Current Price: $0.77 (CVR only)
Offer Price: $3.70
Expiration Date: December 2030
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On Monday October 11, 2021, Pacira Biosciences announced that it would be acquiring Flexion Therapeutics valuing the equity at $450m on a fully diluted basis and an EV of ~$550m. Flexion has one drug currently on the market, Zilretta, which is an extended release injection used to treat osteoarthritis (“OA”) of the knee. Zilretta, and two drugs, FX201 and FX301, currently in Phase 1b of clinical trials are all non-opioid pain relievers, which fits with Pacira’s strategy of becoming a leader in non-opioid pain management. Pacira will pay $8.50 per share for the acquisition, as well as a Contingent Value Right (“CVR”) with additional payments totaling another $8 per share should all the approval and sales milestones be met. The offer (excluding CVR) comes at 47% premium to the pre-announcement price of $5.78. The CVR milestones must be met by December 31, 2030, and are as follows:
- $1.00 per share if total calendar year ZILRETTA net sales achieve $250m
- $2.00 per share if total calendar year ZILRETTA net sales achieve $375m
- $3.00 per share if total calendar year ZILRETTA net sales achieve $500m
- $1.00 per share upon U.S. FDA approval of FX201
- $1.00 per share upon U.S. FDA approval of FX301
The CVR will not be tradeable according to the 8-K, so once the transaction closes those wishing to have exposure to the CVR will likely have to transfer the economics via a participation agreement, thus taking counterparty risk. There are potential alternatives, such as setting up and SPV, or, if the buyer and seller both use the same prime broker, having the prime broker swap who the CVRs are held for the benefit of in street name. However, this requires both parties to agree on the structure and makes litigation more complicated since legal ownership has not been transferred via a purchase and sale agreement. There may be legal arguments that the Pacira cannot legally restrict an investor from assigning their rights to another party, and the CVR Trustee could potentially be pressured to maintain a ledger for
assignments or face litigation, but one should assume that after the deal closes, legal ownership rights will remain with the original holders and those who wish to have legal ownership will need to purchase FLXN shares prior to the closing of the merger.
With FLXN currently trading at $9.27, buyers are creating the CVR at $.77 ($9.27 Stock Price - $8.50 Cash Consideration). Paying $.77 (implied value of $38.7m, or 9.6% of the total potential value based on 50m shares out) for $8, or $402m, of potential payouts does appear to have the type of asymmetric risk/reward skew investors look for in these instruments. Nevertheless, accurately assessing the probability of meeting those milestones, as well as the timing of reaching the various milestones is essential to estimating the expected value and validating the investment’s merits. We estimate the expected value of the combined sales and approval milestones to be $3.70 (4.9x or 48% IRR to 3.8-yr WAL) undiscounted, and $2.17 (2.8x) on a present value basis. The term of the CVR is 9 years and there are no intermediate exploding dates, so this CVR is effectively a 9-year option on achieving any of the milestones. We estimate the WAL of the 1st milestone at 2.85 years and the 2nd at 3.8 years, with 3rd not being meaningful on a WAL basis due to the lower probability weights assigned.
Since Zilretta is already on track to generate ~$100-$110m of sales in 2021, we view reaching $250m in sales and the $1 milestone over the next 9 years as being 100%. The remaining $2 milestone at $375m and $3 at $500m of annual sales will be driven by the ability of Pacira to accelerate the adoption of Zilretta for the treatment of OA of the knee, which approximately 15m Americans are treated for annually, ~5.3m of whom receive ~8m injections annually for pain management. Zilretta has three primary advantages over the current use of cortisone steroid (CS) injections. One, Zilretta is formulated as an extended release, so pain relief is delivered over a 12 to 16-week period versus 8-10 weeks for CS; two, there is a lower dosage of steroidal anti-inflammatory, which results in less damage to the cartilage and joints; and three, Zilretta has a substantially lower impact on blood glucose levels over CS, which is critically important for the 20% of OA sufferers with diabetes. It is also unclear how many of the 2/3 of Americans who do not currently receive CS treatments for their OA of the knee area due to concerns regarding diabetes-related risks. We estimate that if Zilretta were to capture 17 % of the market (1.4m annual injections), it would result in annual sales of ~$417m, which would achieve $3 in milestone payments and 83% of the required $500m sales milestone and $3 payment. Moreover, Zilretta is in Phase 3 trials for use in treating shoulder OA and adhesive capsulitis (frozen shoulder). The company estimates that this could be a one-million injection per year market for Zilretta. The company also noted that ~40% of those with shoulder OA also suffer from diabetes. See "Potential Sales and Market Opportunity" section for full sales analysis.
CVR Expected Value Model
Using sell side analyst consensus estimates complied prior to the announcement of the merger and Flexion withdrawing 2021 sales guidance, it was estimated that Zilretta would achieve the $250m sales milestone by 2023, the $375m milestone by 2025 and the $500m milestone by 2027. The estimates imply that all 3 sales milestones, and $6 in CVR payments are achievable with ~2 years of cushion for slippage.
Approval Process Milestones
The drug approval milestones are the highest risk/lowest probability given the length and time to complete. According to the FDA it takes 4-7 years to complete clinical trials and 12-18 months to receive FDA approval.
- Phase 1: These trials usually enroll 20 to 100 healthy volunteers or people with the condition being studied and last several months. This phase measures safety by testing for any adverse side effects of the treatment, but not necessarily how effective the drug or device is.
- Phase 2: Around 70% of potential new drugs enter Phase 2, which continues to measure safety, while also looking at how effective the treatment is and carefully investigating its side effects. Phase 2 trials recruit up to several hundred patients with the condition to take part. This phase typically lasts several months to two years.
- Phase 3: Just 33% of drugs make it to Phase 3, which tests the potential treatment in the largest number of people. This phase measures both safety and effectiveness with many volunteers, sometimes thousands. Phase 3 trials last from one to four years.
- FDA approval: After Phase 3, a pharmaceutical company may submit a New Drug Application (NDA) or a biologics license application (BLA) for the treatment to the Food and Drug Administration (FDA) which generally takes another 12-18 months.
According to a 2018 study done by MIT Sloan School of Management published in Biostatistics, 14% of new drugs make it from Phase 1 to approval. Approval rates ranged from a high of 33.4 percent in vaccines for infectious diseases to 3.4 percent for investigational cancer treatments. We view OA treatments as being somewhere in between the 14-33% range given that these are not high-risk, experimental treatments.
Other Risk Factors
Given that FLXN is trading above the $8.50 cash portion of the offer, the expected year-end closing, and the lack of antitrust issues, we view deal closing risk as effectively <1%. Another risk factor that must be considered is Pacira’s incentive to avoid triggering the milestone payments. By making the CVR nontransferable, the company is likely trying to disincentivize distressed and litigation funds from a repeat of the Genzyme and Bristol Meyers CVR litigation. That said, there are key distinctions from both of those CVRs. In Genzyme, the approval and sales milestones had to be met by a series of dates to trigger payments. Many of the more achievable milestones were front-loaded in the early years of the CVR which gave Sanofi (the buyer of Genzyme) the incentive to delay actions critical to achieving those milestones so that they would not be triggered. Ultimately Sanofi settled claims related to $800m in damages from their breaches of the CVR agreement for $315m (~40% of alleged damages under the second amended complaint). The terms of the Bristol Meyers CVR litigation were an all-or-nothing payout of $9 per share contingent on the approval of three drugs by a certain date, which was missed by less than 60 days, hence the litigation.
However, in both the Genzyme and BMY CVRs, neither of the drugs had received FDA approval, whereas Pacira is paying $550m cash for Zilretta including net debt of $100m that will be paid off, with an option on FX201 and FX301 which are 6-9 years from approval, if they are approved at all. On a conference call to discuss the transaction, management stated that they ran their deal model on Zilretta to the mid-2030s based on the current patent, with some positive comments based on their IP lawyers diligence that it could be extended to the late 2030s. Given that the CVR has a 9-year term, Pacira has a substantial financial incentive to get a return for its shareholders on its $550m investment and ensure that the drug’s commercial value is fully realized over the next 9 years. Management also believes there will be substantial synergies as a result, which given Zilretta is currently on track for ~$100m in sales in 2021 implies the expected substantial revenue growth.
Flexion currently has one drug on the market, Zilretta, which is a physician-administered drug to treat osteoarthritis (OA). The drug was approved by the FDA in October of 2017 and is an extended-release, non-opioid treatment for the condition. Zilretta is also in a phase 3 trial for shoulder OA while FX201 is in Phase 1b studies of musculoskeletal pain, including OA, and FX301 in phase 1b as a lower extremity nerve block for post-surgical pain. The acquisition aligns with the Pacira’s strategy of “expanding its nonopioid pain medication portfolio” according to the companies’ joint press release. Moreover, the press release states that with the addition of Zilretta, Pacira will be “better positioned to offer another treatment option to manage pain for knee OA at an earlier stage of the patient journey”. Flexion's FX201 and FX301 are complementary to PCRX’s products, Exparel and Iovera, and fit well into the company’s growth pillars in non-opioid pain management and the focus around offering patients an end-to-end solution along the neural pain pathway and would allow the company to better engage with physicians and patients across the same call points.
Pacira highlighted that it expects to capture double-digit operational synergies beginning in 2022 and for the deal to be significantly accretive thereafter, excluding one-time charges and integration costs. More specifically, Pacira noted that it only needs to capture ~30% of the operational synergies of the FLXN transaction to make this deal accretive in 2022. FLXN expects 3Q21 Zilretta net sales to be in the range of $21m-$23m for the quarter, which is well below consensus estimates of ~$33m and withdrew its full-year guidance for sales of Zelretta for FY 2021 of $120-$130m. Management noted that Q3 sales results, particularly in the second half of the quarter, were negatively impacted by: (i) temporary disruptions from rebate program modifications, (ii) covid-related challenges, and (iii) unforeseen manufacturing batch failures that resulted in short-dated Zilretta inventory, causing smaller order sizes by physicians and product returns from specialty distributors. Presumably, Pacira was aware of these issues and may have used them to its advantage in pushing for the large contingent value portion of the deal consideration. Sales of Zilretta had improved 80% YoY in Q2 and 15% in Q1 for a first 6 months total of $52.8m. Based on management’s midpoint guidance of $22.5m for Q3, full 2021 year sales are likely to be in the $100-$110m range.
From Flexion’s perspective, the willingness to sell at levels well below historical trading prices for the stock was likely driven by a levered balance sheet and ongoing operating losses. As with small many biopharma companies, Flexion had one drug, Zilretta, on the market that was in its early stages, as well as two in development. As a result, the company has been incurring substantial cash operating losses over the last 5 years of ~$600m. However, with the growth of Zilretta, the company had narrowed those losses from -$160m in 2018 to -$60m LTM. With FLXN also carrying $220m of debt on its balance sheet and cash and short-term investments having fallen from $392m in 2017 to $130m currently, there were certainly concerns about the company’s standalone ability to maximize the commercial value of Zilretta along with its two drugs in clinical trials. Marketing new drugs require significant investments in advertising, sales force, and rebates to gain market share. The high debt load for a small biopharma company, along with the cash burn likely prompted FLXN’s management and board to be receptive to an acquisition. The company has been public since 2014 and its stock price peaked in 2018 at ~$27 and had fallen to an all-time low of $4.76 in August of 2021, two months prior to the deal’s announcement.
Flexion’s Drug Portfolio
Zilretta (triamcinolone acetonide extended-release injectable suspension) is the first and only FDA-approved non-opioid extended-release therapy for osteoarthritis knee pain. Zilretta is administered by a physician and employs proprietary microsphere technology combining triamcinolone acetonide — a commonly administered, immediate-release corticosteroid — with a poly lactic-co-glycolic acid (PLGA) matrix to provide extended pain relief. The drug is an alternative to the standard cortisone injections, and Zilretta's extended-release formula ensures substantially lower doses are received and the company’s phase three trials showed that relief lasted a period of approximately 12 weeks and up to 16 weeks in some patients. This is a substantial improvement over cortisone steroid injections where relief typically lasts 6-8 weeks. Moreover, because of the side effects, cortisone injections can only be given to a patient a few times a year, leaving them with long periods of discomfort in between. According to the company’s clinical data, patients receive a significant improvement in pain, stiffness, and function compared to standard cortisone as measured by the WOMAC scale and without the side effects that a cortisone shot has.
As a result of the extended-release technology, Zilretta plasma levels are 10 times lower than what a standard cortisone shot generates, so patients do not experience the sudden spike in blood glucose levels that occur with cortisone. The company estimates that ~20% of those suffering from OA of the knee are diabetic as well. Given the substantially lower impact of Zilretta on glucose levels, it is much safer to use on patients who also suffer from diabetes. Additional known side effects of immediate-release cortisone shots include the acceleration of cartilage degeneration in the knee as well as joint damage. The company believes that those suffering from a chronic condition such as osteoarthritis will have significantly reduced complications than the side effects associated with high-dose cortisone shots given the extended-release nature of Zilretta. In addition, there should be less damage to cartilage and joints over time than with cortisone shots, which is a serious concern given OA is a chronic condition with no cure.
Initially, Zilretta was only approved for single use and the label carried the language “not intended for repeat administration”. However, in 2019 the company successfully lobbied the FDA to change the label which now states, "the efficacy and safety of repeat administration" of the drug "have not been demonstrated."
Other label revisions announced by the company in a December 26, 2019 press release, included:
- Inclusion of a study description and safety data from a single-arm, open-label Phase 3 repeat administration trial;
- Removal of a "misleading" statement describing a single secondary exploratory endpoint in the original Phase 3 pivotal trial which compared Zilretta to immediate-release triamcinolone acetonide crystalline suspension;
- Inclusion of nonclinical toxicology data from previously submitted single and repeat administration studies in non-diseased animals.
Flexion recently presented new data on FX201, the company’s intra-articular gene therapy for OA knee pain. The Phase I study revealed that two patients in the low-dose cohort displayed robust improvements in pain levels at one-year post-treatment. FX201 was largely well-tolerated, however, two patients had “Grade 2 index-knee adverse events of pain, swelling, and effusion.” These events were perhaps connected to the treatment but were managed. It is important to note, that all five patients remained in this study up to 56 weeks post-treatment, which indicates that they did not seek an alternative treatment. Flexion is resuming their enrollment and expects data in the second half of this year, which should include data from synovial fluid to assess the biological activity of FX201. Flexion continues to enroll patients in the company’s Phase Ib trial for FX301 for postoperative pain and remains on track to share preliminary efficacy data later this year.
Potential Sales and Market Opportunity for Zilretta
Osteoarthritis, the most common joint disorder in the United States, affects the knee joints of 10 percent of all men, and 13 percent of all women over the age of 60. According to IQVIA claims data, in 2018 15.2m patients were treated for OA of the knee. However, Zilretta has been slow to gain market share, which is likely due to its initial label classifying it as being approved for a single-use only. The label change was approved at the end of 2019 just as the pandemic was beginning, and since Zilretta is administered by a physician, the pandemic certainly played a role its slower than anticipated market penetration, particularly since the elderly who are most affected by OA, were also the most vulnerable to Covid and likely more concerned about contracting it, than treating their OA.
Nevertheless, Zilretta currently has captured <1% of the market for patients being treated with injections for osteoarthritis knee pain, which the company estimated to be ~7.9m injections annually between steroids and hyaluronic acid (HA). One factor may be the cost of Zilretta, which is substantially higher than cortisone steroid injections. Zilretta is priced at ~$600 retail, and while it does have reimbursement from commercial insurers and Medicare/Medicaid (received its J code non-orally administered drug reimbursement code ~3 years ago), physicians have been slow to adopt it, perhaps due to its substantially higher cost versus cortisone steroids. A typical 20% copay would mean that the out-of-pocket is likely around $100-$120 versus $10-$20 copay on CS. With the proper training of the sales force and education of doctors and consumers, this should not be a high barrier to expanding the use of Zilretta, and if fact one of the rationales of the merger is the ability of Pacira to leverage its network and expertise with both doctors and insurers to drive sales and reimbursement rates.
Diabetics with OA of the knee represent a significant market opportunity for Zilretta given its low impact on glucose levels vs steroids. The CDC estimates that 17 percent of Americans between 45 and 64 years of age, and 25 percent of Americans 65 years and older have diabetes. FLXN's CEO stated on a Raymond James investor call that about 20% of OA knee patients are diabetics, which that market alone could represent up to 1.6m injections annually.
If Pacira invests the resources in educating doctors and patients regarding the benefits of Zilretta, particularly for those suffering from diabetes, then capturing just the 20% market share that suffers from diabetes over the 9-year life of the CVR would be 1.2m-1.58m (1.4m midpoint) injections annually using a range of 6m (25% haircut to IQVIA claims data) to 7.9m injections per year.
Assuming Zilretta’s wholesale cost is about 50% of its ~$600 retail cost per injection, implies sales of $300 per injection, or $360m annually, which covers the $275m Sales $1 milestone at the low end and the $375m Sales $2 milestone at the midpoint with $417m in sales, so $3 in Sales Milestone payments appears reasonably achievable.
Furthermore, it is reasonable to believe that if the appropriate efforts are made by Pacira to commercialize the drug, that doctors and patients would prefer the longer relief and reduced side effects provided by Zilretta’s extended relief formulation. Assuming that results in a pickup of an additional 5-10% of the market, that is another 300-600k annual injections and an additional $90-$180m of annual sales, for total of $450-$540m of annual sales using the low end 6m annual injections and midpoint of 7.5% market share results in $495m of sales, $5m shy of the $500m Sales $3 milestone payment. Using the midpoint of 6.95m annual injections and an additional 7.5% additional market share results in 521.5k annual injections and $156m of incremental annual sales, for a total of $516m in annual sales covering the 3rd Sales Milestone of $500m in annual sales resulting in the $3 milestone payment being made.
Zilretta is in Phase 3 trials use in treating shoulder OA and adhesive capsulitis (frozen shoulder). The company estimates that this could be a one-million injection per year market for Zilretta, in addition to OA of the knee. Zilretta’s lower impact on glucose levels makes it ideal for patients with diabetes, and management noted on the Q3 2020 earnings call that the prevalence of diabetic patients with adhesive capsulitis is almost 40%, double those with OA of the knee.
OA of all types, also known as degenerative joint disease, affects more than 30 million Americans and accounts for more than $185 billion in annual expenditures. The prevalence of OA is expected to continue to increase as a result of aging, obesity, and sports injuries. Non-opioid treatments for these conditions, which are chronic and do not have a cure, are a substantial, growing market opportunity as the average of the American population continues to grow. Moreover, OA symptoms are now manifesting in adults at much younger ages (see below), further expanding the potential market for pain management treatments.
Note: Q2 2021 Sales of Zilretta were $28.2m for a YTD total of $52.8m. The company guided to $22m in Q3 2021 and withdrew its $120-$130m guidance. We assume 2021 sales are between $100-$100m.
Note: There are 32 units in 1 injection of Zilretta and sales increased by 56,798 units in Q2 2021.
Alternative Treatments for OA of the Knee
Both Platelet Rich Plasma Therapy (“PRP”) injections and Hyaluronic Acid injections (“HA”) are alternative treatments for OA of the knee, however, they represent a small portion of the overall market for injections. PRP injections are not covered by commercial insurers or Medicare/Medicaid. While Medicare Part B covers HA, the efficacy of Hyaluronic Acid to treat OA of the knee is being called into question, and providers and insurers are starting to reduce or remove coverage for the treatment. AMP Biotech Research in its analysis of Zilretta cited, a recent review article (Bisicchia and Tudisco, Clin Cases Miner Bone Metab. 2017 May-Aug; 14(2): 182-185) which stated:
that analyzed prior primary and meta-analysis of a number of hyaluronic acid (HA) trials, concluded as follows: "Conflicting results have been reported in clinical studies and meta-analysis on the efficacy and safety of HA. Guidelines are controversial and "uncertain" recommendations are provided in most of the cases due to inconclusive evidence in literature.
PRP has shown effectiveness in some studies and has been used by famous athletes such as Kobe Bryant, it is not covered by insurance and costs $600-$800 per injection, which is $1,200-$1,600 annually assuming an injection every 6 months. As a result, it does not present significant competition to CS or Zilretta. AMP Biotech Research cites: "Your Guide to Injections for Knee Osteoarthritis" on everydayhealth.com and concluded there is not enough evidence to show a benefit of PRP over HA. However, AMP also cited peer-reviewed publications such as Guvendi et al (2018), which concluded that there is a long-term benefit of PRP over CSs, although there are limitations to this study, (e.g. it was not a blinded study). Kavadar et al. published another study that showed long-term benefit of PRP, although the benefit appeared better with multiple injections, but there was no placebo control group in this study (Kavadar et al. 2015).