Ernest W. Andberg, CFA [email protected] (612) 492-8836 Specialty Pharmaceuticals Orphan Medical, Inc. (ORPH - $9.70) January 21, 2003 Initiating Coverage – Aggressive Growth STRONG BUY Financial Summary Key Points: S Rev (mil) 2001 2002E 2003E Initiating coverage with a STRONG BUY recommendation and a 9-12 month price target of $22.50. Mar $2.3 $3.7A $4.0 S Key drug launch underway – Xyrem® was approved by the FDA in July 2002 and Jun $2.4 $3.5A $6.0 Sep $2.9 $4.2A $7.5 launched in early October. The drug is the only currently approved treatment for Dec $3.6 $4.5 $8.5 cataplexy, a debilitating disease that has an immediate market potential approaching $125 million in the U. S. FY $11.3 $15.9 $26.0 S Existing product portfolio continues to show surprising strength with growth of P/Sales 8.9x 6.3x 3.9x nearly 40% in fiscal 2002. S EPS 2001 2002 2003E High Gross Margin Model – We expect Orphan to generate gross margins in the mid 85% range, or higher. Mar ($0.19) ($0.11) ($0.44) S Jun ($0.23) ($0.16) ($0.30) Tax Sheltered Earnings – Tax loss carry forwards should shelter earnings over the Sep ($0.24) ($0.42) ($0.19) next four to five years. Dec ($0.14) ($0.42) ($0.11) S Favorable risk reward ratio – In our opinion, the approval of Xyrem has significantly FY ($0.80) ($1.11) ($1.03) reduced the risk of current investments in Orphan’s shares while the upside potential P/E nm nm nm remains substantial. Investment Recommendation: Orphan Medical, Inc. is an emerging specialty pharmaceutical company on the verge of a Price: $9.70 significant expansion of revenues due to the FDA approval and commercial introduction of Xyrem. Xyrem is the only approved treatment for cataplexy, a debilitating disease that has a 52-Week Range: $15.00-5.95 Target: $22.50 market potential approaching $125 million in the U. S. In our opinion, Xyrem will help push Rating: STRONG BUY revenues from approximately $16 million in fiscal 2002 to between $65 to $70 million in fiscal 2005 and produce a rapidly growing, profitable bottom line beginning in the 2004 time Shares Outstanding: 10.4 mil frame. Float: 10.0 mil Mrk. Capitalization: $101 mil Ave. Volume: 35,000 At the current time, we continue to believe that the market is undervaluing the existing Instit. Ownership: 33% portfolio of drugs and the very real upside potential of Xyrem. Assuming our revenue and BV / Share $1.18 earnings estimates for fiscal 2003 through 2005 are reasonable, we believe the shares have Debt / Tot. Cap.: 0% upside potential into the $20- $25 range over the next twelve months. Our target price Est. LT EPS Growth: 50% assumes a terminal multiple of forty times our fiscal 2005 tax adjusted earnings per share Exp. Next Rpt. Date: 1/30/03 discounted at 25% plus a discounted value of the tax loss carryforwards. We are initiating coverage of the stock with a STRONG BUY rating for aggressive investors. Company Description Orphan Medical acquires, develops, and markets pharmaceuticals of high medical value for inadequately treated and uncommon diseases. The Company serves three therapeutic areas that are characterized by well-defined patient populations and served by physician specialists: antidotes, oncology support and sleep disorders. Source: Reuters. Feltl and Company Research Department. Please see important disclosures at end of report. 120 South Sixth Street, Suite 2600 Minneapolis, MN 55402 1-866-655-3431 Investment Overview Orphan Medical is an emerging, specialty pharmaceutical company focused on developing and marketing treatments for uncommon or inadequately treated diseases. The Company was originally established as a division of Chronimed, Inc. to explore and commercialize orphan drugs as defined in the Orphan Drug Act of 1983. This Act provides incentives to companies to develop and market drugs for diseases or conditions that are known to affect fewer than 200,000 people in the United States. The Company became a publicly traded entity when it was spun out of Chronimed in 1994. Today, Orphan’s efforts are targeted at three principal, therapeutic areas; oncology support, antidotes and sleep disorders. Each of these is characterized by a well-defined patient population and treated by an easily identified group of medical specialists. Orphan believes this focus allows a targeted marketing approach that makes a large sales force unnecessary because efforts can be focused on a limited number of medical specialists or patients. Orphan currently has six FDA approved drugs in the market. These include Busulfex® Injection, Antizol® Injection, Sucraid® oral solution, Cystadane®, Elliots B® Solution and Xyrem® (sodium oxybate) oral solution. For all intents and purposes, Orphan looks like a virtual drug company. While the Company has a dedicated sales force to market it products, it conducts no in-house clinical research, and does no manufacturing or distribution. The Company does not conduct basic research and does not attempt to discover new drugs. To expand the pipeline, the Company normally seeks to acquire products that are already in Phase II or Phase III clinical trials, or in an earlier stage with proof of concept established. Clinical research is managed by in-house staff, but contracted out to independent research organizations. Manufacturing is likewise contracted out to third party contract manufacturers and distribution is done through third- party pharmacy benefit management and specialty pharmacy services firms. Xyrem Appoval The U. S. Food and Drug Administration (FDA) approved Xyrem on July 17, 2002 and the drug was launched in early October. Xyrem is the first drug approved specifically for the treatment of cataplexy. Cataplexy is a debilitating symptom of narcolepsy usually triggered by strong emotions such as, laughter, anger, or surprise. Cataplexy sufferers often have fragmented sleep. In its most severe form cataplexy can cause a person to collapse during waking hours. The approval of Xyrem represents the single most important catalyst in the Company’s history. In our opinion, Xyrem will prove to be a commercial success that will produce a rapidly growing revenue stream and lead to significant profitability over the next three to five years. The Market Narcolepsy is a chronic neurological disorder that usually appears in patients in their mid- teens or early twenties. The disease is most often recognized by its primary symptom, excessive daytime sleepiness (EDS), which disrupts normal activities during the day. Additional symptoms include cataplexy, fragmented nighttime sleep, hypnagogic hallucinations (vivid and sometimes frightening dreams when falling asleep or waking up), and sleep paralysis (brief periods of feeling muscle paralysis upon waking). Because narcolepsy is a rare disease and is not easy to diagnose, the total population of potential sufferers is difficult to define precisely, but most observers believe the disease affects approximately 150,000 persons in the United States about half of whom are diagnosed. Between 60-90 percent of narcolepsy patients are believed to also suffer cataplexy. Currently, there are approximately 25,000 cataplexy patients being treated off label with antidepressants (tricyclic and selective serotonin reuptake inhibitors). These drugs have limited efficacy and often produce unsatisfactory side effects. In addition, patients build up tolerance to these drugs over time. Initially Xyrem will target this universe of patients. Based Page 2 Orphan Medical, Inc. 01/21/03 on the initial pricing of Xyrem, this represents a potential market of approximately $125 million in the U. S. ORPH is currently conducting a Phase III(b) clinical trial with Xyrem for the treatment of EDS associated with narcolepsy. The trial is designed to evaluate the effectiveness of Xyrem, in combination with stimulant drugs, in reducing the incidence of EDS in narcolepsy patients. EDS has traditionally been treated with stimulants like Ritalin and Provigil, but these drugs do not treat cataplexy. Earlier trials have shown a statistically significant reduction in EDS when Xyrem was used in combination with stimulants. However, since this was not the primary endpoint of these trials the Company initiated the current Phase III(b) trial. ORPH expects to complete enrollment in this study by the middle of this year and if the earlier trials are born out, intends to file a supplemental NDA in 2004. Assuming a positive outcome and approval by the FDA, the total market potential for Xyrem could then be in the range of $300 to $400 million in the U.S. Marketing and Distribution The active ingredient in Xyrem is sodium oxybate – the sodium salt of gamma hydroxybutyrate (GHB). GHB is a naturally occurring chemical found in the brain and other tissues. It was first synthesized in 1960 and was found to have sedative and anesthetic properties, but was supplanted by more effective anesthetic agents. In the early 1990’s, GHB was marketed as a dietary supplement for enhancing athletic performance, primarily among body builders, and became a “street” drug of abuse often described as a date-rape drug because of its sedative and anesthetic effects. As a consequence, the FDA and a number of states intervened to prohibit the manufacture or use of GHB. In early 2000, a bill was passed and signed into law making GHB a controlled, Schedule I substance, similar to LSD or heroin. This is the most restrictive designation of the Controlled Substances Act. At the same time Xyrem received a Subpart H exemption and will be designated as a Schedule III drug, meaning it cannot be sold, distributed, or provided to anyone except by prescription. As a consequence, ORPH and the FDA have worked to design a comprehensive risk management program for Xyrem. The program includes distribution through a single centralized pharmacy, physician and patient education programs, creation of a patient and physician registry and detailed patient surveillance.