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March 24, 2005 Research Associate: Shilpa Chandak, CA, B.Com Editor: Ian Madsen, MBA, CFA [email protected] Tel: 1-800-767-3771, x 417 Research Digest www.zackspro.com Ligand Pharma. 155 North Wacker Drive (LGND - NASDAQ) Chicago, IL 60606 $7.73 New Comments in Yellow Overview Ligand Pharmaceuticals has been able to establish a number of potentially very favorable R&D collaborations and partnerships with some of the world’s largest pharmaceutical companies. The company seeks to utilize its research focus to develop a sizable high margin royalty stream over the next several years that will in turn fund more proprietary products later in the decade. Additionally, the company has products for pain maintenance and various hematologic cancers than contribute to current revenues. LGND is on the verge of its first positive fiscal year in 2004, and lead product Avinza (pain) will be the driving force. On March 17, 2005 prior to its conference call, management announced that 4Q04 and FY04 earnings would be delayed, along with its 10-K filing due to review of revenue recognition. Ligand stated that the review is in its early stages and that it does not know when it will be completed. The review is largely related to how sales are recorded when the product has a right of return, and the review applies to current and past financial reporting. Strengths/Opportunities Avinza for pain management has experienced a solid ramp, and analysts believe the drug has captured 4% market share so far (in-line with management goals). The company seeks additional label expansion of Ontak, current marketed for CTCL, into other hematologic cancers such as NHL and CLL. A Targretin Gel has the potential to reaccelerate the franchise growth in CTCL and open up new sales into chronic hand dermatitis. The restructuring of the Ontak royalty deal with Eli Lilly, and LGND with Royalty Pharma is designed to be accretive to the company. The SERM partnerships with both WYE and PFE are progressing into late stage clinical development. Weaknesses/Threats Sustained Release Opioid drugs such as Avinza have come under heavy scrutiny from the DEA over their highly addictive nature. Avinza sales in the Q3-04 came in below expectations on Medicare rebates and product returns We found a lack of visibility into the R&D pipeline and the collaborations with large-cap pharmaceutical companies. Some believe that management guidance for 2004 is too aggressive Delay in filing 10k due to revenue recognition The Company markets a number of products in the United States: AVINZA for the relief of chronic, moderate to severe pain; ONTAK for the treatment of patients with persistent or recurrent cutaneous Tcell lymphoma (CTCL); Targretin capsules and Targretin gel for the treatment of CTCL in patients who are refractory to at least one prior systemic therapy, and Panretin gel for the treatment of Kaposi's sarcoma (KS) in AIDS patients. LGND also has a number of high profile R&D collaborations with many in the large-cap pharmaceutical industry. Specifically a PPAR (peroxisome proliferation activated receptor) program with LLY has the potential to bring a significant breakthrough product to the market for Type 2 diabetes. LGND also has ongoing partnerships with WYE and PFE to develop a SERM (selective estrogen receptor modulator) product for osteoporosis. In total LGND has a partnership with seven major pharmaceuticals companies, including three products currently in Phase III clinical trials. The eventual high margin royalty payments expected in the coming years should these products become a success would lead to sizable profitability increases for this small biotechnology company. © Copyright 2003, Zacks Investment Research. All Rights Reserved. Sales Avinza capsules are a modified-release formulation of morphine sulfate indicated for once daily administration for the relief of moderate to severe pain requiring continuous, around-the-clock opioid therapy for an extended period of time. The product received approval in 2002. LGND currently copromotes Avinza with Organon Pharmaceuticals and will pay a 30% royalty on the first $150M in sales. Sales in the Q3-04 came in $7M below estimates at $28.3M. LGND management attributed the Avinza shortfall to a higher level of Medicaid, an imbalanced sales force structure, commercial contract rebates, and product returns. According to IMS health, total Avinza sales in July, August, and September reached $38M representing a 21% sequential growth over Q204. Avinza sales increased due to 10% price increase in January and another 9% price rise in July 2004. An analyst (Banc of America) believes that the shortfall was caused by decrease in inventory level and de-stocking during the quarter. Contract rebates and product returns were also factors that contributed towards it. One analyst (Roth Capital) feels that product returns should stabilize in future, as lots from development stage batches have now been fully withdrawn from the channel and their 6-month policy return limit has expired. In the call, management mentioned the sales force restructuring and rebalancing plan. However other (Banc of America) believes that such an action is unlikely to yield meaningful sales improvement in the absence of a better understanding of both inventory management and contract revenue issues. Our digest average for 2004 Avinza sales declined from $128M to $107.5M after the Q3-04 report. LGND is optimistic on the revenue per script trends with Avinza based on the increase in price, a decrease in coupon use, and a shirt to higher doses. The current revenue per script of around $150 is expected to increase to $160-$170 by year-end as rebates subside. This gives some analysts (Natexis, Fortis Bank, Roth Capital) optimism that LGND can still deliver total sales within the guided range. Avinza’s market share continues to grow in the Q3-04 to 4.8% up from 4.5% in March, 2004. In 3Q-04 Avinza prescriptions increased by 11% over the previous quarter. Analysts (Friedman Billings) believe that Avinza’s favorably listing with Medicaid could allow it to capture nearly 80% of the $300-$350M business. While talking to doctors at the American Pain Society meeting, they found the drug (Avinza) is differentiated on its once-daily dosage and improved sleep profile. Peak Avinza sales look to be around $500M (Friedman Billings, Natexis). Although management commented that all Avinza sales are subject to the right of return, they refused to provide clarity on whether other products might be included in any potential adjustment, or on the possibility that no adjustment will be necessary. Additionally, LGND was tight-lipped on whether the review was spurred by changes in 4Q product return trends relative to previous periods. LGND expanded the manufacturing and packing agreement with Cardinal Health in the Q4, allowing for greater supply in the midst of relatively positive demand trends. Avinza Sales 2003A $66.1M 2004E $100-$110 2005E $125-$200 2006E $140-$290 Est. Growth 40-50% Ontak is indicated for the treatment of patients with persistent or recurrent Cutaneous T-Cell Lymphoma (CTCL). The drug is a recombinant DNA-derived cytotoxic protein composed of the amino acid sequences for diphtheria toxin fragments A and B followed by the sequences for interleukin-2. Ontak is produced as a fusion protein designed to direct the cytocidal action of diphtheria toxin to cells that express the IL-2 receptor. This mechanism inhibits cellular protein synthesis and causes the (cancer) cell death. The drug is also used off-label for other hematologic cancers such as Non-Hodgkin’s Lymphoma (NHL) and Chronic Lymphocytic Leukemia (CLL). On December 5, 2004 LGND presented interim data from a Phase II trial of Ontak in the treatment of T-Cell Lymphoma. Data from 17 heavily pretreated patients demonstrated an overall response rate of 53% and a complete response rate of 12%. The median progression-free survival among the responders was 5 months. Although the Phase II study Zacks Investment Research Page 2 www.zacks.com was small, in conjunction with the previously reported data in B-cell Lymphoma, an analyst (UBS) believes future off-label use of Ontak will be further supported. LGND presented encouraging data at the American Society of Hematology (ASH) conference in early December 2003 on Ontak. Four abstracts showing Ontak’s activity in NHL, CCL, Graft-Verse-Host Disease, and transplantation all demonstrate potential label expansion for Ontak in the future. With a CTCL indication Ontak has roughly $200M peak sales potential (Friedman Billings), but markets for NHL and NSCLC are enormous, and could potentially double the peak sales opportunity of the drug. Yet, our digest average for 2005 of only $47.1M is rather conservative. Q3-04 sales were $9.9 million. One analyst (Roth Capital) is very optimistic and believes label expansion opportunities, favorable distribution service agreements and introduction of second-generation formulations should boost growth in the future. Another analyst (Banc of America) is quite skeptical about the company achieving its in-line product revenue estimates due to inadequate new clinical data, which could have accelerated additional off label use of Ontak and Targretin. Ontak Sales 2003A $34.4M 2004E $36-$38 2005E $38-$60 2006E $41-$65 Est. Growth 15%-17% Targretin Capsule sales were in-line in Q3-2004 at $4.8M. The drug is currently approved for CTCL, with estimated 2004 sales of roughly $18M. LGND is looking to expand its Targretin franchise by conducting two Phase III clinical trials in 600 patients with NSCLC. The company is looking to show that front-line Targretin + chemotherapy extends lives of patients with NSCLC. This trial is considered high risk / high reward by one analyst (Banc of America). The two clinical trials are: SPIRIT I: An international trial studying Targretin + cisplatin + vinorelbine versus cisplatin + vinorelbine alone. SPIRIT II: A US trial studying Targretin + paclitaxel + carboplatin versus paclitaxel + carboplatin alone. According to LGND, Phase III studies of the SPIRIT I and SPIRIT II are on track for the final analysis due at the end of 1Q-05. Results from the study will likely be announced within the next month. One analyst (Roth Capital) believes given the pending positive Phase III trial results, there might be a potential upside to the stock due to huge market opportunity. One analyst (Wachovia) feels that data from randomized trials evaluating other retinoids in clinical development suggest that the rexinoid class, to which agents such as Targretin belong, offer distinct clinical benefits in a variety of solid-tumor settings. The company also has a Targretin Gel product for CTCL, but seeks an additional label expansion into severe chronic hand dermatitis. LGND is progressing into Phase II/III trials to study the Gel in hand dermatitis with 528 patients. One analyst (Roth Capital) considers it as a $400 million market opportunity. Analysts expect data mid-2004. An eventual approval could reaccelerate the Targretin franchise. If the Phase II/III data is positive, LGND could file the NDA by year-end 2004. CMS announced 0074he reimbursement of Targretin gels and capsules for CTCL patients which boosted the sales in 2Q-04.However, another analyst (Banc of America) believes that changes to 2004 CMS regulations might have a negative impact on demand growth. LGND also markets a Panretin Gel for Kaposi’s Sarcoma (KS). KS, purplish-black lesions on the skin, mucous membranes or internal organs, is often common in AIDS patients. Targretin Caps Gel Sales 2003A $10.1M $4.0M 2004E $17-$20 $5-$6 2005E $20-$29 $7-$9 2006E $22-$60 $8-$10 Est. Growth 50%-55% 28-30% LGND has a very significant number of partnerships and co-development ventures that might present an intriguing potential royalty stream in the years to come. Specifically LGND has partnered with a number Zacks Investment Research Page 3 www.zacks.com of large-cap pharmaceutical companies such as Eli Lilly, Wyeth, Pfizer, Glaxo, and Abbott. We have listed a number of these partnerships below: Eli Lilly: LGND and LLY are co-developing a number of PPAR (peroxisome proliferation activated receptor) products for commercialization. The first, a gamma PPAR labeled LY818 started Phase III clinical trials for Type II diabetes in the Q1-2004. The second, an alpha PPAR labeled LY674 should move into Phase II clinical trials for atherosclerosis in mid-2004. LLY announced in early March it would begin Phase III trials with LY818 shortly. Phase II clinical trial of LY818 has shown positive results. The aforesaid drug has displayed comparable to superior efficacy to the popular diabetic drug Avandia. LGND will receive low double-digit royalties on LY818. Peak LY818 sales could reach near a billion dollars in Type II diabetes. Wyeth: LGND and WYE are co-developing a SERM (selective estrogen receptor modulator) for osteoporosis called bazedoxifene. The drug is in Phase III clinical trials as a single agent, and Phase III clinical trials with WYE’s Premarin as a combination osteoporosis/HRT candidate. Wyeth intends to file a new drug application for the prevention of osteoporosis in 2005 and for the treatment of osteoporosis in 2007 and for a combination of bazedoxifene and conjugated estrogen (CE) for osteoporosis and menopausal symptoms in 2007. LGND and WYE are also working on ERA923 for Breast Cancer (Phase II), and NSP989 for HRT (Phase II). Pfizer: LGND and PFE are co-developing a SERM for osteoporosis called lasofoxifene. The candidate is in Phase III clinical trials. PFE plans to file the NDA by mid-2004. This is a big positive for LGND, which receives mid-single digit royalties on sales (First Albany, Friedman Billings). TAP: LGND and TAP are together working on a SARM (selective androgen receptor modulator for male and female sexual dysfunction, osteoporosis, frailty, and male hypogonadism. LGD2226 is in the pre-IND stage for male hypogonadism. LGND is also working with Abbott on a number of preclinical candidates in glucocorticordagonist for inflammation. Glaxo: LGND and GSK are co-developing GW516 for Dyslipidemia (Phase I) and SB49711t for Thrombocytopenia (Phase I). On November 9, 2004 LGND announced the restructuring of two complicated royalty agreements, which was designed to be accretive to the company. In the revised Ontak royalty deal with Eli Lilly, LGND will have the option to pay off the U.S. sales royalty of $33M to Eli Lilly in January or April 2005. Eli Lilly will have options to trigger the same royalty buy-down for a total of up to $37.0 million in 2005, If Ligand decides to excise both options, the company does not need to pay royalties before 2006 in U.S with Avinza sales less than $38 million. However, Ligand will pay for the royalties for 2007 and beyond, depending on the sales. Under the amended terms of another deal Ligand and Royalty Pharma amended, the latter will purchase an additional 1.625% of the three SERM products' net sales for $32.5 million. As a result, Royalty Pharma increased its rights to a total of 3.0125% of the SERM products sales for ten years following first commercial sale of each product. In total LGND has a sizable partnership with seven major pharmaceutical companies, with three products in Phase III clinical trials. Specifically it is the PPAR and SERM programs with LLY, WYE, and PFE that make LGND look interesting at this level (UBS, First Albany). In fact, another analyst (Banc of America) has LGND listed as one of its “potential takeout candidates” for 2004. Partnerships 2003A $26.5 2004E $46-$48 2005E $9-$30 2006E $15-$50 Est. Growth 5-10% LGND should deliver impressive total revenue growth heading into 2004. While 2002 sales were less than $100M, the company should be able to more than triple that amount to well over $375M in 2007. Zacks Investment Research Page 4 www.zacks.com We note that 2004 should be a very interesting year for LGND with a number of Phase III partnership trials commencing and potentially presenting preliminary data, along with in-house products such as Targretin and Ontak seeking expanded labels. Total Revs. 2003A $141.1M 2004E $205-$218 2005E $220-$300 2006E $300-$400 2007E $340-$500 Est. Growth 30%-35% Quick Take: Our digest average for 2004 revenues decreased after the Q3-2004 report (). Margin LGND should begin to see manufacturing improvement heading into 2004 as products such as Ontak and Avinza begin to ramp. As, most of the Phase III products partnered with large-cap pharma companies such as LLY, WYE, and PFE begin to reach the market, gross margins should soar. The royalty payment from potential PPAR and SERM products will reach near 100% as the pharma partners handle the bulk of the manufacturing. This trend of higher royalty payments expected in the coming years leads a number of analysts (Banc of America, First Albany) to model near 85% gross margin by 2007-2008. We encourage investors to take a look at how this ramp will benefit LGND by analyzing some long-term models from the sell-side. 2004E Margins: Digest Average Gross Margin 81.0% Operating Margin 3.8% Net Margin -0.8% The company will also see dramatic improvement in both percent R&D and SG&A expense in the coming years. As total revenues begin to ramp through new products and partnerships payments, the operating margin will soar. R&D should track around $71M in 2004 (33% of sales), and show only a modest increase to about $78M in 2005 (28% of sales). Yet, SG&A, which will track around $63M in 2004 (30% of sales), will increase as new product rollouts and increased promotional marketing for Ontak and Avinza kick in. 2005 SG&A should track around $74M, or 27% of sales. Organon co-promotion expenses of $8.5M were below estimate due to lower than expected Avinza sales. Quick Take: Our digest average for net margin in 2004 increased after the Q3-2004 report (). Earnings Per Share LGND reported a sizable loss in the Q3-2004 due to the lower than expected Avinza sales. The company delivered ($0.09). Our digest average for the full-year 2004 is only $(0.03), well below management guidance of $0.03-$0.09. Street Consensus Company Guidance Low Estimate High Estimate 2004E ($0.03) $0.03 - $0.09 ($0.15) $0.03 2005E $0.06 ($0.10) $0.32 Our range on EPS for both 2004 and 2005 is enormous. This is due to the timing of milestone payments from many of the company’s partners. These payments can create big swings in EPS due to their size and 100% margin. We expect clarity on the timing for some of these payments later in 2004. Zacks Investment Research Page 5 www.zacks.com LGND has lowered its guidance to $170-$180M in product sales in 2004, and $216-$231M in total revenues. LGND tightened its EPS guidance to $0.03-$0.09 for 2004. Analysts (First Albany, Roth Capital) believe that LGND might not be able to achieve the lowered guidance. We note that LGND had $80.4M in cash on hand at the end of the Q3-04, or roughly $1.09/share. Quick Take: Our digest average for EPS in 2004 increased after the Q3-2004 report (). Long-Term Growth We have highlighted two things that we believe will have the largest impact on LGND future long-term growth rate. The first is the progressing Phase III trials with SERM products at WYE and PFE, and the PPAR program at LLY. These products have the opportunity to deliver near 100% gross margin royalty payments to LGND should they eventually reach final market approval. We have seen estimates that model this products at over a $1B opportunity, in turn potentially returning multi-million dollar payments to LGND going forward. LLY highlighted its ongoing PPAR program during its early December ‘Analyst’s Day’, hoping to initiate a Phase III program on LY818 in early 2004. Analysts (First Albany, Roth Capital, Friedman Billings, UBS) are very optimistic on this potential. The second interesting long-term growth rate factor is the ongoing debate between the DEA (Drug Enforcement Administration) and the FDA over the regulation of prescription painkillers like OxyContin (Purdue Pharma) and Avinza. These opioid drugs are highly addictive and can bring along intense withdrawal symptoms during and after use. Clearly the dangers of using an opioid pain medication have been widely documented. The DEA would like to see prescriptions of this class of drugs limited. The FDA disagrees, and instead leaves the prescription decision in the hands of the primary care physician. One analyst (Friedman Billings) believes that even a potential compromise between the two regulatory agencies might lead to tight scrutiny and control over drugs like OxyContin and Avinza. On November 9, 2004 LGND announced the restructuring of two complicated royalty agreements, which was designed to be accretive to the company. In the revised Ontak royalty deal with Eli Lilly, LGND will have the option to pay off the U.S. sales royalty to Eli Lilly for $33M. Eli Lilly will have options to trigger the same royalty buydown for a total of up to $37.0 million in 2005. Under the terms of another deal Ligand and Royalty Pharma amended, the latter will purchase an additional 1.625% of the three SERM products' net sales for $32.5 million. Target Price/Valuation Based on our digest average for 2005 of $0.06, the shares are trading at roughly 129X 2005 EPS. Based on this forward looking 2005 EPS and valuation measure, LGND looks fairly in-line with peers. The current price of $7.73 equates to a market capitalization of roughly $571M. Is LGND worth $0.80B based on the current product lineup of Ontak and Avinza? Probably not; therefore, the ongoing partnership programs focusing on PPAR with LLY and SERM with WYE and PFE must show positive data in the coming year. Most of the analysts (Friedman Billings, Roth Capital, First Albany, Fortis Bank) have reduced their target price estimates due to lowered guidance. Our digest average of $11.25 shows modest upside from today because it incorporates a high $21 estimate from another (UBS, Friedman Billings) analyst that is more optimistic on the shares. We also pose the question – would it cost more than $0.7B to reproduce LGND’s current product portfolio and partnership program? Probably so; therefore, LGND may be an attractive biotechnology acquisition for one of the large-cap pharmaceuticals it currently has collaboration with such as LLY, WYE, GSK, Zacks Investment Research Page 6 www.zacks.com ABT, or PFE. Or, another biotech with core-focus in oncology and metabolic disorders such as BIIB may be an interesting combination. Upcoming Events Date 1H-2004 1H-2004 Mid-2004 Mid-2004 Mid-2004 November 9, 2004 December 5, 2004 Event Data from Phase II Ontak in NSCLC Initiate Phase II/III on Targretin Gel Initiate Phase III on LY818 PPAR Initiate Phase II on LY674 PPAR Ongoing Phase III on SERM products The restructuring of the Ontak royalty deal with Eli Lilly and LGND with Royalty Pharma. Data from Phase II Ontak in T- cell Lymphoma. Comments ‘Proof-of-Concept’ study Severe Chronic Hand Dermatitis With LLY in Type-2 Diabetes With LLY in Atherosclerosis WYE and PFE LGND reported that its 4-year relationship with its financial auditor Deloittee & Touche has ended. Management indicated that there were no disagreements between the company and the auditors over accounting principles and financial statement disclosures. However, majority of the sell side analysts are concerned about this unexplained resignation. During the quarter, the company hired financial advisory firm BDO Seidman as its new auditor Individual Analyst Opinions POSITIVE RATINGS First Albany – Buy ($13): The analyst states,” We are maintaining our Buy rating following an increase in market share by Avinza, as reported by IMS Health for the week ended March 11. Although concerns regarding lawsuits and other possible forms of scrutiny will weigh on the stock, we are maintaining our rating, based on the deeply discounted valuation of the specialty pharmaceuticals business and the Targretin lung cancer "lottery ticket," which now appears free.” Wachovia – Outperform: The analyst states,” Data is expected in Q1 2005 from two randomized Phase III trials evaluating Targretin as an adjuvant to front-line non-small cell lung cancer therapy. If positive, Targretin, already approved for a small indication, could reach $800 million in revenue by 2010. Our sum-of-parts analysis suggests a positive risk/reward benefit at current trading levels. LGND also stands to receive meaningful royalty streams and milestone payments from 2-4 other products in late-stage development at pharmaceutical partners.” NEUTRAL RATINGS Roth Capital – Neutral ($8.5): On the delay the analyst states, We believe its possible that Avinza historical sales, product returns, the level of return reserves against those returns, and current wholesale inventories may have caused a red flag among the company's auditors causing the delay. We also believe that this issue may have complicated the requirement of executive certification of internal controls, as required in Sarbanes-Oxley.” Zacks Investment Research Page 7 www.zacks.com Friedman, Billings – Market Perform ($8): The analyst states, “Ligand announced that it is delaying the release of its 10-K due to a review of its revenue recognition practices. We are lowering our price target to $8 from $10, and we are maintaining our Market Perform rating. Our lower price target is based on a revised EPS estimate of $0.26 in 2007, which is based on lower Avinza estimates derived from competitive concerns unrelated to the accounting issues, times a PE of 40x and discounted at 25%.” Banc of America – Neutral ($9): The analyst states, “Prior to its conference call this morning, Ligand announced that 4Q04 and FY04 earnings would be delayed, along with its 10-K filing. Despite today's weakness, we would continue to avoid LGND shares on the prospects for future adjustments and unknown outcome of the current review. Additionally, we are skeptical about the outcome of the SPIRIT I and II results, expected in 1Q05. We believe investor concern will persist until these concerns are resolved.” UBS- Neutral ($8): The analyst states,” Based on today's announcement, we believe LGND shares are likely to trend down until resolution of this accounting matter is reached. We are placing our rating, price target and estimates under review as we believe the risk associated with a possible negative restatement of prior financial results has increased.” NEGATIVE RATINGS None Appendix-A Analyst sales estimates by product, EPS forecasts, and a consensus income statement are available in LGND.xls. Appendix-B Quick Take Score: How our digest average changed after the 3Q -2004 report: 3 () = (Margins, EPS) 0 () 1 () = (Revenues) Zacks Investment Research Page 8 www.zacks.com