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Kos Pharmaceuticals

The Story

Kos Pharmaceutical's (NNM: KOSP) name comes from the Greek Island of Kos, where the father of medicine, Hippocrates, called home. Hippocrates was creator of the Hippocratic Oath, which is an oath of doctors in which they swear to put the patient's interests before their own. You see, in the time of Hippocrates, doctors were figures of fear, rather than reassurance.

Kos describes itself as a fully integrated specialty pharmaceutical company that develops proprietary prescription pharmaceutical products, mostly for treating cardiovascular and respiratory diseases. Founded in 1988 by Michael Jaharis, a once major shareholder and leader of Key Pharmaceuticals that Schering-Plough acquired in 1986, Kos is focused on developing new pharmaceutical therapies, rather than following the current trend of going straight into generic treatments.

Kos focuses its efforts on existing drugs that have already been approved by the FDA. However, "We don't do generics, although the molecules we work with could be generic or drugs that have come off patent," says Jim Tanguay, Kos vice-president of technical operations. Niaspan, a leading Kos product, is an example of its strategic approach. Niaspan is based on reformulating niacin, which has demonstrated efficacy in treating high cholesterol.

For Niaspan, Kos patented the delivery system, not the drug. The strategy makes sense because the market for generic therapies is big but it's hugely competitive, and margins are constantly squeezed by pricing pressure. Having patent protection gives exclusivity for a period, and the cholesterol treatment market is exploding.

Niaspan is Kos's first main drug. Then came Advicor. "As soon as we had approval for Niaspan, we turned our attention to the formulation of Advicor. It's a niacin-based treatment with a coating of lovastatin, which has demonstrated efficacy in lowering LDL-cholesterol," says Tanguay.

Kos Pharmaceuticals grows by technological R&D, creating a good product, creating demand through education, and acquisitions. They have done a superb job. Tanguay states: "Our growth going forward will be related to our ability to get across the message of the importance of HDL in addition, or just as importantly, as LDL." Kos's top line growth rate has continued to outpace the lipids market. Kos has also recently purchased global rights to Azmacort inhalation aerosol franchise. Azmacort is used in the maintenance treatment of asthma, another high growth area.

Kos Pharmaceuticals has grown from a small facility in Hollywood, FL with a single shift to a three times larger site in New Jersey with shifts running around the clock. There is even more room for growth as Kos recently began tapping the UK and Germany markets. These two countries are untapped in terms of HDL awareness. The international market potential is quite large.

Leadership of Jaharis

Kos has been led from scratch by a pharmaceutical industry maverick. That person is Michael Jaharis, who rose from being a sales rep to a co-owner in Key Pharmaceuticals. With others, he helped turn an almost bankrupt Key into a surprise success in the 1980s. There were a few others at Key who helped him, and most of that essential team is now at Kos. Their experience at Key taught them the lesson that familiar products could be revived by reformulation and sophisticated delivery.

Kos Pharmaceuticals is a growth story that has yet to meet its boundaries. It is a David among a host of large-cap pharmaceutical Goliaths. The company is small enough to be able to bring significant revenue to the bottom line when they succeed, and yet large enough to play in a market dominated by the likes of Pfizer and Merck.

Growth or Value;or Both

Kos has a five-year average sales growth rate of 80.5% with net margins of 20.2%. They have a return on equity of 72.1%, and almost $200 million in cash in the treasury.

But these figures aren't even the best part, which is the value inherent in the stock. KOS has a forward P/E of about 11 from my estimated calculations for 2005 EPS of $3.03. Their PEG ratio is a very impressive 0.55. The Jaharis family own about 35% of the outstanding shares, which is a vote of confidence.

The most recent quarter results at Kos were much better than expected. Kos reported Q3 EPS of $0.94 (vs. $0.37), $0.19 better then the consensus estimate. Pharmaceutical revenues from which Niaspan sales played a large role primarily drove this impressive performance. Also contributing to the blow-out quarter were gross margins of 92.8%.

Total revenues of $132 million increased 79% year-over-year. For the company's core cholesterol management brands (Niaspan and Advicor), revenues increased 50% from the year earlier period. Niaspan sales could reach $350 million late 2005/early 2006.

Why is the Stock Price So Low?

With its spectacular results, how could this company be trading at depressed levels? The main reason is that 64% of Kos's revenues come from Niaspan. Investors are wary of the risk of being so dependent on one drug. In addition, Barr Labs is currently challenging the Niaspan patent and that has the potential to cut into that 64% revenue generator for Kos. Barr is also trying to launch a generic drug that would rival Niaspan. These actions could seriously impact Niaspan, which contributes $315 million to the bottom line.

The operating risk begins March 30th, 2005. Following lawsuits in March and August, 2002, a 30-month stay was issued, which expires in March 2005. The stay prevents final FDA approval for Barr Lab's generic drug until either the earlier of patent expiration (2007) or resolution of the lawsuit (more likely). In June 2003, Barr received tentative FDA approval for its generic dosage forms of Niaspan. As the only generic filer to date on Niaspan, Barr stands to reap a significant profit windfall upon launch of its product.

Down But Not Out!

Mr. Jaharis and Kos Pharmaceuticals still have a proven team that started this company on the foundation of proprietary drugs. They know the threat of generic drugs and have a pipeline in store to deal with challenges. Can I be sure that each one of the new drugs in the pipeline will succeed? No, but I can place trust in the team that built two successful drug companies.

A loss in the courts would be a serious setback, but Kos has several new products in late-stage development.

KS 01-018: treats peripheral arterial disease (PAD), which causes leg pain. This disease is very prevalent in smokers. That's a definite population you want to cater to. The American Diabetes Association issued guidelines that every diabetic patient over age 50 should be screened for PAD. Kos estimates the patient population at 8 to 12 million, the market at $1 billion, and potential peak sales at $400 million or more.

Niacin/simvastatin combination: KS 01-019 combines Niaspin with statin " in this case simvastatin (the active ingredient of Merck's Zocor). Many doctors, when they step up to combination therapy, would like to stay with their statin of choice. Patients are currently being recruited for a pair of Phase III trials, and Kos is aiming for a 2007 launch, shortly after the expiration of Merck's simvastatin patent.

Further back in the pipeline are products for cardiovascular disease, diabetes, and the area where Mike Jaharis first made his mark: respiratory disease.

Inhaled Insulin: In late August 2004, Kos announced the results of a phase IIa study of its inhaled insulin formulation that compared its product head to head with insulin glargine (marketed by Aventis under brand name Lantus), the most prescribed insulin in the United States. After a month of treatment, patients receiving Kos' crystallized recombinant human insulin showed a mean reduction in mean blood glucose of 28%, compared with 23% with insulin glargine. In addition, in the recent trial, Kos' insulin produced a 10% reduction of LDL cholesterol at day 28, compared with an increase of 1.4% with insulin glargine. This was the first time data has shown that controlling glucose levels positively impacts LDL and triglyceride reduction.

Azmacort: Kos acquired Aventis' asthma drug Azmacort for about $200 million this past spring. This was a declining product for Aventis, but turned out to produce $88 million in revenue with minimal sales support in 2003. This past quarter, revenues reached $21.6 million.

KS 01-017: This drug is currently in formulation as a dual regulator of glucose and lipids. The market for such a product is huge as nearly 50 million Americans have been diagnosed with metabolic syndrome.

Summary

Looking at a balance of growth rates and value that is present in Kos Pharmaceuticals, I would recommend adding KOSP to your portfolio. The currently depressed share price is mostly investor psychology, but investors should have faith with the Kos management. They have been down and out before, but always survived.

In addition to accumulating the stock on weakness, an advanced options strategy would create an additional market opportunity. I recommend writing the May 30 puts for $2.80. KOSP recently closed at $32.90. If this stock gets put to you, your cost is just $27.20, which is a discount of 17% from today's close. That would be quite a move further down from the decline started in November from $45. The 52-week low is $28, and if the stock gets put to you at $27.20, the P/E would be about 9.

I'll end this report with a revealing quote from Kos Chairman, Daniel Bell: "We didn't start Kos with the idea of only being a $200 million company. We started it with the idea of growing as quickly as possible to at least a billion-dollar company. That was our goal from the get-go."

Attachment (not included): Financial and Investment Summary Figures and Charts

/LB
February 3, 2005

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Bill Cara note:
The stock is off about 67 cents (2.0 percent) on the day, which is a weak one on Nasdaq, and the May 30 puts are quoted $2.95-$3.10, so they could be sold at $2.95. The open interest is 3,200 contracts. There are 106 days to expiry, and the Optionetics data found on Yahoo is available at this link.

I don't take a position, but I thought Levi's write up would be interesting. Levi is an aspiring investment analyst with an eye for value and also GARP. He knows I like the GICS Sector 35: healthcare, believing it to be over-sold.

/BC

BCara@BillCara.com