Expert Financial Analysis and Reporting

Investment View

I believe that Transcept’s (TSPT) Intermezzo is an important new drug for insomnia and will be a commercial success. I am anticipating that Transcept’s marketing partner Purdue Pharmaceuticals will launch the product in mid-2012. There was a time when new product approvals and launches produced investor exuberance. Now they seem to be met with dread. Managed care has emerged as a major factor impeding launches as gaining formulary acceptance is a time consuming process. Last year, new product launches of Human Genome Sciences (HGSI) Benlysta, Auxilium’s (AUXL) Xiaflex and Cadence’s (CADX) Ofirmev did not meet investor expectations and the stocks of these companies performed poorly. I believe that most investors are extrapolating this experience to Transcept’s Intermezzo in 2012 and 2013 and are expecting modest sales and poor stock performance.

I share the concerns about the slow takeoff and have only estimated Intermezzo sales of $1.5 million in the second half of 2012. Thereafter, I look for significant growth as my model projects sales of $40 million in 2013, $140 million in 2014, and $235 million in 2015. Corresponding EPS estimates are a loss of $0.80 in 2013 followed by profits of $0.80 in 2014 and $2.29 in 2015. Clearly, if my estimates are met, this can be a very good long term investment. Simply applying a 10x P/E ratio to the $2.29 estimate would result in a $23 stock in 2015.

I think that the view that the launch will be slow and will result in poor stock performance is pervasive in the market and well discounted in the current stock price. This gloomy sentiment creates lots of potential for upside surprise in the coming year. This along with the my belief in the long term potential of Intermezzo causes me to lean against what I believe to be the consensus view that the stock of Transcept will not do well in 2012 and recommend purchase.

Intermezzo’s Unique Role in Insomnia

Insomnia encompasses several syndromes: (1) difficulty falling asleep, (2) difficulty staying asleep (middle of the night awakening or MOTN), (3) waking too early and (4) poor quality of sleep. The most widely used drugs currently are the GABA A receptor agonists Ambien, Ambien CR and Lunesta, which produce an eight to nine hour drug sedative effect. They are taken at bedtime to produce sleep onset and to then prevent waking too early. Because of their long half-lives, they are not appropriate to take for MOTN and they are not approved for this indication. The FDA is particularly uncomfortable with their potential for next day residual effects such as grogginess and disorientation.

Intermezzo is the first product to receive an indication for MOTN because of three highly desirable characteristics: (1) it needs to be used only if MOTN occurs, (2) it quickly returns people to sleep and (3) its low dosage of active drug avoids or minimizes next day residual affect. Intermezzo is a low dose, sub-lingual formulation of the generic drug zolpidem, the active ingredient in Ambien and Ambien CR, the most widely prescribed insomnia agents in the U.S.

Ambien, Ambien CR and Lunesta are not approved for MOTN because they have sedation effects that last for eight to 10 hours. If a patient wakes up during the night and takes one of these drugs, physical performance could be seriously impaired the next day. Another drawback of long acting drugs is that they must be taken prophylactically in anticipation of a middle of the night awakening. Intermezzo is only used when needed. This reduces the exposure to drugs and reduces pills taken, which potentially provides an important safety advantage.

Intermezzo’s novel sub-lingual formulation allows about 25% of the dosage to be quickly absorbed through the tissues of the mouth, producing a rapid onset of effect. The remainder of the dose is then absorbed through the gastrointestinal tract and released more gradually like the long acting insomnia agents. It is given as a 3.5 milligram dose for adult males which compares to the standard Ambien adult dose of 10 milligrams. There is also a 1.75 milligram dose for women and the elderly who metabolize the drug more slowly. The more rapid absorption allows Intermezzo to get patients back to sleep faster. Transcept states that in its sleep lab Phase III study, patients got back to sleep in as little as 14 minutes which compares to about 30 minutes for Ambien.

Head on a Swivel; My Past Investment Experience with Transcept Has Been Painful

Transcept has been a very difficult stock for me. I suffer from MOTN and the clinical data on Intermezzo persuaded me that this product was an optimal solution for me and my fellow sufferers. I saw it as having significant therapeutic and commercial potential.

The FDA issued a complete response letter on October 29, 2009 to the initial NDA filing on Intermezzo in which the major issue was possible next day residual effects, particularly in regard to driving. Transcept addressed this concern with a novel study that investigated Intermezzo’s effect on morning after driving; it then resubmitted the NDA. Just prior to the new PDUFA date on July 11, 2011 I wrote that I had 80% confidence that Intermezzo would receive approval at the looming PDUFA date.

To my surprise and shock, the FDA issued yet another complete response letter on July 12, 2011. The FDA stated that there was no question on efficacy but expressed concern about next day blood levels and possible residual effects in sub-populations. This turned out to be women and the elderly who metabolize zolpidem more slowly. The FDA hinted, but did not specifically state that another next day driving study might be needed to resolve the issue. While I felt that the FDA was probably being way too cautious and in asking for more data, the agency has the power to do about whatever it wants when safety is an issue. Reluctantly, I backed away from the stock feeling that it might take as long as two years for Transcept to resolve this issue if it had to conduct a new driving trial that. Given the uncertainty as to whether even this would satisfy the agency, I thought that there was some possibility that Transcept might even abandon Intermezzo.

On September 15, 2011 Transcept unexpectedly announced that it had reached an agreement with the FDA that would allow the resubmission of the NDA without any new clinical studies. Essentially the FDA concluded that a lower 1.75 mg dose for women and elderly and new labeling and packaging adequately addressed their concerns. This represented a180 degree turn by the FDA and led to the approval of Intermezzo on November 23, 2011. With the approval, FDA deputy director Robert Temple gave Intermezzo a solid endorsement when he said that there is “less risk of a person having too much drug in the body upon awakening which can cause dangerous drowsiness and impaired driving.” In comparing the position of the FDA in July with that expressed in November, it is like listening to agencies on two different planets. The Wall Street term for a train of events such as this is being whipsawed. The only consolation for me was that the whipsawing was caused by the vicissitudes of the FDA rather than incorrect interpretation of clinical trial results and the potential role of the product.

Addressing the Negatives

Before I issue a positive recommendation on a stock, my investment discipline requires that I first come to grips with the negatives of the investment scenario; there are always negatives. The issue that bothers me the most is that Intermezzo’s active pharmaceutical ingredient (API) is zolpidem. This is the same API as used in the most widely prescribed drugs for insomnia, Ambien and Ambien CR. Both of these drugs are now generic. Ambien is available as 5 mg and 10 mg tablets. The dosage form for Intermezzo is 3.5 mg for men and 1.75 mg for women and the elderly who metabolize the drug less well. Investors are rightfully concerned that physicians will advise patients to split the 5 mg dose of Ambien to approximate 3.5 mg or 1.75 mg dose of zolpidem used with Intermezzo. I estimate that the price of Intermezzo could be $3.00 to $6.00 per day which compares to generic Ambien 5 mg tablets that are priced at pennies per day.

There is also the issue of intellectual patent protection. Because zolpidem is off patent, generic companies might quickly try to develop a generic version of Intermezzo. A new dosage formulation of a generic drug like Intermezzo automatically receives three years of patent protection in accordance with the Hatch-Waxman act. The next layer of protection for Intermezzo comes from formulation patents that are based on the buffers and sub-lingual delivery system it uses. These cannot block generic companies from developing a product with similar pharmacokinetics to Intermezzo if they use different buffers and means of delivery, but they might have to do clinical trials and the product might not be allowed to be marketed as a generic. Of more significance for long term patent protection are method of use patents which cover the use of low doses of zolpidem for the treatment of middle of the night awakening. The formulation patents have issued, but the method of use have not although they are expected shortly. It is customary for generic companies to file a paragraph IV challenge to almost all marketed drugs challenging the validity of its patents. Hence I would expect a paragraph IV challenge in the first year of marketing claiming that that both the formulation and method of use patents are invalid.

The third challenge for Intermezzo is a problem with new product launches that is industry and not Intermezzo specific. Over the last five to ten years the role of managed care has changed dramatically from passive payment for new drugs to placing high hurdles in front of new product launches through the use of formularies. It is not uncommon for managed care watch a new product for six months before allowing usage under the guise of trying to understand the side effect profile. Once a product goes through the excruciating process of gaining formulary acceptance, managed care only allows doctors to write a prescription after they have tried a generic and it has failed. Last year, all of this was driven home to investors as several closely watched new product launches such as Human Genome Sciences (HGSI) Benlysta, Auxilium’s (AUXL) Xiaflex and Cadence’s (CADX) Ofirmev did not meet investor sales expectations.

Are the Negatives Surmountable?

These appear to be formidable negatives that could cause prudent investors to back away. I have tried to figure out if these negatives can be surmounted and can come up with a number of arguments as to how this can be done. However, the by far the most important argument that I can make is that the private company Purdue Pharmaceuticals has licensed US marketing rights and is investing heavily in the marketing of Intermezzo.

Purdue Pharmaceutical is a very successful company based on $2 billion of sales of its opioid analgesic OxyContin. Purdue has the skill sets that make it the near perfect partner and that also provide confidence that the negatives are surmountable. There is considerable overlap between the physician base that prescribes pain killers and those that prescribe insomnia drugs so that Purdue has good understanding and relationships with many potential prescribers of Intermezzo. As an organization, Purdue has shown great skill in differentiating OxyContin from numerous generic opioid pain killers that sell at much cheaper prices which parallels the situation of Intermezzo and generic Ambien. It also has shown great skill in dealing with managed care to gain reimbursement for OxyContin. Its recent launch of Butrans gives it up to date experience on the issues involved with new product launches. Finally, it is junk yard dog in the patent dispute area based on successfully fending off strong generic challenges to OxyContin.

It is very assuring to have a company with this skill set determine that Intermezzo is differentiated from generics and has strong patent protection. This is the single most important factor that persuades me that the negatives can be overcome. Perdue has put its money where its mouth is by paying $35 million in milestone payments to date. As importantly, Perdue has stated that it will spend $100 million in marketing Intermezzo in the first year of launch.

My argument that negatives can be overcome relies most heavily on the actions of Purdue. Aside from this I would make several other points. Ambien is generic and not approved for MOTN. A physician can prescribe Ambien for off label use, but he is exposed to a significant liability risk if there is next day impairment. Ambien cannot legally be promoted for MOTN and additionally because Ambien is generic no company is promoting Ambien for any indication. Physicians will hear about the attributes of Intermezzo with no counter detailing message in the market. Intermezzo does have a quicker onset of action than Ambien of about 15 minutes as compared to 30 minutes for Ambien, which is not insignificant if a patient is lying in his bed at 3:00 AM in the morning trying to get back to sleep. Splitting a pill is a bother and it is unlikely that the patient can consistently split a pill into the right dose. This is especially the case for the 1.75 mg dose needed by women and the elderly who account for 60% of the potential MOTN market.

Intermezzo is more elegant and easier to use than split up Ambien tablets and the only reason that anyone would even consider using Ambien over Intermezzo is price. The consumer of Intermezzo is not concerned about the price that managed care pays, but rather what their co-pay is. Initially, Intermezzo will likely be positioned as a tier 3 drug on managed care formularies and will probably have a co-pay of $45 to $50. Generic Ambien has a co-pay of $10. It is highly probable that Perdue will elect to pick up much of the co-pay on Intermezzo to reduce the out of pocket expense of Intermezzo to the $10 co-pay for Ambien. This can remove the price disincentive for the patient filling their Intermezzo prescription.

Size of the US MOTN Market

The current insomnia market in the U.S. is 78 million prescriptions and a sales value of $2.1 billion. The major drugs are Ambien, Ambien CR, Lunesta, Sonata and Rozerem. It is estimated that about 14% of these sales are for MOTN even though this is off label use.

It is hard to estimate the size of the MOTN market since there is no approved drug. Based on research involving 9,000 subjects done over four years by the Stanford Sleep Epidemiology Research Center it is estimated that 35% of Americans or 83 million people suffer from insomnia. Of these the number of patients who have no difficulty falling asleep but experience MOTN is estimated at 22 million people. Of these 22 million, 3 million seek medical help. This is the addressable market for Intermezzo. About 90% of people with MOTN experience three or more awakenings over a six month period. As many as 50% experience MOTN three times per week continually for up to five years.

To estimate the size of the market, let us conservatively assume that there are three million patients each year who have on average 1.5 MOTNs per week. If they were to use Intermezzo, this would require 78 days of therapy and 78 pills per year. The estimated price of Intermezzo based on comparison to currently marketed drugs could be as much as $6 per day, but I am assuming that it will be priced at $3.00. With these assumptions, the addressable market would be $700 million.

SmithOnStocks Estimates

A summary of my key estimates for the size of the MOTN market and the potential penetration into that market by Purdue is presented in the following table. I have also included estimates of royalties that Purdue will pay to Transcept and EPS for Transcept. All of these estimates are for the years 2012 through 2016.