AFT Pharmaceuticals — Update 31 May 2016

Founded in 1997 in a spare room in New Zealand with NZ$50,000 in capital (it raised NZ$35.6m in its December 2015 offering), AFT Pharmaceuticals has grown to a large regional specialty pharmaceutical company selling more than 130 proprietary and in-licensed products, covering a wide range of therapeutic categories in the hospital, prescription and OTC markets. 97.4% of its FY16 sales came from Australia and New Zealand, though revenues outside these areas tripled compared to the prior year. The company’s goal is to further expand beyond the confines of Australia and New Zealand, which account for only 2.2% of the developed world’s population, mainly through distribution partnerships to sell Maxigesic and its line extensions.

We value AFT at a DCF-based valuation of NZ$4.73 a share, based on a WACC of 10%. We assume a 25% CAGR for revenues from FY16 through FY20, fading to 2% terminal growth post 2026 and a terminal EBIT margin of 34%. The growth rate and margin expansion is highly dependent upon high growth in royalties from distribution relationships in the rest of world segment (everything outside of Australia, New Zealand and South-East Asia), driven in large part by Maxigesic. We expect this segment to represent 29% of total sales by 2020.

AFT has grown revenues at a CAGR of 19% over the past decade and the company seeks to replicate that success across the globe. We look for revenues to grow at an average annual rate of 25% through FY20. The company had been profitable in the past but has been loss-making since FY13 due to increased investment spending to develop new products and new markets. We expect a return to profitability by FY18 due to a combination of revenue growth and R&D expenses plateauing after 2017. AFT raised NZ$35m in its December 2015 public offering and had gross cash of NZ$28.0m at 31 March 2016. We currently expect the company to burn through NZ$11m between now and profitability, hence we do not expect that AFT will need to raise additional funds in the foreseeable future based on our forecast and the company’s stated plans.

The magnitude and duration of AFT’s growth trajectory hinges on its ability to successfully establish AFT’s products, especially Maxigesic, in new geographies (currently Maxigesic is marketed in four geographies but has partners in 109). Without growth outside of Australia and New Zealand, AFT’s CAGR through 2020 falls from 25% to 11%. AFT will need to depend on sales and distribution partners to grow this segment with the quality of the partners determining how successful the company is in any given region. It operates in an extremely competitive market, so it is very easy for a product launch to get lost in the shuffle. Given the low level of rest of world sales, we are yet to see much evidence of AFT’s ability to successfully market its products outside its home area but anecdotally the fact that Maxigesic attained 4% market share in the United Arab Emirates (UAE) in its second year of launch is a promising sign (Maxigesic has 6% market share in New Zealand after six years on the market). It also faces various regulatory challenges, with different requirements in different countries. The most challenging will likely be the United States, where AFT is currently pursuing an NDA for the iv version of Maxigesic and will be in discussions about the SURF Nebuliser. The FDA may require AFT to spend more on R&D than it is currently planning and may also push back expected approval timelines. Finally, it is facing pricing pressure from government purchasing agencies in Australia and New Zealand, which was a major reason the gross margin fell by 5% since 2013 (other reasons are currency and increased costs).

Over the past decade, AFT has built a well-diversified portfolio of products, customers and geographies by focusing on identifying and developing differentiated products that meet a specific market need.

Since 2008, the company has grown from selling 63 products to over 130 currently, with just over one-quarter of sales coming from products introduced in the past three years. In general, before a pharmaceutical product can be sold in a particular country, it must be approved or ‘registered’ by the relevant government agency in that country. Although there are some local differences, regulatory systems around the world are broadly aligned. This enables AFT to introduce a new product into multiple markets without the need for redevelopment work or further clinical testing.

AFT is currently very diversified, with its top-selling product (Maxigesic tablets) accounting for only 5% of product sales in FY15, reducing the company’s reliance on the success of a single product. In FY15, AFT distribution channels were relatively balanced between prescription (30%), OTC (48%) and hospital sales (22%). This balance was also seen across different product categories (see Exhibit 2).

AFT’s salesforce of c 40 sells into the majority of hospitals in Australia and New Zealand, nearly all pharmacies including key local chains such as Chemist Warehouse and Green Cross Health, and all major supermarkets in New Zealand. AFT has in-market sales teams in Malaysia and Singapore and works with local distributors and marketers in the rest of South-East Asia. 97.4% of its FY16 sales came from Australia and New Zealand, though revenues outside these areas tripled compared to the prior year.

Maxigesic, as mentioned earlier, is a proprietary formulation combining acetaminophen with ibuprofen, two very popular non-opioid analgesics. It provides AFT a major opportunity to grow globally and will be discussed in-depth in the next section. Fibroleve is AFT’s brand name for pirfenidone, which is the same active ingredient that is sold by Roche in the US and EU under the brand name Esbriet for idiopathic pulmonary fibrosis, a deadly progressive lung disease with few/no treatment options. Esbriet was launched in 2011 and Roche reported 2015 sales of US$585m (according to EvaluatePharma, consensus forecasts are for US$2.5bn in peak sales in 2021). AFT in-licensed the product for exclusive sale in South-East Asia from GNI Group, a Japanese biotech company, and currently sells it in Singapore and Malaysia on a named-patient basis (the equivalent of compassionate use). AFT expects to receive approval in Malaysia this year and then file in four other South-East Asian countries. It believes the potential addressable market in its licensed region to be US$764m, though there is limited appetite for expensive drugs in developing countries.

Crystaderm is a topical hydrogen peroxide cream for first aid uses that avoids problems associated with antibacterial creams and antibiotic resistance. It achieved 50% of the New Zealand topical antiseptic market and is in the process of launching in Australia. Expansion to Russia and the Middle East is imminent. The company believes the addressable market is US$44m. AFT is also developing another product, called Pascaderm (or Pascomer in some markets) for a hereditary skin condition using the slow-release dermal delivery technology in Crystaderm, which it believes would target a US$2.8bn market, though clinical development has yet to commence. Management views Pascaderm as a major opportunity for the company, though we await more detail before including it in our model.

AFT is targeting to get nearly two-thirds of its sales from outside New Zealand and Australia within the next five years through the use of local and regional marketers/distributors (we conservatively model 44% of sales coming from outside New Zealand and Australia in five years). AFT will lead geographic expansion with Maxigesic tablets and other formulations as they become available, adding Crystaderm and other products depending on the market opportunity.

Maxigesic uses a unique 3.3 to 1 acetaminophen to ibuprofen ratio formulation (500mg acetaminophen/150mg ibuprofen) for the purpose of pain relief. Maxigesic has demonstrated approximately 33% lower average pain scores over 48 hours after oral surgery in adults compared with an equivalent dosage of either acetaminophen or ibuprofen alone in a 135-patient, randomised clinical trial.1 Results were highly statistically significant (p=0.007 at rest and p=0.006 on activity vs acetaminophen and p=0.003 at rest and p=0.007 on activity vs ibuprofen).

There are a couple of reasons why having a stronger OTC medication on the market would be beneficial. First, it would reduce the need for strong prescription opioids, which in places like the United States have caused a spike in drug addiction and overdose deaths (see Exhibit 5).

Second, it would reduce the risk of an accidental acetaminophen overdose due to inadequate pain relief. According to the FDA, 48% of cases of acute liver failure are caused by acetaminophen overdose. Most alarmingly, liver injury can occur at doses just slightly higher than the current recommended maximum daily dose of 4 grams per day. Depending on the study, the median daily dose that led to injury was just 5.0-7.5 grams per day (something that can easily happen if you feel you need a little extra pain relief).

According to IMS, the worldwide market size for ibuprofen and acetaminophen tablets alone is US$10.4bn, most of it concentrated in the US and Europe. However, simply achieving the same market share in Australia (where AFT recently launched in 2014 and had 0.5% market share as of September 2015) as it achieved in New Zealand (6%) would net the company an additional US$15m (c NZ$22m) in annual sales. Also, with regards to Australia, Maxigesic has recently been down-scheduled so that it can be marketed directly to consumers. Additionally, codeine combination products are expected to be up-scheduled by mid-year from OTC to prescription-only in order to limit codeine abuse. This would mean that while AFT would be able to greatly expand patient awareness of its products, one of its main competitors would face additional hurdles for use.

Additionally, AFT intends to add a number of different formulations to its Maxigesic product line as a way of growing Maxigesic sales in both existing and new markets. Planned line extensions in these geographies alone increase its addressable market by US$4.5bn (US$3.7bn OTC and US$832m for the hospital-based iv version) or 43%. If the company achieves the 6% market share in the OTC line extensions that they achieved with Maxigesic tablets in New Zealand, sales would increase by US$221m (NZ$325m in sales). As the hospital market is less competitive (in the US, for example, there is one iv acetaminophen sold by Mallinckrodt, which had US$263m in 2015 sales), 20% market share is achievable, which would equate to an additional US$166m (NZ$245m) in sales. It is important to note that these sales numbers represent the sales of the product, not the revenues that will be booked by AFT as it will need distributor relationships outside its home area. While the exact economics will vary by the agreement, we believe that between the transfer price and the net royalty to the company, AFT will book 8-20% of the product sales as revenue.

The SURF Nebuliser is a hand-held ultrasonic nasal mesh nebuliser for the intranasal delivery of medication and for the treatment of chronic sinusitis. AFT believes the SURF Nebuliser has a unique combination of advantages over existing nebulisers including portability, a high delivery rate (reducing treatment time), control of particle size, control of dosage amount and breath activation to ensure medication is only delivered to the nose and not to the throat or lungs.

The first application the company will seek to use SURF in will be to administer saline as a wash out in post-operative sinus surgery patients suffering from chronic sinusitis. In this setting, SURF will be classified as a Class I medical device, which is the class associated with the least regulatory burden (eg dental floss is a Class I medical device). Chronic sinusitis affects some 29.4 million Americans annually, with 20% of patients (c 5.9 million) not responding to existing pharmacological treatments and nearly 500,000 patients seeking expensive sinus surgery. Using a US$20 per patient price (assuming several treatments), the addressable market in the US is only US$10m.

AFT is also seeking approval in the US for SURF to deliver midazolam for conscious sedation in the dental and ambulatory surgery markets (midazolam, in its iv form, is already used for procedural sedation). The company will schedule a pre-IND meeting with the FDA later this year. Intranasal conscious sedation is an effective alternative to intravenous conscious sedation and is faster acting than currently available oral medications. If approved, AFT expects the SURF Nebuliser to be the only intranasal method of conscious sedation in major markets. In the US, approximately 125 million dental procedures suitable for conscious sedation were performed in 2009 and approximately 25.7 million ambulatory surgical procedures suitable for conscious sedation were performed in 2006. Using IMS data, the US addressable market for conscious sedation in dental and ambulatory surgeries is c US$3bn at US$20 per treatment. Market research conducted by the company suggests that dentists would use the product in 45% of cases.

In the longer term, AFT may seek approval for SURF Nebuliser to deliver drugs for a number of conditions such as seizure, pain, agitation, opiate overdose, hypoglycaemia, vaccines and sexual dysfunction. The company anticipates development for other drug delivery uses to commence in late 2017/early 2018 and has already received interest from existing business partners for co-development of at least one new use.

SURF will be targeted at physicians and hospitals and revenues will come in three forms: the sale of the SURF Nebuliser device to physicians/hospitals (approximately US$300 each); a per use charge through the sale of RFID (radio frequency identifier) cards, which programme the device for use with particular drugs; and consumables, such as mouthpieces and nasal prongs. We currently do not include the SURF device in our valuation, because the product is still in development.

The magnitude and duration of AFT’s growth trajectory hinges on its ability to successfully establish its products, especially Maxigesic, in new geographies (currently Maxigesic is marketed in four geographies but has partners in 109). Without growth outside of Australia and New Zealand, AFT’s CAGR through 2020 falls from 25% to 11%. AFT will need to depend on sales and distribution partners to grow this segment, with the quality of the partners determining how successful the company is in any given region. Its success will also depend upon the exact deal terms, which will vary by product and by geography. We believe that between the transfer price of the product itself and the net royalty to the company, AFT will book between 8% and 20% of the product sales as revenue.

Given the low level of ROW sales, we are yet to see much evidence of AFT’s ability to successfully market its products outside its home area, but anecdotally Maxigesic attaining 4% market share in the United Arab Emirates (UAE) in its second year of launch is a promising sign (Maxigesic has 6% market share in New Zealand after six years on the market).

Obtaining regulatory approval in multiple regions may prove a challenge, with the most difficult likely being the United States where AFT is currently pursuing an NDA for the tablet and iv versions of Maxigesic and will be in discussions about the SURF Nebuliser. Regulatory approval may take longer and prove more costly than currently expected by the company. AFT also has challenges related to pricing pressure from government purchasing agencies in its hospital and prescription segments in Australia and New Zealand, which has been largely responsible for the 5% fall in the gross margin since 2013, from 42% to 37%.

For shareholders it is also important to note the limited float of the company. The Atkinson Family Trust owns 75% of shares and Capital Royalty Trust Partners (and related parties) owns 14%.

We are initiating on AFT with a valuation of NZ$458m or NZ$4.73 per share, based on a DCF model of the business. We have broadly divided the company into two segments: the direct sales organisation marketing products in New Zealand, Australia, and South-East Asia, and the licensed programmes in the rest of the world. Each of these geographic segments has been further subdivided into hospital, OTC and prescription products and modelled independently.

We have used the market penetration for these segments in New Zealand as a model because it is the most developed market that AFT has operated in. However, we assume in each case proportionally lower penetration for AFT products outside of New Zealand (30-70% of New Zealand segments for Australia) because of increased competition with larger market size, historical precedent and regulatory considerations. We have also included considerations regarding the market expansion from new products, particularly Maxigesic. We have modelled the drug achieving 9% market share in New Zealand and 5% in Australia by 2025. We predict a total revenue from this segment of NZ$163m in 2026, with approximately half of sales originating in Australia.

We have modelled a gross margin for the unlicensed products of 36.5%, which is similar to FY15 (37.2%) and 2016 (35.8%) as well as within the range of other companies in the space (see below). We predict an increasing selling and marketing expense (up to NZ$35m in 2026), but with increasing efficiency with the expanding market (21% of sales in 2026 compared to 31% in 2016).

Overseas markets are also divided into hospital, OTC and prescription segments, with segment distribution similarly derived from the New Zealand test case (with modifications such as longer sales ramps and generally lower peak penetration). However, in the near term, expansion of the Maxigesic franchise constitutes the majority of royalty revenue growth in the ROW segment for FY17-19 (increasing to NZ$43m in royalty revenue by FY19) because of the large number recent and near-term launches overseas. The largest markets overseas for AFT products are mainland Western Europe (launch predicted in late 2017) and the US (launch in 2018). We predict a total royalty revenue of NZ$106m by 2026.

Royalty revenue is derived from both a mark-up in the high teens on goods sold to distributers and a low single-digit percentage of net sales. We currently model these as 18% and 3% respectively. The company has guided on distributer mark-ups of 100-400%, of which we have picked the midrange for the purposes of our model, and this translates to an effective royalty rate of 7%.

Our 10-year DCF model builds to sales of approximately NZ$285m by FY26. We calculate EBIT margins of 34% and we model terminal sales with a margin of 34% (including other operating income). We assume a terminal growth rate of 2% and use a WACC of 10.0%. On this basis, our DCF implies an intrinsic value of NZ$4.73 per share.

We have compared AFT to a selection of other global generic and consumer pharmaceutical companies with market caps between approximately US$900m and US$13.6bn. The gross margins of these companies range from 39% for Perrigo, which has a similar operating segment mix as AFT, to 68% for Taro, which has a niche in developing hard-to-formulate dermatology generics. Our predicted 2026 gross margin of 61.6% for AFT is inflated by royalty revenue, from a direct sales gross margin of 36.5%. We calculate P/E across a large range from the teens to almost 60x for AFT’s peers. We expect P/E values in the 20s for AFT in 2019 (based on the current share price). The peer group average price/sales multiple was 4.88x for the most recent FY, vs AFT’s superior value of 4.58x.

As we outline earlier in this report, the opportunity for AFT is significant; however, with a slew of new geographies and products planned, it is difficult to predict the exact revenue and profitability trajectory over the next few years. We believe that the outlook and visibility for AFT will improve considerably over the next 12 months as the company announces new markets and updates investors on more detailed plans and progress for its SURF Nebuliser.

On 25 May, AFT reported results for FY16. Revenues grew to NZ$64.0m, up 13.9% from NZ$56.2m in the prior year. Management noted on its call that revenue growth would have been somewhat higher (NZ$1-2m) had it not experienced a production problem at one of its suppliers; that problem is being rectified. Gross margins in FY16 narrowed slightly to 36.8% from 37.6% in FY15 (and down from 42% in FY13). The drivers were a mix of downward pricing pressure in the hospital market and currency movement partially offset by higher pricing in the OTC market.

Our model calls for revenues to grow from NZ$64.0m in FY16 to NZ$77.4m in FY17 and then to NZ$157.0m by FY20, a CAGR of 25% from FY16-20. We look for licensing (royalty) revenue from new geographies to grow from NZ$1m in FY16 to NZ$4.4m in FY17 and then to NZ$48.9m in FY20. Our revenue growth assumptions differ significantly between geographies and market segments. In NZ, the market has largely stabilised as evidenced by slow growth in OTC and prescription products and a decline in hospital sales, and we expect this to persist. Product sales in South-East Asia are dominated by hospital products (albeit on small total sales of NZ$648,000 for FY16), but the expansion of AFT’s salesforce into the region should increase sales from other segments, and we predict OTC products will represent 40% of sales from this market by FY26.

In both Australia and the out-licensed territories, we predict growth to be driven by Maxigesic in the near term, although we expect the steady introduction of products to maintain double-digit growth in Australia through FY20 and in out-licensed territories through FY26. The current Maxigesic market share is 0.5% in Australia, and we predict this will increase to 6% by FY26.

We predict an acceleration of Maxigesic sales through FY19 as it enters and gains market share in substantial overseas markets, including the US and Western Europe. By way of example, AFT sold approximately eight “batches” of Maxigesic in NZ in all of FY16. Initial orders at launch were 17 batches in Italy and 14 in the UK.

We forecast operating margins to move into positive territory (4.3%) by FY18. Margin increases will stem from both a greater portion of sales in out-licensed territories (where there is more margin leverage) plus overall operating margin expansion as the corporate expenses are spread over a much larger company. We currently predict NZ$11.3m in R&D spending in FY17 with spend plateauing in the NZ$10-11m range afterwards, based on company guidance. We predict a doubling of selling expenses as the company expands into South-East Asia and increases its salesforce in Australia, growing from NZ$19.6m to NZ$56.7m in FY26. We expect G&A expenses to double by FY24, although becoming a significantly lower proportion of expenses (from 11% of sales to 6%).

As a result of new market and product development investments, AFT is currently not operating cash flow positive. The company used approximately NZ$15.1m in net operating and investing cash flows (including net interest) in FY16, down from NZ$13.6m in FY15. Our forecast calls for operating cash flow losses (including net interest) to narrow to approximately NZ$14.0m in FY17 and to decrease rapidly in FY18 to a burn of NZ$2.4m.

AFT raised NZ$35m in its December 2015 public offering and had NZ$28m of cash and NZ$23.2m debt at 31 March 2016. We do not expect that AFT will need to raise additional funds based on our forecast and the company’s stated plans to reach profitability in 2018.