ViroPharma Incorporated: Value in a Pharmaceutical

| About: Shire PLC (SHPG)

Generally, I tend to stay away from pharmaceuticals, because I find it difficult to accurately handicap the odds of drug trials. However, I have decided to make an exception in this case, because Viropharma (VPHM) has been so severely beaten down that it managed to show up in my very conservative stock screens, and on further examination, it seems to me that there is hidden value here.

Viropharma is a drug company with no research or manufacturing operations. The company licenses drug candidates in late-stage testing and already commercialized but undermarketed drugs from other companies, focusing on niche drugs used by physician specialists or in hospital settings. Large pharmaceutical companies usually pursue blockbuster drugs, and frequently drop drug candidates with a limited target population. Viropharma licenses these candidates and spends its own money to complete drug testing, before outsourcing the actual manufacturing of the drug to third-party pharmaceutical factories. This business model avoids heavy expenditures in basic research and manufacturing associated with traditional pharmaceutical companies, but incurs the risk of drugs failing in late stage trials. The company believes that it can build a business based on niche drugs and specialty marketing to a narrow patient and doctor pool.

Prior to 2005, Viropharma suffered continuing losses due to its research operations. In 2002, the FDA rejected Viropharma’s lead drug candidate, and its stock floundered badly. In a deep crisis, management was forced to reorganize the company and dramatically alter the business model, getting rid of all research operations. In 2004, the company licensed Vancocin from Eli Lilly for $116M. Vancocin is an oral formulation of the last resort antibiotic vancomycin, used to treat intestinal infections with antibiotic-resistant bacteria, primarily Clostridium difficile-associated disease [CDAD]. Viropharma hiked up the price of Vancocin by 47%, a particularly bold move considering the fact that patent protection on vancomycin lapsed in 1996, and outsized profit margins may attract generic competitors. As a result of the Vancocin licensing and price hike, the company first turned profitable in 2005, and has since been consistently profitable.

Vancocin is the sole source of revenue for Viropharma, and supports all of its other late-stage testing operations. Viropharma’s license on the Vancocin brand lasts through 2011, when the brand would revert back to Eli Lilly. The short-term nature of this license, together with the threat of generic competition, is a major uncertainty hanging over the stock. The central process involved in the approval of a generic drug is the demonstration of the “bioequivalence” of the generic drug to the branded drug, which has to be proved in the abbreviated new drug application [ANDA] submitted by the generic drug manufacturer to the FDA. The traditional way to do test for bioequivalence is to administer the drug to patients and monitor blood levels of the drug, showing that the generic drug enters the blood stream and is cleared from the blood at equivalent rates to the branded drug. This mode of testing is problematic in the case of orally administered Vancocin used to treat intestinal infections, since vancomycin does not enter the blood stream, and essentially stays in the intestinal tract. FDA had previously required that in these cases, a limited clinical trial be carried out on patients to demonstrate bioequivalence. This effectively makes generic vancomycin uneconomic, considering the small target population and large costs involved in the clinical trial.

In March 2006, the FDA changed this policy, now allowing an in vitro dissolution test to substitute for in vivo bioequivalence testing. VPHM immediately petitioned for a stay of action, and supplied numerous scientific arguments as to why an in vivo test is required to prove true bioequivalence. Bioequivalence testing is a complex scientific issue, and scientists tend to err on the side of caution, in case a drug that is not truly bioequivalent to another is erroneously approved as bioequivalent, thus harming the target patient population. While Viropharma originally believed that the issue will be resolved by the end of 2006, FDA has yet to make a final decision at this time. In the event that the FDA does allow in vitro bioequivalence testing, Viropharma will likely take a large one-time write-down of the intangible asset value on its books (all of which is related to the Vancocin acquisition), and generic competitors to Vancocin may appear in 2008-2009, rather than the 2010-2011 time frame which Viropharma has originally anticipated.

A strong case can be made that the generic risk in VPHM’s case has been overwrought. Revenues have been growing at a rate of 20-25% since Viropharma licensed Vancocin, partly as a result of additional price increases since the initial price hike, and partly because incidence of CDAD is increasing rapidly due to an ageing population and increasing prevalence of antibiotic-resistant bacteria. Even if generics are introduced, there is typically a lag of 1-2 years before its use becomes prevalent, and a complete loss of revenue is unlikely.

For the first 3 quarters of 2007, VPHM had $156M of revenue, and $75M of net income. For the entire year of 2007, I expect revenue will come in at $200M, and net income at $90M, which means EPS for the final quarter will be $0.21, or an EPS of $1.30 for the entire year. Assuming that revenue growth is flat for the remainder of the Vancocin licensing period (2008 through 2011), and net income remains at $1.30 for the next 4 years, the present value of that cash flow at a discount rate of 10% is $4.33 per share, which in addition to the $0.21 EPS in the final quarter of 2007, means that VPHM is worth $4.54 based on the value of its future cash flows. If generic competition arises in 2008, and income is halved to $0.65 per share for the last 3 years of the licensing period, the same calculations yield a present value of $2.86 per share. As of September 2007, VPHM had $743.5M of assets. Of that amount, I subtract $273M for liabilities, $123.9M for intangibles, $11M for property, plant and equipment, and $20M for working capital needs, yielding an excess asset value of around $315M, or $4.50 per share. Thus, based solely on excess assets on hand and expected cash flows from Vancocin sales, VPHM is worth $7.36 to $8.83. Note that these estimates err on the conservative side because they assume no further revenue growth, and the discount rate used is also pretty steep. Thus, at the current VPHM stock price, the market is essentially attributing no value at all to the drug candidates in the company’s pipeline.

Viropharma has 3 major drug candidates in the pipeline : 1) maribavir for treating/preventing CMV (in phase 3 trials); 2) HCV-796, for treating hepatitis C virus (suspended after phase 2 trials showed elevated liver enzymes in patients, though the company is examining whether to move forward); and 3) an intra-nasal formulation of pleconaril for the treatment of piconarvirus infections (in phase 2 trials).

I think that the success of drug trials is to a large extent unpredictable, and a very high degree of uncertainty should be attached to these potential future revenue streams. In addition, it is unlikely that management will spend its excess cash on share buybacks, and indeed, it is a better use of cash if management can license additional promising drug candidates. Nonetheless, investing in drug candidates is also an activity fraught with uncertainties, and there is considerable chance that at least some investments will not pan out. Thus, I find it difficult to rigorously determine the potential upside to this stock.

In March 2007, the company issued $250M of 2% convertible notes, convertible on or after 2016 at an initial conversion price of $18.87 per share, or at any time when the stock trades for 20 days above $24.50. This suggests that investors believed that there is a good chance that the stock will trade above $18.87 by 2016, and is willing to accept below-market interest rates for a chance to reap profits from stock gains. At the same time, VPHM also spent $92M to buy call options for common stock at $18.87 to prevent dilution of stock upon conversion of debt, and issued warrants to sell stock at $24.97, which earned $62M, for a net cost of $30M. In other words, management is unwilling to sell stock at $18.87, but is willing to do so at $24.97, essentially predicting that VPHM should be valued between $19 and $25. Management has backed up this valuation with heavy insider buying at a stock price of around $8.

In the final analysis, I think that VPHM is a promising stock, with strong downside protection under most likely scenarios, but with a very small probability of complete disaster (all current drug candidates fail to pan out, cash is wasted on acquiring useless drug candidates), and a somewhat higher probability of large gains (one or more drug candidates come through with good revenues, licensing of additional good candidates). I like the fact that management had managed to overcome a crisis and survived, and demonstrates faith in the company by personally buying company stock. Nonetheless, as is my practice with all stocks that show even a remote chance of complete failure, I have decided to hold a smallish position in this company and take a wait-and-see attitude. The near-term significant catalysts to this investment are likely to be the results of the phase 3 maribavir-CMV trials (expected in 2009), as well as the final decision by the FDA regarding the in vitro bioequivalence testing of Vancocin.

Disclosure: Author has a long position in VPHM