Small-Cap Research [email protected]

May 2, 2014 Jason Napodano, CFA 312-265-9421 Small-Cap Research [email protected]

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Cipher Pharmaceuticals Inc. (DND-TSX)

DND: Another Solid Quarter For Cipher UPDATE Cash Balance Growing On May 2, 2014, Cipher Pharmaceuticals reported financial results for the first quarter ended March 31, 2014. Total revenues in the quarter were $7.9 million, up 139% Current Recommendation Buy over the first quarter 2013 and $0.7 million above of our estimate for revenues of $7.2 million. Revenues were N/A Prior Recommendation driven by growing royalties of Absorica from U.S. Date of Last Change 01/03/2012 commercial partner Ranbaxy. Royalties totaled $5.5 million. The company also recorded $0.5 million in Current Price (05/02/14) $8.50 amortized recognition of the upfront and approval $11.00 milestone payments dating back to 2008 and 2012. Cipher Target Price also recorded $0.34 million in product sales relating to sales of Epuris in Canada. This was generally in-line with expectations. We continue to believe the Cipher story is attractive and recommend purchase up to $11 per share.

SUMMARY DATA 52-Week High 9.40 Risk Level Average, 52-Week Low 3.66 Type of Stock Small-Value One-Year Return (%) 123 Industry Med-Biomed/Gene Beta 1.22 Average Daily Volume (sh) 70,006 ZACKS ESTIMATES Shares Outstanding (mil) 25.1 Market Capitalization ($mil) 225 Revenue Short Interest Ratio (days) N/A (millions of CAD) Institutional Ownership (%) N/A Q1 Q2 Q3 Q4 Year Insider Ownership (%) N/A (Mar) (Jun) (Sep) (Dec) (Dec) 2013 3.3 A 5.5 A 5.6 A 12.5 E 27.0 E Annual Cash Dividend $0.00 2014 7.9 A 7.3 E 8.0 E 8.5 E 32.6 E Dividend Yield (%) 0.00 2015 32.0 E 2016 33.2 E 5-Yr. Historical Growth Rates Sales (%) 106 Earnings per Share Earnings Per Share (%) 128 (EPS is operating earnings) Dividend (%) N/A Q1 Q2 Q3 Q4 Year (Mar) (Jun) (Sep) (Dec) (Dec) P/E using TTM EPS N/A 2013 $0.06 A $0.13 A $0.14 A $0.69 A $1.02 A 2014 $0.15 A $0.18 E $0.20 E $0.41 E $0.99 E P/E using 2014 Estimate 8.5 2015 $0.78 E P/E using 2015 Estimate 10.9 2016 $0.78 E

WHAT S NEW

Another Solid Quarter For Cipher

On May 2, 2014, Cipher Pharmaceuticals reported financial results for the first quarter ended March 31, 2014. Total revenues in the quarter were $7.9 million, up 139% over the first quarter 2013 and $0.7 million above of our estimate for revenues of $7.2 million. Revenues were driven by growing royalties of Absorica from U.S. commercial partner Ranbaxy. Royalties totaled $5.5 million. The company also recorded $0.5 million in amortized recognition of the upfront and approval milestone payments dating back to 2008 and 2012. Cipher also recorded $0.34 million in product sales relating to sales of Epuris in Canada. This was generally in-line with expectations.

Operating expenses in the quarter were slightly higher than expected, but some of these expenses related to foreign exchange adjustment and recognition of expenses associate with the planned departure of current CEO, Larry Andrews. Operating income in the first quarter totaled $5.0 million. The company recorded a non-cash tax charge of $1.2 million, which brought net income down to $3.9 million, or $0.15 per share. However, cash generation in the quarter was an impressive $10.3 million, driven by $5.3 million in operating activities and $5.0 million in receipt of a milestone payment from U.S. Absorica commercialization partner, Ranbaxy, on achieving $150 million in net cumulative sales since the commercial launch of the product in late 2012. This $5.0 million was recorded as revenues in the fourth quarter 2013.

Given the strong cash generation during the quarter, Cipher exited March 31, 2014 with $34.5 million in cash on the books. We note the company continues to speak about in-licensing or M&A, specifically with a focus on the North American dermatology market. Given the company s strong cash balance, we would not be surprised to see Cipher acquire at least one more product to promote alongside of Epuris in Canada in the next few months.

Absorica

Total net Absorica revenues in the first quarter 2014 were $6.0 million, comprised of $0.5 million in amortization of upfront licensing fee and $5.5 million in royalties on U.S. sales at Ranbaxy. We note that Cipher receives a mid- teens royalty (we believe ~15%) on U.S. sales of Absorica at Ranbaxy, but then shares that royalty with manufacturing partner Galephar 50/50. Cipher collects a mark-up on transfer to Ranbaxy (we believe ~1.5%). Thus, we believe Absorica sales in the first quarter equated to roughly $60 million.

The launch to date has clearly been impressive. Ranbaxy has 50 sales representatives promoting Absorica to roughly 3,500 prescribing dermatologists. Cipher reported that Absorica held roughly 22% market share at the end of March 2014. The graph below shows the change in market share since the launch in November 2012. We note the recent surge in market share is due to a stock-out of 30 mg generic isotretinoin (sold as Claravis) by chief competitor, Teva Pharmaceuticals. We are unaware how long Teva will be out of the market with Claravis, but it is clear that Ranbaxy and Cipher are benefiting from this competitor mishap.

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The market share gains are clearly encouraging, but even more exciting is that the overall isotretinoin market seems to be bouncing as well perhaps driven by Ranbaxy s active promotion of Absorica. Management noted that total U.S. isotretinoin prescriptions grew by 12% in 2012, with a surge at the end of the year. Total isotretinoin prescriptions in 2013 grew by 15%, acceleration from 2012. In the first quarter 2014, the market grew by 6%. Not only is Ranbaxy taking a bigger slice of the pie, but the pie is getting bigger at the same time.

Absorica is a differentiated product, promoted by a highly motivated and focused sales force, into a nicely growing market. The trend should continue in 2014. Based on existing trends, we estimate the total isotretinoin market in the U.S. is around 1.1 million prescriptions per year. When equated into Absorica (branded) price, this is around $1.25 billion in potential sales. Ranbaxy s ~22% market share as of January 2014 equates to a $250 million annualized run rate. This is consistent with the $60 million in sales we back-calculated off Cipher s royalty line for the first quarter. We originally believed that Ranbaxy can capture a peak of 25% market share, but two things lead us to believe that share gains may not stop at 25%. Firstly, chief competitor Teva remains out of the market with backorders for the 30 mg Claravis product. And secondly, in April 2014, India s Sun Pharma announced its intention to acquire Ranbaxy for $3.2 billion in cash, creating the world s fifth largest specialty / generic pharmaceutical company. The combined Sun-Ranbaxy will be number one in the world in specialty dermatology products, with Absorica as the flagship brand.

Lipofen

Net Lipofen revenue in the first quarter 2014 was $1.1 million, surprisingly above our forecast for $0.9 million. This was a nice snap-back after the weak middle of 2013. We suspect there was some inventory work down in the third quarter and then re-stocking in the fourth quarter of last year, but it looks like sales continued into the first quarter 2014. That said, ultimately we have low expectations for where Lipofen will go over the next year. The product is being negatively impacted by the launch of a generic version of AbbVie s TriLipix (fenofibric acid). In fact, Lipofen is the only remaining non-generic fenofibrate product on the market. Kowa has been raising the price of Lipofen to maintain sales growth, but we expect a challenging market after the patent expires in January 2015.

Prior to the patent expirations, Kowa continues to promote the product in the number two position with roughly 250 representatives. Lipofen has around 1.5% market share of the entire fibrate market. For 2014, we see revenues at $3.7 million for Lipofen, dropping starting in 2015 when the patent expires. We note that in April 2014, Kowa partnered with Amarin Pharma to market its EPA-fish oil product, Vascepa. In 2015, we expect Kowa to drop the product to a third-line detail for non-active prescribers for Lipofen.

ConZip / Durela

Net revenues from ConZip / Durela in the first quarter 2014 totaled $0.4 million, mostly driven by sales of ConZip by Vertical Pharmaceuticals Inc. in the U.S. Cipher gets a 15% royalty from Vertical Health on U.S. sales of ConZip and a 20% royalty from Medical Futures on Canadian sales of Durela. Cipher does not breakout ConZip from Durela, but we note that the company did report Durela royalties were up +56% from the first quarter 2013. ConZip prescriptions grew by 9% in the first quarter.

Late in the fourth quarter 2013, Avista Capital Partners, a U.S.-based private equity firm, acquired a controlling equity interest in Vertical with plans to invest in additional selling resources, while maintaining current management. We remind investors that Vertical is currently promoting ConZip with 75 sales representatives in the U.S. We believe if Avista provides additional cash to Vertical and expand the sales force to 100 representatives or more, Cipher will see increase royalties coming from ConZip in the coming quarters.

One area we may see some new growth from the CIP-tramadol-ER franchise is in Latin America. In late April 2013, Cipher entered into an exclusive distribution and supply agreement with Tecnofarma International Ltd. for the right to market and distribute CIP-tramadol-ER in 18 Latin American countries, including Brazil and Mexico. Under the terms of the agreement, Cipher received an upfront payment and is eligible for additional milestones based upon regulatory approval in Brazil and Mexico. Cipher will supply product to Tecnofarma at a fixed-transfer price.

Cipher and Tecnofarma are working towards regulatory filings in these 18 countries. Management tells us that some of the small countries, ones that work of the U.S. FDA or Canadian regulatory authority, may see some approvals in 2014. Larger countries, like Brazil for instance, may see filings in 2014 and regulatory approvals in 2015. We do not model meaningful revenues from CIP-tramadol-ER outside the U.S. or Canada, so if Tecnofarma can being to generate revenues and start paying royalties to Cipher in 2014 and 2015 it would represent upside to our model.

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Epuris

Sales of Epuris totaled $0.340 million in the first quarter 2014, up from the $0.283 million reported in the fourth quarter 2013. We remind investors that Cipher launched Epuris (the same product Ranbaxy launched in November 2012 as Absorica), on its own in June 2013. This was a big shift in strategy for the company. It hired 6 full time reps and 1 part-time rep to promote the product. Cipher also hired Joan Chypyha as Vice President of Marketing and Sales in early 2013. Ms. Chypyha will head up the company s commercial operations in Canada, and manage the recently created in-house sales force contracted for the Epuris launch. We note that Ms. Chypyha seems uniquely qualified for this role, having spent more than 25 years in the pharmaceutical industry with an emphasis on marketing, sales and business development in the dermatology area. We note her previous role as for 16 years with Hoffman-La Roche, escalating to Business Unit Director for the Dermatology franchise where she was responsible for the management of a specialty sales force that promoted Accutane, among other brands.

Cipher management noted that this specialty sales force that promoted Accutane was 6 to 8 representatives and achieved peak sales between $25 and $30 million. The current Canadian isotretinoin market is only around $15 million in size, but it has been fully genericized and there is no active promotion of any branded products besides Epuris. Cipher noted that in only nine months on the market, Epuris has picked up 7.6% market share of the total Canadian isotretinoin market.

The interesting thing about the Canadian market is that it seems to be bouncing in the recent months, similar to how the U.S. market started to bounce after Ranbaxy launched Absorica. The Canadian isotretinoin market grew by 5% in 2013, with trends roughly six months behind that of the U.S. In the first quarter 2014, the market grew by 6%. We believe that Epuris can be a $6-7 million product for Cipher in Canada based on the early success of Absorica in the U.S. Some private insurers have already picked up coverage of Epuris and Cipher has submitted dossiers to each Province in Canada for public reimbursement. We note that Saskatchewan was the first to provide coverage, and Ontario recently provided coverage as of February 1, 2014. Provincial insurance accounts for 16% of the isotretinoin market. Private insurance, for which Cipher management believes it has around 70% coverage, accounts for the remaining prescriptions. Cipher s goal is to have greater than 80% coverage with the private insurers for Epuris by year end 2014.

Solid Cash Position

Cipher exited March 31, 2014 with approximately $34.5 million in cash and investments. We note the company continues to speak about in-licensing or M&A, specifically with a focus on the North American dermatology market. Given the company s strong cash balance, we would not be surprised to see Cipher acquire at least one more product to promote alongside of Epuris in Canada in the next few months.

The Pipeline

Cipher is also working to file a new drug submission (NDS) for the Betesil Patch in Canada. Previous guidance was to have the filing in by the end of 2013. However, management is speaking with Health Canada about the necessity to conduct some additional CMC work prior to the filing. Cipher is working with Institut Biochimique SA on this issue to see if the FDA will request the data prior to the U.S. NDA filing. We are waiting for guidance on this issue, but note that management stated on a recent call that the time to conduct the additional work is only six months. We believe the costs are minimal, so we do not see this as a major issue. We believe this work should start around the middle of the year with a goal to file the NDS in early 2015.

If approved, we think the Betesil Patch is an excellent complement dermatology product for Cipher s contract sales force to co-promote along with Epuris. We would also not be surprised to see the company look to in-license or acquire another specialty dermatology product in Canada. We think Cipher can achieve breakeven Canadian operations based on the launch of Epuris alone by the end of 2015. This would be sales in the area of $3 million.

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M&A In Cipher s Future, One Way or The Other

We expect the company to continue to receive growth from existing products, led by Absorica, while they focus more and more on building a commercial sales and marketing presence in Canada. The company began marketing Epuris in Canada in late June 2013. This will be complemented by the Betesil Patch, should it receive Health Canada approval in 2015. In addition, we fully expect the company to license in and/or acquire other products, with an emphasis on late-stage to commercial-stage product candidates in specialty dermatology market in Canada. The company s $35+ million in cash as of the end of April 2014 creates significant opportunity for new product licensing or M&A in our view. Finally, we expect the company to leverage its regulatory approvals in U.S. and Canada to pursue licensing agreements in other markets for our once-daily CIP-tramadol and CIP-isotretinoin products.

Based on our financial projections, Cipher should report total revenues in 2014 of around $32 million, with EBITDA of around $20 million, net income of around $25 million (includes non-cash tax asset), and EPS of $0.97 per share. This equates to a P/E ratio of only 8.6x our 2014 figure! We see this as extremely cheap given the company s growth trajectory, strong cash position, and potential for increasing product sales in Canada. We believe all the above makes Cipher an interesting acquisition candidate itself for either a larger Canadian specialty pharmaceutical player, or a company looking to facilitate a tax inversion strategy by acquiring Cipher and then re-incorporating in a lower tax corporate haven like Ireland, Bermuda, or the Netherlands.

Tax inversion has a hot corporate strategy. According to an article on the NY Times, Applied Materials lowered its tax to 17% from 22% by acquiring Tokyo Electron by re-incorporating in the Netherlands. In 2012, Eaton Corporation acquired Cooper Industries, based in Ireland, for $13 billion, and reincorporated there. The company expects to save $160 million a year as a result of the move. In July 2013, Omnicom agreed to merge with Publicis Groupe, its French rival, in a $35 billion deal. The new company will be based in the Netherlands, resulting in savings of about $80 million a year.

This strategy has been particularly hot in pharma. In July 2013, Perrigo acquired Elan, an Irish drug company, for $6.7 billion. Perrigo will also reincorporate in Ireland, bringing its effective tax rate to 17% percent from 30%, with estimated cost savings of $150 million a year in taxes. Another example, Actavis, based in Parsippany, N.J., bought Warner Chilcott, a drug maker with headquarters in Dublin, and said it would reincorporate in Ireland, leading to an estimated $150 million in savings over two years.

Two potential big pharma deals that are being contested right now, Valent Pharma buying Allergan and Pfizer buying AstraZeneca are all about tax inversion. Another example that hits home for Cipher is when Endo Health Solutions, based in Malvern, Pa, acquiring Canada-based Paladin Labs as an intermediate step before reincorporating the merged companies in Ireland.

With a market capitalization of $225 million, Cipher is attractive to any company where the combined entity is made up for 20% Cipher shareholders. So, that s any company with a market capitalization of $800 million or less can acquire Cipher and re-incorporate under the tax inversion laws. Of course, a company with a market value of greater than $800 million could always bid higher for Cipher shares, say $300 million, to make sure that Cipher s ownership stayed above the 20% threshold. This is a very interesting opportunity for Cipher shareholders because it means potentially big returns on take-out.

Beyond the opportunity for tax inversion, Cipher offers an acquirer a low valuation that would result in potentially accretive earnings. The P/E ratio of only 8.6x 2014 EPS is far below industry average. Cipher also offers positive cash flow, significant unrecognized deferred tax assets of $12 million, R&D tax credits of $3.6 million, a net operating loss carryforward of $25 million, and roughly $36 million in current cash and investments (projected as of April 30, 2014). This is the perfect making of a great acquisition target. Therefore, we continue to recommend the shares and are maintaining our target at $11.

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PROJECTED FINANCIALS

Cipher Pharmaceuticals Inc. Income Statement

Model in Canadian Dollars (IFRS) 2012 A 2013 A Q1 A Q2 E Q3 E Q4 E 2014 E 2015 E 2016 E Lipofen Net Revenues $4.6 $3.4 $1.1 $0.9 $0.9 $0.8 $3.7 $2.0 $1.0 CIP-Fenofibrate YOY Growth 109.1% -26.1% - - - - 8.8% -45.9% -50.0% ConZip / Durela Net Revenues $1.4 $2.0 $0.4 $0.5 $0.6 $0.7 $3.2 $3.2 $5.2 CIP Tramadol-ER YOY Growth 75.0% 42.9% - - - - 60.0% 0.0% 62.5% Absorica Net Revenues $2.6 $21.2 $6.0 $5.5 $6.0 $6.5 $24.0 $24.3 $25.0 CIP-Isotretinoin YOY Growth 333.3% 715.4% - - - - 13.2% 1.3% 2.9% Product Sales (Canadian) $0 $0.4 $0.3 $0.4 $0.5 $0.5 $1.7 $2.5 $2.0 CIP-Isotretinoin YOY Growth ------Total Revenues $8.5 $27.0 $7.9 $7.3 $8.0 $8.5 $32.6 $32.0 $33.2 YOY Growth 137.0% 219.4% 139.3% 31.6% 41.1% -32.2% 20.7% -1.8% 3.8% Cost of Goods Sold $0 $0.1 $0.1 $0.1 $0.1 $0.1 $0.4 $0.6 $0.5 Product Gross Margin - 65.8% 70.6% 75.0% 75.0% 75.0% 75.0% 75.0% 75.0% Operating, General & Admin $3.5 $6.2 $2.3 $2.0 $2.1 $2.2 $8.6 $9.0 $10.0 % SG&A 41.7% 23.0% 29.3% 27.4% 26.4% 25.9% 26.4% 28.1% 30.1% Research & Development $1.5 $1.4 $0.4 $0.4 $0.5 $0.5 $1.7 $2.0 $2.0 % R&D 17.9% 5.1% 4.5% 4.8% 6.3% 5.9% 5.2% 6.3% 6.0% Amortization & Depreciation $1.0 $1.1 $0.2 $0.3 $0.3 $0.3 $1.0 $0.9 $0.8 Operating Income $2.4 $18.2 $4.9 $4.6 $5.0 $5.4 $20.8 $19.5 $19.9 Operating Margin 28.2% 67.2% - - - - 63.9% 60.9% 59.9% Interest & Other Net $0.2 $0.3 $0.1 $0.1 $0.1 $0.1 $0.3 $0.4 $0.5 Pre-Tax Income $2.5 $18.4 $5.0 $4.6 $5.0 $5.5 $21.2 $19.9 $20.4 Taxes / Other $0 ($6.6) $1.2 $0 $0 ($5.0) ($3.8) $0.0 $0.0 Tax Rate 0% -36% 23% 0% 0% 0% -18% 0% 0% Net Income $2.5 $25.0 $3.9 $4.6 $5.0 $10.5 $25.0 $19.9 $20.4 YOY Growth -210.1% -1180.4% - - - - 882.8% -20.4% -18.4% Reported EPS $0.10 $1.02 $0.15 $0.18 $0.20 $0.41 $0.99 $0.78 $0.78 YOY Growth -209.3% -1165.4% - - - - 848.3% -23.3% -20.7% Shares Outstanding 24.4 24.6 25.1 25.2 25.3 25.5 25.3 25.5 26.0 Source: Zacks Investment Research, Inc. Jason Napodano, CFA

HISTORICAL ZACKS RECOMMENDATIONS

Chart Generated by Yahoo! Inc. Initiation of Coverage = 1/03/2012 @ $0.64 / share

DISCLOSURES

The following disclosures relate to relationships between Zacks Small-Cap Research ( Zacks SCR ), a division of Zacks Investment Research ( ZIR ), and the issuers covered by the Zacks SCR Analysts in the Small-Cap Universe.

ANALYST DISCLOSURES

I, Jason Napodano, CFA, CFA, hereby certify that the view expressed in this research report accurately reflect my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the recommendations or views expressed in this research report. I believe the information used for the creation of this report has been obtained from sources I considered to be reliable, but I can neither guarantee nor represent the completeness or accuracy of the information herewith. Such information and the opinions expressed are subject to change without notice.

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Zacks SCR has received compensation for non-investment banking services on the Small-Cap Universe, and expects to receive additional compensation for non-investment banking services on the Small-Cap Universe, paid by issuers of securities covered by Zacks SCR Analysts. Non-investment banking services include investor relations services and software, financial database analysis, advertising services, brokerage services, advisory services, equity research, investment management, non-deal road shows, and attendance fees for conferences sponsored or co-sponsored by Zacks SCR. The fees for these services vary on a per client basis and are subject to the number of services contracted. Fees typically range between ten thousand and fifty thousand USD per annum.

POLICY DISCLOSURES

Zacks SCR Analysts are restricted from holding or trading securities placed on the ZIR, SCR, or Zacks & Co. restricted list, which may include issuers in the Small-Cap Universe. ZIR and Zacks SCR do not make a market in any security nor do they act as dealers in securities. Each Zacks SCR Analyst has full discretion on the rating and price target based on his or her own due diligence. Analysts are paid in part based on the overall profitability of Zacks SCR. Such profitability is derived from a variety of sources and includes payments received from issuers of securities covered by Zacks SCR for services described above. No part of analyst compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in any report or article.

ADDITIONAL INFORMATION

Additional information is available upon request. Zacks SCR reports are based on data obtained from sources we believe to be reliable, but are not guaranteed as to be accurate nor do we purport to be complete. Because of individual objectives, this report should not be construed as advice designed to meet the particular investment needs of any investor. Any opinions expressed by Zacks SCR Analysts are subject to change without notice. Reports are not to be construed as an offer or solicitation of an offer to buy or sell the securities herein mentioned.

ZACKS RATING & RECOMMENDATION

ZIR uses the following rating system for the 1092 companies whose securities it covers, including securities covered by Zacks SCR: Buy/Outperform: The analyst expects that the subject company will outperform the broader U.S. equity market over the next one to two quarters. Hold/Neutral: The analyst expects that the company will perform in line with the broader U.S. equity market over the next one to two quarters. Sell/Underperform: The analyst expects the company will underperform the broader U.S. Equity market over the next one to two quarters.

The current distribution is as follows: Buy/Outperform- 16.8%, Hold/Neutral- 75.5%, Sell/Underperform 6.7%. Data is as of midnight on the business day immediately prior to this publication.

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