(December 7th, 2015) Few stories in biotech this quarter have captured the imagination of the retail investing crowd like KaloBios Pharmaceuticals, Inc. (Nasdaq: “KBIO”). This stock was trading for pennies and headed for a bankruptcy liquidation when former Retrophin CEO Martin Shkreli and a buying group bought more than 70% of the common stock of KBIO on the open market in a matter of days and immediately took control of the company. The resulting news of Martin Shkreli’s purchase and subsequent appointment as Chief Executive Officer sent the stock soaring skywards. On the first day of trading it closed at $10.40 and within two days after that it touched $40.

With 4.41 million shares outstanding, 2.89 million of those controlled by Mr. Shkreli’s buying group and another 280,000 recently issued at a price of $29/share each (and locked up for at least 6 months or the effectiveness of any future registration statement) there are only ~1.233 million shares freely trading from which a daily market is made. Over the past week more shares have traded in a day than are freely available to be traded! The resultant volatility therefore in the daily trading of the stock makes it increasingly difficult for anyone to get a proper grasp on what an acceptable valuation for KBIO ought to be, and what the possibilities of future appreciation or decline are for this particular security.

Like most people, I initially watched from the sidelines. Then, last Thursday December 3rd KaloBios announced what I consider to be a game-changing acquisition, an agreement to purchase the development rights to a form of benznidazole, one of two drugs available outside the US for the treatment of Chagas Disease from Savant Neglected Diseases, LLC, a privately-held specialty pharmaceutical company for the paltry upfront sum of $2m. To fund the acquisition and associated costs of bringing this drug to market, KaloBios sold ~280,000 shares at $29, without any warrant coverage or other sweeteners; shares that are restricted and locked up. That gives you a sense those sophisticated and deep pocketed buyers were very comfortable believing that the price of KBIO would be significantly higher come the spring/summer of 2016.

In a number of “live streams” from his desk, and discussed in the second half of a slide presentation made after the benznidazole acquisition, Mr. Shkreli made a strong argument why KaloBios’ failed drug Lenzilumab is worth a second look as a possible treatment for a number of moncytosis leukemias and possibly a variety of autoimmune and inflammation indications. Now, I have to admit that the science behind his arguments as to why this is so sound well crafted but ultimately their merits are beyond my pay grade. In short, I just find it too darn hard to handicap his potential for success or failure in those indications and for the purposes of evaluating the securities of KBIO I’m going to ignore it (I suspect most investors are like myself in this regard!)

Benznidazole, on the other hand, is a much more straightforward asset. In my opinion, its much easier to understand and therefore more exciting as one delves deeper into it. On the basis of benznidazole alone I purchased a small position in KBIO stock Friday, and as a shareholder look forward to seeing this drug develop into a commercial asset over the coming quarters. I think the potential for stockholder appreciation on benznidazole alone is one that I’m comfortable having a cost basis in the $30s, sitting and watching as it plays out. With all the noise surrounding KaloBios as a volatile stock, therefore I thought it of value to make the case for owning KBIO on the backs of this asset, and then more broadly on the basis of the team our new CEO has begun putting together.

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Benznidazole is the Preferred Method of the CDC for Treating Chagas Disease

Chagas disease is a tropical parasitic disease spread mostly in areas where triatomine bugs are prevalent. These bugs usually hide during the day and come out at night to search for blood – when potential ‘hosts’ are usually asleep. Because they usually end up biting the hosts’ face they are colloquelly known as “kissing bugs”. After feeding, they will spontaneously defecate, and in doing so the host is at risk of being infected by the protozoan Trypanosoma cruzi, (known as T. Cruzi) which gets into the body via the original bug bite and will then spread throughout the host. Approximately 6 million people are thought to be infected with Chagas, most in Latin America where the triatomine bugs are most prevalent.

It’s important to divide Chagas patients into two classifications : an acute stage, which occurs shortly after the initial infection, and a chronic stage which can create significant damage to the patient many years after an initial infection.

Patients in an acute stage can be easily diagnosed via microscopic analysis of blood samples or, less common, with PCR. Since there is no approved FDA treatment and acute patients in the US are a rarity, knowledge of Chagas disease is low within most US-based hospital settings. Yet, because of the increased population transfer/travel to and from South America, it seems that patients with the illness have been appearing with more frequency within the US health system. According to KaloBios’ presentation on the subject, there are 3000 – 7000 treatable cases of acute Chagas Disease in the US annually. (Dec 4th Presentation, Slide 15)

If patients do not receive treatment during the acute phase, the initial symptoms (facial swelling, muscle pain, vomiting, loss of appetite and other such symptoms) will resolve on their own after 4-12 weeks. However, left untreated these patients are now infected for life with the parasite, and over the next 10 to 30 years, a significant minority (up to 30%) will experience severe cardiac or intestinal complications. Over time this can be a substantial burden to the health care system; the WHO estimates that Columbia alone spent $267m in 2008 treating Chagas patients.

Because of the seriousness of Chagas and the lack of an FDA-approved treatment, the Centers for Disease Control (CDC) maintains a supply of two drugs given to US-based patients on an emergency, “investigative” protocol allowed under current US law. Those two drugs are nifurtimox and benznidazole; there is a specific team located at the CDC’s Emergency Operations Center that is on staff 24/7 to respond to any US-based health care professionals suspecting that their patient(s) may be infected with Chagas. This section of the CDC maintains a sparse website where some information is given about the recommended response to Chagas along with further ways for health-care professionals to contact the CDC’s anti-parasitic team directly and gain access to either nifurtimox and benznidazole in case of an infection.

Because the CDC maintains stock of two different treatments, its’ important to know which of the two the CDC prefers. Their staff-maintained website is mum on the subject but at the bottom it does refer readers to what the CDC believes is the definitive review of treating Chagas, a paper published in 2007 in the Journal of the American Medical Association (“JAMA”) and which can be downloaded for free here:  JAMA – Evaluation and Treatment of Chagas Disease.

Since this paper is more than 8 years old, we reached out to the staff at CDC to confirm that they still stand by the findings in this paper. To our surprise, we heard back from Atlanta within ~2 hours that they indeed fully support those findings. The conclusion of this paper is quite clear:

Benznidazole and nifurtimox are the only drugs with proven efficacy against
Chagas disease. Because benznidazole is better tolerated, this drug is
viewed by most experts as the firstline treatment. Nevertheless, individual
tolerance varies; if one drug must be discontinued, the other can be used
as an alternative. Neither drug is approved in the United States; both can
be obtained from the CDC and used under investigational protocols.

Now, one of our Twitter followers – @mr100PHD  – kindly brought to our attention a paper recently published in The New England Journal of Medicine entitled, “Randomized Trial of Benznidazole for Chronic Chagas’ Cardiomyopathy“. In it, the authors report on the results of a 5 year study using benznidazole to treat chronic Chagas – not the acute early breakout patients but rather the millions worldwide who have already been infected and passed through the acute phase. In this much, much larger cohort, the conclusion is what you would expect, ie. the drug is no longer a great candidate for curing these patients :

Trypanocidal therapy with benznidazole in patients with established Chagas’
cardiomyopathy significantly reduced serum parasite detection but did not
significantly reduce cardiac clinical deterioration through 5 years of follow-up.

This conclusion of the 2015 NEJM paper is actually very important insofar as orphan drug designation is concerned (more on that later). But for the layman, what’s important to take away from this is that its imperative for the long term health of Chagas patients to quickly receive an anti-parasitic treatment, either benznidazole and nifurtimox, during the acute phase before the patient progresses to chronic Chagas.

There are some people who’ve already jumped on the bandwagon, accusing Martin Shkreli of attempting to use ‘loopholes’ to get a vital drug approved where there is already a need being filled. I would strongly demur; the evidence is that the US health system needs someone getting behind this drug, making sure that all hospitals are aware of the signs & symptoms of early, acute Chagas before the patient goes into remission. Now, I have the utmost respect for the overworked & underpaid staff at the CDC but its clear that the few sparse web pages maintained by the staff in Atlanta, with virtually no outreach & marketing, almost guarantees that the majority of US patients infected will go about the first 4-12 weeks undiagnosed and untreated. Once they pass through that phase the long term potential damage to the patient and the related cost to our health care system is very significant as no treatment currently exists to cure chronic Chagas.

As an FDA approved drug with either 5 or 7 year marketing exclusivity, KaloBios will have the incentive & wherewithal to ensure an adequate information campaign is done to alert the first-line health care professionals most likely to come across patients infected with this potentially-deadly protozoan all the signs, diagnostic tools, and information necessary to quickly get patients treated.

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What is Benznidazole Worth as a Pipeline Asset?

I invest in binary outcomes a lot. With this asset under its’ belt, over the next 24 months KaloBios has a number of outcomes that are possible with this asset. The best way I know to value these opportunities is to spell out all the possible outcomes that are likely, then discount backwards and place conservative percentile chances on their respective outcomes. Doing so, here’s what I come up with:

Scenario #1 : Rapid Approval —-  KaloBios estimates that there are 3000 – 7000 patients in the US annually, with pricing in the range of current hepatitis C antivirals. I have no reason to doubt these figures. Travel between the US and South/Central America has been on a long-term upswing (Venezuela excluded). The WHO evidently agrees as their fact sheet on Chagas, updated March 2015, includes the following statement, “Chagas disease occurs mainly in Latin America. However, in the past decades it has been increasingly detected in the United States of America, Canada, and many European and some Western Pacific countries. This is due mainly to population mobility between Latin America and the rest of the world.”

Pricing –  KaloBio’s compares the future pricing of the drug to current Hep C treatment. I think this is a fair comparison. Left untreated Hep C patients can cause large ongoing medical expenses to the health care system. Chagas patients are similarly situtated. Most Hep C drugs have a cure rate of > 90%; according to the WHO “…Both (anti-parasitical) medicines are almost 100% effective in curing the disease if given soon after infection at the onset of the acute phase. However, the efficacy of both diminishes the longer a person has been infected”. Some studies show the cure rate to drop to the ~60% in larger cohorts as older patients are included. Assuming KaloBios will have to take failed patients into account when pricing its’ drug I would conservately model a base price of $70,000 per round of treatment. Assuming zero usage by chronic patients (while not as effective its clear many many patients in South America and elsewhere do take these drugs during flare ups as the WHO reports that, ” Treatment is also indicated for those in whom the infection has been reactivated (for example, due to immunosuppression), for infants with congenital infection, and for patients during the early chronic phase. “) and only working off the 3,000 patients per year figure we get a market size of $210 million annually. I think that number is very conservative but its’ the figure I will work with.

Why does KaloBios think it will get rapid approval? Well, the company states (Dec 4th Presentation, Slide 12) that it is in possession of the written notes from Neglected Diseases, LLC’s interactions with the FDA to date. Its’ a shame that Martin Shkreli didn’t make any of that public, although one must assume that the buyers of $29/share PIPE had the opportunity to peruse it. In any case, KaloBios believes that the written communication with the FDA, “reflect our expectation that no Chagas clinical trial will be required“. Instead, only “PK, CMC and toxicology studies will enable a NDA filing in 2016“.

Now, there are many within the investment community that are skeptics of biotech pronunciations. Count me as one of them. Clearly, Martin Shkreli also has his share of those who view him negatively. But I can’t argue the point – either you take the company at its’ word or not; certainly you have to assign some probability to the positive event, once you do some real-world fact checking.

Enrolling a placebo controlled study solely to determine the efficacy of benznidazole in treating acute Chagas would be, in my mind, extremely unethical. The literature is clear on benznidazole’s efficacy in this regard and having the FDA knowingly expose US patients to a lifetime of chronic Chagas (which is what everyone of the placebo arm would end up with, even if many of them never suffer long term symptoms of the illness). I cannot possibly imagine an outcome where the FDA requires a controlled trial.

Should the FDA require a trial on chronic Chagas – ie. treatment of a few hundred patients culled from among those millions of patients worldwide already infected with the parasite? Well, KaloBios isn’t requesting a label for that illness and based upon the 2015 NEJM paper its uncertain it could properly prove clinical efficacy in the long term. Clearly such a study is a non-starter.

So when you think about the possible outcomes of what the FDA could require, its clear to me the only probably outcomes are ones where an open-label study is required, or where a battery of post-marketing approval followup studies are ordered. Given that the CDC is already in the business of proscribing this drug to thousands of Americans (and therefore a prospective open label study would only serve to validate the US government’s own position on the drug), its most likely that a rigorous set of pre-IND enabling PK, tox and stability tests would be required by the FDA to ensure that KaloBios is adeqately prepared to supply a safe, stable and GMP-level quality of drug into the US market. So, for all of the above reasons, to my mind its logical to assume that KaloBios’ interpretation of the FDA minutes to date regarding benznidazole are correct.

In this scenario, I am also assuming KaloBios receives orphan drug status for benznidazole. As I’m a CEO of a development stage drug company with our own orphan drug candidate (in a vastly different indication) I am very well familiar with the Federal code surrounding orphan drug designation. This can be found in US Title 21 – Food & Drugs – Part 316, Subpart C, Section 316.20 entitled “Content and format of a request for orphan-drug designation“. There is also a wonderful powerpoint presentation( downloadable here: 2012 Presentation – Dr Rao Orphan Designation 101 ) crafted by Dr. Gayatri R. Rao MD, Director of the Office of Orphan Products Development (“OOPD”) back in 2012 that I’ve found very helpful on the subject.

Having spent the better part of this year understanding the requirements of Section 316.20, I can state definitively based upon my understanding that benznidazole will meet the requirements. Most of the requirements of 316.20 insofar as benznidazole are concerned are perfunctory, however one of them isn’t. That is, KaloBios will have to definitively show how the “orphan subgroup” of patients expected to be treated by benznidazole is under 200,000 and the drug is inapplicable as a treatment for the larger cohort of chronic Chagas patients.

Remember that 2015 NEJM paper? That paper showing that benznidazole failed over a 5 year period to successfully treat chronic Chagas (whose patient population numbers in the millions worldwide, although the size of the US population is unknown) versus acute Chagas (where the case load is no more than 7,000 annually, according to KaloBios’ own figures) works in favor of granting orphan status. In my opinion, therefore, there is an excellent chance KaloBios’ meets the qualifications, and if so market exclusively would be extended by the seven years orphan status brings along.

I also believe that KaloBios claim to earning a PRV (priority review voucher) is an excellent one. While the scope of why that is so is beyond this piece, I recommend the interested reader review the material on the topic assembled by RAPS (Regulatory Affairs Professional Society) which I found to be best layman’s resource for understanding the market and issuance of PRVs. (Link to this material can be found here). If you think that the lack of a lengthy R&D budget is any hindrance to being granted a tropical PRV you ought to Google the story behind Knight Therapeutics. And if you think that PRVs in general are a loophole that Congress ought to close, all I can say is that in this divided Capital Hill we call US Democracy in the 21st Century, there’s not a chance in hell that anything of the sort will get passed anytime this decade.

My assumptions are a valuation of a PRV of $300m – roughly halfway between the price paid by the last two acquirers – Sanofi for $245m in May 2015 and Abbvie for $350m in August 2015). I think any reasonable person who reviews the requirements for issuing a tropical disease voucher will come to the conclusion that if an NDA to market benznidazone is approved the FDA will have no choice but to grant KaloBios a PRV.

So what is benznidazone worth as an approved drug? This is the big unknown. You have to make some hard to reach assumptions, like length of exclusivity, market share size, marketing costs, etc. A good rule of thumb – back of the envelope style – is to take 2 times the dollar figure of the low end range of the market. A multiple like this assumes a small amount of off-label usage, credit for either QDIP or orphan drug exclusivity, and mid-range pricing power. Working off a $70,000 price tag, low-end 3,000 patients per year gets $210 million. Double that and you get a value to the franchise of $420 million. Add an after tax & expenses value to the PRV of $175 million and you get a total shareholder value of $595 million or $135 per share, within 18 months based upon KBIO’s current guidance.

Scenario #2 : FDA Places Hurdles to Approval —- Now its entirely possible that the FDA, against KaloBios’ understanding of the aforementioned minutes of prior pre-IND meetings, requires a suitable registratable trial to be conducted. In this case, KBIO will need to sell some additional stock to raise cash, and work proactively, one assumes, with the CDC (as they are currently getting all the inbound calls from Drs with acute Chagas) in identifying and registering patients. Its’ hard to see how that works smoothly and its another reason why its hard to see FDA, on the merits, going this route. But if they do, I would estimate, again back-of-the-envelope, a cost of $20,000,000 fully loaded (corporate overhead included) and 18-24 months spent getting it done, before you end up with the data necessary to go back to the FDA with. I still believe the outcome, provided the endpoint is acute Chagas, is pre-ordained and not at risk.

A fair back-of-the-envelope would also have to take the time value into consideration given the longer timetable a study would take, but again, I believe the outcome given the preponderance of evidence as to benznidazone efficacy in acute patients, should not be in question.

I would therefore look at the same endpoints in market size, pricing and value, but discounted back 60% for the increased cost, number of shares to be issued, lengthier timeline and concomitant increase in risk.

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Modelling the Odds of Various Potential Scenarios Around Benznidazole

Now that I’ve modeled above the two positive scenarios regarding benznidazole, let’s see what the current stock price of ~$31 per share is telling us about the odds of success of this pipeline asset.

First of all, an investor needs to come up with some normalized value to the lenzilumab program. If Martin Shkreli never purchased benznidazole, would the stock be $30? $20? $15?. Obviously there is some fluff and expectation around what the company’s new owner & CEO would do with the company. Its just not credible to argue that none of the share price in the days before the acquisition included some speculative fervor. Clearly if the acquisition looked stupid to most shareholders on its face – the stock price would have declined!

I’ll be the first to admit that estimating that speculative premium versus the implied optionality of lenzilumab is an art much more than a science. But I have to start somewhere. I will start with the high teen’s stock price KBIO traded around in the immediate aftermath of the news that Martin Shkreli & Co. purchased a controlling stake. I will work with a value of $17 per share for the implied optionality of lenzilumab, and $12 per share (based off the pre-deal price of $29) for the market’s “excitement” over what the CEO would do next. Put another way, if the first announced deal would have been perceived as bomb, I could easily see the stock plummeting to $17 worst case; its very hard for me to see any acquisition no matter how sour pushing shareholders to liquidate the stock down to, say $14 or so.

Now, between the present and the “best case” (scenario #1) the market’s perception of lenzilumab is primed to change over time as the development program continues. According to last weeks’ presentation (Dec 4th Presentation, Slide 26) KaloBios will start dosing the first KB003 CMML patient and report back some preliminary data by the end of the 1st half of 2016. That’s a very aggressive timeline and I wouldn’t be surprised if the milestones slip a quarter or to. But either way you view it, the market’s perception of that asset will undergo a change.

I’ve already said I cannot handicap that asset well enough to make an informed analysis. So I am left with maintaining my $17 per share optionality value, hoping for the best, and knowing that my model needs to be conservate enough that I can afford “to lose” that value in share price if lenzilumab is proven to be a dud in the net 18 months. Given what I know about benznidazole I’m happy with that bet.

So the way I handicap KBIO the stock, at $31 per share I am paying $14 for the “rights” to own a piece of paper that will pay me $54 to $135 per share if anything “good” transpires with the benznidazole program. I also know I need to pony up an additional $17 per share to play, and in exchange I get the “rights” to lenzilumab, which could completely zero out that portion of my bet – or pay off handsomely. Its important to know that on its’ face lenzilumab was the criteria by which Mr. Shkreli and his buying cohorts purchased 70% of KBIO – but of course they only paid a buck or two per share.

Handicapping the outcome of this bet also requires one to take a total overview of Martin Shkreli’s forays into biotech assets. I think his decisions earlier this year in succesfully handicapping both Celladon’s MYDICAR program and Vital Therapies ELAD program – both big zeros for investors – both earned him tens of millions of dollars and also ensconsed him as one of the few proven people who time and again have an uncanny knack for identifying undervalued AND overvalued pharmaceutical assets. Remember that Retrophin (Nasdaq: RTRX) investors are still reaping the value of his’ acquisitions of the Thiola & CTX franchises, both of which have generated far more in shareholder value than they cost in acquisitions. Bottom line here – you may have ethical issues with how drugs are priced but if you do invest in biotech stocks there’s no denying that management of KBIO has a fantastic track record for both uncovering value and staying away/shorting duds.

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In Conclusion

The thought of paying $14 & $17 in optionality value to capture an unknown upside in lenzilumab and a conservative $135 a share in benznidazole seem like very good crap shoots to take. I think the current stock price is undervaluing the optionality by at least 40% – meaning even at $45-50 a share KBIO is a good buy given the odds of success on benznidazole alone. At $31 the entry price to this casino is mouth-watering cheap.

Part of that stems from the controversy over Martin Shkreli and the pricing of Daraprim at his other company, Turing Pharmaceuticals. This piece isn’t meant to take a position one way or the other on that drug. To be fair, a discount has to be applied whenever a lightening rod of a controversy is present in a stock. I know, for instance, more than one of my contacts & close friends will be left scratching their heads wondering what I’m doing in KBIO. My retort to that is that the value created in KaloBios’ two pipeline assets is too cheap to be ignored. When you consider that it was Martin Shkreli’s brilliance that kept this company from liquidating into nothingness I would make the argument that whatever discount you want to overlay on the price of KBIO due to his presence ought to perhaps be a premium. How many biotech CEOs do you know have bought asset after asset after asset (CTX, Thiola and now benznidazole) at prices proven to drive shareholder value? The jury is out on lenzilumab, but I have to say that anyone who told people 12 months ago that both Celladon and Vital were imminently blowing up was also looked at askance – at least by the hefty market caps individual investors placed on both those securities. I simply have to respect his well-proven track record at picking phama winners and losers and tip my hat at his level of conviction in making the growth of KaloBios his full-time job.

I fully expect the team now at place at KaloBios to continue to add underpriced assets to the mix, adding to the inherent optionality at $31. Both the business development team and Board of Directors in my opinion are now comprised of top notch, proven value creators. If the stock market affords me the opportunity to come in alongside them at a price that gives me a potential for a 500%+ return then I’ll make that bet any day of the week. I think there’s a good shot we’ll see north of $150 a share and I’d like to be there when it happens.

Disclosure : At the time of publication of this report, Little Bear and/or its’ affiliates hold long positions in the common stock of KaloBios.