Expert Financial Analysis and Reporting

Investment Opinion

In this report, I present my hypothesis as to why I believe that antibiotics development is in the rapid process of changing from an ignored area for Wall Street investors to one that may evoke the same keen interest as cancer drug development. I see the passage of the GAIN Act in October 2012 as the tipping point for this. The implications for Trius and other leading biotechnology companies involved in antibiotics development are profound. I think that the FDA will move toward more reasonable requirements for clinical trials that will make it easier to gain new indications for existing drugs and make it quicker and easier to bring new drugs to the market. I also believe that it will be easier for Trius and its peers to justify and achieve premium price points needed to realize a satisfactory return on research investments.

Most large pharmaceutical and biotechnology firms have avoided antibiotics for much of the past two decades in large part due to the intrusion of Congress into the regulatory process. As a consequence, big companies de-emphasized the area allowing small biotechnology companies like Trius to take the lead in building strong antibiotic pipelines. For Trius in particular, I think that it can translate this enviable leadership position into lucrative partnering deals. Importantly from an investment consideration, I think that Trius will be keenly looked at as an acquisition target by large pharma companies seeking to quickly rebuild their presence in antibiotics.

In prior reports, I have speculated on the potential price that Trius might realize if management elected to sell the company. I used the December 2006 acquisition in which Forest Laboratories (FRX) paid $594 million (including $494 million upfront) to acquire Cerexa Inc. The company was just about to enter Phase III trials for ceftaroline, an intravenous cephalosporin antibiotic for use against MRSA and certain gram-negative bacteria. Ceftaroline operates in a somewhat different setting than Trius' lead product tedizolid; I consider tedizolid to have much more commercial potential. A takeover value of $594 million for Trius translates into $15 per share. However, if my hypothesis is correct, I think there could be a spirited competition for Trius if management decides to sell that might significantly increase the takeover value.

The focus of this report is on Trius as it is the company that I have done extensive work on and on which I have a strong buy recommendation. I want to point out that the strong tailwind I am expecting for Trius will also help other antibiotic drug developers, but I have finite time and resources and cannot carefully analyze all companies in the space. The conclusions of this report have important positive implications for the publicly traded Cubist (CBST), Durata (DRTX), Furiex (FURX), Anacor (ANAC) and PoyMedix (PYMX.ob). There are also two still private companies that may be the subject of IPOs in the next year; these are Rib-X Pharmaceuticals and KaloBios.

For those who would like additional input on the GAIN Act, I would recommend the Chairman's Blog article on GAIN written by Jeff Stein, the CEO of Trius, the link is:

http://www.thechairmansblog.com/jeff-stein/2012-06/gain-act-implications-for-antibiotic-drug-developers.html

Investment Perspective

I believe that the second phase III trial of tedizolid scheduled to report topline results in 1Q, 2013 will be successful and that this will result in its approval and subsequent introduction in mid-2014. There is likely to be a major partnering deal for European rights to tedizolid that can be concluded in 2013 that could bring in $50 million or more of upfront milestone payments. US marketing plans will probably involve Trius marketing tedizolid on its own or co-marketing with a larger partner I see peak worldwide sales potential of $1 billion and have set a 2020 price target of $60 if Trius remains an independent company.

Much of the investment discussion on Trius has centered on the clinical attributes of tedizolid and its phase III trials conducted for regulatory approval. This is obviously important and I have written extensively on these subjects in prior reports. However, an as important part of my positive investment thesis stems from my belief that the macro-environment for antibiotics is changing dramatically for the better. I expect this to result in a very favorable regulatory environment which will make it easier for companies to gain regulatory approval for new drugs and new indications for existing drugs; this is key to driving unit growth. I am also expecting a much more favorable pricing environment.

Congress is arguably one of the most dysfunctional organizations on Earth, but it does have great power to shape attitudes. Some members of Congress heaped criticism on antibiotic drug developers in the mid-2000s and this prompted the FDA to put up major roadblocks to drug development. Spurred by the emergence of difficult to treat, resistant bacterial strains there is a rapidly developing societal consensus that we are facing a public health crisis and strong action must be taken to develop effective antibiotics to meet these threats. Antibiotics have been a neglected drug development area for nearly two decades, but this is rapidly changing. I believe that antibiotics will be increasingly looked at very much as cancer drugs are now. I think that antibiotic development is moving toward a "war on pathogens" approach similar to the "war on cancer" so familiar with cancer drugs that will create a sizable tailwind for Trius and other antibiotic developers.

The most visible sign of this shift in attitude came from Congress with the passage of the Generating Antibiotics Incentives Now Act or GAIN which became effective on October 1, 2012. This was intended to spur development of new antibiotics through streamlining a regulatory process which has been oppressive for much of the last decade. Responding to the prompting of Congress, I expect the FDA to approach regulatory approval of new antibiotics with the same sense of urgency as drugs for cancer. The end result will be quicker approval of new drugs and new indications for existing antibiotics.

During the debates over GAIN, there were some very encouraging signs that Congress recognizes that antibiotics must carry high prices in order to create the economic incentive for companies to undertake development costs. Trius is in the right place at the right time. I think that the company will be able to do many small trials directed at particular infections with tedizolid and that the FDA will act quickly on these. This should allow the company to significantly expand the label of indications for tedizolid without huge expensive trials, which has been a formula for success with cancer drugs as label expansion is key to increasing unit sales. I also think that hospitals and managed care will follow the leadership of Congress and FDA in speeding the time for formulary acceptance and in accepting high price points. Drugs like tedizolid are used in seriously ill people and sometimes in life or death situations; it is difficult for managed care to fight back against this.

How the Negative Attitude On Antibiotics Developed

Antibiotics were major drivers of sales growth for the pharmaceutical industry in the 1970s, 1980s and early 1990s which caught the attention of the industry's many critics. A consensus developed among politicians, consumer groups and payors that there was no need for new antibiotics as most bacteria were susceptible to existing products. They saw new antibiotics as offering no advantages over existing drugs even though they were priced many times higher. Faced with this hostile environment, drug companies began to de-emphasize antibiotic research and focus on trendy new areas like depression, cholesterol lowering, gastrointestinal reflux disease, etc.

Adding to the move away from antibiotic development was considerable scrutiny about side effects that the industry came under in the early part of the 2000s. A major catalyst for this was the Vioxx side effect issues that caused Merck (MRK) to withdraw this anti-inflammatory drug from the market in 2004. The issue spread to antibiotics in 2006 when a controversy about rare but serious side effects associated with the antibiotic Ketek (telithromycin). Some members of Congress accused the FDA of being unacceptably lax on side effects or even conspiring with the drug industry to ignore side effects and bring dangerous products to the market.

The political hysteria came at about the same time that the FDA was having a significant internal debate about endpoints for antibiotics trials, especially in regard to non-inferiority studies. In reaction to the political pressure, the FDA significantly raised the bar on efficacy and safety standards and expanded the scope of clinical trial requirements. Ignored in all of this regulatory uproar were the voices of physicians who treat infectious diseases. Trial requirements were being determined mainly by biostatisticians without a clear understanding of what goes on in the clinic.

This sequence of events over the last two decades has disincented the development of new antibiotics. As an example, Eli Lilly was the antibiotics powerhouse of the industry in the 1970s and 1980s, but by 2000, it had essentially abandoned antibiotic drugs. The FDA approved 16 new antibiotics from 1983 to 1987. Approvals declined to 10 from 1993 to 1997, to five from 2003 to 2007, and to just two from 2007 to the present. Today, I believe that only two big pharma companies are in late stage trials with antibiotics

Why an About Face in Support of Antibiotic Development Has Begun

One of the most important aspects in evaluating the commercial potential for a new drug is understanding how regulators, payors, the medical community, society as a whole, and investors view the category in which it is being developed. Let's take the example of cancer. There has been (nearly) uniform opinion among all parties that we should make every effort to "wage war" on cancer. As a result there have been a large number of drugs that have been introduced and there are a plethora of new drugs in advanced clinical trials. This has led to some huge investment successes and cancer drug development attracts keen investor interest.

It has been generally accepted that because there are many different type of cancers, most of which affect only a small number of patients, that manufacturers must be incented with high prices to offset development costs which are relatively fixed regardless of disease incidence. As a result, it is common for cancer drugs to be priced at $60,000 to $100,000 per year versus perhaps $2,500 to $3,500 per year for a disease with high incidence of occurrence. As an example, Bristol Myers Squibb just introduced its much heralded anti-coagulant drug Eliquis, a drug used chronically, at a wholesale acquisition cost of $8.35 per day or $3,000 per year. The high prices for cancer drugs are accepted even though they often extend median survival by only a few months; generally a two month increase in median overall survival is accepted as meaningful. While there is beginning to be more questioning of this paradigm, it continues as status quo in the cancer drug development arena.

At the other extreme are drugs for diseases such as gastroesophageal reflux disease or GERD. This condition is well treated by two classes of drugs: protein pump inhibitors like Prilosec and H2 antagonists like Pepcid and Zantac; most drugs in these classes are now generic. Because of the effectiveness of current agents and because there are plentiful generics, there are substantial disincentives for developing new drugs and there is almost no investor interest in this area.

Antibiotics have been viewed in much the same way as GERD drugs for nearly two decades. I believe that this perception is now rapidly changing to an attitude more in line with cancer drugs. There seems to be a broad consensus building that antibiotic drug development has not kept pace with the evolution of bacteria. As bacteria have mutated over time, this has given rise to strains of bacteria such as Staphylococcus aureus, Escherichia coli, and Acinetobacter (brought back by the troops from Iraq and Afghanistan) that are resistant to previously effective antibiotics. The situation has become so severe that antibiotic resistance was listed by the World Health Organization as one of the three greatest threats to human health in 2010.

I think that politicians have caught on as can be seen with recent legislation called the Generating Antibiotics Incentives Now Act or GAIN which became effective on October 1, 2012. The passing of the GAIN act by Congress emphasizes the urgent need to develop new antibiotics and contains important incentives for companies to invest in antibiotic development. Congress has great power to shape attitudes. I believe that this will lead to a major shift at the FDA from obstructing to encouraging clinical development. This can have very important consequences for how antibiotics are developed, how they are used and how they are paid for.

A Look at the GAIN Act

The GAIN Act contains important incentives for the development of qualified infectious disease products (QIDPs). Like the Orphan Drug Act, GAIN provides additional market exclusivity to QIDPs which are intended to treat serious or life-threatening infections. Products with this designation will be given an additional five years of market exclusivity. They will also be given priority review of six months instead of the usual ten months and fast track status; the latter is an FDA process designed to facilitate the development, and expedite the review of drugs intended for serious diseases that fill an unmet medical need.

The legislation also requires the Department of Health and Human Services or HHS to review and update guidance for the design of clinical trials for antibiotics. Over the last decade or so, FDA has been an obstacle to antibiotic drug development. I see a pendulum swing toward cooperation with industry to speed important new drugs to the market and as importantly to accept data from small trials to approve marketed drugs for niche indications.

The most important thing about the GAIN act is not necessarily in the specific guidance given to the FDA, but rather the signal that Congress has reversed its attitudes toward antibiotic drug development. It has changed the previous message given to the FDA that it wants to minimize side effects associated with new drugs which requires large, expensive and lengthy trials. Moving to the opposite extreme, Congress is now asking the FDA to adopt standards that are attuned to the realities of clinical practice and the need to quickly address public health threats posed by rapidly evolving bacteria and other pathogens. This means smaller, shorter and less expensive clinical trials.

Implications of GAIN

Congress is primarily made up of lawyers who are poorly equipped from an educational and work experience basis to oversee regulation of antibiotic drug development. Nevertheless, these shortcomings don't restrain that august body from coming up with legislation to solve problems they perceive. Whatever the limitation of their ability to craft meaningful solutions, they have great power to influence outcomes as can be seen by their action in the mid-2000s that led to severe setbacks for antibiotic development. With the GAIN act they have reversed their position and are now pushing legislation that will greatly encourage innovation. I think this makes for a new era in antibiotic development that will lead to some lucrative investment opportunities

Congress' purpose in enacting GAIN was to encourage the drug industry to make the investments that are required for antibiotic research and development. There are an important number of takeaway messages from the debates that led up to the legislation. It was made clear to Congress that many pharmaceutical companies had quit working in the antibiotics space, because the opportunity to recover research and development expense was just not there. A common expectation was that new antibiotics should be priced like generics at $5 per day, even though they are used for only short periods of time of five to ten days. At these price levels, the industry cannot spend $200 to $500 million on drug development. Antibiotics cannot be expected to be priced like Eliquis at $8.35 per day (previously discussed), which is used on a chronic basis. The price per day of antibiotic usage assuming ten days of therapy has to be $320 per day to produce the same annual sales return as Eliquis.

The FDA is being asked to produce guidance on how preclinical and clinical trials can be designed to allow for an efficient and streamlined pathogen-focused antibacterial drug development program that can lead to approval. This is meant to allow the development of antibiotics that target resistant pathogens even if infections occur in just a few patients. This is in recognition that it is difficult or impossible to enroll large numbers of patients with such infections and it is important to get new drugs into physicians' hands before these "super bugs" become common enough to study in large, traditional trials. An FDA official, Janet Woodcock, stated that this is life-threatening situation that is being treated differently from typical drug development.

This pathogen-focused guidance will make it feasible to develop new products or new indications for existing products that in the last few years would be very hard or impossible to do. These are usually caused by pathogens that are resistant to multiple antibiotics as well as newly emerging pathogens. In dealing with uncommon pathogens or newly emerging forms of resistance, waiting for a few thousand cases on which to do a clinical trial means that the public health crisis will be in full swing while waiting for large clinical trials to be performed.

In traditional antibiotic indications, regulators typically require studies with more than 1,000 patients who have infections in the same organ of the body such as skin, lung or blood. The new pathogen specific approach can make it possible to perform a study satisfactory for regulatory approval with just a few patients and in whom the infections occur in different organ systems of the body. Safety information can be supported from a collective safety data base involving several organs instead of being gathered from a large trial in just one organ. Depending on the severity of the infection, satisfactory clinical efficacy might be determined in non-randomized trials enrolling patients regardless of the site of infection.

Looking beyond the GAIN Act, infectious disease experts, FDA and industry are working on proposals for a new restricted approval pathway that would speed the development of new antibacterial drugs and could address some of the economic disincentives that have driven most pharma companies out of the space. A drug's safety and effectiveness would be studied in substantially smaller, more rapid, and less expensive clinical trials, like those typically used to support Orphan Drug approvals. They would be narrowly indicated for use in small, well-defined populations of patients for whom the drugs' benefits have been shown to outweigh their risks. It would slash the number of patients required to gain approval from about 1,400 for the typical antibiotic indication to 100 or less, cut development time in half, and reduce regulatory uncertainty.