A de-risked biotech with 4x upside

Karst Peak Capital is a Hong Kong and Sydney-based investment manager that focuses on listed companies in the consumer, healthcare, and technology sectors in Australia and New Zealand, with occasional investments in private companies. Our investment approach is contrarian, fundamental, and long-term oriented, with an emphasis on identifying promising companies before they are well-known to the broader market. Our goal is to buy high-quality businesses when they are out of favour, misunderstood, undiscovered, or underappreciated. In the past, Karst Peak funds have been substantial shareholders in Viralytics (VLA), Avita Medical (AVH), Genetic Signatures (GSS) and are currently substantial shareholders in Neuren (NEU), Cyclopharm (CYC) and Pharmaxis (PXS).

No investment better matches our investment approach than Neuren, a biotech company developing orphan drugs in a number of severe neurological conditions. We acquired our first and major stake in the company on 25-Mar-20 (see here). At the time, Neuren was misunderstood, underappreciated, significantly undervalued and not well-known to the broader market. Since this time, Neuren’s share price has increased from A$1 to almost A$4, yet it remains one of our favourite investments. The primary driver of this jump in value was the positive Phase 3 trial results in Rett Syndrome announced at the end of 2021 (see here and here). Even though Neuren’s share price doubled in Dec-21 following positive Phase 3 data, we believe there is still significant upside from current levels; in fact, in our view the risk/reward of the stock is more attractive today than at any point in the past few years and we added to our position following the Phase 3 readout. By our calculations, detailed in point #5 below, we believe Neuren could be worth A$2.5bn, compared to the current market capitalisation of ~A$500m.

In addition to the upside potential, we believe the publication of the top line results from the Phase 3 trial has gone a long way towards de-risking the company’s key value driver. Prior to these results, an investment in the company was fairly binary, with significant downside risk if the trial failed (our diligence suggested it would succeed, which is why we purchased the shares in Mar-20, but it is always difficult to precisely pinpoint the probabilities in these situations). With the convincing trial results in hand, analysing Neuren becomes more of an exercise in sizing the market potential and valuing cash flows, rather than estimating the odds of a successful trial. The drug could still fail to receive FDA approval, as we note in the risk section below, but we believe this is quite unlikely.

Neuren’s moment in the spotlight has been a long time coming. Neuren listed on the ASX in 2005 following the merger of two predecessor companies, which were spun out of the University of Auckland. The company pursued various drugs and indications over the past two decades, but in recent years has slimmed its portfolio to two compounds targeting severe neurological conditions: 1) trofinetide (North American rights licensed to Acadia Pharmaceuticals and currently pursuing an indication in Rett Syndrome), which has completed a Phase 3 trial and 2) NNZ-2591, which is set to enter four Phase 2 trials in CY22.

(Source: Neuren)

Rett Syndrome is a rare paediatric neurological disorder that occurs primarily in females following apparently normal development for the first six months of life. Patients experience a period of rapid decline with loss of purposeful hand use, spoken communication and inability to independently conduct activities of daily living. Signs and symptoms also include seizures, disorganised breathing patterns, an abnormal side-to-side curvature of the spine (scoliosis) and sleep disturbances. Despite the debilitating nature of the disorder, Rett Syndrome patients can live well into adulthood although require constant care.

1. Neuren is set to receive hundreds of millions (and possibly billions) in milestones and royalties from trofinetide in the US market alone

In mid-2018, on the back of strong Phase 2 results for trofinetide (see here), Neuren licensed the North American rights for trofinetide to a San Diego-based, publicly traded biotech company called Acadia Pharmaceuticals. The deal included a US$10 million upfront payment to Neuren, the potential for US$455 million of milestone payments, and ongoing double-digit royalties on sales (which we believe are in the 10-15% range depending on the level of annual sales). Neuren also has the right to one-third of the value of a ‘Rare Pediatric Disease Priority Review Voucher’, if awarded by the FDA.

Importantly, Acadia agreed to fund the necessary Phase 3 trial and related manufacturing scale-up while Neuren obtained the right to use any data generated by Acadia for Neuren’s own use in other territories outside North America. It is worth noting that through to Sep-21, Acadia had spent US$112 million on external service providers related to the clinical development and manufacturing preparations for trofinetide, demonstrating their commitment to the drug and the large upside potential they must anticipate to offset this investment and all the above payments to Neuren.

To determine the upside to Neuren from this deal, we need to estimate potential sales of trofinetide in the US. The first step in estimating the addressable market for a drug is identifying the patient population. There are ~7,000 Rett Syndrome patients on the patient registry run by Rettsyndrome.org. Epidemiology studies suggest that there are up to 10,000 Rett Syndrome patients in the US and anecdotally physicians estimate as many as 15,000 patients. Physicians believe that Rett Syndrome may be under- or misdiagnosed presently and that with an approved treatment, parents will have an incentive to seek a definitive diagnosis, get registered with the patient advocacy groups and seek treatment.

The next step is to estimate potential pricing. Orphan drug pricing in such rare conditions where the unmet need is high ranges from US$100,000 to US$700,000 a year (see chart below). The AIHP state the average price for an orphan drug in 2017 was ~US$187,000 (see here). 

(Source: AIHP)

Several experts we spoke with have stated that Spinraza (approved to treat spinal muscular atrophy) is a good comparable for price. Spinraza costs ~US$700,000 in the first year and US$350,000 in subsequent years. The total patient numbers in the US for this condition is ~9,500 patients (see here). Another comparable drug, Zavesca (approved to treat type 1 Gaucher disease), is priced at ~US$300,000 a year. The total patient numbers for this condition in the US is ~6,000 (see here). Clinuvel’s Scenesse is priced at ~US$300,000 per year with a patient population of ~5,000 (see here). As such, we believe pricing of US$150,000 to US$250,000 is achievable for trofinetide and the drug is expected to be reimbursed by the Centers for Medicare and Medicaid Services (CMS) and private insurance.

If we assume an annual cost of US$150,000 and total number of patients as 7,500, the total addressable market for Rett Syndrome is US$1.1b in the US. We believe these assumptions may prove conservative. Indeed, Anavex forecast a total addressable market of US$2-5b for a drug for Rett Syndrome, based on 10,000 patients with pricing at US$200,000-500,000.

Assuming a blended 12.5% royalty rate and 50% market penetration, Neuren would receive ~A$100m per year on total Acadia sales of trofinetide of US$560m. Acadia have publicly stated on several occasions that they believe peak sales for trofinetide in Rett Syndrome can be in excess of US$500m. If we tax this cash flow at 30% and assign a 10x multiple, the royalty stream is worth ~A$690m to Neuren. It is important to note that these payments to Neuren fall straight to the bottom line after tax, there are no other associated costs with these receipts.

Judging from conversations we have had with a variety of Key Opinion Leaders (KOL) and physicians who treat Rett Syndrome patients, we believe Acadia’s forecast of peak sales may be conservative. A number of physicians we spoke with indicated that close to 100% of their patients would at least try trofinetide. Physicians have told us that parents are very engaged in the treatment of their daughters. They are aware of drugs in development and many have reached out to their physicians after Acadia announced the positive Phase 3 trial data. Physicians also believe that the ramp up in sales can be rapid, with several suggesting that all their patients will be on trofinetide within 3-6 months following FDA approval.

Consider an alternative scenario with 5,000 patients taking trofinetide (relative to an estimated 7,000 – 15,000 patient market) and a US$200,000 annual cost. This yields Acadia sales of US$1bn and annual royalties to Neuren of A$176m, or after-tax profits of A$123m. At 10x this would be worth A$1.2bn.

Recall that these streams of cash relate solely to royalties. Neuren is also positioned to earn US$10m (A$14m) upon trofinetide being filed with US FDA and US$40m (A$55m) upon first commercial sale. An additional ~A$500m can be earned by achieving a set of commercial milestones. We summarise all of these payments below. When considering these figures, recall that Neuren’s current market cap sits at only ~A$500m.

2. We believe that FDA approval is very likely

Before Neuren earns the milestones and royalties mentioned above, trofinetide must first receive FDA approval. To determine the likelihood of this final hurdle, we must analyse the clinical trial results.

In 2017, Neuren published the results of a double-blind, placebo-controlled Phase 2 trial of trofinetide in 82 girls with Rett syndrome, aged 5 to 15. At the highest dose in this trial, trofinetide showed statistically significant improvements in two key measures, the Rett Syndrome Behaviour Questionnaire (RSBQ) and the Clinical Global Impressions – Improvement scale (CGI-I). RSBQ is a comprehensive caregiver assessment examining many of the key symptoms of the disorder, while CGI-I is a clinician assigned score assessing improvement in a patient over time.

On 6-Dec-21, Acadia and Neuren announced top line results for the Phase 3 trial, showing that trofinetide demonstrated statistically significant improvements in both primary endpoints (as agreed with the FDA, the trial had two primary endpoints, the RSBQ and the CGI-I, both of which needed to show statistical improvement compared to placebo). Of note, the p-values of these endpoints were very low at 0.0175 for the RSBQ and 0.0030 for the CGI-I. Other encouraging signs include the fact that trofinetide showed a trend towards improvement in all eight subcategories of the RSBQ, including areas such as Breathing Problems, Fear/Anxiety and Walking/Standing.

Importantly, aside from an increased incidence of diarrhoea and vomiting (which physicians believe can be better managed in the real-world setting), trofinetide was shown to be very safe. In fact, severe constipation is a common condition in girls with Rett Syndrome and many are on aggressive anti-constipation medication as a result, suggesting some adjustment to their treatment regimen may address the incidence of diarrhoea with trofinetide. In addition, trofinetide’s safety profile is far superior to other drugs physicians use to treat symptoms of Rett Syndrome, such as those for seizures.

It is important to note that this is the first and only time that a drug has shown positive results in a Phase 3 trial for Rett Syndrome. We have been speaking with our physician contacts who treat patients with Rett Syndrome following these results and the response has been highly encouraging. While physicians have some tools at their disposal to address symptoms of Rett Syndrome (such as drugs for seizures and sleep issues), there has never been a drug approved that targets the underlying disease itself and its manifold complications. As a result, many of the contacts we spoke with thought 100% of their patients would try trofinetide, with the caveat that if a patient saw no results after 6-24 months, they could choose to discontinue use, particularly if the patient experienced side effects.

In addition, there is likely no competition for trofinetide for many years. The closest competing products are still in pre-clinical development. We should note here that, we believe Anavex’s drug for Rett Syndrome is unlikely to receive FDA approval and thus not competitive given the controversy surrounding its ‘Phase 3’ trial (see here).

Given the strong results in the Phase 2 and Phase 3 trials, the clean safety profile, strong patient advocacy and the lack of any approved drugs for Rett Syndrome, we believe it is highly likely the FDA will approve trofinetide. We expect approval by late 2022 / early 2023 given Acadia’s plan to submit the drug for approval around mid-year.

3. Rest of World (RoW) rights are solely owned by Neuren

As a part of the license agreement with Acadia, Neuren has the right to use all data collected from the Phase 3 trial to support approvals in jurisdictions outside of North America.

The patient numbers for Rett Syndrome in the RoW are considerably larger than in the US, however this is balanced by lower pricing.

(Source: Neuren)

In rare diseases with high unmet need, the price differential between the US and Europe can be as small as ~20%. If we assume that Europe has a 30% price discount to US, then the addressable market is ~€1.2b.

The key question here is what might a RoW deal look like for Neuren? If we focus on Europe, we would assume aggregate milestones lower than the North American deal but with a higher royalty rate. Commonly, for drugs that have completed Phase 3, royalty rates are ~20-30%. If we conservatively assume 17.5% royalty, €92,500 price (~30% discount to our base case in the US) and total patient penetration of 4,000 (the currently identified patients) then Neuren would receive annual royalty payments of €65m or ~A$100m from European sales of trofinetide. On a 10x multiple after tax, this cashflow would be valued at A$700m. Further to this, there will also be an upfront payment as well as regulatory and sales-based milestones, plus sales potential in other RoW markets outside of Europe.

While Acadia’s “Right of First Negotiation” to license the RoW rights has lapsed, we believe it makes sense for them to be very interested given the spend in R&D and manufacturing Acadia has already invested. That said, Acadia do not currently have any operations outside of the US.

4. NNZ-2591 - the jewel in the crown

We see the positive results of trofinetide as de-risking Neuren’s other key asset, NNZ-2591, because of the overlapping mechanism of action. NNZ-2591’s primary mechanism of action is to maintain or normalise the levels of IGF-1 in the brain by ‘freeing’ IGF-1 from its binding protein, which prevents IGF-1 from binding to its receptor. NNZ-2591 is a smaller and simpler molecule than trofinetide thus reducing manufacturing complexity. Neuren has also shown that NNZ-2591 has 100% oral bioavailability. Thus theoretically, the dose of NNZ-2591 will be significantly lower than trofinetide and may not have the same level of gastrointestinal side effects seen with trofinetide.

Neuren are planning on conducting four Phase 2 trials with NNZ-2591. The table below shows that the patient populations in these four diseases are far larger than Rett Syndrome and yet are considered ‘Orphan Diseases’ thus eligible for favourable pricing. Indeed, NNZ-2591 has received Orphan Drug Designation for all four indication from the FDA.

(Source: Neuren)

The asset is early stage with only preclinical and Phase 1 data in healthy volunteers. The Phase 1 data showed that the drug is safe and well tolerated. The preclinical data in mouse models have consistently demonstrated treatment benefit with NNZ-2591 in these four diseases.

Normally, we would not put much confidence in mouse models of neurological diseases. The difference in this case is that these diseases are all caused by a known gene mutation that can be replicated in mice. In contrast, diseases such as depression or anxiety are challenging to replicate in mice, and therefore mouse models are not very predictive.

Looking at Phelan-McDermid as an example, Neuren conducted a trial in mice where the SHANK3 gene has been deleted (called ‘Knock Out’ or KO mice). The results below show a consistent benefit with NNZ-2591 across various measures of disease.

(Source: Neuren)

Seizures as a measure is particularly important as it is an objective measure and is a symptom in humans with Phelan-McDermid. This measure has limited subjectivity in its measurement, either the mouse has a seizure or it does not. The incidence of seizures drops from 60% in the KO + vehicle (i.e. placebo) to 10% in the two highest doses. This coupled with all the other measurements strongly indicates that NNZ-2591 should be trialled in humans.

Similarly positive results have been seen across the other three diseases the company is targeting. While we will not conduct a deep dive into the preclinical results in this wire, all the information regarding the preclinical package can be found on Neuren’s website.

We have had conversations with experts who are KOLs in translational science of neurodevelopmental disorders and the role IGF-1 in these disorders. The feedback has been consistently positive. Experts noted that NNZ-2591 has a clearly understood mechanism of action and the bioavailability means that dosing is convenient and when given orally the drug will reach the required target. These experts also noted that, while mouse models are not perfect, models in these diseases are relevant given the clear aetiology of the diseases under research.

5. Putting it all together

The table below summarises the above sections to determine the upside potential for Neuren.

Neuren currently has a market capitalisation of ~A$500 million (and A$37 million of cash, more than sufficient to cover the Phase 2 trials for NNZ-2591), providing 4x upside to estimated value in our base case and 5x with more bullish US market assumptions. Again, this assigns limited value to NNZ-2591, a compound with many similarities to the now de-risked trofinetide and one which Neuren believes will demonstrate superior efficacy compared to trofinetide due to better bioavailability and other factors.

Upcoming catalysts (in calendar year):

Trofinetide:

• 1Q22: Pre-New Drug Application (NDA) meeting between Acadia and the FDA
• Mid-22: Submission of NDA to the FDA and payment of milestone to Neuren
  
• 2H22: License(s) of trofinetide in RoW territories with upfront payment to Neuren
  
• Late 2022/ Early 23: FDA approval of trofinetide
  
• Early-23: Launch of trofinetide into the US and milestone payment to Neuren
  
• 2023+: Neuren to receive payment from the sale of Rare Pediatric Disease Priority Review Voucher, payment of sales-based milestones and royalties to Neuren from Acadia
  
• 2023+: Approvals in other jurisdictions with payment of milestones and royalties from future RoW partner(s) 

NNZ-2591:

• 1H22: Removal of clinical hold and IND approval by the FDA for 3 indications, Angelman's IND has already received the all-clear to proceed from the US FDA
• Mid-22: Start Phase 2 trials across four indications
  
• 2023+: Results from Phase 2 trials and decision whether to license or continue development
  

6. Key risks

#1: FDA approval is the most significant risk. While we believe that FDA approval is highly likely, we note that questions exist on the clinical significance of a 0.3 improvement in CGI-I, the statistical test used to measure significance in CGI-I, potential unblinding of the patients and investigators due to side effects and effect of the patient drop-out rate on the primary endpoints.

The majority of physicians we have spoken with have stated that they believe the result is clinically meaningful. A CGI-I of 3 vs 4 is important for a patient and their caregivers. Acadia have stated that they have conducted analyses that show patients/investigators were not unblinded by the side effects. Finally, Acadia have stated that patients dropped out due to side effects not due to lack of efficacy.

#2: Execution risk with the launch of trofinetide in the US and RoW markets. We see this risk as mitigated by the lack of approved treatments in Rett Syndrome and high unmet need. The feedback from physicians strongly indicated that up take of trofinetide will be swift. We await data from the open-label extension, LILAC, to see how effective a diarrhoea management plan is in patients in a more ‘real world’ setting (i.e. unblinded). Given that severe constipation is a symptom of Rett Syndrome, we are confident that diarrhoea can be managed.

#3: Clinical development risk of NNZ-2591. Notwithstanding the strong preclinical results, significant clinical risk exists for any drug entering a Phase 2 in neurology. That said, we believe that Neuren is significantly undervalued even when ignoring the NNZ-2591 opportunity thus we view NNZ-2591 as a ‘free option’ at the current market valuation.