Ironwood Pharmaceuticals: Sometimes a Blockbuster Isn't Enough

Small biotechnology companies typically risk everything for their first 15 years or so until their first big drugs win approval. Once sales start rolling in, it should be time to invest in the rest of the pipeline. The last thing a long-term investor wants to see is a cut to the R&D department.

Well, Ironwood Pharmaceuticals, Inc. (NASDAQ: IRWD  ) began marketing its first big drug, Linzess, in the U.S. about fifteen months ago. Analyst estimates vary, but it is likely to reach peak sales of more than $1 billion dollars per year. Sales, general, and administrative costs (SG&A) have risen, but R&D has remained somewhat level.

IRWD Research and Development Expense (Quarterly) Chart

IRWD Research and Development Expense (Quarterly) data by YCharts

Reports of the launch are positive, but Ironwood's earnings are not. As a result, the company is making cuts. According to a recent report in the Boston Business Journal, some of Ironwood's research staff will be cut during the present quarter.

IRWD Chart

IRWD data by YCharts

Lets take a closer look at Ironwood and its Lizness strategy to see if we can explain this head-scratcher.

The opportunity
Bowel disorders are a big business brimming with opportunities. Frost & Sullivan estimates the U.S. market alone is worth more than $4 billion and rising. Between the two main subtypes, irritable bowel syndrome (IBS) and the more severe inflammatory bowel disease (IBD), there is an inverse relationship between the patient pool and the availability of effective therapies.

For IBD patients with Crohn's disease or ulcerative colitis, there is a growing variety of therapies aimed at the source of inflammation. Sufferers of IBS with symptoms of either constipation (IBS-C), diarrhea (IBS-D), or both (IBS-M) represent an enormous untapped market. Reported cases of IBS outnumber IBD by about ten to one, but there is a surprising lack of effective therapies to treat the condition.

The magnitude of unmet need is well illustrated by the rapid increases in Linzess prescriptions. The FDA approved Lizness for the treatment of chronic idiopathic constipation (CIC) and IBS-C in August 2012, and marketing in the US.. began about a month later. Through November 2013, Ironwood Pharmaceuticals and its North American Lizness partner Forest Laboratories (NYSE: FRX  ) have reported over 500,000 prescriptions. Between the second and third quarters of 2013, that figure rose 42% from 125,000 to 178,000.

Ironwood estimates a whopping 48 million adults in the U.S. suffer from Linzess' approved indications. Roughly 80%, or about 38.4 million, have access to linaclotide through their insurers or government payers. If U.S. prescription counts keep expanding at their current rate, all of those with access will be on the drug about halfway through 2016.

Typical deal

Before you get too excited, now is a good time to take a closer look at the partnerships Ironwood has forged. Typically, biotechs with a promising compound but no source of revenue make agreements with much larger companies during lead or preclinical stages. The larger company takes responsibility for the immense costs of clinical development and post-approval marketing. In return, smaller companies with practically no financial resources, like Ironwood, are relieved of nearly all of risk while collecting milestone payments whenever their compound manages to jump through regulatory hoops.

Should a co-developed compound reach a commercial stage, the smaller company is armed with collected milestone payments and steady royalties. It can can afford to develop new compounds, and market the same compound in regions where it maintained rights. The smaller company earns less from the partnered compound, but risked very little and now has opportunity to try for a repeat.

Raw deal

Ironwood's partnership with Forest Laboratories is not typical. In the U.S., the two are generally splitting both costs and revenue down the middle. Forest also has sole responsibility for the drug's development and commercialization in Canada and Mexico. In the long run, the deal will probably work out quite well for Forest, but Ironwood is now has to resort to post-approval equity and debt offerings.

In the third quarter of 2013, Forest recorded revenue from linaclotide sales of $34.4 million. Ironwood combines all sales and expenses from the Forest partnership and reports the net gain or loss as a single item. So far it has recorded nothing but losses. In the third quarter, the net loss from the Forest partnership was $6.2 million, and I expect further losses over the next several quarters.

More of the same
With losses piling up, it seems Ironwood cannot afford to market linaclotide in regions outside of the U.S. without help. In China, Ironwood has partnered with AstraZeneca (NYSE: AZN  ) . In return for just $25 million upfront and $125 million in commercial milestone payments, Ironwood and AstraZeneca will split all net losses and profits in the region. In Japan, Ironwood sold rights to linaclotide to Astellas Pharma for modest milestone payments and escalating royalties on gross profits beginning in the low-twenties. The company also entered a similar deal in the E.U. with Almirall.

Final thoughts
If you're interested in smaller biotechnology companies, let this example serve as an important lesson. Investing in a company with an approved product, a large market, and facing little competition makes good sense. Before you go jumping in, though, it pays to take a closer look those collaboration agreements.

Ironwood isn't necessarily in trouble. It may even become wildly profitable, though that won't be until far into the future. For now, I don't think watching earnings slide further negative more than a year after the launch of a potential blockbuster is worth the headache. Cuts in R&D don't bode well for the company's long-term prospects either.

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