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Summary

  • Vertex Pharmaceuticals announced positive results from Phase 3 trials of a combination regimen for cystic fibrosis.
  • The stock has soared, and the company trades at a very high multiple of current sales.
  • Vertex has had disappointing outcomes with prior drug products it developed, but it may be poised for significant success now.

Background: Vertex Pharmaceuticals (NASDAQ:VRTX) is one of a group of biotech/biopharma companies that focuses on oral medications, not injectable proteins. The company has had a creditable record of drug discovery, including the AIDS drug product, Agenerase, and the anti-hepatitis C product, Incivek. The latter was initially very successful, but then faded even before Sovaldi came to market. Vertex has now sold its rights to Agenerase, a follow-on product known as Lexiva, and Incivek.

Vertex has been focusing on its current core competency, oral meds for cystic fibrosis, a genetic disease that has orphan designation. It is the world-leader in this regard. The main affected organ in CF is the lungs, which are prone to repeated infections related to difficulty in mobilizing mucus. Abdominal organs are affected as well, and the name "cystic fibrosis" actually refers to damage that was seen in the pancreas many years ago.

Vertex has been ramping sales of its approved product Kalydeco, a twice-daily tablet for a small number of patients with CF, those with a specific genetic defect. On Tuesday, the company announced favorable results from both its Phase 3 studies of the combined use of the active ingredient in Kalydeco, ivacaftor, along with an anti-CF drug called lumacaftor. Lumacaftor has different mechanisms of activity. The two studies reported Tuesday, which have the acronyms TRAFFIC and TRANSPORT, may be reviewed as a presentation on the Vertex website. Given prior analyst uncertainty about the results, the favorable data sent the stock soaring, closing around $93, up 40% on the day. VRTX now carries a $22 billion valuation. It is expected to have non-GAAP sales this year slightly north of $500 million.

Vertex has been public since the early 1990s. It has cumulative net losses over $2 billion. The question of the day is whether VRTX has a favorable risk-reward, following Tuesday's surge to a price right around its all-time high set in the fall of 2000. Here is the long-term chart, which is beginning to resolve itself into the now-familiar bottom left-to-top right pattern.

(click to enlarge)

Splits: Aug 24, 2000 [2:1]

Introduction: According to Vertex, Kalydeco as monotherapy has a global addressable market of only around 7000 patients, and the company has not shown effectiveness in enough patients to even get to that number. More work and regulatory submissions will be needed.

The world of genetic diseases and regulation of pharmaceuticals to treat them has become quite complex. In the old days, CF would be diagnosed fairly readily via clinical symptoms plus a "sweat test" to confirm the defect in chloride transport characteristic of this disease. Now, individual mutations are identified and tested separately. It turns out the Kalydeco is effective only against a minority of these mutations. Investors who have been following the outcry about Sovaldi's pricing (to cure hepatitis C), which reaches $84,000 per 12-week treatment course, may be surprised to hear that Vertex is able to get as much as $300,000 per year for Kalydeco.

Kalydeco may bring in over $500 million this year, based on only perhaps 2000 patients treated globally. In contrast, the company estimates that over 28,000 CF patients can be treated with this combo, and believes that they can be rapidly identified. The basic investment question is simple: What is Vertex's CF franchise now worth?

Before running the numbers, let's examine the studies that were reported Tuesday.

The TRAFFIC and TRANSPORT studies: These placebo-controlled studies used two strengths of an investigational (unapproved) drug, lumacaftor, once a day and a twice-daily dose of ivacaftor. Ivacaftor is the active ingredient in Kalydeco. Ivacaftor was dosed in these studies at a higher level than is found in Kalydeco. All primary and secondary endpoints were met. The primary endpoint, lung function, improved modestly but consistently in all arms of the study. Importantly, hospitalizations and other clinical measures of health and well-being were improved. Some additional side effects were seen with the drug groups versus placebo, but nothing looks serious that I can see.

The statistical strength of the results was very high. I expect that the regimen tested will be expeditiously approved by the FDA and the European authorities, given the clinical need. Note that FDA approves drug products without regard for the cost. Vertex will have to fight for the highest pricing it can get. Vertex expects to file for approval with the FDA and in Europe late this year. This treatment regimen has received Breakthrough designation by the FDA, and should be on the market by about Q3 next year, I would guess - assuming favorable regulatory action. Please be aware that one never knows what data the regulators will focus on, so nothing is guaranteed until it actually occurs.

The numbers: Biotech/biopharma valuations sit out there in their own world. These companies are, correctly, viewed as companies with great potential. The problem for investors is that pricing is often simply frothy. VRTX has an up-down-up-down history that reflects its success in HIV, its initially-great success with Incivek for hepatitis C, and now, its growing success with the CF regimen. What degree of sustained profits awaits this company, which markets its own products and thus must pay all those expenses while advancing its R&D effort?

The 10-K makes clear that while the company believes it has a multi-year lead on the competition in CF treatments, several large companies are working in this space. The sustainability of sales is unclear, just as it was for Incivek.

Another issue is that Vertex owes single-to-double digit royalties on these products to the Cystic Fibrosis Foundation Therapeutics Inc., so its margins are thereby affected. No serious patent issues are noted in the 10-K, though. Patents extend to the 2026 range for ivacaftor and lumacaftor.

A material positive for Vertex is that the substantial preponderance of CF patients is treated by a small number of specialists. Also, given the absence of effective treatments, patients and generalist physicians will readily find out about the Vertex treatments.

Given variable R&D expenditures, biotech/biopharma companies tend to be valued on a price:sales basis. Given the immense reimbursement levels for Kalydeco, guessing at what reimbursement will be allowed for the larger, but still very small, patient population for a combination of two medications daily is difficult. From Vertex's Q1 earnings presentation, we learn that if the company can get enough indications to treat 7000 patients with Kalydeco alone, it can bring in $1.5 billion in annual revenue from Kalydeco. The new combination regimen that was reported Tuesday will potentially address four times as many patients as that, however.

Vertex estimates that the mutation that the ivacaftor-lumacaftor regimen has an addressable population of 28,000 or more. Could that regimen bring in $5 billion per year? What will the yearly pricing be? Will there be much price reduction from Kalydeco's price given a larger, but still very small, pool of patients for the combined regimen than the Kalydeco monotherapy addresses?

Preliminary discussions with payors may be starting soon regarding the combination regimen. Given all the precedents that have now been set for extraordinary price points for breakthrough drug products, I would tend to estimate toward the high end of whatever range the Street is thinking. There is, however, no way to know where pricing will be set.

Veterans such as yours truly have trouble getting used to these numbers. However, when comparing the risk and effort inherent in developing niche products, such as these treatments for CF, to those for very large markets, it is not clear that reimbursements for breakthrough niche pharmaceuticals are out of whack. The developed world has generally agreed to create price incentives for private industry to continue to develop innovative treatments for previously-untreatable or inadequately-treatable medical conditions. The result is the prices per treatment that we see prevailing in the biotech/biopharma space. Pricing for breakthroughs such as Kalydeco continues to be strong, and could stay strong indefinitely.

Could we be looking at $1+ billion from Kalydeco alone and up to $5 billion from the combined regimen, to give $6 billion yearly sales? If so, an 8X sales stock price, which is approximately where larger peers Gilead Sciences (NASDAQ:GILD) and Celgene (NASDAQ:CELG) trade on projected 2015 sales, suggests a $48 billion valuation for VRTX, more than double that achieved on Tuesday. My bias would tend to be more conservative for VRTX than for GILD and CELG, if for no other reason than the significant royalties that Vertex is paying, but Vertex's pipeline weakness is important as well. A haircut to 6-7X sales might be fairer, and still leaves room for the stock price to appreciate a good deal farther.

Other products and pipeline: VX-661 is a drug that is similar to lumacaftor. It showed good results in a small-scale trial recently, when given with ivacaftor. Vertex has been positioning it to be part of a 3-drug regimen that would treat especially refractory cases, but the results of that study were encouraging enough that Vertex has indicated that it may find other indications as well.

A drug for rheumatoid arthritis, VX-509, did well in Phase II trials and is awaiting a collaborator before undergoing additional testing.

Recently, Vertex announced that a drug to treat influenza, VX-787, has been licensed to Janssen, a subsidiary of Johnson & Johnson (NYSE:JNJ), following promising Phase IIa studies. The up-front payment was $30 million, with milestones and royalties possible.

Overall, this is a thin pipeline, reflecting, among other things, stringencies relating to the disappointment over Incivek.

If Vertex can find a way to treat what it estimates are an additional 17,000 or more patients who are especially difficult to treat, its revenues could exceed the above numbers. See slide 4 from the TRAFFIC-TRANSPORT presentation (linked to above) for an analysis by Vertex of its potential CF patient pool.

Risks: Upcoming competition and reimbursement levels are two prominent fundamental risks to VRTX. The sparse pipeline implies increased expenditures down the road. However, the RA drug might be a bit of a sleeper, if it surprises to the upside commercially.

Vertex shares have been unstable; Value Line lists VRTX as only being in the 15th percentile of stocks it follows for price stability. This price volatility surprisingly occurs with below-average correlation to the stock market as a whole; VRTX has a beta of only 0.80.

Dividends are unlikely to be paid this decade, in my view. The company does, however, have a strong net cash position, and if it becomes solidly profitable, it might surprise investors with cash dividends - but I doubt it.

Summary: When Mr. Market is in a good mood, it may be prone to both project multi-billion annual sales ad infinitum for Vertex and give the shares a high price:sales multiple. Because Vertex has actually been an innovative company, it is rational to capitalize it highly and trust that it will use a cheap currency - a highly-valued stock price - to acquire and internally develop new drugs which turn out to have high returns on invested capital. On the speculative basis that VRTX could double from current levels over the next two years, I took a small position in VRTX at the close of trading Tuesday. Vertex is a niche company that has repeatedly developed useful, innovative products. Given its very well-defined current focus and a price that remains (slightly) below a split-adjusted price it reached in Y2K, I think there is acceptable downside risk versus upside potential, and may add some additional shares if profit-taking ensues in the days ahead.

Source: Vertex Soars On Phase III Trial Results: Assessing The Upside Potential From Here

Additional disclosure: Not investment advice. I am not an investment adviser.