Skyepharma — Update 3 December 2015

Skyepharma is making good progress with its research and development effort. The company’s expertise lies in reformulating established and approved chemical entities, by utilising its proprietary inhalation and oral drug delivery technology. The CMD highlighted its technologies and we gained more insight into the near-term development plans for the inhalation and oral portfolio.

Skyepharma’s R&D approach significantly de-risks the research and development process in comparison to its new chemical entity (NCE) developing pharmaceutical and biotech peers. Investors can gain exposure to novel therapies that are at lower rates of attrition versus NCEs. Furthermore, by out-licensing products to partners at the proof-of-concept stage, Skyepharma reduces the financial burden and risk of drug development associated with large Phase III clinical trials and sales and marketing infrastructure.

With the balance sheet strengthened due to the repayment of bonds and legacy debt, and flutiform’s life cycle development plans well underway, management has the time and resources to address the need to replenish the new product pipeline. Collaborations, where the partners fund development on a time and materials basis, will continue in both oral and inhalation technologies. These underpin a major part of the infrastructure costs and effectively leverage the self-funded R&D efforts. The intention is to create a balance of own- and partner-funded products in development. For FY15 the planned net expenditure is £10m. The major focus will be on developing respiratory assets SKP-2075 and SKP-2076 to Phase II and initial formulation stages respectively before out licensing, in addition to advancing several novel, oral drug delivery technology platforms.

However, despite this broad portfolio, the near- and medium-term investment case rests on the success of flutiform. According to our forecasts, this one product (in multiple territories) is expected to contribute over half of Skyepharma’s royalty income, as well as generating sizeable profit from manufacturing and supply, with the market uptake continuing to suggest the sales trajectory could exceed our forecasts. Newsflow from the CMD underpins the short- to medium-term contribution:

At the CMD we learnt more about two key respiratory assets in development: SKP-2075 and SKP-2076. While it is a little too early to introduce explicit sales forecasts for these products into our model, we believe that SKP-2075 has a higher chance of success than the average industry product in development. Preparation for the Phase II proof-of-concept study is underway for 2016 and should complete in 2017. SKP-2076, triple therapy inhaler for asthma is expected to move into GMP pilot scale manufacturing in 2016 and has the potential for early partnering in 2016.

Skyepharma has industry-leading expertise and technology in developing and manufacturing inhalers for the treatment of asthma and COPD, which combined, addresses a c $29bn global market. One only need look to its existing partner base to see the myriad of mid to large global pharmaceutical players that are reliant on Skyepharma’s technology.

Professor Dave Singh of the University Hospital of South Manchester, an eminent pulmonologist, outlined the more recent advances in the understanding of COPD pathophysiology. As a reminder, COPD is a chronic respiratory disorder linked to cigarette smoking and characterised by reduced lung function and severe shortness of breath, with worsening exacerbations triggered by viruses, bacteria and pollution; one in 10 hospitalised patients do not survive upon that admission. Treatment is more symptomatic, and under GOLD guidelines1 varies depending on classification of COPD and the patient’s severity. The mainstay of treatment is LAMA/LABA/SABA/SAMA2. More severe patients also receive inhaled corticosteroid (ICS); the addition of an ICS to LABA leads to a 14% reduction in the mean number of exacerbations than LABA alone, compared to a 25% reduction compared to placebo (Exhibit 1).

Part of the reason for this mediocre overall 14% reduction is due to corticosteroid resistance in COPD, linked to downregulation of Histone Deacetylase 2 (HDAC2, a protein coding gene). Corticosteroids use HDAC2 to switch off activated inflammatory genes. Exhibit 2 highlights the pathway to ICS resistance mediated by HDAC2 downregulation.

Furthermore, the current treatment paradigm does not differentiate between the different endotypes of COPD. An endotype is defined as a subtype of a clinical condition defined by a distinct pathophysiological mechanism. Combining the latter points lead us to the crux of SKP-2075, through the potential optimum combination of ICS and low-dose theophylline in a metered dose inhaler.

A drug with proven efficacy in COPD is theophylline, which is often given orally and intravenously in the acute setting to aid control of an exacerbation. However, systemically administered theophylline is associated with intolerable side effects, which can limit its use in the chronic setting at the current high oral dose indication. Theophylline works to alter the P13K signalling pathway, which in turn affects HDAC2 and increases its expression. By administering theophylline by the inhaler route, a lower dose of drug can be delivered directly to the diseased lung tissue and bypassing the side effects associated with high-dose systemic administration. In summary, combining ICS with low-dose theophylline should theoretically elicit a higher immunomodulatory response than ICS alone.

An endotype of COPD is COPD/smoking asthma, where the underlying pathology resembles asthma with an influx of a particular inflammatory cell type; the eosinophils. In fact, post-hoc clinical trial analysis has shown that inhaled corticosteroids have greater utility in patients with high sputum eosinophils or high blood eosinophils.

A GSK-funded post hoc analysis of data from two phase III studies published by Pascoe et al (Lancet Respir Med 2015) highlighted the short-term benefits of inhaled corticosteroids for patients with COPD are greater in patients with evidence of eosinophilic airway inflammation. Across all doses of inhaled corticosteroids, fluticasone furoate and vilanterol reduced exacerbations by 29% compared with vilanterol alone (mean 0.91 vs 1.28 exacerbations per patient per year; p<0.0001) in patients with eosinophil counts of 2% or higher; whereas exacerbations were reduced by just 10% (0.79 vs 0.89; p=0.2827) in patients with eosinophil counts lower than 2%.

Effectively, this is an example of personalised medicine, where a specific marker can be identified to tailor treatment accordingly. In summary, ICS has great utility in COPD/smoking asthma patients with a high blood eosinophil level. Note that this is an easy and cheap blood test.

Therefore, it is clear from the hypothesis outlined above how SKP-2075, which is an inhaled fixed dose combination ICS plus low-dose theophylline to enhance the anti-inflammatory potential of ICS, represents a new approach for the treatment of COPD/smoking asthma characterized by eosinophilia.

Skyepharma acquired global rights and related intellectual property (including granted patents and patent applications) to a novel inhaled therapy platform from Pulmagen Therapeutics in 2014. SKP-2075 (a single capsule dry powder inhaler, comprising the ICS fluticasone propionate in combination with low-dose theophylline) is the first product developed through this technology since the acquisition. While good progress is being made in formulating the product and the start of non-clinical studies, the company has outlined a clinical trial programme designed to offer a relatively quick development pathway for Europe, with a comprehensive Phase II data dossier to maximise the economic returns for the partnering process. Specifically, the updated development programme is as follows:

The investment required to formulate a suitable inhaled dosage form and complete the Phase II POC trial is estimated at around £18m through to the end of 2017 (£14m previously disclosed, plus a further £2m per annum in 2016 and 2017 announced at the CMD for the additional studies), and will be funded from internal cash generation including additional revenues from flutiform. Under the terms of the deal with Pulmagen, there is no upfront or fixed fee, with Pulmagen receiving launch milestones (in specified but undisclosed markets), and a share of Skyepharma’s licensing income from any eventual deal. The proportion of this share will reflect the amount of work that has had to be performed in developing SKP-2075.

If the potentiating effect of low-dose theophylline on ICS therapy is confirmed in larger and more robust trials, it could find a useful role in treating all stages of COPD, with a possible role as an integral part of the widening range of inhaled combinations being employed. From a commercial perspective, such combination products would benefit not only from additional patent protection, but would also offer greater differentiation in an increasingly complex and crowded therapeutic segment. Despite the attraction of this therapy platform, we currently do not include any explicit forecasts for SKP-2075 in our DCF model.

Skyepharma has started feasibility work on its triple ICS/LABA/LAMA combination product for the treatment of asthma patients who are not adequately controlled on currently available combination ICS/LABA products. The rationale 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 that 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 asthma market (£9.7bn in 2014) there is room for multiple players developing a triple therapy. ICS/LABA will likely remain the mainstay of therapy.

Skyepharma has identified the following characteristics to target while it makes good progress with initial formulation: one device with known chemical entities, aiming for twice-daily dosing and a rapid onset of action.

The next step is to move SKP-2076 into GMP scale manufacturing in 2016. Furthermore, the company is engaged in partnering discussions to license and further fund development post the initial formulation stage.

Soctec gastro-retention is an oral drug technology involving developing a capsule that remains in the stomach part of the gastrointestinal tract, releasing the drug slowly in the upper gastrointestinal tract and thus ensuring optimal drug delivery. The application would benefit poorly and highly soluble drugs. After encouraging proof-of-concept study data, the company is looking to optimise this technology and plan for scale-up. Soctec is also being marketed to potential partners to work on specific applications.

Skyepharma is also developing hydrophobic raft, a novel gastro retentive technology attempting to deliver extended drug release at the optimal site of delivery in the upper GI tract, particularly for drugs requiring high therapeutic doses (not amenable to the Soctec technology). The concept is encouraging but early stage and a pharmacokinetic proof-of-concept of study is planned for H116.

The repayment of the bonds and legacy debt has removed a large element of uncertainty that had been hanging over Skyepharma and now the focus is firmly on operational, rather than financial factors. The main sensitivities are flutiform’s achievement of a meaningful share of the ICS/LABA market in Europe and Japan and, to a lesser extent, revenues from the remaining portfolio products.

The degree of market penetration in Europe is particularly important. Pricing remains a critical determinant of uptake in several markets, while the scientific merits of the combination and attractiveness of the delivery device to patients are also important. The medium-term outlook here is particularly difficult to gauge as the segments' dynamics are set to alter due to the introduction of new combination products, notably GSK’s Ellipta-based Breo/Relvar, Anoro and Incruse (although Skyepharma receives a modest royalty, capped at £9m overall on these) as well as the likely launch of generic versions of market-leading seretide and symbicort.

The past 18 months 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 positive earnings, we also refer to earnings-based measures as a reality check. Skyepharma’s key metrics are shown in Exhibit 3. These show 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 peers in the healthcare space offering 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 helps to capture 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 £395m, which equates to 377p per share. We will be reviewing our forecasts and valuation in due course, most likely with the release of FY15 results.

Looking at the sensitivities in our model, the most important is flutiform sales in Europe and, to a lesser extent, Japan (Kyorin has guided to annual sales of ¥10.3bn, or approximately £55.5m, for the 12 months to March 2016). This reflects not only 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/decrease in our flutiform sales assumptions currently results in our valuation increasing/decreasing by 8%.

Over the past 18 months, Skyepharma has successfully transformed its balance sheet and now has net cash (£20.9m at June 2015). The investment case is now clearly focused on operational, rather than financial factors. The company highlighted in the accompanying trading update at the CMD that year-end cash is expected to be ahead of its previous expectations, driven by higher cash receipts; we currently forecast net cash of £23.3m at year-end 2015, but this could be higher given the company’s recent guidance.

flutiform is expected to make the greatest contribution to the incremental growth, resulting in the generation of over half of Skyepharma’s royalties and the bulk of the manufacturing and supply income by 2018. Our expectations remain based on conservative assumptions, notably for the flutiform contributions, and we will review these as the complexities of the ICS/LABA market become clearer. The GSK royalty payments are also an important consideration, with virtually all the payments made, a maximum of £9m pa, flowing straight through to the bottom line (Exhibit 5).

Skyepharma is targeting net R&D spend at 10-15% of sales, plus around £8-10m in capex for FY15. This investment can easily be met by cash from operations now the company is virtually debt-free, underpinning our confidence for medium- to longer-term earnings growth potential.