The Market Is Wrong About Vanda

| About: Vanda Pharmaceuticals (VNDA)
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After a surprise FDA approval for Fanapt (iloperidone) for second-line schizophrenia therapy in May 2009, Vanda Pharmaceuticals (NASDAQ:VNDA) stock rose nearly 800% and has traded in the $12-$15 range since then until mid-April of this year. This approval was a surprise because Vanda had initially received a non-approvable letter after completing two massive clinical trials involving 4,000 patients. After the approval, investors were justifiably bullish on VNDA, as Vanda found a marketing partner in Novartis (NYSE:NVS), who secured exclusive US and Canadian rights to sell Fanapt. Interestingly, Vanda had bought the rights to iloperidone from Novartis several years earlier and managed to successfully bring it to FDA approval. Novartis as a partner made sense: Development of iloperidone was presumably to replace their blockbuster drug clozapine, which has gone generic. Under the terms of the agreement, Novartis made an upfront payment of $200 million and VNDA will be eligible for additional payments totaling up to $265 million for certain milestones as well as royalties from the U.S and Canadian sales of Fanapt (Titan Pharmaceuticals (NASDAQ:TTNP) will also receive some royalties from Vanda Fanapt sales). The fact that Novartis paid $200 million upfront (plus royalties) to Vanda to market their own once-discarded drug is a complete turnaround. Novartis’ CEO Joe Jimenez commented on their about-face for Fanapt, saying here, "We have to look very hard before we give up on a compound."
However, if VNDA stock price is any reflection, the fairy tale appears to be over. Currently, VNDA is trading below $7, a far cry from its peak of $15. The slide of VNDA share price seemed have begun with a poor review given in The Manual of Clinical Psychopharmacology, the standard drug reference guide used by psychiatrists. The Manual cited disadvantages of Fanapt: Fanapt has been shown to cause irregular heart rhythms and low blood pressure, and patients are required to start at low doses, gradually building up to the maximum dose. In addition, Fanapt provided no advantage over other medications in diminishing the side effect of weight gain. However, Fanapt is not alone in having these side effects; several “atypical” medications (atypical refers to the absence of side effects like tremors and rigidity seen with first generation antipsychotic medications) for treating schizophrenia have these side effects.
Yet, as time passed, criticisms of Fanapt’s stiff competition also surfaced: Fanapt is the seventh atypical antipsychotic on the market in the U.S. There are many branded as well as two generics available, some with derivatives like extended release formulations and injections. Critics claim that Fanapt will not be able to capture significant sales with so much market saturation, especially in the face of generics. But investors are not really considering the hard data: Despite the fact that there are so many atypical antipsychotics on the market, the market for these drugs is more than $20 billion (according to IMS Health). The leading drugs are Eli Lilly’s (NYSE: LLY) Zyprexa and AstraZeneca’s (NYSE: AZN) Seroquel, each which generate worldwide sales of about $5 billion per year. Pfizer’s (NYSE:PFE) Geodon sales are about $1 billion per year; and Bristol-Myers Squibb (NYSE:BMY)’s Abilify sales are about $2 billion per year. The remaining $7 billion is sales are from the generic drugs risperidone and clozapine and other traditional psychotic drugs. Factoring in the generics, branded drugs are capturing $13 billion of the market, which is thriving even in the face of generics.

The reason the non-generic competitors are doing so well is due to the nature of the therapy: Psychiatry is an empirical, clinical science; experience, trial and error, and responsiveness to patients' progress are what determine the course of therapy. Unlike high cholesterol or high blood pressure, where a straightforward test and well accepted course of therapy are mandated, psychiatry itself depends on a patient-specific exploration of options which is constantly altered and refined throughout the therapy to try and obtain the optimal result. A patient doesn’t walk in to a doctor and say “I have schizophrenia” and the doctor says “Fine, here is clozipan” and the two part ways and live happily ever after. Diagnosing and treating schizophrenia is a lengthy process for which the psychiatrist relies on a variety of treatment options, determining which is best through trial and error.
This trial and error is the reason why so many different antipsychotics are needed. Even within the atypical psychotics, there are three different types of classes of drug, and each drug in the class has a unique mechanism of action. Although all the “atypical” drugs bind serotonin as well as dopamine receptors, some bind one over the other better and may also have activity towards serotonin receptors. In essence, each different drug affects each of these receptors differently. Drugs like clozapine are more potent against the serotonin than the dopamine receptors; drugs like risperidone are more potent against the dopamine than the serotonin receptors; and drugs like aripiprazole (Abilify) actually activate the dopamine receptors and block the serotonin receptors.

Depending on each patient's unique needs at a given period in the treatement (which cannot be determined upfront), each patient may have to try two or more of these classes of drugs. LEK Consulting states that about 50% of all schizophrenic patients taking atypical antipsychotics switch medicines during therapy. This includes refractory patients, who don’t respond well to the initially prescribed medication, and stable patients, who switch medications in attempts to improve results. Since Fanapt is only indicated for second-line treatment (after failure of one of the first-line agents), its market niche is perfect.

The sales for Zyprexa and Serequel are so large because they have multiple indications for other CNS disorders besides schizophrenia, like bipolar disorders or depression. In reality, Fanapt is only competing with these drugs for the indication it is approved for: schizophrenia. Cowen and Company, a biotech investment banking company, estimates that schizophrenia accounts for approximately 60% of the antipsychotic market; diminishing the $20 billion to $12 billion. So in essence, Fanapt is competing in a $6 billion dollar market (50% of $12 billion). So that “$20 billion” market is in reality a smaller but still healthy $6 billion market. Although people are quick to assume Fanapt can easily generate $1 billion in sales per year, based on 5% of a $20 billion market, these numbers need to be scaled down significantly.
However, the market Fanapt is competing in is still quite large. Fanapt has exclusive marketing rights until 2016. In the meantime, Zyprexa (2011), Seroquel (2012), are going generic, putting pressure on first line therapies but not necessarily second line therapies. In fact, perhaps to many investors’ ignorance, this is what Vanda has clearly indicated in the past: that Fanapt will be competing for second line; and the numbers make sense. Certainly Novartis considered these numbers before paying $200 million for exclusive rights to Fanapt.
Fanapt really only faces solid competition from the recently approved Saphris (asenapine) from Merk (NYSE:MRK) and Geodon, both of whom are indicated for second-line therapy like Fanapt. Saphris is touted as better than Xyprexa because it does not cause as much weight gain but still has some of the involuntary movement side effects (Akathisia) seen in this class of drugs. Fanapt is in a different class than Saphris, and does not have Akathisia side effects. Geodon will soon be the most threatening of the competitors, as it is going generic in 2012.
Even though many analysts and investors were touting $1 billion in sales as likely, reality has sunk in, and VNDA’s price has sunk with it. But with all of these details in consideration, what is a realistic sales number? Investors need to remember that Geodon faces competition from 5 competitors, two of which are generic, and it still manages to have $1 billion in yearly sales. Admittedly, it took 8 years to reach the $1 billion sales mark, but Geodon started with $150 million per year in sales, increasing about 30% per year on average until it reached the $1 billion mark in 2008. Perhaps this is the type of growth we can expect from Fanapt, adjusting the numbers down some in consideration for the fact that it does have the two competitors Geodon and Saphris.
Although the FDA mandated a REMS strategy based on potential cardiac issues, Fanapt does avoid some of the major tolerability problems associated with Geodon. Although weight gain is improved with Saphris, the akathisia side effect may limit its use compared to other options. Really, in the end, it all depends on the sales force. If the Fanapt sales force can convince physicians and psychiatrists that Fanapt is a viable option compared to Saphris or Geodon, it could gain considerable traction. In consideration of the fact that the sales force is backed by the heavyweight Novartis, it could easily (it would seem without trying) capture 10% of the $6 billion second line market. Thus, $600 million is not too unrealistic.
Novartis began selling Fanapt in 2010. Novartis reported first quarter Fanapt sales of $21 million for the quarter in mid April. Novartis did not break down Fanapt's sales, but according to IMS market intelligence data, only about $1 million of Fanapt was sold to schizophrenia patients in the first quarter, and the rest was due to initial stockpiling of inventory. It clearly was at this point that VNDA’s recent fast slide began. Adding to this, Novartis CEO David Epstein stepped down and announced a massive reorganization, putting the Fanapt sales force in question. These factors put the reality of hyperbolic Fanapt sales numbers into question for investors.
However, it is simply too early to assume the worst.

Since Novartis has only reported less than one quarter’s worth of Fanapt sales since the beginning of its sales launch, how much Fanapt Novartis can really sell remains to be seen. Investors are nervously waiting for these numbers and updates from Novartis about Fanapt marketing. A closer look at the numbers suggests that the cloudy future is unjustified. In their first quarter of 2010, Vanda reported $3.7 million in product revenue for Fanapt inventory sold to Novartis and $2.1 million for royalty from sales of Fanapt by Novartis. Vanda’s first quarter 2010 results showed them to have a total of $12.5 million in revenue; the remainder of revenue is due to amortization of $6.6 million of the $200 million upfront payment, netting a break-even $500K in income.
Perhaps more important than the Fanapt sales numbers, these cash flow numbers show importantly that with $21 million per quarter in Fanapt sales by Novartis, the product and royalty revenue is sufficient to make Vanda cash flow positive. Thus, the minimum bar needed for Vanda to break even with current expenses is about $80 million in Fanapt sales per year. If Novartis captures an extremely modest 1.5% of the $6 billion market it is vying for, the royalties to VNDA are sufficient to keep it cash flow positive. It is significant to note that even without Fanapt revenue, VNDA would be able to survive 5 years on its cash alone. VNDA’s current market cap is far less than the mostly intact $200 million Novartis payment. This valuation seems disproportionately low, and the market cap is seemingly pricing in liquidation of the company, which is totally unrealistic.
Apart from the cash in hand, and the assumption of zero Fanapt sales, investors are not even considering any other of the potential long term value in VNDA: Vanda is making progress on an injectible form of Fanapt, which should eventually gain approval quickly and easily through the 501b(2) mechanism. VNDA was recently awarded a patent for this, which will provide protection until 2023. Even better, under the Fanapt agreement, Novartis is responsible for development costs for approval in U.S. and Canada. Vanda also has full rights to commercial development for Fanapt outside of the U.S. and Canada. Although protection ends for oral Fanapt in 2016, diminishing the likelihood of this pursuit, the patent life for injectable Fanapt until 2023 makes this a viable option for VNDA to pursue.
Vanda also stated significant progress in evaluating potential opportunities for tasimelteon, Vanda's compound for the treatment of circadian rhythm sleep disorders. On January 19, 2010, the FDA granted orphan drug designation status for tasimelteon for Non-24-Hour Sleep/Wake Disorder (N24SWD) in blind individuals with no light perception. Tasimelteon has already been shown in clinical studies to significantly improve sleep onset and sleep maintenance parameters and to affect the sleep/wake cycle. Vanda plans to conduct additional clinical trials to pursue FDA approval of tasimelteon for the treatment of N24SWD in blind individuals with no light perception beginning in the second quarter of 2010. Vanda expects to report top-line results for this trial in the fourth quarter of 2011. Vanda anticipates filing a NDA with the FDA for tasimelteon in N24SWD by the first quarter of 2013. Vanda and Bristol-Myers Squibb also entered in restated license, development and commercialization agreement for tasimelteon, suggesting that BMY will continue to pursue development of this drug.
Right now, I feel it is a good time to pick up some VNDA shares as we get a better look at second quarter Fanapt sales in August. Although VNDA has not shown any signs of rebound yet, I believe improving market conditions, options expiration, and upcoming 2nd quarter results, will result in a short “pinch” (if not a squeeze, just a pinch at least). Many analysts and commentaries on VNDA have painted a very gloomy picture for Fanapt, and the ridiculous scenario of total commercial failure of Fanapt and liquidation of Vanda is priced in as VNDA is trading for less than its current cash position. Investors are not even considering the revenue potential captured in injectible Fanapt and tasimelteon in the next few years if they are marketed (at Novartis and Bristol-Myers Squibb’s expense!). All of these aspects don’t even consider a buyout of VNDA from either company, which given the deals in place, cash position, and progress Vanda is making, is a plausible scenario. Clearly, in this case, the market is wrong.
Accompanying all this doom and gloom, there appears to have been a massive shorting initiative, and perhaps this has prevented a rebound in stock price: According to recent short interest reports, 18% of the float is short, with 10 days to cover at average volume. As well, there is nearly zero open interest for July put options (compared to a nearly 4:1 put/call ratio in June), suggesting that the short assault is over, and now covering will be necessary. I expect this covering of short positions to put some pressure on VNDA stock, causing the “pinch” I mentioned. If the shorts have not covered by August, and the Fanapt results are anything but abysmal, there is good potential for a short squeeze catalyst as investors are reassured about Fanapt sales. Investors who have taken a good hard look at Fanapt, and not believed all the hype, nor all the doom and gloom, will be able to comfortably secure a position in cash-rich VNDA and wait for these conditions to manifest. I am one of those people, and I can’t wait to see what happens to VNDA stock in the coming weeks.

Disclosure: I have a long position in VNDA.