With the majority of statins now generic, pharmaceutical companies are on the hunt for the next blockbuster cardiovascular drug to replace what was once a $30B+ per year drug class. Enter darapladib, GlaxoSmithKline’s (GSK) Phase III Lp-PLA2 inhibitor that the company believes could reduce the chances of cardiovascular events such as heart attack or stroke in patients with cardiovascular disease. In 2008 and 2009, GSK initiated two immense trials, the STABILITY and SOLID-TIMI 52 studies, enrolling more than 15,000 and 13,000 patients respectively, to evaluate the drug’s clinical benefit on this patient population. You might expect impressive efficacy in earlier studies considering GSK’s conviction to run such large and expensive trials — that’s where darapladib’s story veers from the commonplace. Darapladib actually failed two mid-stage proof-of-concept studies in 2008.
But investigators nevertheless pointed to evidence that the drug was producing a beneficial effect on the stability of detrimental plaque buildups in arteries — atherosclerosis — and GSK pushed forward with the current Phase III program to the surprise of many in the industry. Thus far, available clinical data for darapladib and the Lp-PLA2 enzyme have been relatively inconclusive, but GSK’s willingness to shell out beaucoup bucks for continued development suggests some level of confidence in the target. And it could pay off. If the drug works, darapladib sales should contest those of the top statins in their hey-day — $5-10 billion annually.
But given GSK’s $122B valuation, darapladib, if it works, won’t move the needle for GSK in a significant way. We believe there’s another opportunity for speculative investors to be involved with limited downside risk and impressive upside potential through a little-known nano-cap vehicle — diaDexus Inc. (DDXS).
DiaDexus develops and markets the PLAC Test—the only FDA-approved diagnostic for measuring Lp-PLA2–and has an exclusive license with GSK to provide a companion diagnostic for darapladib if the product makes it to market. More importantly, diaDexus has already built a sustainable, revenue-generating business around its approved diagnostic, and we believe that darapladib is only partially factored into the company’s unassuming nano-cap valuation. Investors have overlooked this name due to its listing on the OTC Markets and a lack of biotech-esque catalyzing events, but diaDexus’ relatively new management team has turned the PLAC Test into a strong growth-driver. Meanwhile, the market has yet to take notice of this fundamentally sound diagnostic company.
Understanding that the core business alone offers a strong backdrop, we believe that DDXS carries an asymmetric and positive risk/reward given the tremendous upside if darapladib succeeds in its late-stage studies, turning the PLAC Test into the go-to Lp-PLA2 test. To be specific, we believe that DDXS is arguably undervalued now considering growth of the diagnostic, and darapladib is a cheap call option on the stock that could make DDXS worth 10x where it trades today.
Investor interest in DDXS will increase as the darapladib story resurfaces in the back half of this year and as the first critical darapladib read-out approaches. In our view, if darapladib reduces CV risk in coronary heart disease, DDXS could be worth north of $400 million — almost $8.00 per share — a 1000% return from today’s $0.77 share price.
History of darapladib and Lp-PLA2
The underlying process in most heart attacks and strokes is atherosclerosis, an inflammatory disease characterized by the build-up of plaque in the walls of arteries. The rupture of unstable atherosclerotic plaque causes most heart attacks and strokes, as the ruptured plaque creates a blockage in the artery at the site or further downstream. Lp-PLA2, or lipoprotein-associated phospholipase A2, is an enzyme found in blood and in these atherosclerotic plaques, and increased presence of Lp-PLA2 activity has been implicated in the genesis and progression of atherosclerosis. The enzyme is secreted by macrophages and able to hydrolyze oxidized fatty acids from oxidized phospholipids in LDL, releasing pro-atherogenic fatty acids. Researchers have proposed that inhibition of this enzyme activity may then be anti-atherogenic, and the hypothesis has been confirmed in vitro and in animal studies. A meta-analysis of 79,036 participants in 32 prospective studies funded in-part by GSK demonstrated that Lp-PLA2 activity and mass were associated with risk of coronary heart disease and vascular death. Nevertheless, inhibition of the enzyme has yet to prove a clinical benefit in humans, and some questions remain about the enzyme’s predictive qualities in terms of cardiovascular risk assessment. Caslake and Packard argue that the association between Lp-PLA2 and atherosclerosis is ambiguous, while Gorelick and Elkind et al both suggest that Lp-PLA2 levels do show an association with risk.
Following early and suggestive preclinical work, darapladib was evaluated in a Phase II trial of 959 patients with coronary heart disease. The trial compared several darapladib doses (40, 80 and 160mg) to placebo for reduction of Lp-PLA2 activity alongside Pfizer’s (PFE) LDLc-lowering drug Lipitor (atorvastatin). Plasma Lp-PLA2 activity was unchanged in the placebo group but decreased in a dose-dependent manner in the darapladib arm by 43%, 55% and 66% at 12 weeks (p<0.001). While cholesterol and triglyceride levels declined in both arms of the trial, there was no difference between placebo- and darapladib-treated patients, suggesting that changes were actually due to continued treatment with atorvastatin. However, investigators observed a 20% reduction in high-sensitivity C-Reactive Protein in the group that received 160 mg of darapladib (p=0.003) versus baseline, a nonsignificant 13% decrease when compared to placebo. Interleukin-6 was also reduced in the group receiving 160 mg darapladib, 22% compared with baseline (p<0.001), 12% compared with placebo (p=0.028). The trial was completed in 2008.
Another Phase II trial, the Integrated Biomarker and Imaging Study-2 (IBIS-2), utilized surrogate endpoints for outcome benefits in patients with coronary heart disease on standard-of-care treatment. After baseline angiography; assessment of plaque composition using a modification of the intravascular ultrasound (IVUS-palpography); and assay of Lp-PLA2 and other inflammatory biomarkers, 330 subjects were randomized to darapladib at 160mg or placebo for one year. Again, darapladib treatment produced a sustained reduction in plasma Lp-PLA2 activity, a 59% reduction at one year compared to placebo (p<0.001). But most importantly, neither of the co-primary endpoints for the trial — a reduction in plaque deformability by IVUS-palpography, nor reduction in hsCRP — was achieved. The trial was also finished in 2008.
Yet GSK noticed one outcome that proved favorable. After assessing vessel wall changes in the 330-patient trial, investigators found evidence that the necrotic core volume in the placebo group had increased significantly (+4.5mm3 from baseline, p=0.009) but was halted in darapladib-treated subjects (−0.5mm3 from baseline, p=0.71). Essentially, researchers theorize that darapladib stabilizes plaques and may reduce ruptures. Darapladib has been well tolerated throughout clinical trials, the only unpleasant side effect being an unpleasant odor in some patients.
With evidence in hand that darapladib had an effect on the necrotic core, GSK moved forward with the first of its two large trials evaluating darapladib for a clinical benefit in coronary heart disease. The STABILITY Trial (NCT00799903, n=15,828), initiated late in 2008, evaluates darapladib at 160mg once daily + standard of care versus placebo + standard of care in subjects with chronic stable CHD for a reduction in Major Adverse Cardiovascular Events (MACE). Meanwhile, the SOLID-TIMI 52 trial (NCT01000727, n=13,000), initiated late in 2009, tests whether daily administration of darapladib at 160mg + SoC within 30 days of an acute coronary syndrome reduces the incidence of MACE versus placebo + SoC. The STABILITY trial, says GSK, although event-driven, should read out by the end of 2013, while the SOLID-TIMI 52 trial will be complete in 2014.
Considering the size of the Phase III program, we estimate the cost to run these trials at over $1.5B. That’s not considering the cost to acquire the product — GSK paid $3B to pick up Human Genome Sciences in 2012 — thus GSK is out on a limb for a few billion with a questionably efficacious product. There’s a strong case to be made that Glaxo is chasing a pipe dream given the mid-stage findings, however- if darapladib succeeds in the Phase III program by demonstrating a meaningful benefit in patients with CHD, it could usher in the next major cardiovascular drug class. Before losing exclusivity, Lipitor achieved peak sales of $13B in a single year; AstraZeneca’s (AZN) Crestor did $5.4B in 2009; while Merck’s (MRK) Zocor did $5B in 2004, just two years before it lost exclusivity. Statins were, in their hey-day, cash cows for large pharma, and a follow-on/adjunct product that further limits CV risk could rival branded statin sales. If darapladib works, GSK could have the first-in-class and sole commercialized Lp-PLA2 inhibitor on the market.
While we do consider darapladib a Hail Mary, we’re interested in being involved in an opportunity at outsized gains. DiaDexus, as a derivative trade on darapladib, offers the ideal vehicle for just that, with mitigated downside risk given the company’s stable and growing business.
Limited Downside for diaDexus: A Growing Business
DiaDexus and its Lp-PLA2 diagnostic are actually a GSK brainchild. DiaDexus is the successor to a company initially formed as a joint venture between SmithKlineBeecham Corporation (now GlaxoSmithKline) and Incyte Pharmaceuticals (INCY). SmithKlineBeecham granted the company an exclusive license to certain diagnostic intellectual property, including exclusive rights to develop diagnostic assays for Lp-PLA2. In July 2010 through a reverse acquisition of then-defunct biopharma manufacturer Vaxgen, diaDexus went public. A year later, late in 2011 through mid-2012, diaDexus’ board almost entirely replaced diaDexus’ acting/interim management team, and since then, diaDexus has generated consistent top-line expansion through sales of its Lp-PLA2 diagnostic. DiaDexus markets the PLAC Test ELISA Kit, which measures Lp-PLA2 levels, in the U.S. and Europe to aid in assessing risk for both coronary heart disease and ischemic stroke associated with atherosclerosis. In addition, the PLAC Test for Lp-PLA2 Activity, which is easier for most institutions to use given that the test can be analyzed with an automated clinical chemistry analyzer (does not require a CLIA lab), has been granted a CE-Mark in Europe. DiaDexus plans to pursue a 510(k) filing for approval of the Activity Test in the U.S., and while the company withdrew its marketing application in 2011 after discussion with the FDA, diaDexus is again talking with the FDA regarding how best to proceed with the approval process. DDXS is in the process of identifying clinical trials acceptable to the FDA from which blood samples of patient cohorts may be obtained and then tested to demonstrate the effectiveness of the PLAC Activity Test. If darapladib proves a success, it will most likely be the Activity Test or a variation that becomes GSK’s companion diagnostic and the Lp-PLA2 testing go-to.
We believe that investors can own DDXS as a stable emerging-growth diagnostic company with immense upside potential in the event that darapladib succeeds in its Phase III trials and hits the market as a new FDA-approved drug for the treatment of cardiovascular disease. GSK has granted diaDexus an exclusive license to the companion diagnostic for darapladib, meaning that if darapladib and the inhibition of Lp-PLA2 prove to have a beneficial effect on CV outcomes in patients at risk for cardiovascular disease, the Lp-PLA2 diagnostic could become a standard part of every lipid profiling.
DiaDexus carries a market capitalization of just $42.3M and its enterprise value of $33M reflects minimal debt and the company’s $13M in cash & equivalents at the end of the first quarter. But what’s impressive and has gone largely overlooked by the markets is that diaDexus reported 2012 net revenues of $20.8M including royalty and license revenue (product sales of $18.1M during 2012). The company reported a net loss in 2012 of $2.78M, or $0.05 per share. Discounting R&D expenses for the year, however, which management has made a key focus in order to expand its product offering in the near-term, DDXS would actually have generated a net income of $1.41M in 2012 — EPS of $0.03.
DiaDexus is guiding for between $24 and $25 million in revenue in 2013, and royalty revenues have slowed to a trickle over the last year; thus, we expect that guidance is based entirely on product sales in 2013. Discounting royalty and license revenues, over the last three years, product sales at diaDexus — sales of the PLAC Tests — grew by 65% and 55% in the years 2012 and 2011, respectively, and if our assumptions regarding royalty revenues are correct, will grow by another 33% through the end of 2013. Our model suggests that diaDexus, at consistent growth, similar gross margins, and no major additional R&D expenses into 2014, is on track to generate a net income next year on the order of $0.03-$0.05 per share.
On average, profit-generating diagnostic companies trade at a P/E of just over 36, a forward P/E of 30. For a better small-cap comparison, we consider ChemBio (CEMI) to be a similar emerging-growth diagnostic story. A look at valuation metrics suggests that diaDexus, as it transforms into an income-generating business in the next two years, will be due for a significant up-tick in share price as the market accounts for EPS generation. The $45M NYSEAMEX-listed ChemBio markets a number of point-of-care tests for diseases like HIV and Syphilis and has been generating a net income annually since 2010. Analysts now expect EPS of $0.13 in 2013, and at $5.02 per share, the market is attributing a forward P/E of 38 to the small company.
Applying a similar forward P/E of 38 to the low end of our 2014 EPS range for diaDexus suggests fair value at $1.14, a 48% gain from current prices that may emerge as revenues and 2014 guidance materialize towards the end of 2013 or early next year.
Based on the strength of the core business alone we’re willing to take a bet on DDXS, and darapladib offers a compelling catalyst-driven reason to own the stock towards the end of this year with a highly asymmetric ratio between risk and reward.
Darapladib and the Upside Scenario
Our interest in diaDexus derives primarily from the opportunity if darapladib and the lowering of Lp-PLA2 prove to be a safe and efficacious treatment for atherosclerosis, validating both Lp-PLA2’s effect on the body and the utilization of the enzyme as a risk assessment tool. As the sole Lp-PLA2 diagnostic and the exclusive companion diagnostic for use alongside darapladib, diaDexus would be tapping into a substantial market if lowering Lp-PLA2 levels demonstrates a clinical benefit.
Essentially, the diagnostic would likely be added to the standard battery of tests suggested for patients at risk for cardiovascular disease. The National Cholesterol Education Program’s (NCEP) guidelines for detection of high cholesterol (endorsed by the American Heart Association) indicates that all adults age 20 or older should have a fasting lipoprotein profile once every five years. According to the 2012 U.S. consensus, that’s more than 240 million Americans. Of course, approximately 50% of patients are non-compliant when visiting their primary care physician, thus we estimate the number of Americans on an annual basis receiving a standard lipid profile at approximately 24 million (240,000,000/5 years*0.5). Assuming, then, a correlation between darapladib’s inhibition of Lp-PLA2 and a clinical benefit in CV events, this is the same number of Americans most likely to receive the LP-PLA2 test on an annual basis.
In the last year that diaDexus discussed test volumes — 2011 — the company was doing ~1 million tests annually. That year, diaDexus reported product sales of $12.2M, thus we extrapolate that the company books ~$12 per PLAC Test.
For conservatism’s sake, we’ll assume that just 50% of the 24 million Americans that we estimate undergo standard lipid profiling on a yearly basis will actually receive the PLAC Test. This assumption means that diaDexus could see peak product sales upwards of $140M (12M*$12).
With the success of darapladib, the markets will undoubtedly take a more liberal approach to valuing what will then be considered a development-stage story. We apply a 3x revenue multiple (back-of-the-envelope industry standard) to our peak revenue estimate to derive a $420M fair value for diaDexus if darapladib proves efficacious. For DDXS shareholders, that’s a 10x return from diaDexus’ $42M valuation today.
It then becomes clear why we’re interested in diaDexus, despite what many consider darapladib’s low probability for success. At $42M, we believe DDXS is currently undervalued as it moves into a period of continued growth and closes in on profitability, while the shot at a $140M+ product suggests immense upside and a cheap call option on the stock.
Conclusion
We’ve been made aware of a number of generalist funds involved in DDXS exclusively for the underlying business, but we’ve also been in contact with some large players who only recently got involved due to the very reasons listed above – an outsized reward/risk based on darapladib. Regardless of our assertion that diaDexus is ultimately undervalued based on revenue growth and forward-looking EPS estimates, we do expect some immediate downside in the case that darapladib fails its late-stage trials; some investors will undoubtedly exit the stock if darapladib comes off the table.
A look at DDXS’ 1-year chart demonstrates that there’s been considerable buying interest in the name over the last five months — darapladib is up 100% since February when GSK gave clear guidance that one of the darapladib trials would read out this year. While we attribute some of this buying to explicit interest in the upcoming darapladib read-out, this is the same time-frame in which DDXS released compelling 2013 revenue guidance (March 7). If darapladib fails the first of its two late-stage trials at the end of this year, we expect downside of ~25% to the $0.60 range as the shareholder base rolls over from those involved explicitly for the darapladib trial to those existing shareholders interested in the fundamental business.
Transversely, if darapladib works and receives approval, we see long-term fair value for DDXS at ~$7.75 ($420M market cap/54,206,637 shares outstanding). To be clear, we’ll likely be adding to our position under either scenario, as a 25%+ sell-off will undervalue the company significantly, and we don’t expect the markets to immediately pick up on the tremendous upside if darapladib is a success, as DDXS remains a little-known name.
We’ve spoken with a number of cardiologists regarding darapladib, and while the cardio community’s take on Lp-PLA2 inhibition is varied, consensus seems to be that darapladib has a ~15-20% chance of success (note that Wall Street analysts covering GSK attribute zero value to the pharmaceutical company for darapladib). Thus, with a 15% chance at $7.75 and an 85% chance at $0.60, we calculate a probability weighted fair value ahead of the darapladib read-out at $1.67. In our view, an ~$0.80 entrance point is justifiable.
As we conclude our opinion on this opportunity, consider the following: diaDexus teeters at the edge of profitability, has generated consistent growth on the top-line, and overall presents a stable business built around its PLAC Test. These factors alone should more than justify its current valuation, but factoring in the tremendous upside potential if GSK’s darapladib succeeds in the ongoing Phase III program, DDXS is a steal at these prices. In our opinion, the risk/reward of DDXS over the next six months is highly advantageous for small-cap healthcare investors.
In connection with DDXS, PropThink has taken a long position.
