormously reduced. Why? The reason is that the Company has an attractive business based on Advanced Wound Care products that should achieve sales of $45 million in 2014, has organic growth potential of about 30% annually and with acquisitions might grow faster.

Key to the Advanced Wound Care business segment is an innovative portfolio of products sold by an effective and steadily expanding sales force. This sales force makes DSCI an attractive partner for smaller companies looking to sell or license their products. This is the reason that I believe that Advanced Wound Care has the potential to grow in excess of 30% annually for the foreseeable future.

In my basic report, I argue for a 2018 price target of $20 to $27 under the assumption that DCC-127 fails in phase 3 and development is abandoned. I further suggest that with success in the phase 3 trial that the stock could sell at $31 to $45 in 2018. The reason that I focus on this somewhat distant year of 2018 is that by then we will know if DSC-127 is commercially successful (or has failed) and the price will reflect whichever of these two outcomes emerge.

Interview with CEO Ed Quilty

I spoke with Ed Quilty, the 14 year CEO of Derma, in a wide ranging interview which is reported below. I think it is very valuable to look at a Company through the eyes of the CEO. The Company has gone through an amazing transformation over the last seven years from a producer of commodity wound healing products to an innovation based wound healing company with an intense focus on treating diabetic foot ulcers. With the rapid increase in obesity leading to diabetes and resultant diabetic foot ulcers, this promises to be an area of attractive growth.

As the architect of this strategy, I think that an interview with Mr. Quilty provides a valuable insight into the potential of Derma Sciences. Mr. Quilty is candid and straightforward and I hope that you will enjoy reading the interview as much as I did in conducting it. This is not an in-depth analysis of Derma and for those looking for more details, I would refer you to my initiation report on my website. To put some of Mr. Quilty’s comments on sales, I have provided the following projections.

Sales Projections for Derma Sciences: 2014 to 2018
$ millions	2011	2012	2013	2014 E	2015 E	2016 E	2017 E	2018 E
If DSC-127 is Unsuccessful
Advanced Wound Care
 Medihoney	$6.9	$10.3	$16.0	$22.4	$29.1	$36.4	$44.6	$53.5
 TCC-EZ	0.0	5.7	8.4	11.4	15.3	19.9	25.9	33.7
 Amniomatrix, Amnioexcel	0.0	0.0	0.0	2.0	10.0	20.0	26.0	33.8
 Other	9.0	8.8	9.5	10.0	10.7	11.4	12.2	13.1
Total Advanced Wound Care	15.9	24.8	33.9	45.8	65.1	87.8	108.8	134.1
Traditional Wound Care	46.7	47.8	45.8	47.0	47.5	48.0	48.5	49.0
DSC-127	0.0	0.0	0.0	0.0	0.0	0.0	0.0	0.0
Total Sales	$62.6	$72.6	$79.7	$92.8	$112.7	$135.8	$157.2	$183.1
If DSC-127 is Successful
Advanced Wound Care
 Medihoney	$6.9	$10.3	$16.0	$22.4	$29.1	$36.4	$44.6	$53.5
 TCC-EZ	0.0	5.7	8.4	11.4	15.3	19.9	25.9	33.7
 Amniomatrix, Amnioexcel	0.0	0.0	0.0	2.0	10.0	20.0	26.0	33.8
 Other	9.0	8.8	9.5	10.0	10.7	11.4	12.2	13.1
Total Advanced Wound Care	15.9	24.8	33.9	45.8	65.1	87.8	108.8	134.1
Traditional Wound Care	46.7	47.8	45.8	47.0	47.5	48.0	48.5	49.0
DSC-127	0.0	0.0	0.0	0.0	0.0	0.0	50.0	100.0
Total Sales	$62.6	$72.6	$79.7	$92.8	$112.7	$135.8	$207.2	$283.1
Source: SmithOnStocks Projections

SmithOnStocks’ Larry Smith: Ed, could you tell us how you came to Derma Sciences?

Ed Quilty, CEO of Derma Sciences: My first involvement with Derma Sciences was when I met the founder of the Company Mary Clark. She invented Dermagran, the first wound healing product that was ever sold by the Company and that was the basis for founding Derma Sciences. She invited me to become a board member and I became the Chairman of the board in 1996 and CEO in 2000. Sales in 2000 were about $4 million and we are projecting 2014 sales of $92 million.

SOS: Where were you before becoming CEO?

Ed: I have spent my entire 25 year career in the healthcare industry. I began with Baxter/ American Hospital Supply and held a variety of positions in sales, marketing and management. From July 1994 to November 1995, I was CEO of MedChem Products, which was acquired by C. R. Bard in November 1995. From March 1992 to July 1994, I was CEO of Life Medical Sciences, a publicly traded company. Both MedChem and Life Medical sold specialty medical products including wound healing agents

SOS: Which companies do you view as peer companies to Derma?

Ed: There are no direct peers to Derma with whom we compete head to head across the breadth of our product line. Smith & Nephew and 3M are examples of two larger companies that are extensively involved in wound care. There is also Convatek, which was previously owned by Bristol-Myers Squibb and is now a private company; and Kinetic Concepts is also a company focused on wound healing.

Interestingly, Johnson & Johnson has largely exited business lines that compete with Derma’s products. The recently in-licensed products from BioD compete with comparable products from MiMedx (MDXG) and Osiris (OSIR). Overall, there is basically no direct competitor or peer, just companies that compete against us in certain sectors.

SOS: What was the initial business of Derma Sciences and how has the Company evolved?

Ed: Besides Dermagran, the initial business model was based on Traditional Wound Care products which still account for 51% of sales.

We entered this business through the acquisition of the Canadian company, Dumex Medical, in 2002. Dumex imported raw materials from China and finished manufacturing them in Canada. Subsequently, all traditional wound care manufacturing operations have been moved to China.

In this business, we found ourselves competing with giant companies like Covidien and Medline in selling commodity products to group purchasing organizations. This didn’t make much sense from a business standpoint because of the tremendous economies of scale that they enjoyed and we began to focus on private label manufacturing.

Then in 2005, we decided to look for differentiated products on which we would not have to compete on the basis of price. We had an advantage in that we could move much quicker on acquisitions than big companies like Johnson & Johnson  and Bristol-Myers Squibb . At the time these companies were big participants, but have since de-emphasized the wound healing business.

Over the last nine years, we have maintained modest growth in Traditional Wound Care and have used the cash flow from that business to move into Advanced Wound Care. We have acquired or in-licensed six differentiated wound care product since that time that are the basis of our Advanced Wound Care business. Additionally and importantly, we licensed DSC-127, a small molecule drug for wound healing that is in phase 3 clinical trials.

SOS: Medihoney is the largest product in your Advanced Wound Care portfolio. Could you talk about this product?

Ed: We began working with Comvita, the developer of Medihoney in 2005 and became the distributor for the Americas in 2006. We acquired a worldwide license for perpetuity in 2010 for $4 million.

Medihoney has helped tens of thousands of patients with chronic non-healing wounds and is highly respected by clinicians around the world.

Medihoney became a catalyst for Advanced Wound Care. Our thought was that this could become the next big wound care product after the silver based products that were such a significant advance in managing chronic wounds and burns which were difficult to heal. This was our thought and hope at the time, but you never know. Now with seven years of sales experience under our belts, we think we made the right decision.

SOS: Medihoney was not approved through the PMA process which requires clinical trials. How did it gain approval?

Ed: Medihoney does not have unique product claims that arise from clinical trials which can be specifically promoted. It was cleared for marketing under the 510 K regulatory process which requires a series of safety tests, including biocompatibility. Its package insert has similarities to most wound healing products.

It can be promoted for providing a moist wound environment conducive to wound healing. While the package insert for Medihoney is similar to the other 510K wound dressings, it is unique in that it also states how the product can help to lower the pH of wounds and also provides an osmotic gradient to help pull more wound fluid from the wound.  Both these mechanisms of action have been shown to be helpful to wound healing.

Medihoney can be used for the management of diabetic foot ulcers, pressure ulcers, venous leg ulcers, partial thickness burns, post-operative wounds and other basic types of wounds.

SOS: How did Medihoney gain traction?

Ed: We initially only had 5 reps selling this product who were focused on just a small number of the 1200 wound centers in the US that are the target market. With such a small sales force, we only had limited reach. Our reps would attempt to persuade nurses and physicians to try the product on perhaps 5 or 6 patients who had difficult or stalled wounds that were very difficult to treat.

As the product was tried, health care professionals found that it was quite effective. This led to word of mouth advertising, testimonials and physician sponsored trials and resultant abstracts that spread awareness. There was no high powered promotion. Medihoney is only successful because physicians and nurses have found that it is an effective product. It has helped many thousands of patients.

SOS: What is the potential for Medihoney? Where is it in its life cycle?

Ed: The key to growing Medihoney is capitalizing on its strong and  growing reputation and increasing the number of reps who can persuade physicians to give it a trial on tough to heal wounds. If physician see results, we are confident that they will expand use to more patients and spread the word to colleagues.

Medihoney sales in 2013 were up over 50% to $16 million which compares to $1 million in 2007 when we licensed the product. We are predicting another 30% to 40% increase this year. The unit market for Medihoney is large as annually there are over 5 million chronic wounds treated in the US.

The product is relatively cheap as Derma receives about $7 per dressing. The average patient gets three dressings per week and the dressings are usually used for about 10 weeks (within a range of 4 to 12 weeks). Hence there are 30 dressings at $7 per patient or $210 per course of therapy. It is a relatively cheap product as $15 million of sales requires selling just over 200,000 dressings.

As we could afford it we added new sales reps beyond the 5 we started with and today we have fifty territories in the US. With sales growth exceeding 40% the last three years Medihoney is still early in its life cycle. The product line should exceed $20 million of sales in 2014. Some of the more successful brands in wound dressings have sales levels of $50 or $60 million and I believe Medihoney has that kind of potential.

We will continue to invest in new reps that will allow us to address more wound clinics and also to better serve existing clients; this is an important growth driver. We also will emphasize new uses such as burns treatment which is a key focus for 2014. Medihoney will continue to drive sales as medical professionals are already sold on its value.

SOS: That is a good overview of Medihoney. Before we move on to two recent new product offerings, TCC-EZ and the amnio membrane products  (Amniomatrix and Amnioexcel) which I am most interested in, could we touch on some of the smaller products of the Advanced Wound Care portfolio?

Ed: Xtrasorb and BioGuard lack the same potential as Medihoney, TCC-EZ and the amnio membrane products. However, they are great dressings for prevention and protection of wounds and over time we think that both could approach $10 million of sales.

SOS: Let’s turn the discussion to TCC-EZ, your total contact casting product. How has your initial experience been with it?

Ed: TCC-EZ was introduced in 2008 by the small, private company, MedEfficiency. Dr. Jeff Jensen was the founder of MedEfficiency and is now a valued consultant to our company. While total contact casting was known to be the gold standard treatment for diabetic foot ulcers, products used before TCC-EZ were difficult and required a lot of time to apply. Dr. Jensen focused on making the application easier and faster and developed proprietary technologies to allow this.

Derma worked as the distributor and contributed importantly to a successful launch. By the end of 2011, MedEfficiency and Derma each had difficult strategic decisions to make. MedEfficiency had to decide whether to build its own sales force and Derma had to decide whether it wanted to use its valuable direct sales force asset to distribute another company’s products.

This started discussions that led to Derma acquiring MedEfficiency in April of 2012. At that time the run rate of TCC-EZ was about $4 million. By the end of 2013, we had doubled the annualized run rate to $8 million and are predicting 30% to 40% growth for 2014.

SOS: Is TCC-EZ a commodity product?

Ed: TCC-EZ is not a product that another company can easily copy. There are two strong components of the intellectual property position. The first relates to the sleeve and the second is around the use of a supportive boot in conjunction with the sleeve.

SOS: What kind of sales potential do you see for TCC-EZ?

Ed: It is a very promising product in the new health care environment of outcomes based medicine. Clinical studies indicate representative costs for TCC-EZ plus standard of care for a course of treatment is around $12,000 versus $22,000 for standard of care. This savings is due to TCC-EZ’s greater wound healing effectiveness that reduces the need for costly treatment of complications. It has an 89% success rate when used properly over an 8 week treatment period.

These cost savings are obviously impressive to payors. What we are hoping for and striving to achieve is to persuade payors that TCC-EZ should be designated as standard of care. Without this type of endorsement, we see it as a $50 to $60 million product. However, if managed care widely embraces it, it could be much larger.

TCC-EZ had a $4 million annual run rate in April 2012 when it was acquired by Derma and it had a $6 million run rate at the end of 2012. In 2013, sales increased about 40% to $8 million. This product does require intensive sales training and support so that its sales will be determined by the size of the sales force. Hence, the expansion of the sales force by 20 reps in 2014 should help. There is also synergy with the recently in-licensed amnio membrane products.

SOS: Are you having discussions with managed care about TCC-EZ and if so, could we hear something this year?

Ed: I can’t comment on that.

SOS: What aspects of the amnio membrane products (Amnioexcel and Amniomatrix) which you in-licensed from BioD attracted you?

Ed: We began to look at the skin substitutes market because of the success of Shire’s (SHPGY) Dermagraft and Organogenesis’ Apligraf. Both products received PMAs based on positive clinical trials and went on to get excellent reimbursement. We were even more attracted to this market when we saw the success of the 361 regulatory approved products from MiMedx and Osiris. These products do not need regulatory approval or clearance because they are based on tissues taken directly from human donors.

The skin substitute market was approaching $500 in revenues by the end of 2013. The relationships Derma had built in the 1200 wound centers in the US along with the ongoing expansion of our sales team made this a natural product extension for Derma. We found a great partner in BioD and with its products; we know we can compete successfully.

The market is growing and this fits nicely in our portfolio. Success won’t happen overnight but we will get our fair share. In addition the average selling price is higher than the other products in our basket and they have a gross margin of 70%: this will help us leverage our salesforce and achieve faster profit growth for AWC.

Derma was looking for a development partner at the same time that BioD was looking for a commercial partner. It was then serendipitous that at about the same time CMS changed the reimbursement for Dermagraft and Apligraf in a way that makes it much more difficult for these products to compete. This actually caused Shire to sell Dermagraft to Organogenesis and exit the market. Organogenesis has a challenge because both products are sold in only one product size and the new reimbursement scheme favors multiple sizes to reduce waste.

We were particularly attracted by the success of the 361 products that were recently launched. MiMedx has achieved sales of $40 million and Osiris is at $15 million in short periods of time. We think that the 361 products of these companies and the new amnio membrane product line of Derma/ BioD are well positioned for the new reimbursement environment.

SOS: How do you see the sales potential for Amniomatrix and Amnioexcel?

Ed: One of the things that I would point out is that the price level is much higher than with Medihoney. Assuming three changes in dressing per week for ten weeks at a price per dressing of roughly $7, the price of Medihoney is about $210 per course of therapy. The price point of Amnioexcel for each graft is about $750. Generally there are about three grafts over the course of six weeks so that the price per course of therapy is about $2,250. This higher price point should result in much greater sales potential than for Medihoney and TCC-EZ.

The key is getting reimbursed. There are eight regional Medicare Administrative Contractors (MACs) that act as fiscal intermediaries for Medicare reimbursement. One of these does not name specific products covered in its policy for skin substitutes, so we were able to get reimbursement in the 4 states where this MAC is located. We are working on obtaining coverage from the other seven MACs. This will require randomized controlled studies to justify the price levels when compared to wound dressings such as Medihoney.

We think that because of our breadth of product line offerings for diabetic foot ulcers with Medihoney, TCC-EZ and now Amniomatrix and Amnioexcel that we can offer a more complete solution than any other company. This should give rise to cross selling and other synergies. Our success with our Amnio family of products remains to be seen but if we do it right, I think we could achieve $50 to $100 million in revenue.

SOS: You have made some good acquisitions in Advanced Wound Care. Do you think that there will be more in the future?

Ed: The answer is definitely yes. Our recent equity offering that brought in $82 million gives us ample financial resources to make additional acquisitions. There is good potential for an acquisition in 2014. Acquisitions are a big part of the Derma story.

I have to say that Derma Sciences under Barry Wolfenson’ s leadership has had more successful new products into its portfolio than any of our competitors in the last ten years. Medihoney, TCC-EZ, Amnioexcel and Amniomatrix and potentially DSC-127 give us many treatment options for clinicians to choose from to help patients get better.

SOS: I next want to turn to DSC-127, the new small molecule drug that is in phase 3 for the treatment of diabetic foot ulcers. This is a very large investment as you have indicated that this trial will cost $55 million. What was the decision process in deciding to develop this product?

Ed: Eleven years ago I hired Barry Wolfenson from Bristol-Myers Squibb. His charter was to find products that could differentiate the Derma product line. He brought in Medihoney, TCC-EZ, Amniomatrix, Amnioexcel, Xtrasorb and BioGuard.

Barry met the researchers who discovered DSC-127 at a meeting; Dr. DiZerega and Dr. Rogers were the inventors of DSC-127. At the time, they were about to file an IND. Barry expressed an interest in working with them and told them that when they were ready to partner with someone that they should let him know. They did and Barry and I flew out to California to meet with them.

Dr. DiZerega had been involved in product development efforts on other products with big companies. In those efforts, he was largely left out of the development effort. With DSC-127, he wanted to be integrally involved and was eager to work with a small company like Derma so that he could play a lead role in development.

Derma’s Board was initially skeptical as to why if the product was so good would the inventers want to work with an inexperienced company like Derma. However, Dr. DiZerega spoke with the board and convinced them of the promise of the product and his intention to take an active part in the product development. Derma then went on to in-license the product from the University of Southern California.

SOS: Investors are keyed to news on the pace of DSC-127 enrollment in the phase 3 trial which seems to be slower than originally expected. Could you address this?

Ed: It is not as easy to enroll patients in this phase 3 trial as one might think. The challenge with diabetic foot ulcers trials in general, not just the DSC-127 trial, is finding a large number of homogenous patients.  Unfortunately, patients with diabetes have a plethora of other co-morbid conditions that tend to exclude them from these types of pivotal studies.

The treatment of a diabetic foot ulcer is usually begun by the local podiatrist. If he is unsuccessful, patients are referred to one of the 1200 centers that specialize in treating more difficult cases of foot ulcers. The phase 3 trial is in 85 of the leading wound care centers, podiatry clinics and research centers.

The aim of the trial is to treat patients who don’t or are unlikely to respond to standard of care. For the first two weeks of the trial, potential patients are treated with standard of care. Investigators are only interested in enrolling patients with non-healing wounds; if the wound size decreases by 30% during the run-in period, the patients are excluded from the trial. They are looking at non-healing wounds only and the screen failure rate is 50% to 60%.They also consider the size of the wound since complete closure at ten weeks is the endpoint of the trial.  Finding the right patient is difficult.

The question is how long will it take us and can we meet the primary endpoint? There is no question that for a trial of this magnitude and complexity we aimed a little high in our initial enrollment and completion targets. The goal is to complete enrollment and have a data read out by the end of 2015.

SOS: Wound healing has been a nightmare for drug development. What gives you confidence that the phase 3 trial can succeed?

Ed: Many physicians and key opinion leaders have participated in the pharmacokinetic studies and safety studies as well as the phase 2 randomized trial. Their consensus view is that this drug is biologically active. That doesn’t assure that the trial will be successful. However, I believe that there is a good opportunity for success.

Even though our phase 2 trial involved a small number of patients, the results were pretty darn good and have held up to intense scrutiny from some pretty smart people. Some of the best in wound care have expressed the opinion that this drug has accelerated wound healing activity.

We have designed excellent trial protocols and worked closely with FDA. We will not compromise those protocols to speed up enrollment at the expense of failure. In my opinion there is good reason for optimism that this trial will be successful.

SOS: What guidance are you giving the Street on 2014 results?

Ed: We are projecting revenues of $92 million, which would be a 15+% increase over 2013. We project that Traditional Wound Care which is 51% of revenues will grow at 2% to 5%. We expect Advanced Wound Care to increase at 30% to 40% without taking into account any sales contribution from Amniomatrix and Amnioexcel. Our initial expectation for these products was about $2 million of sales in 2014, but this could be low.

We think that gross margins will improve in advanced wound care, but there will be modest pressure on traditional wound care gross margins. Overall, we expect over a 1% increase in corporate gross margins. We will spend $34 million on sales and marketing, mostly in the US; $28 million on R&D and $15 million on G&A. About $9 million of our expenses are non-cash items. We project a cash burn rate of $35 million for 2014. This should leave us with a yearend 2014 cash balance of $70+ million.

SOS: What about 2015?

Ed: We expect trends in revenues similar to those in 2014 although we haven’t issued any guidance. We think that gross margins will continue to improve. We may begin to get leverage from expenses for sales and marketing and general and administrative which could grow at a lesser rate than sales. We expect a big drop in R&D in 2015 to the $7 to $8 level as enrollment for the phase 3 trial winds down.

We feel that 2015 and beyond will only get better. The DSC-127 trial will be coming to completion. We see continued strong growth trends for AWC, we will be fully up and running with our amnio membrane family of products and we will find new products for our Advanced Wound Care portfolio. Traditional Wound Care will continue its steady performance.

One of the things that we will be considering is how rapidly we want to expand the sales force. It is a balance between realizing that the return on investment after the first year is very high versus the investment concern of reaching cash flow break even. We will probably add reps, the question is how many?

SOS: The US is about 72% of revenues, Canada is 19% and international is about 9% of revenues. What kind of growth are you projecting for international?

Ed: We see 30% to 40% annual growth. There are two parts of international: Europe, Middle East and Africa (EMEA) and Asia Pacific Latin America (APLA). We have six direct sales reps in the UK and the rest of the EMEA is handled by distributors. All of APLA is handled by distributors. With our limited resources, we will continue to make most of our investments in the US and rely on the distributor model for international.

We have great leadership with Maeve Kelly in EMEA and Mario Neto in APLA. Their goal is to successfully bring on new distributors and to work with those already in place to achieve 30% to 40 % growth of AWC products outside the US.

SOS: What should investors focus on in 2014 and are there any issues that worry you?

Ed: Investors should feel good that I worry all the time. I feel a great sense of obligation to the company and to our shareholders. We have built a great company and the best is ahead. I look around at all the talented people that have been with us for as long as fourteen years and my sense is that they are part of something special. It is a great time to be a part of Derma.

We got off to a slow start in 2014 because of the weather and as a result we are expecting no sequential growth in revenues for 1Q, 2014 in comparison to 4Q, 2013. However, there is no reason to be alarmed and even with this slow start we have not changed our revenue guidance of $92 million of sales for the full year.

There are always things to worry about, but for us execution is the key and to the extent that we execute well, we can control our future. We are in good shape financially as we have ample resources to complete the phase 3 trial of DSC-127 and still have the resources needed to make an acquisition, if the opportunity presents itself. Positive news on managed care deciding to make TCC-EZ a part of standard of care would be a big psychological and commercial boost. Also, watch for broader reimbursement on Amniomatrix and Amnioexcel.

We will announce when we meet halfway enrollment point for DSC-127. The goal is to be there before the end of 2014. We were originally too optimistic on enrollment. The addition of two new centers in South Africa could speed enrollment. We expect to release topline phase 3 results in late 2015 or early 2016.

SOS: Thanks for time Ed. Like all of the stocks that I recommend, I own DSCI. I would suggest that for those readers who want to do more dilligence that they read my iniation report on the Company. The link to that article was included in the first paragraph of this intervew.

 

 

 

 

 

Tagged as Amnioexcel, Amniomatrix, Derma Sciences, DSC-127, DSCI, Medihoney, TCC-EZ + Categorized as Company Reports