Vertex: Risk-Reward Less Favorable If HCV Pipeline Is In Question

| About: Vertex Pharmaceuticals (VRTX)

What happened: Amid the positive biotech earnings on Thursday, Vertex (NASDAQ:VRTX) announced after the close that the FDA had put the US Phase 2 study of VRTX's hepatitis C [HCV] drug VX-135 on partial clinical hold. This clinical hold halts the evaluation of the 200mg dose group but allows treatment with the 100mg VX-135 dose, in combination with ribavirin, to continue in the US study. The reason given for the regulatory caution was because the FDA learned the 400mg VX-135 dose with ribavirin led to elevated liver enzymes in a separate European Phase 2 study.

Details from the press release on Thursday:

European Study of VX-135 in Combination with Ribavirin:

Dosing of 100 mg and 200 mg of VX-135 in combination with ribavirin as part of a 12-week Phase 2 study in Europe is complete, and all patients are in the post-treatment follow-up period. Ten patients with genotype 1 hepatitis C were enrolled in each dose group and all 20 patients completed 12 weeks of treatment. Both the 100 mg and 200 mg doses were well tolerated, no serious adverse events have been reported and no liver or cardiac safety issues have been identified. All patients achieved undetectable HCV RNA during the 12-week dosing period, and 70 percent and 80 percent of patients in the 100 mg and 200 mg dosing arms, respectively, had undetectable HCV RNA within four weeks of initiating treatment. HCV RNA was undetectable at the end of the treatment period in all patients with available data. Complete safety and efficacy results from the 100 and 200 mg arms of the study are expected to be available in the second half of 2013. Following completion of enrollment in the 100 mg and 200 mg arms of the European study, the study was amended to evaluate a 400 mg dose of VX-135 in combination with ribavirin in ten patients. Elevated liver enzymes were observed in three of ten patients in this dose group, including one serious adverse event, and the 400 mg arm of the study was discontinued. Following the discontinuation of dosing, liver enzyme levels returned to baseline in all three patients.

What you needed to know before this:

HCV is the part of the VRTX pipeline that I'd argue is still relatively unappreciated (the other big part being cystic fibrosis, of course). However, sellside analysts and investors have been growing increasingly excited about the upside potential of VX-135 (aka ALS2200, which was exclusively licensed from Alios), which has been in Phase 2 studies. Like cystic fibrosis, HCV is undeniably a blockbuster market. VX-135, like Gilead's (NASDAQ:GILD) GS7977 (aka sofosbuvir/PSI-7977), belongs to the exciting, but controversial new drug class in HCV treatment of nucleoside analogs or "nucs." The nucs can arrest DNA replication and therefore help prevent the virus from multiplying. Basically, the nuc class has demonstrated the potential to become the dominant backbone of a next-generation all-oral HCV regimen (briefly, they have shown potency, unprecedented cure rates beyond conventional treatments, a relatively high barrier to developing viral resistance, and tolerability). Certainly, this is the potential future GILD seems to be envisioning for 7977. And not only is VX-135 also a nuc but it is also of the uridine type (one out of the four possible DNA nucleotide bases) like GILD's 7977. However, where the controversy lies, the clinical and regulatory hurdle VX-135 must clear, is safety. Several nucs (BMS094/INX189, PSI-938, IDX184) have been put on clinical hold by the FDA for safety concerns, presumably including heart failure and liver enzyme elevations. Of the clinical stage nucs, only GILD's and VRTX's drugs were left standing after the FDA's previously raised concerns. On the 1Q earnings call, VRTX management guided to the first 12-week safety data for VX-135 being available from roughly 40-60 patients by year-end. Many institutional investors have seen this dataset as critical to derisk the safety profile of VX-135, albeit a larger dataset of >100 patients would likely be needed to make the decision to take the drug into pivotal trials.

My $.02:

Given the prior FDA stance, Thursday's news raises serious questions about the future of the VX-135 program and the HCV pipeline. Elevated liver enzymes can be clinically irrelevant or they can be potentially concerning, if indicative of drug-induced liver injury. Appropriately, the FDA is not taking any chances on that possibility. On a positive note, I would pick a liver enzyme elevation over a known cardiac issue to contend with any day and the fact there is a partial clinical hold, not a full hold, allows other studies and doses to continue to accumulate safety data. Even so, questions remain whether VX-135 is likely to continue development and if it does, whether this safety issue would effectively cripple the commercial competitiveness of VX-135 or the ability to combine/partner VX-135 with other HCV assets. Without VX-135, the hopes of building a competitive all-oral HCV regimen would likely evaporate. Then, VRTX would end up with no HCV franchise at all, since most professional investors assume that sales of Incivek (the marketed HCV protease inhibitor) will basically go away once far superior HCV regimens become available in 2014.

VRTX is one of those biotech companies that have delivered plenty of controversy in the last couple of years, whether it's from the competition weighing against its lead drugs or, more recently, from an ill-timed stock sale by management. However, until today, it seemed to be doing well recently (stock rallied from $50s into low $80s) on the heels of positive data developments in its cystic fibrosis (CF) pipeline, leading VRTX to emerge as the dominant player in the CF space. (As a reminder, cystic fibrosis is a genetic disease where mutations in a gene lead to thick mucus. This clogs the airways and predisposes to infections and worse life expectancy.) With Kalydeco already in the CF market and a handful of other complementary assets to combine with, VRTX has the potential to target a substantial portion of the CF mutations (I estimate $6-7B in sales potential).

However, prior to today, my long thesis on VRTX has been that with potentially two strong blockbuster franchises in CF and HCV, VRTX would have flexibility in determining its next leg of revenue growth. Without VX-135, the story erodes significantly and VRTX would become more dependent on success in CF and the rest of the pipeline (e.g., VX-509 for rheumatoid arthritis), which is far less exciting to me.

The trade:

For fundamental investors, I mention the aftermarket selloff (~$6-7 off) of VRTX seems appropriate to me to reflect removing the risk-adjusted value of VX-135 from the VRTX valuation (which for me is based on a sum-of-the parts). Without VX-135, my upside valuation of VRTX loses $20-30/share from removing the full value of an all-oral HCV combo regimen. Before this, I would have argued the risk-reward of VRTX becomes less favorable around $90-ish/share. Now, I would argue the risk-reward becomes less attractive once the stock gets into the low $80s. On the other hand, the scarcity value of GILD's 7977 just went up as it's the only clinical-stage nuc left with a clear regulatory path.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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