Orexo — Orexo wins patent litigation appeal

On 10 September 2018, the US Court of Appeal declared by a three-to-zero ruling that Orexo’s ‘330 patent was valid, offering a “significant improvement” for the treatment of opioid dependency and that its “novel formulation” provided patients with lower doses [of buprenorphine/naloxone] and less dependency. This means that the decision taken in November 2016 declaring the invalidity of the ‘330 patent in favour of Actavis (now Teva) has now been declared invalid.

Actavis’s challenge of Orexo’s patents had been broad, covering two patents and initially two of the dosage strengths that corresponded to Zubsolv 1.4/0.36mg, and 5.7/1.4mg buprenorphine/naloxone. In a bittersweet judgement in November 2016 by the District Court, the ‘996 patent protecting Zubsolv’s exclusivity until September 2019 was judged as valid and would be infringed by Actavis’s products. The ‘330 patent, due to expire in September 2032, was, however, judged to be invalid. Orexo quickly appealed the decision in December 2016 and oral arguments were heard from both sides at the Federal Appeals Court in October 2017. The final ruling from the appeal was expected to take about three to six months, although it actually took 11 months.

Meanwhile, Orexo had been doing a textbook market access job by gaining and renewing formulary access in the face of generic competition in the opioid dependency category, with exclusive and non-exclusive price-volume contractual agreements with companies like Humana (on Medicare Part D), United Health and CVS (commercial). This had resulted in Zubsolv being almost universally reimbursed in the commercial segment and, for the latest two quarters of 2018, being the only branded product in the category growing its volume market share. At the same time, Orexo had been taking advantage of the higher Zubsolv volumes with manufacturing efficiencies that have reduced its cost of goods.

It is not surprising, therefore, that Zubsolv in the US and Orexo’s IP covering the drug delivery and release profile of the drug combination should be a target for generic companies, even though there is generic competition in the buprenorphine/naloxone category. The US Court of Appeal’s declaration of invalidity of the District Court’s judgement is now expected to have three effects:

We have kept our near-term model drivers unchanged, as is Orexo’s 2018 guidance, although we have taken the opportunity to reflect longer-term changes to our model in the valuation section below.

With patent infringement cases initiated by Orexo against Actavis still outstanding and expected to come off hold now that the ‘330 appeal has been upheld, we have not made any changes to our forecast for administrative expenses (which includes legal expenses related to IP litigation) for FY18 of SEK104m.

Following Orexo’s successful appeal of the patent litigation that was a result of Actavis’s challenge on the ‘330 patent, we have made a number of routine and more significant changes to our valuation.

Since Orexo is cash-generative, our valuation has been updated firstly to include the expected cash generation in Q318. We have also incorporated the changes to the exchange rates carried forward since Orexo has sales and costs in US dollars, and royalties in euros. (The US$/SEK rate moved to 9.09 from 8.78 while the €/SEK rate moved to 10.52 from 10.29.) We have also incorporated the detail in the Q2 report on Orexo’s tax-loss carry-forwards by absorbing most of Orexo’s losses until the tax-losses are exhausted. This suggests that, based on our estimates, Orexo will start paying meaningful tax on profits at the Swedish corporate tax rate from 2025 which, by then will be 20.6%. (We had previously estimated Orexo’s tax rate at 3% based on the profit earned by a subsidiary.) We have also brought forward the gross margin improvements to US Zubsolv, as it was announced at the Q2 results that the more expensively produced inventory, which had been produced at lower volumes and had been depressing gross margins, had all been sold in the higher volumes of H1.

We had constructed a new financial model on Orexo earlier in 2018 with a separate horizon period running until 2027 and a terminal value representing cash flows beyond 2027. Some of those timeframes have to be redrawn and, in the first instance, the horizon period now runs until the expiry of the ‘330, ‘421 and ‘900 patents, which all extend until September 2032. We have assumed that Orexo continues to grow Zubsolv market share in the US and does not suffer direct generic competition until 2032.

Our valuation changes from SEK2.52bn or SEK72.0 per share previously, to SEK3.3bn or SEK94.5 per share, based on continuing US Zubsolv market share growth until 2032 (representing 72% of our valuation) and a smaller terminal value that includes any Zubsolv sales after 2032, sales of OX124 and any acquisitions of products to be sold by the US commercial team (representing 22% of our total valuation). Royalties on Zubsolv in the EU, Abstral and Edluar are smaller components of our valuation in comparison to Zubsolv in the US. The effect of the changes to our model as a result of our preparation for the Q3 results and the patent appeal win are shown in Exhibit 1.

Orexo’s announcement of the patent litigation win was accompanied by no expected changes to its previously announced financial guidance for FY18. We have made minor changes near term to exchange rates, for example, and the cash we expect to be generated in Q3, but the only substantive changes we expect to make to our model in the medium term are in administrative expenses to reflect legal costs (on Actavis’ generic versions of Subutex and Suboxone tablets), and any damages awarded, or settlement agreed to, from the patent action against Actavis.

Orexo’s Q318 financial results are expected to be announced on 25 October. We have left our estimates of the quarterly sales and expenses largely unchanged until then; our estimates for FY18 and FY19 are summarised in Exhibit 2.

We estimate net income of SEK108m for FY18 and SEK35.6m for Q318 on total revenues of SEK814m in FY18 and SEK221m for Q318. Orexo has previously guided to operational expense of SEK500m for FY18 and our model estimates SEK515m. Our 70% gross margin estimate for Q318 now rises to 80% gross margin by Q120 (previously 75%), to reflect the earlier-than-expected sales of the more expensively produced, lower-volume batches of Zubsolv in the US, which were previously expected to be in the inventory until Q219. It is important to note that gross margin is calculated only on the Zubsolv batches that Orexo sells itself in the US, although when royalties start to flow from EU Zubsolv sales via Mundipharma we may have to make an additional assumption on the toll-manufacturing margin.

Orexo’s licensed products (other than Zubsolv) are sold by distributors that includ Zubsolv by Mundipharma ex-US. EU Zubsolv was launched in Q218 and we are assume minor royalties of SEK3.2m in the EU and SEK5.9m for the rest of the world for Zubsolv ex-US in FY18.

We forecast SEK121m in royalties for Abstral (fentanyl sublingual tablets for severe cancer pain) and SEK17.6m for Edluar (zolpiderm sublingual tablets for sleep disorders) in FY18.

We forecast that Orexo will end Q318 with SEK524m in cash, having generated about SEK30m in the quarter. Orexo has SEK320m in debt (SEK325m including capitalised expenses). Given that the big uncertainty has passed, we will be interested in hearing the business development plans for Orexo’s cash balance that could add in-licensed products to leverage its US commercial organisation.

On the conference call following the announcement of the patent appeal win, management mentioned that product acquisitions that are compatible with Orexo’s US salesforce are now more likely, since potential licensors would have been restrained by the unresolved appeal and its implication for Orexo’s cash balance. Now that Orexo is successfully past that point, it is possible that potential licensors and M&A partners would regard an Orexo equity component of a licensing transaction much more favourably and this could open the door to much larger transactions.

Orexo is a Swedish speciality pharmaceutical company founded in 1995 to use its drug delivery technologies to develop and market products to treat addiction and pain. Orexo’s products are based on its patented drug delivery technologies and its expertise in reformulation (in particular employing sublingual formulations). It has three marketed proprietary drugs. Orexo’s lead drug Zubsolv (for opioid dependence) has been sold by Orexo in the US through its dedicated salesforce since its launch in September 2013. Mundipharma has been granted the licence to the ex-US rights and launched Zubsolv in the EU in Q218. Abstral (cancer breakthrough pain) and Edluar (insomnia) are sold by partners worldwide. Orexo also has a pipeline of reformulations of approved compounds that include OX124 – a naloxone rescue medication for opioid overdose that will start Phase I in Q418. Orexo has 89 employees (excluding the c 50-strong US salesforce); US commercial operations are based in New Jersey and its R&D facility is located in Sweden. It adopted the name Orexo in 2003 and was listed on NASDAQ-OMX Stockholm in November 2005, raising SEK333m gross (3.7m shares at SEK90). Subsequent equity raises include SEK250m in June 2011 (6.6m shares at SEK38) and SEK346.3m in September 2014 (2.5m shares at SEK139).

Our valuation has been updated to include the expected cash generation in Q318, the changes to exchange rates carried forward and our estimation of the exhaustion of Orexo’s tax-loss carry-forwards in 2025. Our valuation changes from SEK2.52bn or SEK72.0 per share previously, to SEK3.3bn or SEK94.5 per share based on continuing US Zubsolv market share growth until 2032 (representing 73% of our valuation) and a small terminal value that includes Zubsolv sales after 2032, sales of OX124 and any acquisitions of products to be sold by the US commercial team (representing 21% of our total valuation). Royalties on Zubsolv in the EU, Abstral and Edluar are minor components of our valuation in comparison to Zubsolv in the US. We have also brought forward the gross margin improvements to US Zubsolv, since it was announced at the Q2 results that the more expensively produced inventory had all been sold in the higher volumes of H1.

Orexo has guided to a third year of profitability in FY18 and we currently estimate net income of SEK108m for FY18 and SEK35.6m for Q318 on total revenues of SEK814m in FY18 and SEK221m for Q318. Orexo has guided to operational expense of SEK500m for FY18 and our model estimates SEK515m and a 70% gross margin for Q318, rising to 80% by Q120.

Orexo is an operating speciality pharmaceutical company with positive cash flow and growing franchises. This means that:

Orexo is targeting the addiction and pain specialists where new products could leverage its commercial operation.

Although our model has been updated for a number of recent positive events at Orexo, the potential for generic companies to clog up the patent courts should not be underestimated. The US Federal Court of Appeals has remanded the erroneous invalidation by the trial judge on the ‘330 patent back to the District Court for review. Actavis (now Teva) may try other routes to invalidate the ‘330 patent, but its best attempt has probably already been rejected by the Appeals Court. Moreover, Orexo has other US Zubsolv patents (‘421 and ‘900) that run until 2032, as well as other patent infringement actions against Actavis (Teva) based on Orexo’s ‘996 patent, which has been judged valid (and which Actavis has not appealed). Therefore, the greater potential now is probably for Orexo to be awarded damages based on sales of Actavis’s generic versions of Suboxone and Subutex that would be an upside sensitivity to our valuation.