Skyepharma — Update 17 January 2016

Skyepharma’s full-year 2015 trading announcement increases our confidence in our 2016 and beyond forecasts for current marketed products. FY15 revenues are anticipated to be ahead of prior expectations as Mundipharma has agreed that the first flutiform sales milestone of €10m will have crystallised in 2015 rather than 2016 as we had originally forecast. While no cash will be received as net royalties and sales milestones are subject to a clawback until Mundipharma has recovered up to €25m of development costs, the news underpins our forecasts for flutiform in the near term.

Partner Pacira has reported unaudited sales estimates for Exparel as $67.2m in Q415, an increase of 13% from Q315’s $59.7m. The Q415 sales estimate does not reflect the resolution and subsequent broadening of the Exparel label, as discussed below. It does, however, increase our confidence that the Exparel sales trajectory will likely reach and exceed the $250m annual sales milestone to trigger the $8m sales milestone payment in 2016.

The group’s net cash position at 31 December 2015 was approximately £35m, affected by positive operating performance in the year and the later timing of some capital expenditure for the year, which will now be invested in 2016.

Skyepharma has started feasibility work on its triple inhaled corticosteroid/ long-acting β2-agonist/ long-acting muscarinic antagonist (ICS/LABA/LAMA) combination product for treating asthma patients who are not adequately controlled on currently available combination ICS/LABA products.

Asthma is a chronic inflammatory lung disease that is estimated to affect 300 million people. The market for asthma treatments is forecast to grow from £9.7bn in 2014 to £11.2bn in 2021, despite the entry of multiple generics within this period. While ICS/LABA combinations will remain the mainstay of therapy, the rationale for triple-therapy development follows emerging data that the addition of a LAMA may confer higher bronchodilator efficacy and reduction in exacerbations over ICS/LABA combinations alone. The UniTinA-asthma programme presented at ERS 2014 showed the addition of Boehringer Ingelheim’s Spiriva (LAMA) to ICS/LABA maintenance therapy reduced the risk of a severe asthma exacerbation by 21% (Kerstjens et al, NEJM 2012). Skyepharma joins a limited number of pharmaceutical players developing a triple-combination inhaler for asthma, including Novartis and Boehringer; however, given the relative size of the global asthma market (£9.7bn in 2014), there is room for multiple players developing a triple therapy.

Skyepharma has identified the following characteristics to target while it makes good progress with the initial formulation:

Skyepharma has entered into a feasibility and option agreement with Mundipharma for SKP-2076, a potential asthma therapy that combines three established drugs (ICS/LABA/LAMA) into one inhaler. The programme has the potential for relatively quick development in Europe by Mundipharma given the triple-therapy component ICS/LABA/LAMA are approved chemical entities.

While we had hoped for this collaboration, its execution enables Skyepharma to focus on the feasibility studies, due to complete later this year, paving the way for its clinical development plans to start in 2016. Mundipharma has the option (on completion of the feasibility studies) to continue development and subsequent commercialisation of SKP-2076 under a global licence agreement. We have updated our 2016 forecasts to include a non-refundable option fee from Mundipharma, of ‘several hundred thousand euros’, which we estimate at £250,000. Further milestones and royalties are also expected, once the development and licence agreements are finalised. These may be substantial although we do not currently include any sales, royalty or further milestone payments for SKP-2076 in our model.

Exparel is a local analgesic that uses bupivacaine in the Depofoam delivery platform. As a non-opioid analgesic it is indicated for use at the surgical site to provide post-surgical pain relief. Exparel is marketed by Pacira and Skyepharma receives 3% of net sales on a cash received basis and up to a further $44m in milestones. An $8m milestone was received in 2014 when annualised sales reached $100m, with a further payment of $8m due when annualised sales reach $250m (likely in 2016) and $32m if they reach $500m (in addition, a further $4m is payable on first launch in one of the five major European markets). These milestones and the share of net sales result from the terms of the divestment of the Injectable Business (now Pacira) in 2007.

In October 2011, the FDA approved Exparel with a broad label for use; however, in September 2014 the FDA Office of Prescription Drug Promotion issued a warning letter to Pacira related to certain promotional material. Pacira filed a lawsuit against the FDA in September 2015 and subsequently the FDA withdrew its letter from its website. This was followed by a formal rescission letter by the FDA commissioner in December 2015, thereby nullifying the original warning letter. Furthermore the FDA affirmed a broad label for Exparel, not limited to those surgeries studied in the pivotal trial.

In the FY14 results announcement, before the warning letter was issued by the FDA, Pacira guided to $310-330m in Exparel sales for FY15. Exparel sales dipped as Pacira announced they were just $57m in Q215. However, with the revocation of the letter and the revised broader label, Exparel should continue on its pre-warning letter growth trajectory and hit $250m sales, which triggers the $8m milestone to Skyepharma. Additionally, with a broader label and as Pacira have said it is working on additional indications, it is conceivable that Exparel could go on to hit the $500m sales threshold sooner than our 2018 assumption, triggering a $32m (estimated at £20m) milestone to Skyepharma.

Over the past two years we have seen an absolute transformation in Skyepharma’s balance sheet, with the repayment of bonds and other expensive loans resulting in materially lower financial charges. As the financial risks recede, the operational aspects become more important. We currently value Skyepharma using a DCF model, which we still view as a pertinent measure.

However, as Skyepharma has begun to report profits, we also refer to earnings-based measures as a reality check. Skyepharma’s key metrics are shown in Exhibit 1. These highlight how the growth in earnings and EBITDA is reflected in the attractive fall in multiples through to FY17e. Although not listed in the table, Skyepharma compares favourably to both the market in general and peers in the healthcare space that offer similar growth rates.

Our DCF valuation model forecasts product sales (and related cash flows) through to 2027. These include the royalty streams from the portfolio of products that use Skyepharma technologies, as well as known milestones and manufacturing and supply chain incomes. While accepting that forecasting product sales more than a decade in advance cannot be expected to result in accurate projections, it is adjusted for patent expiries and expected product competition.

These cash flows, together with a terminal value, are discounted back using a 10% discount rate to give a valuation of £442m, which equates to 422p per share. This represents a 11.3% increase on our December 2015 valuation of £395m (or 377p per share), and arises as a result of the changes to our forecasts as detailed below, in addition to re-basing our DCF model to 2016.

Placing the company on P/E multiples of 29x for FY16 (taking an average multiple metric of profit generating companies of a similar size in the European healthcare space – Exhibit 2) generates an implied value of 441p. .

We have reviewed our model incorporating the FY15 trading update in addition to information released in press releases during the latter half of 2015.

The main factor is the increasing visibility of flutiform revenues; we expect the investments in improving the flutiform supply chain, coupled with increased expectations of in-market sales in Japan, to flow through as higher-margin profit contributions in FY16 and beyond. We have updated our 2016 forecasts to include a non-refundable option fee from Mundipharma, of ‘several hundred thousand euros’, which we estimate at £250,000.

FY15 revenues are anticipated to be ahead of prior expectations as Mundipharma has agreed that the first flutiform sales milestone of €10m will have crystallised in 2015 rather than 2016 as we had originally forecast. However, net cash will not be impacted as no cash will be received as net royalties and sales milestones are subject to a clawback until Mundipharma has recovered up to €25m of development costs.

The group’s net cash position as of 31 December 2015 was approximately £35m, affected by positive operating performance in the year and the later timing of some capital expenditure for the year, which will now be invested in 2016. We have therefore reflected the reduced capital expenditure for 2015 by £3m to £5m, and accordingly increased 2016 capital expenditure by £3m to £9m.

Looking at the sensitivities in our model the most important is, understandably, flutiform sales in Europe and, to a lesser extent, Japan. This reflects not just the effect of the geared nature of Skyepharma’s structure on the royalty stream, but also the fact that manufacturing income benefits from the associated higher volumes. We have modelled peak sales for flutiform in Europe of around £200m pa, but this reflects our caution ahead of an expected increase in competition both from the launch of new product combinations and the introduction of generic versions of existing blockbuster products. To put this into perspective, a simple 10% increase or decrease in our flutiform sales assumptions currently results in our valuation increasing or decreasing by 8%.