Harmony Biosciences Is A BUY

I've been concentrating on the "Hare" side of the Green Screen lists recently. We have a good selection of larger, more conservative names in the portfolio and Watch List. I wanted to offset that with some smaller, faster growing, higher risk/return names.

We took a look last week at 2 - Aehr Test Systems and Symbotic - but ultimately decided that both had a number of undesirable characteristics that makes me want to avoid them at present.

After some more digging, today I want to highlight a stock that I think has potential and covers enough of our characteristics to make it investable. That's not to say there are not risks - there are a lot - but I do believe this company has serious upside even at today's prices.

Let's take a look at Harmony Biosciences (HRMY).

What Harmony Biosciences Does?

Harmony is a commercial-stage biotech. It has a single commercial product called WAKIX, which is the marketing name for the compound pitolisant.

Currently, WAKIX is approved to treat excessive daytime sleepiness (or EDS), and cataplexy (sudden muscular weakness) stemming from narcolepsy. Narcolepsy is a chronic neurological disorder that prevents the body's ability to properly manage its sleep-wake cycles.

WAKIX is what is known as an "orphan drug". Orphan drugs treat rare diseases that affect fewer than 200,000 people total in the U.S. These drugs would be unprofitable to develop without special considerations from the government. These include 7 years of market exclusivity, a 25% tax credit for clinical research, and research grant funding. These allow developers to recoup expenses with relatively high sales prices. To wit, WAKIX costs about $110 per tablet!

There are other treatments for the side effects of narcolepsy. Modafinil (marketed as Provigil) and armodafinil (Nuvigil) are moderate stimulants, while stronger and more habit-forming stimulants like Adderal, Dexedrine, and Ritalin may be prescribed for more serious cases. All of them fall under the "controlled substance" category, meaning they have the potential for dependence or abuse.

This is the key advantage of WAKIX/pitolisant. It is not a stimulant, but instead a histamine that has shown no signs of dependence, tolerance building, or withdrawal symptoms. It is the only FDA approved drug for EDS and cataplexy that is not controlled. Over 90% of patients taking the traditional narcolepsy treatments have expressed a desire for new treatment options. WAKIX's entry into the market just a few years ago fulfills this major medical need.

Is There Growth and Recurring Revenue Potential?

Harmony has an interesting growth story. Let's go through the different facets here.

First, pitolisant is currently approved for EDS and cataplexy. Management believes these alone could represent a $1 billion potential market at present. The drug only has 5,600 patients, vs. an affected population of well over 125,000 in the U.S. With a current revenue run rate of $500 million, that represents a 2x opportunity just on the currently approved commercial indications.

But there is plenty more life to this compound. The firm recently filed for pediatric approval for current indications. Further, Harmony is in Phase 3 trials (the final stage) to get it approved to treat Idiopathic Hypersomnia (IH), which is a disorder that causes sleepiness even after a good night's sleep. It won orphan status for IH in early September, but commercialization is still a ways off. Additionally, pitolisant is in Phase 2 trials for treatment of Prader-Willi disease (a childhood eating disorder), and Myotonic Dystrophy (a type of muscular dystrophy leading to weakness and muscle loss).

All told, Harmony believes these additional indications could add another $1 billion to the annual sales potential for WAKIX/pitolisant, addressable within the next few years if all goes well.

Management has also expressed a desire to pursue acquisitions to broaden the product portfolio. To this end, the company announced it was purchasing Zynerba Pharmaceuticals a few months ago. Zynerba's lead drug candidate is Zygel, a cannabinoid (cannabis-based) drug for treating Fragile X Syndrome (FXS).

Fragile X is a rare genetic disorder that results in intellectual disability and behavioral challenges. It has a small patient population, only about 80,000 sufferers in the U.S. The drug is in Phase 3 trials at present. It is hard to say what the revenue potential is, but given the patient population it seems reasonable to assume that $250-500 million annually isn't out of the question. Also, management believes Zygel has broad use case potential, not unlike pitolisant.

Readers know I am always skeptical of growth-by-acquisition strategies, but here I think it makes a lot of sense. Diversifying away from a one-product company helps blunt a lot of the risks inherent in this stock.

Finally, recurring revenue. WAKIX/pitolisant is a once-daily pill, and narcolepsy is a chronic condition, meaning patients are likely to keep taking it for an indefinite period. That is pretty much the definition of recurring revenue in my book.

How Wide Is The Moat?

Pharmaceutical companies rely on REGULATORY PROTECTIONS in order to earn a return on the tens to hundreds of millions in research, regulatory, and marketing costs to bring a drug to market. Harmony is no different.

Pitolisant has strong patent protection up through at least early 2030, and management is working on new formulations to extend that by as much as 10 additional years. Additionally, the drug's orphan status protects it from ANY similar market competition until 2027. Harmony should be able to enjoy strong pricing and no competition for several years going forward.

If approved, Zygel would be patent-protected until 2040, and likely would receive orphan status as well.

What's more, firms focusing on orphan drugs like this are by nature "big fish in small ponds". It doesn't make any sense for huge multi-nationals like Pfizer or Amgen to pursue them as the market is just too small to make a difference. New startups don't generally bother entering spaces where established orphan drugs dominate (the high barriers to entry aren't worth the small rewards). This creates a natural competitive barrier.

Still, investors should be aware that there will always be attacks on this moat. Just last month, Harmony won a patent case challenging WAKIX, and there will likely be more going forward.

Management and Financial Health

Jeffrey Dayno took over as President and CEO earlier in 2023. He was the firm's first Chief Medical Officer, joining shortly after the company's founding in 2017. He's been with Harmony since almost the beginning, well before pitolisant was even close to being a commercial product.

I'm a little disappointed in his ownership stake, which only amounts to a little under $3.3 million dollars. That said, insiders own over 28% of the company, so there is plenty of leadership "skin in the game" here. Dayno has had a major role in the success of pitolisant, so he is well suited to lead the firm. I don't see any major concern with management.

Financially, Harmony has performed very well since commercializing WAKIX in 2020. The 3 year CAGR in sales is over 46%, and even 3 years in, sales are still rising over 25% (a rarity for an orphan drug). The firm has over $400 million in cash and less than $200 million in debt, a reasonable ratio. Importantly, Harmony is converting sales to free cash flow at a 33% margin, and earning a cash return on invested capital of over 60%. These are all excellent figures.

It is not too often you see a small biotech announce a $125 million share repurchase program, but that's exactly what Harmony did back in July. That is a testament to the company's confidence in its near term results.

Risks

Without question, if added to the portfolio, Harmony would EASILY become the riskiest stock on the ledger!

Right now, this is a one product company. If any long-term issues with WAKIX develop, the company is in trouble. If it loses a key patent lawsuit, the company is in trouble. If a better, novel treatment using a substantially different method comes to market (or an existing - probably cheaper - drug is shown to be effective), Harmony stock will suffer. There is serious event risk here - investors need to be aware of this!

Longer term, the future is hazy. Regulatory protections are strong up through 2027, but after that things will become more difficult. Orphan drugs don't grow sales for long - their major downside is a small patient population. Harmony will have to acquire and effectively bring to market new products, which can be a daunting task that takes time and money with no guaranteed return on investment. Most stocks I recommend have clear 10-year horizons, at least. Harmony's is 3-4 years, at most.

Furthermore, biotech has not really been a reliably lucrative or predictable area to invest in. Approval schedules are unpredictable. Payments are transparent, handled through large insurance companies and governments that can reduce or eliminate reimbursements basically on a whim. Expensive drugs like WAKIX often come under the crosshairs. Patent protections are often shown to be tenuous.

Finally, I don't have much of a track record recommending medical stocks, let alone small biotechs. I'm going out on a limb somewhat for this one!

All of this means 2 things. One, when calculating a fair value estimate, we need to use a much larger than normal discount rate to account for all of these risks. And two, if we do decide to buy in, the position should be small - no more than 1/2 of a typical position (I'd say no more than 2% of a portfolio at most).

Conclusion

Harmony looks attractive enough to classify as a "green dot" stock. It has recurring revenues, solid growth potential, excellent financial metrics, and numerous regulatory protections that afford it time to develop a longer-term strategy. I don't necessarily see this as a 10-year hold, and in fact I would probably sell this one a little before most of our others (say, at 25% overvalued instead of 50% or more).

The main reason I'm highlighting this stock now is that it looks like a very good buy at current prices. I've modeled it for near-term 20% annual growth (in-line with estimates), a 29% free cash flow margin (below current performance), and a much higher than normal 13% discount rate (to account for the risks). All told, I get a fair value estimate of $56 per share. At a current quote of $37, that puts the stock at a 35% "margin of safety", well over our threshold of 25%. That gives the stock over 50% upside to the fair value target.

Those several layers of protection make Harmony Biosciences a BUY right now! I'm adding it to our Buy List immediately and we will continue to track it as an active portfolio stock going forward.