Adherium — Update 6 October 2016

Adherium is a digital health company developing technologies that address suboptimal medication use and remote patient management in chronic diseases. Clinical evidence shows that its Smartinhaler platform substantially increases adherence and reduces exacerbations in adults and children with asthma. Adherium operates a business to business model, selling its devices to international pharmaceutical and medical technology companies, and to healthcare networks, insurers and other payers. Adherium and AstraZeneca (AZN) entered a 10-year commercial product development and supply agreement in July 2015. The initial Product Supply Schedule under the agreement covers Adherium’s Turbu+ (SmartTurbo) devices tailored to AZN’s Turbuhaler dry powder inhaler sold with its Symbicort and Pulmicort drugs outside the US. AZN began market testing the commercial roll-out of the Turbu+ programme in selected countries in the first half of CY16 as part of patient support programmes for asthma and chronic obstructive pulmonary disease (COPD). Adherium listed on the ASX in August 2015, raising A$35m at A$0.50/share, including a US$3m investment by AZN.

In July 2016 Adherium raised a further A$8m (before costs) through a placement to Fidelity International that was priced at A$0.50 per share, in line with the IPO price. The placement lifted pro forma cash to ~A$35m giving the company additional funds to accelerate its product development and commercialisation programmes across multiple distribution channels alongside its existing AZN relationships.

In the first half of CY16 Adherium appointed two senior vice presidents of business development to lead market expansion in North America and Europe. An important part of the roles will be to build relationships with managed care organisations, healthcare networks, insurers and other payers, and to communicate how improving adherence to asthma and COPD medications results in cost savings for healthcare networks as well as better outcomes for patients.

We see good potential from this side of the business and are encouraged by the resources being put in place to drive growth. However, we recognise that it takes time to establish a presence and build credibility in these markets in order to drive longer-term revenue growth. We forecast sales to managed care organisations, hospitals, insurers and other healthcare networks of A$1m in FY17, growing to A$15m by FY20.

Adherium’s engagement with AZN continues to expand on a number of levels. The two most recent examples are a clinical study in COPD patients in the US announced in June and a commercial pilot programme in Australia announced in August. New Chairman Thomas Lynch has considerable international commercialisation experience which will bolster the commercialisation strategy.

Importantly, the Australian commercial pilot will use fully featured Smartinhalers with data connectivity that will use Adherium’s mobile app and cloud platform, and aims to show how the devices improve medication adherence in asthma and COPD patients. We believe that the data connectivity will appeal to prescribing physicians because for the first time it will give them access to accurate information about patients’ medication usage patterns and enable them to better manage their patients’ health.

While most individual projects remain confidential, Adherium has previously disclosed that collaborations under the AZN agreement include multiple projects across the entire span of operations including product development, regulatory approvals, supply chain and logistics, clinical operations, and product internationalisation, including both embedded and external devices, new and existing inhalers, and major new clinical studies.

While the relationship with AZN continues to strengthen, large pharma companies take a cautious approach to introducing new products, creating a long commercialisation runway which cannot be shortcut.

FY16 covered the 15 months ended 30 June 2016 as the company transitioned from a 31 March to a 30 June balance date. For convenience we refer to the nine months to 31 December 2015, the period covered by the interim financial report, as H116.

Total sales in FY16 of A$2.6m were 7% below our forecast of A$2.8m. Exhibit 1 shows the sales, number of devices sold and average price per device for FY15 and FY16.

In the nine months to December 2015 Adherium sold 48,000 devices at an average of US$25 each. The average price was much lower than in FY15 because 52% of devices sold in H116 were low-cost, reminder-only devices without data connectivity (not expected to be a significant product line in future periods), and because of the commencement of commercial supply at volume-based pricing.

In H216 (the six months to June 2016) 8,000 devices were sold at a much higher average of US$96 per device. There was no specific commentary in the FY16 accounts relating to the composition of sales in H216, but based on the low volume of devices and high average price we conclude that there were very few if any commercial sales of devices to AZ in the second half of the year, with sales in that period primarily devices for use in clinical trials plus related data subscriptions and support services.

Given the announcement in August that Adherium will supply Smartinhalers for an AstraZeneca Australia commercial pilot programme in 2016, it is clear that commercial supply to AZN will recommence in the current period. However, at this stage of the product roll-out we are uncertain about the volume of devices that AZN will order under the commercial supply agreement in the near term.

Transfer of volume manufacturing operations to an Asian-based contract manufacturer has reduced manufacturing cost per device by 28%, delivering gross profit margins of ~50% despite significantly lower average device selling prices.

The FY16 net loss of A$7.9m included A$1.4m of one-off costs, including expenses associated with negotiating the AZN agreements and the ASX listing (~A$0.8m), expensing of capitalised product development costs relating to potentially superseded projects (~A$0.3m) and non-cash expenses relating to convertible notes that were converted into shares at the IPO. Normalised NPAT was a loss of A$6.4m.

Exhibit 2 summarises the main changes to our financial forecasts for FY17. It also includes changes to underlying but previously unpublished FY18 forecasts.

We have reduced forecast sales revenue by 21% in FY17 and reduce by 18% our not previously published FY18 sales due to slower forecast roll-out of Smartinhaler devices under the AZN commercial supply program and lower forecast sales of devices for use in clinical trials. Clinical trials sales are lumpy, being driven by the number of trials of inhaled medications that pharma companies are conducting. FY15 was a particularly strong year as it included two large clinical trials conducted by AZN. We have rebased our forecasts of clinical trial revenue to be A$2m per year (based on annualising the sales in H216), growing at 4% pa, vs our prior assumption of A$3m per year.

Adherium is eligible for reimbursement of 20% of eligible R&D expenditure from the New Zealand government’s Callaghan Innovation programme. Following advice that a number of components of reported R&D expenditure, such as patent costs, do not qualify for reimbursement under this programme we now assume that grants are equal to 10% of total reported R&D spend (previously 20%).

We have modestly increased SG&A expenses by 2% and 9% in FY17 and FY18, respectively. We have maintained our previous forecasts for R&D to more than double in FY17 compared to FY16 as Adherium maintains its objective to accelerate its product development and commercialisation programmes.

Overall, our forecast operating loss for FY17 increases by 8% to A$11.1m.

We reduce our valuation for Adherium to A$171m from A$188m (to A$1.01 per basic share from A$1.31, or to A$0.98/share diluted for the 7.0m options on issue [exercise price 8-67c], from A$1.26). Our valuation is based on a risk-adjusted discounted cash flow model, which includes our estimates of the future costs and revenue streams from sales of Smartinhaler devices and data management services to AZN; to hospitals/managed care, etc, to improve outcomes for asthma patients; and for use in clinical trials.

The main contributor to the 8% fall in NPV is the fact that we have lowered our forecast gross profit on each inhaler that utilises embedded Smartinhaler technology; we expect drug delivery inhalers with embedded Smartinhaler technology to be launched in 2020 and to totally replace sales of clip-on devices to AZN by 2023. We have reduced forecast gross profit on each embedded Smartinhaler from US$2.50 to US$2.00 per device, as we take a more cautious approach to the likely trade-offs in pricing in exchange for the increased uptake when the Smartinhaler technology is embedded within the drug delivery device. Under this revised assumption, annual gross profit per patient for embedded devices is 80% of that for clip-on devices. We continue to assume that the change to embedded devices will see uptake of Smartinhaler technology increase from 30% of Symbicort patients in 2020 to 100% by 2023.

The additional 16m shares issued to Fidelity International in the placement in July sees the value per share decline by 22% compared to the 8% decline in rNPV valuation.

Exhibit 3 shows our forecast assumptions for the four revenue streams and the sum-of-the-parts NPV. Apart from the lower gross profit per embedded device, our other assumptions remain unchanged; key assumptions are highlighted below.

We assume that that the uptake of the clip-on Smartinhaler device reaches 30% of Symbicort users in Europe, Japan and the US by 2020. We further assume a 75% likelihood that in 2020 AZN will launch a version of Symbicort with Adherium’s Smartinhaler technology embedded into the drug delivery device, lifting uptake to 100% of Symbicort users by 2023 and displacing clip-on sales to AZN. Exhibit 3 includes forecast revenues in FY20 and FY23, the years when we forecast peak penetration of clip-on and embedded devices, respectively, to be reached.

We assume that at volume production (eg 1.2m devices in 2020) fully-featured, connected clip-on devices sell at US$25 per device, and earn a 50% GP margin.

We assume that over time Adherium enters agreements with a combination of managed care/pharmacy/hospital and disease management organisations that cover the supply of inhalers to 230,000 (1%) asthma patients in the US, and 115,000 patients outside the US.

We extend our cash flow forecasts for 15 years (to 2031) but do not include any terminal valuation. We assume a long-term exchange rate of US$0.76/A$ and apply a 12.5% discount rate. Under our base case assumptions, we forecast Adherium to become profitable in FY19 and begin paying tax at the NZ corporate tax rate of 28% in FY21.

At this stage we do not include any revenue from: 1) additional device supply agreements with pharma or med-tech companies; 2) monetising insights from analysis of the data collected; or 3) technology expansion beyond respiratory disease to the management of other chronic diseases.

Adherium’s business is subject to the usual risks associated with any emerging technology: slower than expected commercialisation timelines, lower rates of adoption, technology leap-frogging, patent litigation, as well as regulatory and commercial risks. While the company is at an early stage of commercialisation, its clinical trials business has a track record of revenue growth and positive gross profit margins. Adherium currently relies on a single Asian-based contract manufacturer for volume production, which increases the risk that it may not be able to guarantee supply of devices. This risk is mitigated by active supply chain management and known alternatives.

The Product Supply Schedule under the agreement with AZN does not yet include a Smartinhaler device suitable for the US market, although our analysis shows that it has a strong incentive to do so. If AZN does not sign up for a device suitable for the US market then that would be downside risk to our valuation. SmartTurbo pricing is unknown and there is no track record of patient uptake rates, so we rely on our own assumptions for these key factors in our valuation.

Exhibit 4 shows the sensitivity of our NPV model to the price at which Adherium sells Smartinhaler devices and the gross profit margins achieved. The NPV ranges from A$0.44/share at US$20 per device and a 30% gross profit margin to A$2.05/share at US$40 per device and a 60% gross profit margin.