Theravance: Baby Thrown Out With The Bath Water - 35% To 65% Upside

Mar.31.14 | About: Innoviva, Inc. (INVA)

Summary

16% collapse in the biotech index since February 25th has triggered a 24% collapse in THRX.

Blue chip investors(GSK: 27% and Baupost 18%) have recently bought more THRX shares 20-25% higher than the current price.

Received approval for two potentially blockbuster respiratory drugs, both distributed and marketed by GSK.

Separation into royalty and development companies in the second quarter of 2014 is a potential catalyst. Separation may partly be a market-test prior to an acquisition by GSK.

Theravance (THRX) is a biopharmaceutical company focused on the discovery, development and commercialization of small molecule medicines across a number of therapeutic areas including respiratory disease, bacterial infections, and central nervous system/ pain. It has two approved drugs addressing a large and growing respiratory disease market and a deep pipeline of respiratory and non-respiratory programs. Development and commercialization for the two approved drugs and most respiratory pipeline drugs are under agreements with GSK, which will pay annual royalties to Theravance.

Unless stated otherwise, information is from the 10-K and/ or a March 2014 company presentation.

ABBREVIATIONS

  • LABA = Long-acting beta2 agonist
  • LAMA = Long-Acting Muscarinic Antagonists
  • MABA = Bifunctional Muscarinic Antagonist-Beta2 Agonist
  • ICS = Inhaled corticosteroid
  • COPD = Chronic Obstructive Pulmonary Disease

ADDRESSABLE MARKET - LARGE, CHRONIC AND GROWING DISEASE

COPD refers to a group of lung diseases that block airflow and make breathing difficult. Damage to lungs from COPD can't be reversed, but treatment can help control symptoms and minimize further damage. The main cause of COPD is tobacco smoking.

Asthma is a condition in which airways narrow and swell and produce extra mucus. This can make breathing difficult and trigger coughing, wheezing and shortness of breath. It isn't clear why some people get asthma and others don't, but it's probably due to a combination of environmental and genetic factors.

Global sales of products containing Long-Acting Bronchodialators, which are used to treat COPD and Asthma, were $21 billion in 2013. Sales grew 6.4% pa. for the last three years and are expected to grow to $26 billion by 2020. GSK's Advair, AstraZeneca's Symbicort and Boehringer's Spiriva, which are direct competitors of Theravance-GSK's drugs, have current combined sales of $16.5 billion. GSK and Theravance developed one of their recently approved drugs specifically to replace GSK's Advair (dominant market share with 2013 sales of $8.3 billion), which is expected to face generic competition soon.

In developed countries, patient population is expected to grow due to widespread tobacco smoking over the last few decades leading to more patients with COPD, especially with an ageing population and with better diagnosis - about half of the 27 million Americans with COPD are undiagnosed. Further, long-acting bronchodialators are likely to have more widespread use among the current patient population due to availability of novel therapies, less frequent dosage and more familiarity in doctor and patient populations - more than a third of US patients with COPD are not on any long-acting bronchodialator regimen.

In developing markets the patient population is expected to be large and growing, especially in countries with significant smoker populations - China, India, Indonesia. The company is in the process of getting regulatory approval in China.

APPROVED DRUGS AND PIPELINE

RELVAR®/BREO® ELLIPTA® ("Relvar/Breo")

  • BREO® ELLIPTA® is the proprietary name in the U.S. and Canada for the once-daily combination medicine of an ICS, fluticasone furoate "FF", and a LABA, vilanterol "VI" (FF/VI) administered using the ELLIPTA®, a dry powder inhaler. RELVAR® ELLIPTA® is the proprietary name for FF/VI outside of the U.S. and Canada. Theravance is entitled to receive annual royalties on sales of FF/VI as follows: 15% on the first $3.0 billion of annual global net sales and 5% above $3.0 billion
  • Relvar/Breo is approved in the US (COPD), the EU (COPD and Asthma) and other countries (COPD and/ or Asthma)
  • Relvar/Breo is aimed to succeed GSK's Advair® /Seretide™ (salmeterol and fluticasone as a combination), which had 2013 sales of $8.3 billion, and to compete with AstraZeneca's Symbicort® (formoterol and budesonide as a combination), which had sales of $3.5 billion
  • While Relvar/Breo is not a first in class drug, it is a once a day/ 24 hour acting drug. 43% of COPD-patients adherer to their treatment schedules when using a once-daily dosage plan vs. 37% for twice-daily, 30% for three-times-daily and 23% for four-times-daily. Further, patients with COPD with higher adherence experienced fewer hospitalizations and lower Medicare costs than those with lower adherence behavior
  • In March 2014, Theravance reported that patient recruitment was completed in its Relvar/Breo Study to Understand Mortality and MorbidITy (SUMMIT) in COPD. If positive, SUMMIT data is expected to boost Breo's potential market share
  • Relvar/ Breo was launched in the US and three countries in Europe in late 2013-early 2014. While early data indicates sales may be lower than bullish estimates, it is still very early in the launch. Further, GSK management has stated that Breo sales potential is not represented by prescription data due to limited Medicare Part D coverage which causes rejection of prescriptions and due to free samples.

ANORO™ ELLIPTA™ ("Anoro")

  • ANORO™ ELLIPTA™ (umeclidinium and vilanterol inhalation powder) is the first once-daily product approved in the U.S. that combines two long-acting bronchodilators in a single inhaler for the maintenance treatment of COPD. ANORO™ ELLIPTA™ is the proposed proprietary name for UMEC/VI, a combination of two bronchodilator molecules-umeclidinium, a LAMA and VI, a LABA, administered using the ELLIPTA™ inhaler. Theravance is entitled to receive annual royalties on sales of Anoro as follows: upward tiering 6.5% to 10% on global net sales
  • Anoro is approved in the US (COPD), recommended for approval in the EU (COPD) and other countries (COPD)
  • Anoro, which is also a combination product, is targeted as an alternative treatment option to Boehringer's Spiriva® (tiotropium), a once-daily, single-mechanism bronchodilator, which had 2012 sales of $4.7 billion
  • Anoro is a first in class drug and is expected to be launched in the US in early 2014. Anoro is expected to have a >1 year head start over potential direct competitors
  • In March 2014, Theravance reported positive results from three Phase 3 studies comparing Anoro to Seretide and Advair in patients with COPD

Theravance's deep pipeline includes therapies in the respiratory market (MABA; phase 2 and MABA/ICS, UMEC/VI/FF, TD-4208-LAMA; phase 2), drugs focused on bacterial infections (TD-1792; phase 2 and TD-1607; phase 1), central nervous system pain (RD-1211 and TD-9855; both phase 2), Gastrointestinal Motility Dysfunction including irritable bowel syndrome (TD-5108 and TD-8954; both phase 2) and others.

Theravance also owns Vibativ, an FDA-approved injectible antibiotic to treat patients with hospital-acquired and ventilator associated bacterial pneumonia.

GSK-Theravance Relationship

GSK and Theravance collaborate under two agreements: 2002 LABA collaboration (Relvar/Breo, Anoro and UMEC/VI/FF) and 2004 Strategic Alliance (MABA related). Under the agreements, Theravance is required to make milestone payments to GSK and receives royalties on the sales of the drugs.

GSK is the global leader in drugs related to respiratory diseases, which account for approximately 40% of its sales. This is led by Advair (approximately $8 billion sales), which lost patent protection in 2010 and is expected to face generic competition in 2016. The delay in generic competition is due to the time taken by the FDA to provide guidelines for how generics manufacturers might establish an acceptable bioequivalence for Advair and due to the complexity of developing an alternative inhalation device. GSK is primarily relying on its Theravance-partnership drugs to protect and grow its respiratory franchise in light of the imminent generic competition to Advair. GSK will put its massive global financial and marketing muscle to ensure that its Theravance-partnership drugs will become blockbusters.

GSK owns 27% (30.3 million shares) of the outstanding shares of THRX, with the latest 342,229 shares purchased in February 2014 for $12.8 million ($37.5 per share) and it has purchased a total of 3.7 million shares between April 30, 2013 and February 11, 2014 for $136 million (average price $36.53). There have long been rumors of GSK buying all of THRX (latest estimates of $45-$55 per share). Our unsubstantiated speculation is that GSK wants to buy all of Theravance but has not been able to agree on a price. Further, we speculate that part of the reason that Theravance has chosen to separate into two companies (see below) is to perform a final market-test prior to finalizing the price at which GSK acquires all of Theravance.

SEPERATION/ SPIN-OFF

In the second quarter of 2014, Theravance will complete the separation of its late-stage partnered respiratory assets from its biopharmaceutical operations which is highly likely to create shareholder value. The two businesses will attract a distinct shareholder base, will have different capital allocation plans and will highlight the significant discount the stock is trading at on the sum-of-the-parts basis.

Our speculation is that the separation/ spin-off is driven by two considerations (1) unlocking of value and (2) attempt by management of Theravance to "prove" to GSK that THRX is worth more than GSK is willing to pay to acquire the entire company. It is likely that after the two companies trade separately for a few month, there may be less disagreement on what price GSK has to pay to acquire all of THRX.

Theravance, Inc. (Royalty Company "RoyaltyCo")

  • Will have minimal drug research and development risk, will be structured with a tax efficient capital structure, will have minimal employees, will distribute most of its cash flows to shareholders and will be domiciled in a tax friendly jurisdiction
  • RoyaltyCo will directly hold and continue to manage Relvar/Breo, Anoro and VI monotherapy. All three of these programs are partnered with GSK
  • All other programs currently partnered with GSK, including MABA, MABA/ICS, and UMEC/VI/FF will be held and managed by a limited liability company subsidiary of RoyaltyCo. 85% of the LLC's economic interests in those programs will accrue to Theravance Biopharma and 15% will accrue to RoyaltyCo
  • The milestone payments due to GSK (related to Relvar/Breo and Anoro) and Theravance's outstanding convertible notes will remain as obligations of RoyaltyCo. RoyaltyCo is also anticipated to retain Theravance's net operating loss carryforwards.

Theravance Biopharma ("BiopharmaCo")

  • BiopharmaCo will be a drug discovery, development and commercialization company. It will be led by an experienced leadership team and will maintain Theravance's integrated R&D capabilities
  • The key product and product candidates in Theravance Biopharma's portfolio will include VIBATIV® (telavancin), a bactericidal, once-daily, injectable lipoglycopeptide antibiotic developed by Theravance for the treatment of Gram-positive infections (hospital-acquired and ventilator associated bacterial pneumonia), TD-4208, an investigational muscarinic antagonist administered once-a-day as a nebulized aqueous solution in patients with moderate to severe COPD, TD-1211, an investigational, once-daily, orally-administered, peripherally-selective, multivalent inhibitor of the mu opioid receptor designed with a goal of alleviating gastrointestinal side effects of opioid therapy without affecting analgesia, and TD-9855, an investigational norepinephrine and serotonin reuptake inhibitor for the treatment of central nervous system conditions such as chronic pain, including fibromyalgia
  • Theravance currently plans to capitalize BiopharmaCo with approximately $300 million at separation, which is expected to fund operations through significant potential corporate milestones over the following two to three years. Future development may also be supported via royalties received from BiopharmaCo's 85% economic interest in the limited liability company subsidiary of RoyaltyCo (detailed earlier).

VALUATION: $40.4 per share stand-alone (34% upside); $50 take over (66% upside)

Stand-alone sum of the parts: $36.2 to $43.9 per share (33% upside at the mid-point)

I. Royalty stream from Relvar/Breo and Anoro - discounted cash flow analysis: $25.6 to $32.4 per share

  • Peak sales of Relvar/Breo = $2.6 billion to $3.2 billion. While Relvar/Breo has been developed specifically to replace Advair ($8.3 billion sales), generic competition in approximately two years and existing and future competition may result in Relvar/Breo capturing only 31% to 39% of Advair sales
  • Peak sales of Anoro = $3.5 billion to $4.0 billion. Anoro is a first in class drug with a material lead time over competition. Estimates are based on a range of Theravance and GSK sell side analyst numbers, which appear reasonable to us based on the details provided in the addressable market section above
  • Relvar/Breo royalty: Theravance will receive 15% on the first $3.0 billion of annual global net sales and 5% for all annual global net sales above $3.0 billion.
  • Anoro royalty: Theravance will receive upward tiering 6.5% to 10% of annual global net sales
  • Operating margins 95%: Royalty stream has negligible fixed and marginal cost
  • Tax rate of 15% on Relvar/Breo and Anoro: A reduced tax rate is being used since RoyaltyCo is expected to be domiciled in a tax friendly jurisdiction.
  • Number of years 17: No terminal value
  • Discount rate 11%
  • Number of shares 112.8 million: Assumes full conversion of convertible debt (due 2023)

II. Valuation of the pipeline drugs and Vibativ: $6.0 to $6.9 per share ($681 million to $784 million)

  • Respiratory (MABA, MABA/ICS and UMEC/VI/FF) is valued on a risk adjusted discounted cash flow basis and accounts for 57% of the pipeline value
  • Bacterial (Vibativ, an approved drug), Gastrointentional (TD-1211 etc) others (CNS pain, respiratory, bacterial) are valued based on analyst estimates and account for 16%, 16% and 11% of the total pipeline value respectively.

III. Cash of $4.6 per share. The analysis assumes that the convertible debt is converted to shares at the $27.79 per share conversion price.

IV. Potential upside not included in the sum of the parts analysis

  • Net operating loss balance of $1.5 billion has been ignored due to lack of information about the amount that will be left over after the tax impact of the spinoff
  • Bullish estimates for combined Relvar/Breo and Anoro sales are as high as $9+ billion as against $7.2 billion in the sum of the parts analysis above. The bullish estimates are based on strong results in additional studies and growth in the overall market size, both detailed in the addressable market section earlier
  • Bullish estimates for the pipeline and Vibativ are as high as $13.7 per share, as against $6.5 in the sum of the parts analysis above.

Historic discount to analyst targets: $40.8 per share (35% upside)

  • The stock is trading at a 38% discount to median analyst target of $48.50. If the stock trades at its historical discount to analyst targets of 16%, it would trade at $40.8

Potential acquisition by GSK: $45-$55 per share (66% upside at the mid-point)

  • There have long been rumors of GSK buying all of THRX (latest estimates of $45-$55 per share).

Knowledgeable and well-considered insider buying has been at prices significantly higher than the current price and indicates that the earlier sum of the parts valuation is conservative

  • GSK last purchased shares in February 2014 at $37.5 per share and it has purchased a total of 3.7 million shares between April 30, 2013 and February 11, 2014 for $136 million (average price $36.53). GSK would not buy at $37.5 if it believed that the stock was worth just $40.4
  • Baupost Group (Seth Klarman) owns 18% of the outstanding shares of Theravance and is the second largest holder after GSK. Baupost last purchased 1.6 million shares at an estimated price of $36.3 in the fourth quarter of 2013. Baupost would not be buying shares at this price if it believed that the stock was worth just $40.4
  • In March 2014, four insiders Aronld Levine (director), Mathai Mammen (officer), George Whitesides (director) and Bradford Shafer (officer) exercised options to purchase a total of 190,538 shares. While these were not open market purchases, only Bradford Shafer sold some shares (65,806), which is a bullish indication from the insiders. These insiders would have sold all the exercised shares in the mid-to-high $30's if they believed that the stock was worth just $40.4.

RISKS

  • Current and future competition: AstraZeneca (Symbicort), Boehringer (Spiriva), Generics for GSK's Advair and Symbicort, Forest Labs (Tudorza), Novartis (QVA149), Boehringer (Striverdi Respimat) etc
  • Weak data from the ongoing Relvar/Breo SUMMIT or other comparative performance studies
  • GSK is incentivized to emphasize sales of drugs other than Breo, for which GSK has to pay the highest royalty rate
  • Negative regulatory decisions: FDA rejection of Breo as a treatment of Asthma, FDA and EU rejection of Anoro as a treatment for Asthma, negative trial data or negative regulatory decisions on any of the pipeline drugs.

CONCLUSION

The 16% collapse in the biotech index (NASDAQ:IBB) since February 25th has triggered a 25% collapse in the shares of Theravance. This is akin to throwing the baby out with the bathwater. Theravance has a blue chip investor base (GSK: 27% and Baupost 18%) which has recently bought more Theravance shares at prices approximately 20-25% higher than where it is trading currently. Theravance recently received approval for two potentially blockbuster respiratory drugs, both to be distributed and marketed by GSK, which is the global leader in respiratory diseases. The separation of the company into a royalty and development company in the second quarter of 2014 is a potential catalyst. Separation may partly be a market-test prior to an acquisition by GSK. ~35% (stand-alone) to ~65% (take-over) upside.

Disclosure: I am long THRX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: KL Investment Partners may change or exit its position without updating this article and without informing the Seeking Alpha community