Vertex Pharmaceuticals Inc (VRTX)

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Vertex Pharmaceuticals: Great Pipeline, Valuation And Future

The past 6 months have proven that biotech mergers & acquisitions are soaring. Gilead (GILD) gobbled up Pharmasset (VRUS), and Bristol-Myers (BMY) bought Inhibitex (INHX), and dozens of companies are rumored to be next. The surge in M&A in this sector has inflated stock prices across the sector, as investors bet on the next deal. Yet one company has been ignored in this rally, and we think that it is time investors take note of it.

Vertex Pharmaceuticals (VRTX) is a biotech company that develops therapies for a wide range of diseases. Its primary product is Incivek, for the treatment of HCV (also known as HCV), and Lexiva, for HIV, which it sells in a partnership with GlaxoSmithKline (GSK). Incivek is one of the first new therapies for HCV in years, and it has been responsible for an almost 74% rise in Vertex's stock price over the last 10 years. Yet, as merger mania in the biotech sector heats up, Vertex has been left in the dust. We think that is a situation that cannot last for long, given the company's products and pipeline. Below we profile Vertex, its drugs, and its future.

Overview

Vertex received FDA approval to sell Incivek in May 2011, after nearly 15 years of development. The drug is on pace to break the record for the fastest product launch to reach sales of $1 billion. And just a quarter after launching the drug, Vertex announced that it has become profitable, posting EPS of $1.02 on revenues of $659 million in the third quarter of 2011. Many biotech companies spend years in the red even after launching their drugs. Yet despite all this, Vertex stock has languished over the past year.

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Over the past year, Vertex has lagged both the S&P 500 and the broader biotech sector (XBI), falling over 9%. There are two factors at play here. The first is takeover mania in the biotech sector. The second is concerns with Incivek.

Takeover mania: After it was revealed Bristol-Myers was buying Inhibitex, both Achillion Pharmaceuticals (ACHN) and Idenix (IDIX) rallied sharply. Achillion rallied 16% and Idenix soared 34%. And what about Vertex, the only biotech company with an actual HCV drug on the market? Its shares rose a paltry 4%. With a surge in M&A action, it would make sense that the company most likely to be pursued by big pharma would be a company with a profitable drug on the market and a promising pipeline. Rumors would suggest that Johnson & Johnson (JNJ), Vertex's partner on the Incivek, would be a good fit for the company. In addition, Abbot Labs (ABT) could also be looking to expand its own HCV franchise. But with a market capitalization of over $7.5 billion, Vertex carries a hefty price tag, even without the premium necessary to seal an acquisition. The fact that it would take much more work to buy out Vertex than its peers in the HCV space has depressed the stock. Yet as each biotech's scarcity value increases, the chances of someone paying top dollar for Vertex increases.
Incivek: Multiple companies are developing the next generation of HCV therapies, including Pharmasset, Inhibitex, Achillion, and Idenix, as well as Merck (MRK). The mania surrounding the HCV developers is due to the fact these companies, while having no product on the market, are developing therapies that do not use interferon. Interferon has been a staple of HCV treatment for years, but it comes with a host of unpleasant side effects, some of them worse than the symptoms themselves. As such, many patients simply do not get treatment. But the next generation of therapies work far differently than current treatments. These nucleosides and nucleotides have proven themselves in many clinical trials. Gilead paid an 84% premium for Pharmasset precisely because its HCV treatment uses no interferon. The same goes for Inhibitex, Idenix, and Achillion. Incivek, on the other hand, is an improvement on existing treatments, yet must still use interferon, diluting its "value" relative to the other drugs in development. As such, Vertex has seen its stock depressed since the launch of Incivek, as investors fret that new treatments will render its drug useless.

These 2 factors have depressed Vertex's stock, and we think that this creates an ideal time to buy the stock. Vertex's future is nowhere near as grim as investors currently believe it to be. There are 2 primary reasons for this. The first is that pessimism about the company's HCV franchise is overdone. The second is that Vertex is rapidly diversifying away into new markets.

HCV

Medical data from a variety of biotech companies proves that interferon-free therapy is simply more effective than Incivek. That is a reality that Vertex investors must accept. Merrill Lynch, in cutting its estimates for Vertex, laid bare the situation. It slashed sales estimates for Incivek, citing competition from interferon-free therapies and waning demand due to the side effects of interferon.

Global Incivek Prescriptions: Merrill Lynch

Estimates have been slashed dramatically for Incivek's global potential, particularly in 2014 and beyond. This is due to the fact that 2014 is the projected date for interferon-free therapies to hit the market, led by Gilead's PSI-977, the primary driver of the Pharmasset deal. A variety of studies have shown that these therapies are superior to Incivek. There is no denying that. But, until 2014, Incivek will remain a leading choice for HCV patients, for it is an incremental improvement on prior therapies. Incivek has already demonstrated that it can allow Vertex to acheive profitability after just several months on the market. This allows Vertex to fund its research internally, without diluting its shareholders or weakening the balance sheet, something many other biotechs must resort to, even after starting sales of their drugs.

While Vertex was the first biotech to launch an HCV therapy, Incivek is certainly not its last drug in development for this disease. Vertex is fully aware that interferon-free therapies are the future, and it is planning accordingly. The company's 2012 business plan highlights its plans for the HCV franchise. Vertex is set to begin Phase III trials of VX-222, the successor to Incivek. VX-222, when given in combination with Incivek, cuts the maximum treatment time to 24 weeks, versus up to 48 weeks of treatment with Incivek alone.

In addition, Vertex is not sitting idly by in the interferon-free subsector. Vertex is collaborating with Alios BioPharma in developing interferon-free therapies. ALS-2200 and ALS-2158 are currently in Phase I trials. Data is expected in the second quarter of 2012, with Phase II trials set to begin in the second half of the year. Vertex has worldwide rights to these therapies, and in its deal with Alios it must pay royalties on future sales. At this point, readers may be wondering what good this will do Vertex, for these therapies are at least several years away from commercialization, and by then Incivek could be rendered irrelevant. However, we think investors are too focused on Incivek. Even in 2016, Incivek will be a profitable drug, despite the competition on the market. And by then, Vertex will have branched out into an entirely new area of medicine: cystic fibrosis.

Cystic Fibrosis

This is a disease that affects around 30,000 people in the United States and 70,000 worldwide. It is a rare and life-threatening disease with no current cure. So what is Vertex doing to address this? VX-770, to be marketed as Kalydeco, targets an extremely rare subset of cystic fibrosis patients, who have a specific mutation in the G551D gene. Only about 1.6% of all cystic fibrosis patients have this mutation, making it extremely rare. That is why Kalydeco has been given orphan drug status, and is on a fast track review at both the FDA and the EMA (European Medicines Agency). A target review date of April 18, 2012 has been set by the FDA, and all indications are that Kalydeco will be approved in both the US and Europe.

Orphan drugs are ones that treat extremely rare diseases. Given that they meet an unmet medical need, companies developing orphan drugs are given a variety of incentives for developing them, such as longer exclusivity, clinical research tax credits, and fast reviews at the FDA. The current poster child for the success of orphan drugs is Alexion (ALXN), whose Soliris drug treats several extremely rare diseases. Any Alexion investor can tell you that they are very happy with how the company has done, given its 1,300% rise over the last 10 years.

Credit Suisse estimates that while Kalydeco can ultimately address just 5% of the cystic fibrosis market, it can charge up to $250,000 per patient per year, which translates into annual sales of around $1.9 billion. Vertex plans to expand the market for Kalydeco beyond the G551D mutation, and multiple trials are planned for 2012 to determine if this is possible. While this is healthy on its own, a potential combination treatment of Kalydeco and VX-809, a new cystic fibrosis treatment, could expand Vertex's sales to around $5 billion in this market by targeting more common forms of the disease. But, current data has been underwhelming regarding the efficacy of this combination. Further data, set to be released in 2012, will show whether this upside can be realized. Either way, sales of around $1.9 billion are still very healthy, and the downside risk to Vertex in the cystic fibrosis market is limited. But HCV and cystic fibrosis are not the only diseases Vertex is targeting.

Arthritis, Epilepsy, and Influenza

Even while investing huge sums of capital into HCV and cystic fibrosis, Vertex is working on these 3 diseases as well. VX-509 targets arthritis as well as several other inflammatory diseases, and VX-765 targets epilepsy. VX-509 and VX-765 are both in Phase II trials. A 6-month Phase IIb study of VX-509 is set to begin in the first quarter of 2012, and VX-765 is set to enter new testing phases as well. While it is a bit too early to gauge the financial impact of these products, existing clinical data on VX-509 is promising, with patients showing significant improvements relative to existing therapies. As for VX-765, clinical data shows that the drug is well-tolerated, and Vertex is continuing to invest in it, though more data is needed to specifically determine its efficacy. Vertex is also initiating more trials of VX-787, its investigative influenza treatment for both swine (H1N1) and bird (H5N1) flu. VX-787 is currently in Phase I trials, and data is expected in the second quarter of 2012.

Financials

What many people seem to forget is that Vertex is already profitable, unlike many of its peers with new drugs on the market, such as Dendreon (DNDN) and Human Genome Sciences (HGSI). Vertex posted EPS of $1.02 per share last quarter, on revenues of more than $659 million. The company has more than $250 million in net cash on the balance sheet, and has no need to tap the debt or equity markets anytime soon. Vertex trades at just 8.1x 2012 earnings estimates ($4.48 per share), and we do not see any reason why the shares should be this cheap. Vertex is trading at the same multiples as big pharma trades, yet 2012 earnings are set to grow over 1,559% over 2011. Below we provide an overview of Vertex's earnings and revenue estimates for the next 5 quarters. Vertex is set to report fourth quarter 2011 earnings on February 2.

Vertex Earnings & Revenue Estimates

Vertex faces no profitability issues in 2012, and most estimates do not include revenues (or profits) from Kalydeco. Given the strong need for new cystic fibrosis treatments, we see no reason why Kalydeco could not see the same rapid uptake as Incivek did. 2012 will be a great year for Vertex financially. 2013 and beyond would be even better as Kalydeco ramps up and Vertex's other drug candidates enter the market. The current Reuters average price target for Vertex is $48.05, representing upside of over 32% from current levels. And considering how badly analysts missed the last quarter (predicting Incivek sales of $300 million versus $420 million in actual sales), we think analysts are likely to raise price targets and earnings estimates in 2012 as Vertex proves its skeptics wrong.

This company's future is far brighter than many would believe. And at 8.1x 2012 earnings, the shares are far too low relative to Vertex's potential. We think now is an opportune time to add to or initiate positions in Vertex Pharmaceuticals. This company has demonstrated that in can successfully launch a major drug into the market. It has a great pipeline and the financial strength to translate that into commercial success. We think that the skepticism surrounding this company is far too great, and that investors who have faith in the company and its products will be rewarded greatly for their loyalty.

Disclosure: We are long VRTX on its own, and are long GILD, ALXN, HGSI, and DNDN via the First Trust NYSE Arca Biotech Index Fund, an ETF that tracks a basket of 20 biotech stocks We are long ABT, JNJ, and MRK via the PowerShares Dynamic Pharmaceuticals Portfolio. In addition, a mutual fund we own grants ALXN a weighting of 1.19%.

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