Robust M&A activity drove overall sector valuations in fiscal 2013, and we believe expectations of same will continue to support near term healthcare valuations at or above current levels in fiscal 2014.
In particular, we expect specialty pharma and pharma out-sourcing valuations to outperform as they did last year, driven by strong EBITDA margins that this healthcare subsector generates on average, driven by valuations applied to recent transactions (most notably Paladin Labs by Endo Health Solutions), and by expectations that M&A activity will continue (industry giants like Valeant and Teva have said as much in recent updates).
Another major subsector we are tracking is med-tech, and for many of the same reasons. Stryker’s acquisition of orthopedic surgery device firm MAKO Surgical last year raised awareness of the value public firms can realize on takeout by industry peers, and our Canadian healthcare universe is proportionately well-populated with attractive medtech firms simultaneously meriting institutional investor interest and peer group interest.
TOP PICK: Cipher Pharmaceuticals (TSX:DND)
Buy Rating $11.00 Target Price
Projected Return: 39.9%
Valuation: 15X EPS, 10X EV/EBITDA (F2015)
Expect sustainable cash flow from lead drug Absorica to drive near-term profitability. Originally created as the drug development division of CML Healthcare (now LifeLabs) and operating as an independent specialty pharmaceutical firm since Jan/04. Cipher has experienced a bit of a renaissance in the last year or so, with all of its original extended-release CIP pipeline now FDA-approved and commercialized in North America, led by market-leading cash flow-augmenting once-daily isotretinoin form Absorica, which partner Ranbaxy Pharmaceuticals (RLL-N, NR) sells for the firm in the US, and quite successfully so far. In Q313, Cipher generated $3.7M in operating cash and exited the quarter with $20M in cash ($0.80/shr) and no debt.
Cipher’s entire pipeline is now FDA-approved and positively contributing to EBITDA and cash flow. Absorica is the most significant revenue/EBITDA driver in our model, projected by us to contribute net royalties in F2015 of $25.2M, about 70% of consolidated product revenue we are projecting in that period ($35.9M, as shown in our financial summary to the right). But the firm also markets a CIP-formulated once-daily form of the triglyceride-lowering fenofibrate, branded as Lipofen by partner Kowa, and a CIP-formulated once-daily Tramadol, branded as ConZip in the US by partner Vertical Pharmaceuticals and as Durela in Canada by partner Medical Futures. Each is projected to contribute 7.5% ($2.7M) and 6.9% ($2.5M) of our F2015 product revenue forecast – clearly well below our Absorica expectations but, still positive to cash flow and with no residual clinical/regulatory risk.
Absorica US market share growth started to attenuate in FQ413 but cumulative sales still exceeding our original expectations. IMS Health data shows us that Ranbaxy’s US Absorica prescription market share continued to climb from FQ313-end levels of 17.5% to about 18.9% in Oct/13 before retracting somewhat in Nov/13 to 18.2%. A few points on this: (1) Most important, we remind investors that even with modest market share pull-back in Nov/13, Absorica sales are substantially above our original projections (we thought year-end market share would be 12% – as did Ranbaxy, by the way!), and at current run-rate would still generate substantial quarterly operating cash (at or above the $3.7M Cipher generated in Q3/F13) that Cipher can redeploy to new EBITDA-enhancing product acquisitions, but also, (2) the overall US isotretinoin market in which Absorica is capturing market share is growing – probably driven by Absorica sales and Ranbaxy’s promotion that could be impacting the category, not just Absorica – and so Absorica revenue did grow in Nov/13 even though its market share did not.
Partner Ranbaxy funded all Phase III clinical, regulatory and launch costs for Absorica and the price for this ‘benevolence’ is that Cipher’s Absorica economics is comparatively modest in absolute terms, though it is more attractive on a return on capital employed by Cipher itself; our model assumes Cipher receives a net 9% royalty on US Absorica sales. We believe Cipher/Galephar should be entitled to an Absorica sales milestone either in Q413 or Q114 ($10M, shared by the two partners, when cumulative US sales exceed US$150M).
Close Cipher watchers (like us!) will know that Absorica has already been flagged as an attractive generic target even though its core Orange Book patents do not expire until Sept/21. Launching an even more aggressive assault on patent status than even the most predatory generic drug developer usually launches, CA-based generic giant Actavis (ACT-N, NR) submitted a CIP-isotretinoin ANDA back in Sept/13. This was far earlier than the typical generic regulatory strategy that files ANDAs 30 months prior to patent expiration of branded drugs. Absorica has market exclusivity until May/15 regardless of patent status and we believe that the reasonable-case scenario is that Actavis and Ranbaxy will reach a legal settlement on timelines to generic Absorica launch, finding a reasonable compromise between May/15 and Sept/21. Accordingly, our model assumes Absorica will be free of generic competition during our forecast period, though there is clearly some risk to our H215 Absorica sales projections.
Valuation scenarios for Cipher
RoW markets are not yet embedded in our valuation and provide growth opportunities for global Absorica franchise. On the milestone watch, we expect Cipher to identify RoW partners for CIPisotretinoin, focusing initially on the second largest isotretinoin market, Brazil, and we believe the firm could identify new partners in that geography sometime in H114. Absorica is not approved in non-North American markets so any future partner would initially be responsible for regulatory filing and review, and even under the best-case scenario, we would not expect filing in Brazil before H214 or approval before H215. Our model does not yet incorporate RoW sales for Absorica or any other drug in Cipher’s commercial portfolio, thus, RoW markets provide upside to our forecasts.
Separately, Cipher in-licensed a clinical-stage betamethasone patch drug, Betesil, from the Swiss drug developer Institut Biochimique SA back in Aug/12; the drug does not yet contribute to our valuation, but Phase III data are available and positive and could be filed in Canada by Cipher before end-of-year. Our revenue expectations for Betesil are modest, but because Cipher already has a regional dermatology sales force in place to market CIP-isotretinoin in Canada (as Epuris), we believe it is strategically sound to augment Cipher’s dermatology portfolio, and the portfolio can profitably include Betesil, in our view.
TOP PICK: Novadaq Technologies (TSX:NDQ)
Buy Rating (U.S.) $23.00 Target Price
Projected Return: 27.8%
Valuation: NPV, 25X EPS, 17.5X EV/EBITDA
Novadaq is a Mississauga-based medical imaging firm focused on developing its indocyanine green (ICG)-based real-time fluorescence imaging platform SPY in multiple surgical and interventional markets, including robotic surgery (partnered with Intuitive Surgical) and reconstructive surgery (partnered with LifeCell), among others.
Expect sustainable pace of SPY adoption to support sustainable pace of revenue- EBITDA growth. We have flagged Novadaq as our Top Pick before (justifiably, as it turned out) and believe the firm merits that designation again in 2014, as it continues to augment US market penetration for its indocyanine green (ICG)-based real-time surgical imaging platform SPY in multiple surgical markets. SPY is exquisitely effective at assessing tissue perfusion (the dye ICG binds tightly to serum albumin once injected, and goes wherever albumin-containing plasma/lymph goes in the body) and doing so has well-documented impact on reducing surgical complication rates and improving overall patient outcomes in virtually all markets that Novadaq and its partners participate (principally Intuitive Surgical [ISRG-Q, NR] and LifeCell). The firm recorded sequentially strong quarterly revenue in every financial period since FQ212 and continued that trend into FQ413 for which Novadaq already preannounced revenue of $10.7M, that though essentially at our forecast was above consensus at the time.
Abundant medical evidence supporting not just SPY utility, but SPY necessity, in several niche surgical markets. We have several studies to choose from.; two highprofile studies nicely demonstrating SPY’s indispensability include the 140-patient PILLAR II laparoscopic colorectal resection surgery trial (using rigid endo-scope PINPOINT as the SPY platform), summarized at Novadaq’s investor conference in Nov/13, that showed PINPOINT flagged multiple cases (11% of total) for which revisions to operative plan were required due to anastomotic leak, a leak that would not have been identified by visual inspection alone. And interim analysis of a 100-patient breast reconstruction surgery trial at Stanford University, also updated in Nov/13, showed substantially lower complication rates (usually from tissue flap necrosis) in SPY cases than in control cases where tissue flap perfusion was assessed by visual inspection alone. Data showing SPY utility in avoiding bile duct damage during gall bladder surgery is equally compelling.
Investment thesis & valuation
We are transparent in our views that Novadaq and its industry-leading SPY platform represent an attractive acquisition target for any mature global medical imaging firm, and the multiples we use in our valuation are tacit recognition of this. Plausible acquirers include existing partners of course and the lead candidate therein is LifeCell, in our view, for two reasons: (1) LifeCell is targeting the US breast reconstruction surgery market with its SPY Elite platform. Breast reconstruction is probably the first major surgical market where SPY imaging was unambiguously shown to be not only useful, but essential to standard of care. Complication rates that are usually around 9-11%, even in high-volume centres, go to zero when tissue flap perfusion (and thus viability) is assessed beforehand, with SPY; and, (2) the LifeCell five-year alliance, which matures in Sept/15, is probably more critical to LifeCell’s overall commercial prospects in tissue regeneration than it is to Intuitive other surgical imaging firms — at least right now.
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