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We wrote a report on Vivus (VVUS) before its highly anticipated FDA action on its weight-loss product, Qnexa (renamed Qsymia) (How to value Vivus ahead of FDA decision?). The company indeed received FDA approval of this product to be used for people with obesity in the late afternoon on July 17, 2012. It was a major achievement for a mid-cap pharmaceutical company such as Vivus, following the approval of Stendra for erectile dysfunction by FDA just a few months earlier in April 2012.

However, the enthusiasm for the VVUS stock was short-lived: it traded as high as $31.2, closed at $29 on July 18, and continued to slide to current $22-23 range. Two major factors may have contributed to the precipitated decline of the stock following its FDA approval. The first is profit-taking by investors. The second factor was a negative report released by short-seller Citron Research that attacked the company's patent strategy and related business issues (Why FDA approval is not the prescription).

After reading the Citron report and digging into Vivus' patent portfolio, we decided to write this report to rebut Citron's arguments on Vivus patent position and to re-evaluate the VVUS stock after FDA approval.

Vivus has 4 granted patents and 5 pending patent applications covering the combination of topiratmate and phentermine, the two ingredients in Qsymia, in treating obesity and other disorders. We believe Vivus stands in a strong position to defend its commercial rights for Qsymia and prevent other companies from copying their inventions in the US. We thus raise the price target for VVUS from $33 to $36, now that the uncertainty about FDA decision is lifted.

The patent saga

The main argument of the Citron report centered on the Shank Patent (Shank patent 1997) and the McElroy patent (McElroy 1999 patent). Citron argued that these two patents may threaten Vivus' freedom-to-operate on the commercialization of Qsymia. It then elaborated that the Shank patent was owned by Johnson and Johnson (JNJ) which has enormous financial clout for potential litigation or infringement lawsuit.

Before we get into the specifics, it is important to note that the composition patents for topiratmate and phentermine, the two ingredients in Qsymia, have long expired. So, essentially, all patents discussed here, including the Najarian patents as well as the Shank and McElroy patents are all "use patents", which cover new use of known compounds.

After reviewing the Shank and McElroy patents and comparing them with the Vivus patents, we believe that Vivus has a strong case to defend its inventions and intellectual properties. In fact, Vivus has built a strong patent portfolio consisting of four granted US patents and five pending patents filed in the US to cover the combination of topiratmate and phentermine, the two ingredients in Qsymia, in treating obesity. These patents will provide Vivus a strong position to fend off competition and copycats in the lucrative obesity and weight-control markets.

The four granted Vivus patents describe "a novel therapy for effecting weight loss which involves treating a subject with a sympathomimetic agent (e.g., phentermine or a phentermine-like drug) in combination with an anticonvulsant sulfamate derivative (e.g., topiramate) such that the subject experiences weight loss. The combination methods of the present invention also are effective against symptoms associated with Syndrome X. The invention also features pharmaceutical compositions and kits for use in the practice of these novel therapies." (Najarin patent 7056890, 2003; Najarian patent 7553818, 2003; Najarian patent 7659256, 2006; Najarian patent 7674776, 2006).

As the clinical trials progress, the company filed five additional patent applications on the Composition and methods for treating obesity and related disorders (Vivus patent 2008/0255093), Combination therapy for effecting weight loss and treating obesity (Vivus patent 2010/0105765), Novel topiramate compositions and an escalating dosing strategy for treating obesity and related disorders (Vivus patent 2009/0304789), and Low dose topiramate/phentermine composition and methods of use thereof (Vivus patent 2010/0215739, Vivus patent 2011/0262535). Essentially, these patent applications cover specific pharmaceutical compositions, formulation, dosing, treating regimens for weight-loss, obesity, and other disease indications.

Now, let's look at the two patents cited by Citron that it claimed could challenge Vivus patents. The Shank Patent was filed in 1996 and issued in June 1997 and owned by JNJ. It is entitled: Anticonvulsant derivatives useful in treating obesity and describes "A method for treating obesity comprising administering a therapeutically effective amount of a compound of the formula: ##STR1## is disclosed". This patent covers topiramate for the treatment of obesity. The patent is scheduled to expire in 2017.

Does Qsymia infringe the Shank patent? Vivus could argue that it does not, because the Shank patent only cover one component topiramate, whereas Vivus patents describe the unique combination of two components (topiramate and phentermine) in order to achieve optimal weight-loss benefit. If JNJ challenges Vivus on this patent, there are 3 possible outcomes with the litigation. First, both companies could settle the case in court. Assuming Vivus' chance of winning the case is 50:50, if it wins, the case is resolved. If it loses, Vivus could license the patent and pay for royalties. Since the patent will expire in 2017, the value of this patent is limited even if Vivus needs to license it and pays for royalties (which is usually 2-5% of revenue depending on the agreement). So, we believe its impact on Vivus' valuation is manageable.

Next, let's look at the McElroy patent. Citron argued that this patent challenged a Najarian's patent in term of first-to-invent status. The McElroy provisional patent was filed in February 1999, whereas Najarian's first patent was filed in June 1999. We disagree with Citron's viewpoint.

First, the US patent system is based on first-to-invent not first-to-file (before 2013). Both patents were filed several months apart, but the invention was clearly made well before the filing dates. Therefore, both parties can claim that the inventions were made independently.

Second, the McElroy patent claims the "Use of sulfamate derivatives for treating impulse control disorders." Although its claims cover the treatment of impulse control disorders using a class of sulfamates that includes topiramate, one could argue that it did not explicitly describe the use of topiramate in inducing weight-loss. Also, Vivus could make the similar argument that the McElroy patent only covers one component topiramate, whereas Vivus patents describe the unique combination of two components (topiramate and phentermine).

The strongest argument that the Vivus patents (the Narajian patents) are valid and distinct from the Shank and McElroy patents is that it specifically describes a unique combination of two components (topiramate and phentermine) in treating obesity, which the other two patents did not cover. The fact that the USPTO has already granted 4 patents to Vivus is the strongest argument that the US Patent Office viewed these inventions to be novel and non-obvious. The Patent Office is certainly fully aware of the Shank and the McElroy patents when granting these patents to Vivus.

As discussed above, Vivus has built a very strong patent portfolio since 2000 with four granted patents and five pending applications on Qsymia. These patents cover the unique combination of two key components in Qsymia in treating obesity, syndrome X, diabetes, hypertension, respiratory disorder, sleep apnea, and dyslipidemia. They also cover the specific dosing and time-release formulations in order for the drug combination to work in the most optimal fashion in humans. Most importantly, the patent claims were supported by clinical trial data that have demonstrated efficacy of Qsymia in treating obesity. Therefore, we believe Vivus stands in a strong position to defend its patent position and prevent other companies from copying their inventions in the US.

As for other business risks cited by Citron, including the ability to get FDA approval of its products, to secure patents, to contract providers to produce the drug, these are known business and operation risks for any biopharmaceutical companies. As a common practice for all public companies under SEC ruling, Vivus fully disclosed those potential business risks and forward looking statements in their annual report (VVUS 2011 10K filing). For investors to mitigate their investment risk, these risks are usually included as a discount in the valuation model ( see below).

VVUS valuation after Qsymia approval

So, how do we price Vivus stock after Qsymia has been approved? For Vivus and its investors, the most important milestones are the FDA approval of Qsymia in July 2012 and the approval of Stendra in April 2012. Investors should not underestimate the significance of these events in their valuation model and investment decision. The approvals essentially eliminate major uncertainty and development risks associated with clinical development programs of biopharmaceutical companies. Now the Company can fully dedicate its efforts on engaging business development activities, seeking pharmaceutical partners for commercialization and marketing of its products (Stendra, Qsymia), launching its products, solidifying the patent portfolio, and defending its inventions. These events and actions will create value for the company and its shareholders.

How do we factor in potential business risks and uncertainties in the future? Financial analysts utilize discount rate in their valuation model to reflect business and operation risks associated with a given corporation. For a small company with a riskier business, the discount rate is higher than a large and stable corporation. (Note: applying a higher discount rate in valuation model will result in lower valuation).

We applied such principles in our valuation model and derived a price target of $33-34 for VVUS at the end of 2012 (How to value Vivus ahead of FDA decision?). With the Qsymia approval, the 10% uncertainty is eliminated. The VVUS price target is now increased to $36. We believe the price target represents conservative estimates.

First, we applied a discount rate of 15% based on a modified Fama-French model (estimates: risk free rate 3%, equity risk premium 5%, small company premium 3%, company specific premium 4%). A large cap pharmaceutical company such as Pfizer would have a lower discount rate of ~8-9%.

Second, our estimate for Qsymia sales of $25M (2012), $100M (2013), $220M (2014), $440M (2015), $750M (2016), and $1.12B (2017) represents a conservative increment in market penetration rate of ~1.4%, 3.1%, 6.1%, 10.4%, and 15.6%, respectively from 2013 to 2017. The revenue growth slows down to 8% after 2017 as competition increases. These estimates are for US sales only. Our estimate of net profit margin is ~20%-25% and free cash flow ~10%-15% of revenue. If Vivus improves its margins and sales or expands its products to global markets, the valuation will be higher.

Potential catalysts for the stock in the future may include any announcement of scheduled product launch, partnership agreement, patent approval, decision of its product approval in European Commission, buyout deal, etc. With a valuation as a guide, investors can apply better strategy to navigate through the volatile stock market.

Disclosure: I am long VVUS.