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All You Ever Wanted to Know About Retrophin But Were Afraid to Ask

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All You Ever Wanted to Know About Retrophin But Were Afraid to Ask

(June 2nd, 2014) Humans, like atoms, abhor unsteady states of existence. Just like electron transport gravitates towards a steady-state, people gravitate towards peaceful lands and away from battleground areas.

Stocks, whose daily prices mirror human emotions, show similar tendancies. At any given time 90% or so of the publicly traded companies in our country trade off known multiples, sales estimates, gross margins, price-to-book etc.

But there always exists a handful of stocks that exhibit high volatility. These “battleground stocks” posses passionate long and short traders, chirping incessantly, generating plenty of electronic ink along the way, as Mr. Market tries to determine who’s ultimately right.

Shareholders of Retrophin (Nasdaq: “RTRX”) must feel like they were teleported to the front lines of the old French Maginot line as, in one fell swoop we learnt last week that our company has access to (relatively) cheap debt, long term shareholders willing to add to positions via convertible debt struck significantly above the current market price, and a drug in development (RE-024) that, while still in the early innings, looks extremely promising (more on RE-024 later).

Yet the shareholders also own a stock that initially traded – after the Thiola (Tiopronin) announcement alongside an $80 million financing – as high as $17 in the premarket while closing at its lows in the mid 14’s. And that’s after a long, sickening slide from the low 20s all the way down to $10 and change. No one could blame them for asking out loud, “what the heck is going on here??”

It’s simple: You own one of the most controversial battleground small-cap biotech stocks on the entire exchange.

Now readers of my Twitter feed know that in the early goings of Friday’s trading I recommended that overweight holders of the stock lighten up. I sure did – letting go of at least 20% of my family’s position. But then again I’m a guy who went all in at $4.50, then over the top at $18 and each dollar downward after that, all the way down to $11. I guess the company’s critics could say that I’m as schizophrenic as the CEO!

Besides publishing my discounted cash flow analysis, which I thought would be extremely useful for long-term shareholders like myself given the paucity of analyst coverage, I’ve tried to stay quiet and let the company, its stock price and the heavy institutional ownership do the talking.

To be quite honest I’ve always been puzzled by the extreme positions taken by the company’s critics, and how many otherwise bright portfolio managers and high net worth investors in the biotech arena have steered clear of owning the company’s stock. But after Friday I think I’ve come to a better understanding as to why that’s so and I think it would be helpful to lay out my thesis as well as the bears’ thesis at the same time. By doing so I hope to better illuminate what drives the company’s stock price in the short and medium-term, and hopefully in the process give owners of the company more confidence in its’ prospects; helping anyone on the sidelines make a better determination as to the suitability of this investment for them.

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95% of biotech investing can be summed up like this : a promising scientist has a great idea. Maybe it’s just a hunch, maybe he fooled around on the lab bench and came up with some interesting data, or maybe it’s a team of people putting into practice ideas long thought to be theoretical.

Whatever the case may be, the idea is exciting and said founder(s) goes ahead, raises a little bit of money – perhaps he gets a grant from some University foundation or government entity – and they are off to the races.

Animal data gets generated, papers get published, scientific staff gets hired, and the monthly bills pile up. After all, biotech companies never generate any revenue from the get-go! At some point in time the company needs to raise more money than the private markets will give them, the original investors begin to get antsy, and if the market is right and the IPO window is open, said company gets to go public.

If the IPO works, more human trials get funded. If the phase 2 data looks good, and institutional investors get on board the stock, the company can do a secondary. It can raise even more money, maybe start some additional drug development programs and hopefully move slowly towards putting together a ‘full dock’ of phase 1 through 3 data and approach the FDA with its NDA (new drug application).

From start to finish the process could take a decade – or more. With plucky, well run companies the total dollar cost could be $100, $200, or even $300m of capital invested. Within large pharma, the same process, when averaged out for all the R&D projects that go nowhere, can cost upwards of a billion or so.

Most of the time along the way no one really asks the hard question – namely, what the return on investment at each round of financing is expected to be. Investment bankers with an eye towards collecting fees make darn sure the DCF’s look rosy (if you want to look at an especially egregious example of this take a look at the 85 to 90% range of assumed success that some analysts on Intercept Pharmaceuticals (Nasdaq: “ICPT”) currently have on it’s lead compound). Usually the analysts (Roth?) come along for the ride. Sometimes a firm has a bold enough research team – think JP Morgan or Barclays – that buck the trend. But usually the hard work in deciding whether or not the odds of success, multiplied by the ultimate profit payoff if the drug does get approved, are never done right. Its the prime reason why upwards of 70% or more of approved drugs never pay back their cost of development – when weighted for the time value of money.

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People may call Retrophin a biotech company; certainly the index firms lump it in together with the rest in the various small cap indexes. But Martin Shkreli – whom I believe to be the youngest ever CEO of a publicly traded biotech (if you have an example of someone younger, please email me!) – has turned the traditional model of biotech business creation on its head.

What I believe Martin is doing is using quaint, traditional metrics few within the biotech sphere use. If you read the transcripts to the past three conference calls Martin explains the thought process that went into each company-transforming transaction in plain English. Put simply, each deployment of capital – be it acquiring a new drug, pipeline compound, R&D expenditure or clinical program – is measured on the basis of ROI. That’s right, a little old thing called Return On Investment. Something so simple, done thousands of times every day at businesses across the country, yet in seemingly short supply within the world of publicly traded small-cap biotechs.

Take the Manchester acquisition. For $62 million, Retrophin bought two licensed drugs. Chenodal had a roster of 50 customers whose lives depend on the drug. In a rational world, you would charge a half a million per head, spend $5m per year on supplying the drug and paying the overhead. An additional $5m would go out the door for continued research into both better understanding the lead indication as well as pursuing new, similar ultra-rare illness where the same MoA (mechanism of action) could save the life of a dying patient. Maybe your numbers are off by an additional $5m, maybe not. Either way, you pocket $10m minimum.

Ah, but the nattering nabobs of negativity protest. They hop on their righteous mantle and claim that you can’t do that; by increasing the price of an existing drug 500% you are ripping off the US Government, States, Counties, private payors and all those who contribute into the health care system. The bears point an accusing finger at Martin personally, calling him names, accusing him of being a modern day robber baron.

I find this this approach laughable. But I’m not laughing today, mainly because I’ve come to understand how widely prevalent this belief is. In my talks with hedge fund managers and high net worth investors, this line of reasoning is given serious consideration. But when you peel back the curtain you come to realize its completely false.

My column isn’t the appropriate place to launch into a full dissertation of drug pricing, but I’ll present the short short version : Prices for drugs ought to reflect (a) the R&D cost to develop; (b) the marginal cost to produce; (c) the ongoing cost to support the patients being serviced by the drug; (d) overhead to manage all of the above; (e) and appropriate level of profit. But in reality linking the above five things to a particular drug price is neigh-impossible.

Banks and drug companies have one important thing in common. The costs of their services have little to do with the amount they charge. Borrowers pay interest on loans at a rate that’s irrelevant to what your local branch is paying in rent. Drug companies charge a price for what the market will bear.

What Retrophin does understand is that you can’t charge what the market will bear without being a responsible corporate citizen. That means ensuring that your business perfectly executes on (c), above. This, by the way, is the real difference between Questcor and Retrophin. For half a decade Questcor’s  R&D spend was miniscule. The business relied on the fact that its’ patients had nowhere else to go. Only recently has that company’s management realized that you need to reinvest in your patient population in order to survive long term.

By contrast, Martin and his team have jumped in with both hands (in the case of the Manchester acquisition) into servicing the CTX patient population. As one father told me a month after the deal was announced, “Retrophin has done more for the CTX community in the past three weeks than I’ve seen Manchester do in the past three years”.

That father wasn’t alone. In my due diligence in the space it became very clear very quickly that Retrophin was doing all it could to ensure support for existing patients, identifying new ones, reaching out to care givers and supporting whatever institutions are necessary to further the treatment and thereby improve the lives of people taking chenodal.

This is a win/win for everyone involved. Shareholders will benefit by growing revenue long term. Patients who suffer from CTX but are not aware they have the gene will benefit with early intervention (like many degenerative illnesses, the sooner a patient goes on therapy the better the long term prognosis). I am extremely excited by Retrophin’s plans to test for CTX a retrospective group of five years worth of teenage patients who have undergone cataract surgery. It’s anyone’s guess what the numbers will be, but running a few different models tells me to expect over time anywhere from 20 – 200 new CTX patients just from this analysis.

Let’s be clear : These patients would likely be young adults suffering from assorted complications, starting with cataracts and progressing to things like seizures, dementia and various psychiatric disturbances. If treated early enough, they could be spared the worse of a lifetime of suffering. Yet the bears would have you believe society would be better off keeping the price of the drug low and never identifying these treatable patients!

There is much more to being a responsible drug company than just identifying new patients. I spoke with one CTX parent who told me about a family he know of with a middle aged adult who  recently lost one parent. This CTX patient has been shuttled from various assisted living facilities due to his mental retardation. In the past his parents always made sure that his new caregivers understood the importance of his Chenodal regimen. When his other parent ultimately passes away, who will look after this patient’s needs? Under Manchester’s management there was no one looking out for these patients. But this same parent mentioned to me that after speaking with the new folks at Retrophin assigned to Chenodal, he felt very comfortable that there was enough personnel who understood these challenges that it would be handled appropriately. Why shouldn’t it be with a half a million dollars a year on the line?

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If you buy into Martin’s M&A strategy, you believe two things : (a) drug positioning and pricing can be highly inefficient; (b) Martin and his team has the skill set to out-execute the sellers of assets. I believe both assertions to be true.

Some commentators on Twitter have wondered aloud why there exists companies like Manchester and Mission Pharmacal who are managing their portfolio of assets in an inefficient manner. Again, this column isn’t the place to present a dissertation but it is a fact that as far as industries go, pharmaceuticals is one of the more inefficient markets.

An example I often use is the market for baseball players. There are 30 major league teams in the market for free agents. Everyone has access to all the statistics on each player. Players are all represented by agents who know the weaknesses, strengths and finances of all the teams. It makes for an almost perfect market. That doesn’t mean that each player gets exactly what they ought to, but it does mean that one player doesn’t get paid $3 million at the same time a team would be happy paying him $10 million. Call it an almost-perfect market.

By contrast, there are at least 10,000 drugs approved by the FDA and many of them languish as “dead drugs”. Some have on-label uses that no longer are therapeutically “best-in-class” while others have significant off-label uses that aren’t well-known. Some, like Thiola, are poorly marketed because of historical pricing and the drug owners own disinterest in reinvesting in the opportunity. Others, like Vecamyl, have off-label usages that even the manufactures of the drug aren’t completely aware of. Bottom line is that there is an enormous amount of inefficiency in the drug market, and anyone who tells you otherwise just hasn’t studied this business well enough.

Martin has proven to me that he can identify and acquire, for reasonable sums, three approved drugs (I’m ignoring Oxytocin for the moment). I believe, but can’t prove it yet, that these drugs have a significant ROI associated with them (financials for the latest quarter haven’t been published yet. It’s clear to me in due diligence calls that  Chenodal is selling nicely and generating solid cash flow.)

There is no reason in my mind why Retrophin cannot acquire over time 20 or 30 drugs similar to Thiola and Chenodal. Time will tell, of course, but the opportunity is there and I believe Retrophin has the talent to execute. I’ve met almost a dozen of their middle-management folks, alongside talking to many who’ve interacted with them, and I’m convinced Martin has done a top rate job of attracting solid talent.

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So what all this worth? Martin may have gotten a few laughs (including from people like Adam Feuerstein who should know better) over the “earnings power per share” metric, but fundamental long term investors like myself already use metrics like this in assessing biotech companies

How else would you analyse the underlying profitability of a company like Amgen with its $1b annual R&D budget? People think that Teva’s 32x P/E is high but when you factor in an R&D budget larger than its after-tax earnings the company’s stock no longer looks so cheap.

Of course, R&D spend cannot be completely severed from the income statement. Existing drugs have a lifecycle of patent exclusivity. Companies like Pfizer have had difficulty replacing enough of their revenue over time with new drugs that the income statement goes stagnant. This is a problem that large pharma have, but present day Retrophin deserves to have its’ R&D spend viewed as a investment in future growth, not as a capital expenditure in pursuit of maintaining existing revenue.

When I look at Retrophin’s capital efficiency, I see a thing of beauty. Were it not for ongoing R&D, Chenodal and Vecamyl looks like a $25m business growing by 50% or more throwing off $15 to $20 million. I haven’t had enough time to do the due diligence on Thiola but management is claiming its’ half to 2/3rds the size of the Manchester assets. Given that Retrophin put down less than $10 million for Thiola (compared with more than $60 for Manchester) you can understand why Martin referred to this on the conference call as, “the best deal we’ve ever done at our company, and will be a hard one to surpass for some time to come”.

I remember hearing from a number of investors I trade with who called me right after Retrophin announced the $80 million financing predicting it would hurt the stock price. Nothing could be further from the truth. When management sells stock or converts to fund accretive acquisitions, the stock market rewards such capital efficiency.

Hopefully when Retrophin publishes its’ next few quarterly earnings investors will be given additional information to back up the earnings power of these franchises. In the meantime shareholders will have to do their own due diligence, starting with the CTX & cystinuria communities.

UpToDate is a paid service for the medical community. They have experts in individual fields write up exhaustive summaries on all types of illnesses. I cannot reprint their research, but on cystinuria the author Dr. Elaine Worcester (highly respected at the University of Chicago as an expert in kidney stones) makes a strong case for Tiopronin being a superior treatment than the competitive product penicillamine – even though Tiopronin’s market share is miniscule. I chalk up the dichotomy to a poor job Mission has done marketing the product to date. I believe Martin’s team can do a much better job, especially after raising the price closer to penicillamine and putting some of that excess cash to work on behalf of the cystinuria community.

If you have access to the UpToDate service, I strongly urge you to read her report. Modeling out the drug using various market share and pricing assumptions, I get an earnings power for Thiola similar to management’s – namely $12 to $25m a year. Bottom line – there’s lots of value to be unlocked here. 

When I look at Retrophin’s existing stable of marketed drugs, it’s no stretch of the imagination to see these franchises throwing off a combined $40 to $50 million in 2015. That would equate to upwards of $1.75 per share in earnings power.

Now the bears, as well as those on the sidelines, would argue that we haven’t seen the financials to back this up. Fair point. Buyers of Retrophin today get to place a bet that Martin follows through successfully. I think that’s a very safe bet to make. From what I can tell management is out-executing on Chenodal and there’s no reason to believe the team assembled to manage Thiola will do any less of a solid job. Stay tuned over the next three quarters and try to cultivate friends within the CTX and cystinuria community (that is, if you want the heads up before the market does). In fact, I think my numbers might even look conservative a year from now.

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Retrophin cannot exist on mere M&A opportunities. The company’s business model is to direct free cash flow to an R&D budget packed with low upfront investments in a stable of promising molecules with 100x payoff opportunities.

Two in particular, Sparsanten & RE-024 look very attractive. On the May 30th conference call the CEO made this intriguing comment about RE-024, ” A quick word on PKAN. We’re encouraged by our early experience with the first patient to take RE-024 via European compassionate use program. We’ll be releasing 28-day data on this patient next month. The only thing we are reporting at this time is that we are encouraged by the data thus far and the drug is extremely well tolerated. More patients are in the pipeline to be enrolled in investigator-led emergency trials for RE-024.”

PKAN stands for Pantothenate Kinase Associated Neurodegeneration. It’s a degenerative disease. Kids (approximately 75% of PKAN patients are children) don’t get better from PKAN over time; they get worse.

Parents who have a child with PKAN face a terrible future. You would think that any glimmer of hope, even comments such as “we are encouraged” would be big news for this community. Certainly the financial media coverage of Retrophin should have picked up on it.

Anyone I’ve spoken to with knowledge of the illness think this could be the big one. The underlying word is could be. On the prior Q1 conference call I asked Martin what quantitative data they will be tracking in patients tested with RE-024 and he specifically mentioned dystonia. If Martin’s “encouraged”, there’s a good chance he’s seeing improvement in the patient’s dystonia. If so, the odds of success have got to be better than miniscule.

I’ve updated my NPV model of Retrophin using a percentage chance of success of RE-024 of 30% given these comments. If RE-024 becomes an approved treated with patients with PKAN, it’s a home run on par with Naglazyme (used to treat Maroteaux–Lamy syndrome, with less than 1,500 US patients) or Fabrazyme (used to treat Fabry’s disease with approx. 2,500 US patients). Go look up where the manufacturers of those drug are trading at.

Yet instead Bloomberg news treated us to a caricature of Martin and his tweets. You can’t blame Bloomberg as the story was too juicy to pass up. But its truly a shame when incrementally good news about a drug that could save the lives of a thousand sick children in our country is overshadowed by ill-timed tweets.

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So why is the stock trading where it is? I think the controversy over the unorthodox use of twitter is only part of the story. As I intimated earlier, Retrophin as a business doesn’t fit neatly into a box labeled ‘biotech’. It certainly doesn’t have the financial heft of a mainline pharmaceutical company. Its not, strictly speaking, a roll-up. With the percentage of trading done these days by algorithmic. as opposed to fundamental, traders, Retrophin is bound to be both underfollowed and undervalued.

Martin Shkreli would have investors focus on the underlying earnings power, not the daily gyrations in the stock price. As he stated on last week’s conference call, ” My sole focus is a growing EPS over time including an R&D spend that will enhance our long-term growth. Our stock price is not a primary focus for me. There is no realistic benefit that comes from a high stock price. And those of you who know us well, understand this is deeply held opinion at Retrophin, with no analyst coverage, no conference presentations, no IR people, very infrequent road shows, we are focused solely in growing our business, not growing our stock price.”

Now that’s a pill to swallow if you mark your performance in the stock market on a daily or monthly basis. Allowing the twitter controversy to overshadow RE-024 fits right in with the strategy enumerated above.

In my conversations with investors sitting on the sidelines even though they are knowledgeable about Retrophin’s pipeline, the number one reason I hear for why they aren’t buyers of the stock is because of the various unorthodox methods by which the CEO communicates his thoughts. Without solid analyst research, you can’t blame market participants for writing off the company at this stage in its’ growth.

From my vantage point, the discount afforded Retrophin because of it is just an opportunity to grab cheap stock. But that discount shouldn’t last forever.

I do believe that over time the earnings power of the various franchises will be appreciated by Wall Street. In the short term, if RE-024 begins to show replicable efficacy in treating PKAN patients on an experimental basis, it will be impossible for Wall Street to ignore the potential blockbuster status of that molecule.

What’s RE-024 worth?

Rare disease companies with successful franchises trade at some of the highest multiples on the market. Part of this is due to the legal protections afforded marketers of orphan drugs. Part of this is due to investor perceptions of the relative safety of such cash flows: who in their right mind would commit large $$$ to competing with an entrenched competitor servicing a handful of patients with a drug that appears efficacious?

You can quibble about the comps, but one thing is for certain; the number is surely in the billions.

I have updated my DCF analysis to include an improvement in the odds of success for RE-024 given Martin’s comments.  In order that this research not be viewed as an attempt to create a frenzy in the market, I have password-protected the piece, for download only to my readership. If you wish to unlock the report, please email me a request for the password, acknowledging the following : (a) you are not relying on any information contained herein solely for the purposes of investing in Retrophin common stock; (b) you will not disseminate this research report to anyone and that you are downloading it solely for your own use; (c) you acknowledge that the author of this report and his family are directly and indirectly own shares of Retrophin and therefore the opinions contained herein cannot be viewed as free of any conflicts of interest.

Existing readers who have downloaded and received the prior DCF analysis can use the old password to access the updated version

New Readers : Email me (using the email address at the top of this page) that you agree to the above, and you will get the password to the research report sent to you.

The updated DCF research report can be downloaded here : Retrophin NPV Updated 6.2.14

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In conclusion, I understand why there aren’t too many buyers in the market for shares of Retrophin. You have to go against the grain to buy into a business model that doesn’t fit with an easy label. The CEO is young, and comes across as unorthodox at times. The company encourages little analyst coverage (part of the motivation I’ve had to publish on Retrophin is precisely the paucity of research on the name) and doesn’t actively pursue the conference speaking circuit.

Buying the stock of Retrophin is a vote of faith that Martin Shkreli knows what he’s doing and that the team he’s hired can create lasting value. If you don’t put in the time to investigate whether or not that statement is true then I can understand why most would pass at owning the equity.

I think, however, that if you do put in the time to understand what Martin is doing, that the common stock of the company is a fantastic opportunity to buy real value within the biotech space. I simply cannot model too many scenarios where the company’s stock price turns out to be ill-timed right here, and I can see numerous scenarios where the stock can easily triple, quadruple or more.

One thing I’m absolutely certain about. A year from now the answer as to whom is more right – the bulls or the bears – will be much easier to answer. And if bulls are right, there will be thousands of patients and their families who will be much better off, with the team of highly-skilled professionals at Retrophin to thank for it.




” Concentration is my motto – first honesty, then industry, then concentration. ” Andrew Carnegie