In the past, I have written fairly negative assessments on the value of Vertex (NASDAQ:VRTX). See, for instance, "Vertex Pharmaceuticals, Dog Of The Nasdaq 100 Biotechs". While listening to the Q2 2014 analyst conference, I started doing some math in my head, then on an envelope, and decided that the current Vertex price was maybe not as out of touch with reality as I had thought. If everything were to go perfectly in the future, today's price could seem like a bargain in retrospect.
Here, I'll analyze Vertex's historic numbers and pipeline potential. I'll use Alexion (NASDAQ:ALXN) as the primary comparison, since Alexion is also a biotechnology stock in the Nasdaq 100 specializing in rare disease therapies. I'll also compare to Gilead (NASDAQ:GILD), which has a far larger market capitalization and has been at the center of the national controversy about drug pricing.
Here is a table with some basic data to refer to:
|Closing 8/1/2014 price||$87.53||$159.12||$91.50|
|Market cap (billions)||20.8||31.4||139.3|
|Q2 revenue (millions)||$138||$513||$6,530|
|Q2 non-GAAP EPS||(0.61)||$1.12||$2.36|
|Trailing P/E (GAAP)||none||79.8||20.7|
|Net Cash (end of Q2)||$1.2 billion||$1.5 billion||$1.1 billion|
The first thing to note is the vast disparity between revenue and market capitalization for the three companies. Vertex's market capitalization was about 151 times revenue. Alexion's was about 61 times revenue. Gilead's market cap was just 21 times revenue.
Unlike Alexion and Gilead, Vertex lost money in Q2. So why have investors bid up Vertex stock to such a high price, compared to the revenue or earnings they can buy at Alexion or Gilead?
Buyers could just be following the momentum into bubble-land. But in biotechnology, more so than in traditional industries, investments are bets on the future, not the past. The future is in increased sales of drugs approved by the FDA and global medical agencies, and in the pipeline of therapies that might be approved by the agencies.
Gilead is likely to substantially increase the sales of therapies it has already commercialized, and also has an extensive pipeline. I believe Gilead is substantially undervalued, but it is understandable that a new therapy or two, unless it is a blockbuster like Sovaldi, is only going to add marginal value to Gilead's hefty market capitalization. Alexion also has a nice pipeline, which represents a substantial amount of its market capitalization if Gilead's P/E is used as a standard of comparison.
Vertex's value appears to be almost exclusively in increased sales of its currently approved indication of Kalydeco for cystic fibrosis, for patients whose disease is caused by the certain mutations. Combined with another drug, Lumacaftor, there is also positive Phase III data for patients with two copies of the F508del mutation. Vertex plans to file for commercialization with the FDA for this indication in Q4.
That is where the whole question of Vertex's value comes in right now. Cystic fibrosis is not a common disease, as the mutations are recessive (both parents must contribute a defective gene to manifest the disease). CF affects about 30,000 people in the U.S., and is almost exclusively a disease of people of European descent. When broken down by the various mutations causing it, the number of people helped by Vertex's drugs are quite small.
When looking at the value of a pipeline, analysts estimate the price that will likely be charged and the number of people that will likely be treated. There used to be a tendency to ignore drugs that treated just a few people, but that has changed due to laws designed to encourage the creation of orphan drugs. But the most important variable for Vertex has been price.
The controversy over Gilead's $80,000 or so price tag for curing hepatitis C has two components. One is the price per patient. The second is the extraordinarily large number of people infected with hepatitis C. The good news for insurers is that the $80,000 is a one-time event per patient.
Vertex is believed to charge about $300,000 per year per patient for Kalydeco (per the New York Times). So Q2 revenue represented treatment of about 1500 patients. Note that this is a lifetime commitment, and it would appear that Kalydeco is a life-changing drug that should greatly extend the lifetimes of patients. If started at an early age, the lifetime cost might run to $18 million per patient. Or $18 billion per thousand patients.
The addressable market for the Kalydeco plus Lumacaftor, CF F508del mutation is estimated by Vertex to be 22,000 patients. At 22,000 patients, this would still be an orphan therapy.
Watch the analyst do the math: 22,000 times $0.3 million would be $6.6 billion per year. Of course, that assumes Vertex would treat the entire addressable market.
Cost of goods sold would run to about $200 million per year. Even with a continuing commitment to R&D and an expanded SG&A staff and raises all around, total costs should come in under a billion a year. Call it $1.6 billion, to be conservative.
That leaves $5 billion in earnings per year. Even if the P/E eventually drops to something normal like 20, Vertex should end up with a market cap of about $100 billion. That would be about five times today's market cap and put it in the same league as Gilead.
But before you rush out and buy VRTX, consider that Gilead is maintaining the health of a majority of HIV patients, curing hepatitis C, has some cancer therapies, and is catching grief from those responsible for national healthcare budgets.
The key question is what price will Vertex be able to charge for the much larger number of patients it may be treating in a year or two? Assuming $300,000 per year may be assuming too much.
Suppose insurers and the national health systems in Europe push back, and say $80,000 a year is the most they can pay. In that scenario, we would be looking at annual revenue of $1.8 billion, a more frugal attitude towards corporate spending, and earnings perhaps around $1 billion.
One billion per year in earnings would still be quite impressive for a company that was in the red in Q2. It would mean, again if the P/E sank to 20, a market cap of about $20 billion, pretty close to where we are now.
I believe that at least in the short run, Vertex will be able to maintain its pricing in the U.S. and will have to fight to maintain pricing in Europe, and will likely eventually have to discount from the current price. So my best guess is that in two years, Vertex's stock price will be up from where it is today, probably substantially.
But it is not a sure thing. If payers push back enough or if the therapy is not adopted to the extent projected, Vertex could see its stock price fall, perhaps considerably. If payers continue to push back against Gilead's pricing, they may set a precedent that can be used against Vertex. The U.S. Congress and the agencies that approve reimbursements in Europe, Canada, and Australia have a lot of power to influence Vertex's future stock price.
A final upside is that Vertex will continue to expand the number of mutations its therapies work for, and also address other diseases, so the number of treatable patients can expand over time.
I want to close by saying that whatever happens to Vertex's stock price, it has done a real service to CF patients. It is good science and good medicine, the only question is to what extent stockholders will be rewarded for it.
Disclosure: The author is long GILD. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.