Zogenix: 3 Key Investing Takeaways From 2013

2013 was a year to remember for Zogenix (ZGNX), the painkiller maker that has rallied more than 135% since the beginning of the year. The company scored a major victory in October when the FDA approved Zohydro ER, its extended-release of the narcotic painkiller hydrocodone.

However, that victory was a highly controversial one, since Zohydro ER is five to ten times more potent than Vicodin, which is a comparatively milder mix of hydrocodone and the non-narcotic painkiller acetaminophen.

Due to its potency, Zohydro was classified as a Schedule II controlled substance due to its potential for abuse. Zogenix, however, believes that there is still a market for the drug, since it does not contain acetaminophen, which could cause liver damage at elevated doses.

Source: YCharts.

To better understand where Zogenix is headed in 2014, let's take a look back at three investing takeaways from Zogenix's volatile but rewarding year, and how its future could also affect Mallinckrodt (MNK), Valeant Pharmaceuticals (BHC 1.05%), and Teva Pharmaceutical (TEVA 0.63%).

1. Zogenix by the numbers
Zogenix, which is currently unprofitable, has two main sources of revenue -- net product sales of the injectable migraine drug Sumavel DosePro, which is co-marketed with Mallinckrodt; and service fees from Valeant for the co-promotion of Migranal Nasal Spray, which is used to treat migraine headaches.

Source: Zogenix third-quarter report.

Revenue from Sumavel sales declined, but overall prescriptions and units sold rose 4% year over year -- indicating a decline in overall pricing. Meanwhile, the steep drop in service revenue was due to a large payment from a co-marketing contract with Astellas in the prior-year quarter, which has since been replaced by the new agreement with Mallinckrodt.

Therefore, Zogenix's core business is highly dependent on migraine treatments. However, that market is an increasingly fragmented one, divided among various brands of ibuprofen, acetaminophen, triptans, ergots, opioid drugs, and NSAIDs (non-steroidal anti-inflammatory drugs). That increased competition is most likely the cause for the 19% decline in Sumavel sales.

2. Zohydro ER's price
Based on Zogenix's year-long rally, investors might think that Zohydro ER is a guaranteed blockbuster drug.

However, it's not -- in an investor presentation earlier this month, Zogenix stated that it hoped to generate annual peak sales of $300 million from Zohydro ER, assuming that it can capture 1% of the total market of current hydrocodone users. That estimate assumes that each prescription will cost $7.87 per day (the same price as Purdue Pharma's OxyContin), for a total prescription cost of $236 per patient. Zogenix believes that Zohydro has the potential to eventually treat 1.27 million patients.

Zohydro's price, however, could be the problem. Its $7.87 price (for two pills per day) was intended to match OxyContin, but it simply cannot compete with generic Vicodin, which is manufactured by Teva and other generic manufacturers. Those generic tablets, which are immediate rather than extended-release products, can cost as low as $0.50 per pill.

3. Teva and Purdue could render Zohydro obsolete
To make matters worse, more than two dozen state prosecutors recently sent a letter to the FDA requesting that it rethink its approval of Zohydro ER due to its potential for abuse.

Zohydro is not tamper-resistant, meaning that it can be crushed, injected, and dissolved in alcohol. This could lead to a repeat of Purdue's OxyContin scandal six years ago, when the drug was crushed and injected by drug users to produce a heroin-like high. Purdue and three of its top executives were eventually fined more than $630 million in 2007 for overselling the drug's safety. In response, Purdue introduced a tamper-resistant version of OxyContin in 2010.

The OxyContin scandal led to an increased demand for tamper-resistant drugs that cannot be crushed, injected, or dissolved. Teva is developing a tamper-resistant version of extended-release hydrocodone, which could render Zohydro ER obsolete.

Zogenix intends to launch Zohydro ER by March 2014. Considering that the FDA is now under pressure to rethink Zohydro's approval and Teva's tamper-resistant hydrocodone is already in phase 3 trials, I believe that the FDA could grant Teva's drug a fast-track approval to allay these concerns.

If Teva's drug hits the market earlier than expected, then Zogenix can expect a quick, premature end for Zohydro ER, and the stock could easily give up its triple-digit gains from 2013.

The Foolish bottom line
In closing, Zogenix has very few strengths and plenty of weaknesses.

The company currently has $17.4 million in cash and equivalents, but is shouldered with $28.7 million in debt. The company has been burning through more than $10 million in cash per quarter, and it expects these losses and negative cash flow to continue throughout 2014. Meanwhile, sales of Sumavel DosePro, its only real source of revenue, could continue falling by double digits.

Zogenix is pinning all of its hopes and dreams on Zohydro's launch in 2014, and a lot could go wrong. The FDA could be forced to rethink its approval of the drug, hospitals might decide against prescribing Zohydro due to its price, and a larger company like Teva could introduce a tamper-resistant, extended release of hydrocodone soon.

Therefore, although Zogenix enjoyed a great run in 2013, I believe that the road ahead in 2014 could be a very tough one for this company.