Vical (NASDAQ:VICL) is a biotechnology company with a cancer drug (Allovectin-7 (or A-7)) nearing completion of its pivotal phase 3 clinical trial. Normally when I put together an investment thesis on a stock, I try to estimate a future share price based on projected earnings at a reasonable P/E multiple. For this write up, I will mostly defer to this Conaccord Genuity analyst report. If Vical is successful in getting A-7 approved, the analyst predicts U.S. launch and profitability in 2013, E.U. launch in 2014, and ~$1 billion in sales and $330 million of net income in 2018. Based on those numbers, and assuming a 25% chance of success for A-7, and a 12% discount rate, Conaccord Genuity has a price target of $8 for VICL. It currently trades just under $4.

For the most part Conaccord’s analyst report looks about right to me. Where my opinion differs substantially is on the estimated 25% chance of success. I would say that 50% is a very conservative estimate of the likelihood of success. Based on that probability, the price target should be $16/share. And to be honest, my read of the information suggests that the odds are probably closer to 75%, which would put the price target at $24/share. That represents a 500% gain from current prices. That’s a very attractive potential opportunity, but we have to keep in mind that this is a bit of a lottery ticket. If Vical is unsuccessful with A-7, expect drastic losses on this investment.

So let’s look at the data that makes me so confident that Vical will be successful with A-7. The phase 3 trial for Allovectin-7 is in metastatic melanoma, a late-stage, aggressive form of skin cancer for which the best therapies give a median survival time of only 6-9 months. Vical has already completed a phase 2 trial of A-7 in metastatic melanoma, so we can look at the results of that trial to see what we might expect from the phase 3 trial.

I’ll consider the Allovectin-7 safety data first, since that data is simple and compelling. Cancer drugs generally have nasty side effects. In a trial of the standard metastatic melanoma drug DTIC (dacarbazine), 22% of patients had severe (grade 3 or 4) side effects. For the recently approved drug Yervoy (Ipilimumab, from Bristol Myers Squibb (NYSE:BMY)) grade 3 and 4 side effects were reported in 23% of patients (including a number of drug-related deaths). In the phase 2 trial of A-7, there were no reports of grade 3 or 4 events. Zero. That will be a major advantage for Vical/A-7 when it comes to competing with other drugs on the market.

Now let’s consider the phase 2 efficacy results. Here is a slide from a Vical slide set that shows the above-mentioned safety data along with some efficacy comparisons.

DTIC is used in the control arm of the ongoing phase 3 trial, so that is the most important comparison. For now, I will focus strictly on the standard efficacy measures: response rate and median survival. I’ll get to the durable response and duration of response later. Response rate is the percent of patients with significant tumor shrinkage (50+%) at any point in the treatment. This is the primary endpoint for the phase 3 trial, and A-7 showed significantly better results in phase 2 compared to DTIC in this historical study. Median survival is the secondary endpoint of the phase 3 trial, and A-7 shows well over double the survival time of DTIC (18.8 months vs. 7.8 months). From another slide in the same presentation DTIC is shown to have a typical 1 year survival rate of 25% compared to 65% for A-7 in the phase 2 trial. And I’ve found another reference that shows typical 18 month survival rates to be roughly 11%, which is also substantially lower than the ~50% rate for A-7.

So just based on the phase 2 results, I would have estimated a greater than 25% chance of success for A-7. Now let me describe some changes that were made to the phase 3 protocol that I believe substantially increase its chances of success. First, in the phase 2 trial patients typically didn’t respond to A-7 until roughly 16 weeks of treatment. A-7 is an immunotherapy (it causes the cancer cells to be targeted by the immune system), and it seems that this mechanism takes longer to have an effect than chemotherapy. The phase 2 protocol required that patients stop treatment if there was any tumor progression. Because of this requirement, 62% of the A-7 patients had the treatment stopped with less than eight weeks of treatment, before it had much chance to have an effect. The phase 3 protocol stipulates that all patients will receive at least 16 weeks of treatment with A-7. This should significantly increase the response rates. Very optimistically, with 2-3 times as many patients receiving a full course of treatment (100% in phase 3 compared to 38% in phase 2), you might expect response rates to be 2-3 times higher. More conservatively, it clearly increases the likelihood of improving on the approval-worthy (superior to Yervoy) response rate of the phase 2 trial (11.8%).

The second change to the phase 3 protocol is the timing of the response assessment. The phase 2 trial counted responses that occurred at any time during treatment. Chemotherapy for metastatic melanoma exerts its effect very quickly, in the first few weeks of treatment (if it has an effect at all), but patients generally relapse in the subsequent few months. By contrast, A-7 responses were slower but much longer-lived. The phase 3 trial only counts responses that are still in effect six months after the beginning of treatment. This is what is labeled as “durable response” in the table above. You can see that by this measure, DTIC’s response rate drops from 7.5% to 3.6%, while A-7 still has a 11.8% response rate at six months. So while A-7’s response rate was 57% higher (11.8 vs. 7.5) than DTIC according to the standards of the phase 2 trial, they are 228% higher (11.8 vs. 3.6) than DTIC by the phase 3 standards. This change also seems to move the odds very much in Vical’s favor in phase 3.

The third beneficial change in the phase 3 protocol is a restriction on the patients enrolled. In the phase 2 trial, roughly 40% of patients had failed chemotherapy, and only one of those patients responded to A-7. Of the 60% who were chemotherapy naive, 14 patients responded. So it seems that A-7 is more effective on chemotherapy naive patients, and the phase 3 trial excludes patients who have been previously treated with chemotherapy. This change should also increase the response and survival rates.

Having committed these arguments to writing, I feel like even my 75% probability of success might be conservative. But clinical trials do have a way of throwing curve balls, so I’ll stick with my 75% number. As I stated above, that implies that Vical’s stock is wildly underpriced (under $4/share compared to a price target of $24) based on its high probability of success with a high-value drug (though with a 25% chance of major losses).

Just a few more details to wrap this story up. Vical expects to have the data from the phase 3 trial by the end of this year, but it could come as late as February 2012. At that point, we’ll no longer be dealing with probabilities. At that point, the trial will have failed (price target: $1?, 75% loss) or succeeded (price target: ~$32, 700% gain). If it is successful, the mechanism of A-7 is not specific to melanoma. If it works in this trial, it should hypothetically be effective against any solid tumor. Also, there is more to Vical than Allovectin-7. It has an influenza vaccine in phase 1 trials, a cytomegalovirus vaccine almost ready for phase 3 trials, and a critical limb ischemia treatment that has already shown impressive phase 3 results (unfortunately, it will only get single-digit royalties on this product). So if A-7 works out for Vical, the company has some great opportunities to reinvest profits for even more growth.

Finally, there’s a nice video presentation with slides available here, where you can see Vical’s CEO present the case for the company and Allovectin-7.

**Disclosure: **I am long VICL.