business

An Appealing Play in Pain Management

S&P sees Alpharma capturing a sizable piece of the transdermal pain-treatment market in coming years and rates the shares a strong buyby Herman Saftlas

Pharmaceutical concern Alpharma (ALO; recent price, 27) in recent years has streamlined its overall corporate structure and paid down a prior heavy debt load, using proceeds from the sale of a slow-growing generics business. More recently, under the helm of a new management team led by Chief Executive Dean Mitchell (who came to the company in mid-2006), Alpharma set course to significantly expand its exposure in the high-margin, specialty, branded pharmaceutical business, with particular focus on the pain-management market.

Building on the success of its Kadian extended-release morphine sulfate pain treatment, Alpharma has expanded its reach in this market through the recent launch of the Flector pain patch, the first topical, nonsteroidal anti-inflammatory drug (NSAID) approved for the U.S. market, and the recent in-licensing of what we see as a promising ketoprofen gel pain treatment.

Boosted by these products, we see Alpharma eventually capturing a sizable piece of a projected multibillion-dollar transdermal pain-management market by 2012. In addition, we expect Alpharma to grow its oral pain-management franchise through the planned launch of Embeda, an abuse-deterrent version of Kadian, as well as new abuse-deterrent versions of oxycodone and other pain treatments.

We view the planned sale of the company's Active Pharmaceutical Ingredients (API) business for $395 million in cash, subject to necessary approvals, as a positive event in enhancing shareholder value. Management recently noted that to remain competitive in the API business would have required significant investments in resources that Alpharma believes, and we concur, are probably better invested in higher-margin, specialty pharmaceuticals or in buybacks of the company's common stock.

Despite the recent runup in the shares, we still believe Alpharma offers attractive value. We also think Alpharma also offers a measure of takeover appeal at current levels. Our recommendation is 5 STARS (strong buy).

Company Profile

New Jersey-based Alpharma produces and markets pharmaceutical products for human and animal health markets. In 2007, animal health products accounted for 51% of revenues and operating income of $72.6 million; active pharmaceutical ingredients for 26% of revenues and operating income of $34 million; and pharmaceuticals for 23% of revenues and an operating loss of $61.5 million (largely reflecting a $60 million in-licensing payment for ketoprofen gel). About 72% of 2007 revenues were derived from the U.S., 8% from Denmark, 2% from Norway, and the remainder from other countries.

Alpharma's animal health business produces medicated feed additives and water-soluble therapeutic-type products for poultry, cattle, and swine. The global medicated feed market is estimated at about $1.6 billion. Animal health products primarily consist of anti-infectives such as bacitracin and chlortetracycline that are added to the feed and water of livestock and poultry. Although this is a relatively slow-growing business, operating margins of 20% have been maintained in recent years, as Alpharma has maintained its No. 2 position in the medicated feed market.

Pharmaceuticals presently consist of two products: Kadian, an extended-release morphine sulfate product, and the Flector pain patch. Kadian was in-licensed from F. H. Faulding & Co. in 2006 pursuant to a perpetual, royalty-free license. Sales of Kadian increased 21%, to about $168 million, in 2007.

Representing the first prescription topical NSAID approved by the FDA, the Flector patch delivers anti-inflammatory analgesic effects of diclofenac epolamine to treat acute pain associated with minor strains, sprains, and contusions. Alpharma purchased Flector from Institut Biochimique, a Swiss drug company, for $100 million in cash, plus certain other patents, in August, 2007.

Corporate Strategy

We believe Alpharma has made a major commitment to the pain-management market, with the recent launch of the novel Flector patch, and the in-licensing of a ketoprofen gel for osteoarthritis. As topical formulations, these products, in our view, offer better safety profiles than systemic oral pain drugs. We project the overall transdermal NSAID market to expand to more than $2 billion five years from now.

As Flector was the first entrant in this market, we believe it has gained an important lead over other potential competitors. We think the next competitor in the U.S. market will be Voltaren Gel, a NSAID gel that Endo Pharmaceuticals (ENDP) recently in-licensed from Novartis (NVS). However, we believe Flector will be the therapy of choice for most users given its dosing and efficacy competitive advantages. We think recent anecdotal evidence from physicians prescribing Flector has been highly encouraging, with weekly prescriptions rising to 6,694 in the fifth week after its launch in mid-January 2008. We see continued robust uptake for Flector over the coming months, helped by an expanded sales force and greater acceptance among managed-care providers.

Besides growth in the overall market, and some shifting away from oral treatments, we also think Flector has the ability to take market share from Endo Pharmaceuticals' Lidoderm pain patch (sales of $706 million in 2007), which is used to treat pain associated with shingles. We project Flector sales of over $60 million in 2008.

Another key expansion in the pain portfolio took place in October, 2007, with Alpharma's in-licensing from IDEA, a German biopharmaceuticals firm, of U.S. rights to market ketoprofen in Transfersome gel for $60 million in cash at closing, plus up to $142 million in contingent milestone payments. Similar to Flector in that it is a topical NSAID, this gel differs in its active ingredient (ketoprofen instead of diclofenac) as well as in its ability to treat pain on body joints such as knees and wrists. Presently in phase III trials for the treatment of osteoporosis, we expect this product to reach the market in 2011.

Aiming to grow its extended-release morphine sulfate drug franchise after Kadian loses patent protection in 2010, Alpharma has developed and recently filed a New Drug Application (NDA) for a new abuse-deterrent extended-release morphine sulfate to be sold under the Embeda brand name. We think the abuse-deterrent feature will represent a key competitive advantage, given the growing incidence of prescription drug abuse, especially for opioid drugs.

We think Embeda has a good chance of being the first abuse-deterrent opioid drug to reach the market. The second one will probably be Remoxy, in our view, an abuse-deterrent oxycodone-based drug that King Pharmaceuticals (KG) in-licensed from Pain Therapeutics (PTIE). Alpharma is also working on its own abuse-deterrent versions of oxycodone and similar drugs.

Near-Term Prospects

Primarily reflecting the planned absence of the API business (which Alpharma has classified as a discontinued operation), we expect total reported revenues to decline 10% in 2008, to about $650 million. However, we see significant growth in pharmaceutical sales, primarily reflecting contributions from Flector, as well as strong momentum in Kadian. We also think there's a good chance Embeda will be approved and launched in the fourth quarter. In addition, we project mid-single-digit growth in sales of animal health products, helped by expansion in new Asian markets.

However, we expect 2008 earnings to be affected by the absence of the API division, which we believe accounted for more than 50¢ of 2007 earnings per share (EPS). We also see results impacted by heavy selling, general, and administrative and research-and-development spending related to new pain drugs. We forecast operating EPS of 40¢ for 2008, vs. 2007's $1.06. Results in 2007 exclude the $60 million up-front payment for ketoprofen gel. Reflecting solid growth in the expanding pain franchise and cost streamlining measures, we see EPS ramping up to $1.30 in 2009.

Company Finances

We have a largely favorable view of Alpharma's financial position, with its total assets of $1.3 billion at the end of 2007, including $303 million in cash and cash equivalents; $255 million in receivables inventory; $284 million in property, plant, and equipment; and $446 million in other assets. Current liabilities were $198 million, other liabilities $48 million, long-term debt $311 million, and stockholders' equity $731 million as of yearend.

Long-term debt consists primarily of $300 million in convertible senior notes that were sold in March, 2007. We believe those funds have provided Alpharma the flexibility to take advantage of attractive product acquisitions such as the in-licensing of the ketoprofen gel product.

Excluding the $60 million up-front payment related to ketoprofen, earnings before interest, taxes, depreciation, and amortization (EBITDA) totaled $114 million in 2007, with free cash flow of $45 million. Capital expenditures were $60.5 million, of which $41 million consisted of spending for the API division (which is being divested).

After adjusting for closing costs and other payments, Alpharma expects to net about $365 million from the proposed sale of its API division. We think the deal, which we find attractive at eight times API's 2007 EBITDA, makes long-term strategic sense, as it should allow Alpharma to invest in higher-margin and faster-growing drugs, as well as provide funds for potential share buybacks.

Valuation

Our 12-month target price of $30 is derived from a blend of our discounted-cash-flow, price-to-sales, and sum-of-the-parts valuation models.

Corporate Governance

We view Alpharma's overall corporate governance position as superior to most peers in the pharmaceutical industry. Positive factors, in our view, include that only one insider director (the CEO) serves on the board, and no affiliated outsiders serve on the board; the nominating, compensation, and auditing committees are composed solely of outside directors; the CEO serves on the board of two or fewer other companies; and the company does not have a poison pill antitakeover defensive in place.

Negative factors, in our view: Shareholders do not have cumulative voting rights in director elections; the board is authorized to increase or decrease the size of the board without shareholder approval; and a plurality standard is employed in director elections.

Investment Risks

Risks to our recommendation and target price include greater-than-expected competitive pressures and an inability to achieve significant growth in key Kadian and Flector pain drug lines. Unexpected weakness in the animal health business, problems in developing and commercializing new products, and failure to complete the planned sale of the API business represent additional risks, in our view.

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