Merus Labs International: A Pharma Stock With Growth Potential

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Mar 30, 2015
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Contributing editor Ryan Irvine is here this week with a new stock pick and updates on two previous recommendations. Ryan is the CEO of KeyStone Financial and one of the country’s top experts in small cap stocks. He lives in the Vancouver area. Here is his report.

Ryan Irvine writes:

It’s not easy to find quality stocks at decent prices in today’s market, but we have one for you this week. It’s Merus Labs International Inc. (TSX: MSL) (MSLI, Financial), a specialty pharmaceutical company focused on acquiring established products. The company leverages its expertise in European and North American markets to optimize the value of underdeveloped pharmaceutical assets. It currently has products in the area of urology/women’s health, anticoagulants, and anti-infectives.

Corporate Strategy. Merus acquires prescription medicines in the following categories:

  • On patent but at maturity stage of product life cycle.
  • Branded generics.
  • Under promoted products.
  • Niche market pharmaceuticals.
  • Products with annual sales below the critical threshold for large pharmaceutical companies.

Once a product is acquired, Merus implements a focused sales and marketing plan to promote it with the goal of increasing sales and market share.

Primary products. In July 2012, Merus acquired from Novartis the Canadian and European rights (excluding France, Spain, and Italy) to manufacture, market, and sell the branded prescription medicine product Emselex/Enablex (darifenacin) extended release tablets.

Darifenacin is a muscarinic antagonist used for the treatment of overactive bladder with symptoms of urinary incontinence, urgency, and frequency. The product’s specific mechanism of action is the blocking of the M3 muscarinic receptor, which is primarily responsible for bladder muscle contractions. As overactive bladder is a chronic condition, Emselex/Enablex is prescribed as a medication to be taken once daily and the extended release tablet format is produced in 7.5 mg and 15 mg dosage strengths.

Revenues attributable to Enablex for the year ended Sept. 30, 2014, were $20.7 million versus $22.2 million recorded partially on a net basis for the prior year.

In September 2014, the company acquired from Novartis the rights to manufacture, market, and sell the branded prescription medicine product Sintrom (acenocoumarol) in certain European countries. Sintrom is an anti-coagulant drug prescribed by physicians for the treatment and the prevention of clotting disorders like thromboembolism diseases, which obstruct the normal flow of blood and can create serious health problems in the process. Sintrom may also be referred to as a blood thinner. It does not have the capacity to dissolve clots that have already formed in the blood vessels but rather is used as a preventative treatment. It functions as a vitamin K antagonist and the active ingredient is acenocoumarol.

Sintrom was approved in Europe in the early 1950s and its patent expired in 1964. As a result, the product has not only been on the European market for over five decades but also faced generic competition over the same period. It is important to note that the product is not subject to intense competition from generics given its legacy nature (effective and well known), its low price, and strong market share. These key competitive features make Sintrom uneconomical for new generic entries. In calendar year 2013 the product had net sales of approximately US$28 million in the territories acquired.

Threat. During the last year, Merus was informed by the German Federal Joint Committee (G-BA), which is responsible for directives on drug reimbursement policy, that there is a plan to introduce a single reimbursement class for all anticholinergic-based OAB products in the German market. This new classification would effectively set a maximum reimbursable price for public payers. The Committee invited Merus to provide a rationale for Enablex being excluded from the class, which the company has done. The process of assessing arguments for exclusion, the determination of a reimbursement price for the class, and that price becoming effective could take up to a year or more.

We believe it is likely that Merus will receive news, either positive or negative, in this regard in mid-2015. Management has stated that the company has factored in a negative response to its 2015 EBITDA guidance of approximately $30 million. A positive response would likely provide upside on the EBITDA guidance for 2015. If darifenacin is not excluded from the class and is subject to a maximum reimbursement price, there may be a material adverse effect on sales.

Growth. Merus’s acquisition of Sintrom was made late in fiscal 2014 and contributed less than one month of revenue to 2014 results. As such, we expect the company, which had net sales of approximately US$28 million in the applicable European territories in 2014, to more than double its consolidated revenues and EBITDA. Sintrom will be sold predominantly through distributors with whom Merus already has established relationships to wholesalers and pharmacy networks.

Acquisitions. The new management team reported they were pleased with recent business development momentum. Over the last two months, the company has initiated active discussions on ten products with combined EBITDA of over $100 million per year, with five global pharmaceutical companies. Management reports that cash generation from existing products and access to future capital to finance new deals has never been better. The company believes it is well positioned to execute one or two small acquisitions with existing financing.

Management change. Another potential positive for Merus was the company’s late fall management change. In our opinion, a number of institutional investors were negative on the prior leadership and the company’s new CEO, Barry Fishman, is the former CEO of Teva Canada and previously of Taro Pharmaceuticals (Canada). He comes with a good track record and, at the very least, gives the company a fresh outlook. While with Taro, he grew Canadian revenue by three times in three years and as the CEO of Teva Canada by five times in 10 years. Perhaps more importantly from our perspective, he managed to consistently grow profit faster than revenue.

Conclusion. While the North American biotech and specialty pharma segment is relatively richly valued at present, our investment thesis on Merus is three pronged. First, there has been a positive management change; second, there is new accretive cash flow from recent acquisition (Sintrom); and third, we see attractive relative valuations. Merus trades at a discount relative to its Canadian peers and this held the largest weighting in our decision to buy the stock.

Management has stated that Merus’s baseline adjusted EBITDA generated from existing products, after factoring in a potential price reduction for Enablex in Germany in mid-2015, is expected to remain steady in the $30 million range over the next few years. Results could be materially higher if the company’s current Enablex price level is sustained. This does not factor in future acquisitions.

Based on the $30 million baseline adjusted EBITDA, Merus trades at 7.7 times enterprise value to EBITDA as compared to Cipher’s ratio of 18 and another Canadian specialty pharma peer, Biosyent Inc., at 25 times. From a balance sheet and execution perspective Cipher has been superior to Merus. However, year-to-date in 2015 Merus’s shares have gained 25% whereas Cipher is flat and Biosynt is down 12%.

If Merus investors view the new CEO and his vision for the company as a positive and the company hits EBITDA targets in 2015 and pushes into profitability, the stock could continue to be re-rated with a higher multiple. Given the higher leverage and uncertainty related to pricing of Enablex in Germany, we believe that Merus deserves to trade at a discount to the average specialty pharmaceutical company but the current discount is likely too large.

Our fair value estimate on the company is for an EV/EBITDA of 10.5 (still a significant discount to peers) with a price of $3.30. As such, we rate the company as a Buy.

Warning. Near-term caution is needed in the biotech sector. The Nasdaq Biotech Index has roared out of the gate for the second year in a row and with the index itself holding a p/e of over 50, the sector is broadly overvalued. Similar to 2014, the index is up more than 20% already in 2015. Adding fuel to the potentially overvalued flames, the index is up about 240% since the beginning of 2012. That dwarfs the 82% gain logged by the Nasdaq 100 tech index, which tracks the largest technology companies listed on the exchange. Mid last week, the sector dropped over 4% in one session. The concern for investors now is that the sector has gotten ahead of itself and is due for a correction. We believe this is necessary and healthy.

If we look back to 2014, from late February through mid April the Nasdaq Biotech Index gave up all of its gains from the first two months and was down on the year for a brief period, falling a total of 21%. That said, the index quickly recovered and finished the year well above its early year highs. We would not be surprised to see a similar correction in this volatile sector once again at some point in 2015. We would see this as a buying opportunity for Merus and potentially another Canadian specialty pharma company we follow closely.

Action now: With this in mind, our strategy at present would be to buy a half position in Merus with an eye to adding the rest when the biotech segment settles. The stock closed on Friday at C$2.72, US$2.13.