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Minimizing Mistakes in a Volatile Biotech Market: H.C. Wainwright's Ed Arce RLYP, AKBA, CBAY, ACRX, SCMP, CNAT
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Ed Arce Continuing stock market volatility is causing some investors to rethink their biotech investments. For generalists, in particular, choosing a winning company is almost a roll of the dice. In this interview with The Life Sciences Report, Ed Arce, a managing director with H.C. Wainwright & Co., shares insights investors can use to avoid mistakes when evaluating up-and-coming companies, and identifies some likely winners for 2016.

The Life Sciences Report: Picking companies that will be winners is difficult for seasoned biotech investors. For generalists, it's even more difficult. What do generalists, in particular, need to know about the biotech market, especially in light of the recent market downturn?

Ed Arce: The biotech industry is one of the most volatile in the stock market, so investors need to be prepared for that. If investors aren't prepared, they should consider investing in funds—either a biotech index fund or exchange-traded fund (ETF)—or select an experienced investment manager with a good track record in the space.

Biotech stocks may be affected by broad movements within the sector, but otherwise largely trade independently of other sectors and of the market in general. But biotech is sensitive to global risk factors. When investors move broadly to safe havens, including more stable industries, biotech is one of the first sectors affected, and the trades are more pronounced than those for most other industries. China's issues with its stock market, for example, have definitely impacted the global markets broadly, and biotech has felt this strongly.

TLSR: What makes biotech so different from other sectors in this regard?

EA: Fundamentally, each biotech company has very specific risks. Many have to do with particular milestones around particular clinical development programs. Earnings are another example. They are a staple of larger companies, but in the small-cap biotech space, earnings are really not much of an issue. These companies generally don't have a drug approved yet, much less earnings or profitability.

TLSR: How do you recommend investors look at these companies and make informed decisions?

EA: In the biotech space, investors choosing individual stocks must look at the individual risk components for that particular company. Other industries typically have a few companies investors can use as comparisons, but in biotech there are few such companies. Often the programs in development are one-of-a-kind for a particular indication, so it behooves the investor to look closely at the particular market for that drug, and the patients that it will serve.

TLSR: Biotech is still outperforming the Standard & Poor's 500 Index, and the fundamentals are strong, but analysts are beginning to advise companies and investors to prepare for a possible downturn. Is this good advice? How should investors react to this?

EA: The capital markets for biotech have been quite strong for the past few years and have been very accommodating to companies with novel, differentiated drugs. This is especially true for those with near-term meaningful value inflection points, both for initial public offerings (IPOs) and for follow-on financings. But more recently, in the past four or five months, there has been a noticeable decrease in willingness to fund various types of companies. There has been more emphasis on near-term value and the science behind it.

"When investors move broadly to safe havens, including more stable industries, biotech is one of the first sectors affected."

That change was triggered by the broad market downturn caused by macro events, like the aforementioned stock market issues in China and the 2016 U.S. presidential election gearing up. Historically, there's always a bit more volatility during election years because the executive branch can, and often does, change the status quo. That uncertainty is always a key concern for investors.

TLSR: Given this environment, how should investors proceed?

EA: Despite the capital markets tightening, investors—particularly longer-term fundamental investors—should continue to focus on choosing those companies with solid scientific backgrounds, strong management teams and the ability to create value inflection points that will allow for continued funding.

TLSR: A few years ago, biotech investors were mainly biotech specialists. Now generalists also are investing. How should a generalist approach assessing specific companies?

EA: First, try your best to understand the underlying science. If the product is novel, do your own due diligence to see what can be learned about that particular pathway, or what is understood molecularly about the science. At the end of the day, if the science is weak, there's really nothing that can correct for that. That particular point is hard for generalist investors to ascertain. It will always be a point of weakness from their perspective.

Aside from that, even companies with solid products based on good science often have problems that have nothing to do with the science itself. The issue may have to do with the way the development program is being undertaken. Often, a company's scientific founders develop novel, exciting science, but face a disconnect between developing that product and interpreting the science to non-scientists, and between developing the concept and taking it through the regulatory process to commercialization. Frequently, there's a change of management from scientific founders to professional managers as drugs approach Phase 3 clinical trials. That change enables the team to focus more on commercial aspects.

TLSR: What challenges do truly novel products face?

EA: When a company pioneers a new area, it may undertake several exploratory trials in different, but related, indications. Although these trials may produce positive results, the registration pathway often is unclear. Positive results, then, set up poor expectations for investors who don't really understand how that data will help the company get closer to market.

"Consolidation among healthcare insurers and providers has created a structural shift, in which payers have more power to negotiate pricing."

There's often some degree of impatience, especially among investors who are more concerned about achieving a near-term catalyst than about developing a drug for an indication in which it is supremely suited.

TLSR: Venture capital investors often say that companies need to have sufficient cash to reach the next inflection point, and how a company is structured helps determine that. What does that means for investors analyzing a company?

EA: Sometimes, unfortunately, plans don't work out the way the management teams would like, and they're left with a wider gap between meaningful data milestones. If investors are leery of adding money in these long periods, these sorts of stocks will suffer until they find a way to get some sort of bridge financing.

TLSR: Should the exit strategy matter to investors?

EA: Smaller biotech companies rarely have a commercial infrastructure in place. There's really no need for it. As they get closer to Phase 3 data and new drug application (NDA) filing, they typically begin to put in place a chief commercial officer and parts of the core commercial organization. The importance of this for investors depends on whether they believe the company can maximize the potential value of that particular drug itself, or whether the company needs the marketing muscle of big pharma or big biotech.

For example, if the drug is for an ultra-orphan indication, the company may need no more than a hundred or so sales reps. That can be managed easily by a smaller biotech, with some funding of course, before commercialization. In those cases many investors will view that as comparable to having out-licensed a product. But when a company's products are focused on much larger indications and need a larger marketing infrastructure, the company requires an external partnership. In those cases, to the extent that the drug is viewed positively, I think the merger-and-acquisition (M&A) question becomes part of the dialogue.

TLSR: Moving on to some of the companies you cover, which stand out as solid investments for 2016?

EA: Because of the volatility with biotech, a lot of investors do focus on the shortterm. Of the companies I cover that will have meaningful catalysts in 2016, I would highlight Relypsa Inc. (RLYP:NASDAQ) and Akebia Therapeutics Inc. (AKBA:NASDAQ). They both have important potential inflection points, but for different reasons.

Relypsa's main drug, Veltassa (patiromer) was approved recently and launched last month. Veltassa is a potassium binder that's used in patients with either chronic kidney disease or heart failure. Another drug available today is a drug called Kayexalate (sodium polystyrene sulfonate; SPS). Kayexalate was approved by the FDA well before formal efficacy trials were required for drug approval. Therefore, sodium polystyrene sulfonate hasn't really undergone a formal efficacy trial. Additionally, the side effect profile of SPS is so pronounced that most patients can't tolerate it for more than a few days.

Veltassa comes into this landscape with a generally safe profile and only mild gastrointestinal (GI) side effects. Importantly, as it binds to phosphate it exchanges it for calcium without increasing the calcium itself, which is different from a competitor that exchanges the phosphate for sodium, and potentially could increase the risk profile.

"Investors choosing individual stocks must look at the individual risk components for that particular company."

Veltassa was approved with a black box warning for drug-to-drug interactions, essentially warning physicians to administer it either six hours before or after administering other oral drugs. These chronic kidney disease or heart failure patients almost always have comorbidities, and so take several other drugs concomitantly. The question that came about upon approval was how much of an impact this black box warning would have on commercial uptake of Veltassa. What's important to remember here is that virtually all the drugs these patients take—for example, renin-angiotensin system (RAS) inhibitors—also have serious black box warnings, yet are used regularly as standard of care.

Relypsa recently released results from an in vivo drug-drug interaction study involving 12 drugs commonly taken by the Veltassa patient population. The results, in my view, were quite positive. They indicated a three-hour separation between drug administrations, as opposed to the six-hour separation on the label, is feasible. None of the 12 drugs were shown to have any meaningful interaction with the other drugs.

Based on those results, many—including myself—believe Relypsa will present data to the FDA in the coming months to reduce the separation requirement or to remove the black box warning altogether and keep the drug interaction data further down in the label.

TLSR: You also mentioned upcoming inflection points with Akebia Therapeutics.

EA: Akebia Therapeutics has a novel hypoxia-inducible factor (HIF) inhibitor. This is an oral drug for anemia in patients with advanced stages of chronic kidney disease. The standard of care for the past two decades has been a drug called erythropoietin (EPO), which has well-known side effects and efficacy issues. Physicians must monitor patients' hemoglobin levels constantly and adjust dosing accordingly. In contrast, in two Phase 2 studies Akebia's drug has been shown to have very smooth control of hemoglobin out to 20 weeks. Phase 3 testing is underway. At this point, stock is trading on its lead compound.

Akebia announced a commercialization partnership in December with the multinational corporation Mitsubishi Tanabe Pharma Corp. (4508:Tokyo) for the Asian region. That was a big milestone. The economics of that deal were quite positive, both in terms of upfront and milestone payments, as well as the royalties to be paid upon approval and commercialization. By early Q3/16, Akebia expects to announce another commercialization partnership for the European region. I would expect the economics of that deal to be substantially greater, given the larger size of the territory.

TLSR: Is there another company you'd like to talk about?

EA: Yes. AcelRx Pharmaceuticals Inc. (ACRX:NASDAQ) is a specialty pharmaceutical company focused on pain. One drug, sufentanil, is well known and well characterized, and used in niche applications because of a very short half-life. To resolve that issue, AcelRx has formulated a minitab to be administered under the tongue and absorbed sublingually. This produces a much longer effect and half-life, as well as an onset of action that is even quicker than intravenous (IV) morphine. Sufentanil nanotabs are being developed for multiple applications, including patient-controlled analgesia. These tabs are smaller than an aspirin and rarely, if ever, induce the natural gag reflex when the tablet is placed under the tongue.

For dispensing, AcelRx has developed Zalviso. This hand-held device is undergoing trials to evaluate the potential for device errors, to ensure that one, and only one, tablet drops when the patient presses the button on the device.

TLSR: Do you have other companies to bring to investors' attention?

EA: Sure. Historically, Sucampo Pharmaceuticals Inc. (SCMP:NASDAQ) has focused on its prostone technology. Since the arrival of the new CEO, Peter Greenleaf, about a year and a half ago, there's been much more willingness to acquire outside assets and expand development within the company's broad gastrointestinal focus.

"Historically, there's always a bit more volatility during election years."

The first step was acquiring R-Tech Ueno, its Amitiza (lubiprostone) supplier. When it announced that acquisition, the management team issued preliminary guidance around 2016, and described how the acquisition would be accretive to both revenues and earnings. When the deal was consummated, Sucampo issued follow-on guidance that included the amortization and debt costs associated with acquiring the company. I think there was a perception by some market participants that the company had actually lowered guidance, which really was not the case. It simply adjusted the guidance for a factor management had not been able to fully incorporate earlier.

Sucampo also has formed a commercialization partnership for another drug being developed outside the company. For at least the coming year or two, I think catalysts for Sucampo will continue to revolve around deal activity rather than its legacy drugs.

I am also watching Conatus Pharmaceuticals Inc. (CNAT:NASDAQ), which is focused on liver disease broadly. Its lead compound, emricasan, is an orally active caspase inhibitor that targets both inflammation and apoptosis (programmed cell death). In liver disease, both inflammation and apoptosis are fundamental to the progression of the disease, regardless of whether it comes from alcoholism, hepatitis, fatty liver disease or other sources. The program is focused on nonalcoholic steatohepatitis (NASH) patients with cirrhosis—a more advanced stage of liver disease.

That makes sense for a couple of reasons. One, among all the companies involved broadly in NASH treatments, Conatus stands apart in its focus on the later stage of cirrhosis. This is particularly important because its drug targets apoptosis, which becomes more pronounced in the later stages of the disease.

The company is funding two small trials itself. The Phase 2 ENCORE program encompasses five separate trials looking at emricasan as a treatment for NASH, cirrhosis and fibrosis, as well as assessing its value for long-term liver function. There is one longer-term study. Conatus expects readouts from these studies during the next two to three years, which will set the company up for discussions with agencies regarding multiple pivotal trials and indications within the broader liver disease space.

TLSR: Are there any other companies that you'd like to discuss?

EA: I'll briefly touch upon CymaBay Therapeutics Inc. (CBAY:NASDAQ). CymaBay has two drugs in development. Its lead compound is a Phase 3-ready asset for gout. The company is in discussions to partner the drug for Phase 3 development. We expect some news on that front in the coming months.

"At the end of the day if the science is weak, there's really nothing that can correct for that."

CymaBay's second compound, MBX-8025, is under the radar of most investors. Readouts are expected in Q1/16 on its Phase 2b trial for an ultra-orphan indication called homozygous familial hypercholesterolemia (HoFH). The company's market cap is around $26 million, so positive results from its proof-of-concept Phase 2 program, which would allow for a pivotal Phase 3 in an ultra-orphan indication, could be quite meaningful.

TLSR: This year opened with the global stock market fluctuation and ends with a new U.S. president. Given this environment, what advice would you have for biotech investors this year?

EA: Lots of broader themes are being discussed this year, including the ongoing issue of drug pricing. With the longer-term austerity we've seen globally, and the lackluster economy here in the U.S., novel pricing mechanisms—like performance-based pricing—are likely to become increasingly common.

Consolidation among healthcare insurers and providers has created a structural shift in which payers have more power to negotiate pricing. This means investors must take a close look at the pricing of drugs already in the market when considering investing in potential competitors. To compete, new drugs must be priced on par with existing drugs or show significant and meaningful benefit in terms of efficacy or safety to justify a higher price. While this pricing pressure applies across indications and types of therapies, drugs for orphan indications will continue to enjoy higher prices than those for broader markets.

TLSR: Thank you very much.

Ed Arce is a managing director in equity research and a senior analyst covering companies in the biopharmaceuticals and specialty pharmaceuticals sectors for H.C. Wainwright & Co. Previously, Arce was a senior research analyst with ROTH Capital Partners. Prior to ROTH, he covered biotechnology, biopharmaceutical, specialty pharmaceutical and select medical device companies as an analyst at MLV & Co. Prior to MLV, Arce covered the biotechnology sector at Wedbush Securities, and large-cap pharmaceuticals at UBS Securities. Arce started his equity research career in 2005 as a research associate at First Albany Capital, covering specialty and generic pharmaceutical companies. He holds a master of science degree in finance (MSF) from Boston College, as well as a master's degree in business administration and a bachelor's degree in civil engineering, both from Florida International University. Arce is a board-licensed professional engineer, and a Level III CFA candidate.

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DISCLOSURE:
1) Gail Dutton conducted this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report and The Life Sciences Report, and provides services to Streetwise Reports as an independent contractor. She owns, or her family owns, shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of Streetwise Reports: None. The companies mentioned in this interview were not involved in any aspect of the interview preparation or post-interview editing so the expert could speak independently about the sector. Streetwise Reports does not accept stock in exchange for its services.
3) Ed Arce: I own, or my family owns, shares of the following companies mentioned in this interview: None. I personally am, or my family is, paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: As of Jan. 31, 2016, neither the H.C. Wainwright & Co. LLC nor its affiliates beneficially own 1% or more of any class of common equity securities of AcelRx Pharmaceuticals Inc., Akebia Therapeutics Inc., Conatus Pharmaceuticals Inc., Relypsa Inc. and Sucampo Pharmaceuticals Inc. H.C. Wainwright & Co. LLC or its affiliates did not receive compensation from AcelRx Pharmaceuticals Inc., Akebia Therapeutics Inc., Conatus Pharmaceuticals Inc., Relypsa Inc. and Sucampo Pharmaceuticals Inc. for investment banking services within twelve months of today. H.C. Wainwright & Co. LLC or its affiliates does not make a market in AcelRx Pharmaceuticals Inc., Akebia Therapeutics Inc., Conatus Pharmaceuticals Inc., Relypsa Inc. and Sucampo Pharmaceuticals, Inc. as of the date of this report. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I determined and had final say over which companies would be included in the interview based on my research, understanding of the sector and interview theme. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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