Summary

Zafgen's partial clinical hold has made it lose more than half its market cap in a few days.

If things go smoothly, this itself presents a high-risk, high-reward opportunity, considering beloranib's efficacy.

If things go downhill, the stock is trading about $3 above its cash per share.

Zafgen (NASDAQ:ZFGN) has had an interesting few days, with the dramatic cancellation of an Investor Day and, more importantly, an investor dinner. While the bosses were probably having a private dinner that night, the stock fell 35% - well, that can't be true, because the stock fell during the day - not night - but anyway, an interesting week nevertheless.

Two days after all this, and while the stock was still down to $13 from $35, it was announced that a patient had died in the phase III Beloranib trial, for reasons unknown. The FDA had been updated on the issue, and an investigation was in progress.

Well, I also had an article in progress while these things were happening, and that article was going to be a bullish one. In the light of these happenings, I revisited my thesis for a reality check. It still seems to me, however, that Zafgen has considerable upside, which is tentatively confirmed by Mr. Market, because after the apparently negative announcement, the stock didn't double over, but actually doubled back from $13 to $21. That leads me to my thesis.

Zafgen's lead product candidate is beloranib, a novel, first-in-class, twice-weekly subcutaneous (SC) injection. It is being developed for the treatment of multiple indications, including two rare diseases: Prader-Willi Syndrome (PWS) and hypothalamic injury-associated obesity (HIAO), including craniopharyngioma-associated obesity.

Beloranib has ODD in PWS in the U.S. and EU, and recently received ODD in the EU for the treatment of craniopharyngioma. The drug is currently in Phase III trial for PWS, Phase II for HIAO and Phase II for severe and complicated obesity.

The company's pipeline also includes ZGN-839, which is in pre-clinical stage for NASH; and 2nd-generation injectable MetAP2i, which is also in pre-clinical stage for obesity.

ZFGN's strategy is to focus initially on the niche areas, and then expand to bigger opportunities like NASH. The strategy could pay off, as PWS has no effective pharmacological treatment available right now. If beloranib is approved and successfully commercialized, the company will have the opportunity to expand its pipeline, which is targeting much bigger markets. But even based on the potential of the drug in just PWS, ZFGN has significant upside from current levels.

Prader-Willi Syndrome

PWS is the most commonly known cause of life-threatening obesity. It is a rare genetic disorder where, from childhood, the patient becomes incapable of regulating metabolism and appetite. This results in a high number of PWS patients suffering from hyperphagia and obesity. Over the years, scientists have begun to realize that chronic obesity is, in many cases, a complex medical disorder, not something in clear control of the patient. It involves appetite dysregulation and altered lipid and energy metabolism. This anomaly causes excess fat to accumulate in tissues, and in certain conditions, can become life-threatening. The disease conditions of both PWS and HAIO can be caused by treating certain mid-brain tumors, like craniopharyngioma. Damage may be caused to the hypothalamus, resulting in uncontrolled hunger and overeating, because the part of the brain that regulates the neurophysiological drive to eat is disrupted.

Zafgen concluded a successful Phase 2 trial of beloranib for PWS in January 2014, where reductions in body weight, body mass and body fat content and reductions in hyperphagia-related behaviors were observed. Two Phase 3 trials were initiated thereafter, one in the US and the other in EU, with the first one starting September 2016. This is the trial where one patient died of still unknown causes. I will discuss this issue separately below.

Beloranib has orphan drug designation for PWS in both regions. The estimates for prevalence of PWS in the U.S. and EU range from 1 in 8,000 to 1 in 50,000. If the prevalence is assumed at mid-point of the estimated range, i.e., 1 in 29,000, then in the U.S. alone, Zafgen's addressable market would be around 10,000. Considering that this is a rare disease, the treatment cost could be easily around $50,000. So, in the U.S. alone, the addressable market for PWS is around $500 million.

While there are pharmacological treatments for various symptoms of PWS, currently there are no effective pharmacological treatments for obesity and hyperphagia in PWS. Bariatric surgery - where the stomach size is either reduced by removal or otherwise, or a stomach bypass created - is contraindicated in PWS patients because, well, bariatric surgery is contraindicated in most people. It can be life-threatening, causing gastric perforation, among other things.

HIAO

HIAO is a related syndrome caused by damage incurred during removal of a central nervous system tumor called craniopharyngioma. However, it can also be caused by less common types of hypothalamic injury, like strokes, brain trauma or radiation therapy to the brain. There are around 400-500 new cases of crainopharygioma annually in the U.S. and 650 to 850 cases in the EU.

About Beloranib

Beloranib is a novel, first-in-class injectable small molecule that inhibits MetAP2, an enzyme that controls certain metabolic processes which may cause the feeling of hunger, and also stores fat throughout the body. The drug causes reduction of hunger, and also stimulates the metabolic process to use stored fat as an energy source. It also reduces hepatic fat synthesis.

A prototype of the molecule was first evaluated in a 2002 study published in the Proceedings of the National Academy of Sciences, where its use in animals induced loss of fat tissue and increased fat oxidation (fat burning). Animals were also observed to have reduced their food intake. Why this happens is not clearly understood: it may be caused by direct neurophysiological effect of the molecule, or because the use of stored fat creates a feedback loop into the brain, reducing appetite.

In 2004, further study showed that beloranib induces a deactivation state of a particular signalling protein, ERK1. ERK1 has been known to cause high fat diet-induced obesity and insulin resistance. So, its deactivation by beloranib may be what causes some of its metabolic benefits. The agent also interacts with several molecules involved in energy metabolism, which is probably another reason for the weight-reducing effects of the drug, as well as glucose metabolism.

Clinical Trial Summary

According to Zafgen, beloranib by IV infusion twice weekly for four weeks, or eight doses, at dose levels of up to 3.0 mg, was safe and well tolerated. However, the highest dose of 4.0 mg used in a new SC formulation was less well tolerated, resulting in TEAEs from mainly gastrointestinal events and sleep disturbance.

These dosage testing trials, however, demonstrated significant decreases in body weight and large decreases in the sense of hunger. In a later trial, reduction in blood pressure and positive effects in cardiovascular diseases were also tentatively observed.

The ZAF-211 trial for PWS and the ZAF-221 trial for HIAO have both demonstrated benefits in terms of reduced body mass and body fat content, improvements in hyperphagia-related behavior, and in HIAO, reductions in placebo-adjusted body weight. These positive results made a Phase 3 trial necessary for submitting an NDA; however, the patient death has somewhat marred the prospects of the drug.

The Patient Death

It has now been confirmed that the patient who died in the trial was taking beloranib, not placebo; however, a direct linkage to the drug has not been established yet. The FDA partial clinical hold is to screen patients for thrombotic diseases, or blood clots. According to the Boston Globe, "Dr. Dennis Kim, the company's chief medical officer, said the FDA would allow patients to resume their trial as soon as they obtained informed consent from them and screened them for blood-clot disorders, a process he estimated would take no more than two weeks. He said three-quarters of patients in the trial - one of two important trials planned by the company to show the drug's effectiveness - had already completed the six-month treatment regimen."

The FDA is overly cautious about obesity drugs, which is a con - as in, pro and con. On the other hand, beloranib has had excellent trials so far. Moreover, it appears that before the hold was clamped, they had indeed completed a considerable amount of dosing, probably enough to provide us some top line results early next year.

Moreover, the patient in question was a 23-year old with Prader-Willi, who also suffered from a number of other severe health problems and had a body mass index of 55 (possibly weighed over 400 pounds). He was treated with a 1.8 mg dose of beloranib, the lower of the two being tested in the Prader-Willi trial. Of over 400 patients tested with beloranib so far, 6 had possibly related thrombotic events, although it has not yet been determined whether this was a drug-drug interaction from one of the many medications PWS patients normally take.

IP

On the IP front, one aspect looks a little shaky prima facie, because an exclusively licensed set of US and EU patients related to beloranib compositions of matter will expire in 2019. That basically means that someone else can manufacture and market the drug just on the basis of IP.

However, Zafgen also owns "two issued U.S. patents relating to beloranib polymorph compositions of matter that will expire in 2031 and three issued U.S. patents to methods of treating obesity that will expire in 2029." So, in that regard, at least some aspects of using beloranib in treating obesity is patent-protected until 2029.

Also, if the drug receives ODD at approval, that will grant it 7 years of exclusivity in the U.S. and 10 in the EU. Considering all that, patent protection is not a major issue.

Zafgen's strategy is to focus on subpopulations of obese patients. By doing this, the company believes it can rapidly develop and commercialize its lead product candidate with less costly clinical trials. If the clinical trials remain on track, beloranib could reach commercialization stage by 2018. ZFGN's value is currently based entirely on the potential of beloranib in PWS and HIAO. At the end of the June quarter, the company had $220 million in cash on its balance sheet, which translates to around $8 per share, or more than 25% of its current market cap. The cash burn rate is around $12 million per quarter.

Valuation

Beloranib in PWS is the key value driver for Zafgen. Following the partial clinical hold, it is not certain whether the drug will ever reach commercialization stage. I have assigned a 20% probability of approval, which is well below the average for drugs in Phase III stage. The average, according to data from Stern, is around 65% for drugs in this stage. The 20% probability of approval takes into account the risk associated with beloranib following the partial clinical hold.

PWS is a rare disease, and therefore, I have assumed treatment cost of $50,000. Zafgen's addressable market is around 28,000 patients in the U.S. and the EU, based on a prevalence estimate of 1 in 29,000. I have assumed the patient population to grow at a CAGR of 3%. I have also assumed that the treatment rate will be 50%. I have assumed a one-year delay in launch (2019) due to the partial clinical hold. At its peak, I have assumed that beloranib will capture 75% of the market, which is reasonable considering there is no competition.

Based on these assumptions, I get risk-adjusted peak sales of $141 million in 2025. This translates to roughly $5.20 per share, so ZFGN currently trades at around 2x peak sales estimates. But remember that Zafgen has around $8 per share in cash on its balance sheet as well. While the risk here is huge, the reward could be significant if the partial clinical hold is lifted and beloranib manages to reach commercialization stage.

The peak sales for beloranib, without taking into account the risk, is around $700 million, or around $26 per share. Assigning a multiple of just 2x sales, which is significantly below the average for the biotech industry, I get a value of around $52.

The downside from current levels, on the other hand, while significant, is not as much as the potential upside. I believe that there is a case for going long on ZFGN, provided investors have a huge risk appetite. If the hold is lifted and beloranib reaches the market, then the upside from current levels could be at least 400%. But I would reiterate that this is a high-risk play.