Vertex Pharmaceuticals May Be Turning Some Major Corners – Seeking Alpha

Introduction - Rationale for the article

One of the several smaller but commercial-sized biotechs that has been around for decades but is yet to truly emerge as a profitable enterprise, Vertex Pharmaceuticals (NASDAQ:VRTX), is a $37 billion market cap stock. It was one of the early rational drug design companies. With 96% of the shares held by institutions, the public is apparently little involved in trading the stock. However, there are close to 20,000 Seeking Alpha members who have VRTX on a watch list, and certainly many others who follow it, at least from time to time, consistent with the sophistication of Seeking Alpha members.

One of the problems following VRTX is that the terminology used for the disease it specializes in developing drugs for - cystic fibrosis, or CF - is complicated to the point of being inscrutable without special training.

It is hoped that this brief piece may organize and clarify certain technical matters about CF as well as regarding the large and somewhat confusing pipeline that VRTX has amassed. Links to helpful documents and slides are provided that, it is hoped, will be accessible to a general readership.

Introduction to CF

This is a genetic disease. Almost always, neither parent will have CF and will instead be of average health. Thus, CF is a sporadic, seemingly random disease. Per the NIH, the disease occurs in 1 in 2,500 to 3,500 white newborns. Cystic fibrosis is less common in other ethnic groups, affecting about 1 in 17,000 African Americans and 1 in 31,000 Asian Americans.

The clinical hallmarks are most notable in lung function and susceptibility to lower respiratory tract infections and gastrointestinal problems. Cases of CF range from severe to (rarely) mild; some cases are pulmonary-predominant and others have GI-pancreas symptoms more prominent. The simple, accurate test for CF is to measure the amount of an ion, chloride, in the person's sweat. If this is elevated above a certain level and appropriate symptoms exist, CF is generally present. This is the "sweat test" or "chloride sweat test" that you may see if you get into the VRTX and CF literature.

Patients with CF produce abnormally thick fluid in the lungs. Normally, thin mucus or fluid is produced deep in the lungs and swept upward toward the throat, thus clearing germs and particles away from the deepest parts of the lungs. With CF, the mucus or airway fluid is too thick; this is believed to be a key reason for the susceptibility to lung infections, both pneumonia and bronchitis in this disease. Pulmonary problems as well as nutritional insufficiency lead to a diminished quality of life and typically a much shortened life span, especially before the quality of treatment improved in recent decades.

When VRTX tests a drug to ameliorate CF, it measures how much air a CF patient can exhale in one second. This is the FEV1 test, which stands for forced expiratory volume in 1 second. Sometimes this is written as ppFEV1. The higher the FEV1, the better the response to the drug.

Among the secondary endpoints other than additional pulmonary metrics are both general quality of life and weight gain, which is usually desirable in CF patients given their digestive problems.

Some technical details about CF

The specific defect causing CF arises when both parents transmit a mutant CF gene (or allele) to their child; this gene is located on chromosome 7. This mutation leads to inadequate numbers and/or inadequate function of a protein called CFTR (see below for details on CFTR, which is a term used both for the CF gene and for the protein itself).

There are numerous different types of mutations found in CF. Each mutation has a name, which VRTX tends to include in its regulatory filing and press releases, but the specific names do not need attention from investors. What matters most is how many new cases are now eligible for treatment with a VRTX drug.

As an example, on slide 4 of the PowerPoint presentation accompanying the Q2 earnings release, VRTX refers to F508del, a common mutation in CF. This is also called F508 delta. A difficult and common form of CF to treat is one where each parent contributes the same allele, each the F508del mutation. In this case, the CF patient is designated as having the F508del/F508del type. This designation is shown in both the first and the second boxes in that diagram as an important treatment class.

An even more difficult CF type for drug treatment is one where one allele is F508del and the other causes minimal function of the malfunctioning protein. This is called F508del/min. There are also different CFTR types of malfunction which are called "residual function" defects, and VRTX calls the appropriate ones residual function/F508del (or related terms).

These classifications are especially useful to investors in thinking about the market opportunity for VRTX in CF and in assessing its pipeline.

Perhaps the most important point is that if one is studying VRTX, having an understanding of what the company is talking about can demystify the situation enough to allow a focus on the profit opportunity down the road.

Details on CFTR (more technical)

VRTX's marketed and major pipeline drugs have the -caftor suffix unless they are not yet listed by name. This naming is done because the protein that is lacking and/or defective in CF is the cystic fibrosis transmembrance conductance regulator. So, C F T R made into a chemical suffix was turned into caftor.

The CFTR gene contains the code for the CFTR protein. Defects within the spectrum of CF include the CFTR protein:

The CFTR protein plays an important role in regulating fluid balance emanating from epithelial cells. In CF, basically what ends up happening is that sodium is reabsorbed excessively, and sodium carries water with it. This leads to inadequate water content in mucus, thickening it and causing various sorts of damage to pancreatic and other ducts, digestion in the GI tract, and issues with the lungs (and other functions). At the same time, chloride is not reabsorbed properly, leading to high chloride levels in sweat that is a convenient marker of CF.

Because this defect affects epithelial cells in general, CF is a multi-systemic disease.

Introduction to VRTX's marketed drug products for CF: Royalties

Years ago, the company licensed promising caftors from the Cystic Fibrosis Foundation. I seem to remember a 10% royalty rate on drugs that made it to the market, but this is what VRTX says about the arrangement as it exists now in its Q2 10-Q (p. 11):

The Company has a research, development and commercialization agreement with Cystic Fibrosis Foundation Therapeutics Incorporated ("CFFT") that was originally entered into in May 2004, and was most recently amended in October 2016 (the "2016 Amendment"). Pursuant to the agreement, as amended, the Company has agreed to pay royalties ranging from low-single digits to mid-single digits on potential sales of certain compounds first synthesized and/or tested between March 1, 2014 and August 31, 2016 and tiered royalties ranging from single digits to sub-teens on any approved drugs first synthesized and/or tested during a research term on or before February 28, 2014, including (i) KALYDECO (ivacaftor) and ORKAMBI (lumacaftor in combination with ivacaftor), which are the Companys current products and (ii) tezacaftor in combination with ivacaftor. For combination products, such as ORKAMBI, sales will be allocated equally to each of the active pharmaceutical ingredients in the combination product.

Since VRTX plans to more or less replace Orkambi with a tezacaftor/ivacaftor ("T/I") product and use T/I as the backbone of 3-drug combos for the most difficult cases to treat, it's important to note that the royalty rate stays the same for T/I as for the two marketed drugs at this time: Kalydeco and Orkambi. It would appear, though, to me, that the candidates for the third drug may be headed for about 4-5% royalties. If so, then perhaps the royalty rate on these drugs would be around 8%. Depending on the mix of drugs sold, royalties to CFFT, which the company includes in cost of drugs sold, would shrink just a bit as a percentage of revenues if one or more 3-drug combos reached the market - which is, I believe, required for VRTX to end up being a rewarding investment.

Why VRTX may do better with T/I than Orkambi

While Kalydeco demonstrated robust gains in FEV1 and other parameters, it only treats a small percentage of the estimated 75,000 patients with CF in the higher-frequency parts of the world. Orkambi, on the other hand, generated just good enough data to get approval but was less effective than Kalydeco. Then, it has some unwanted side effects, including shortness of breath in some patients. Between limited efficacy and a side effects profile that is not ideal, Orkambi has been a tougher sell than Kalydeco, especially ex-US.

To the rescue is T/I, which VRTX reports had good efficacy in Phase 3 (no direct comparison to Orkambi), though not superb, but a better side effects profile. Marketing applications have been submitted in the US and EU, so I expect marketing to begin in the first half of next year in the US and later in the EU.

The T/I combo is critical to the bulk of VRTX's growth plans.

The promising data on triple therapy

For the toughest cases, and (I speculate) possibly for some cases where T/I may be indicated but may not work too well, three-drug combos may represent a further breakthrough in therapy. VRTX has reported promising results on three different novel agents used in combination with T/I. It has discussed these in press releases and on the conference call, as well as in its 10-Q (pp. 35-38).

What was so well received by the Street in this heavily institutional stock is that unlike Orkambi and T/I, the clinical improvement with these 3-drug combos in the Phase 2 and Phase 1 studes was robust. Thus, these could be impressive medical breakthrough drugs. At least one of the drugs was associated with some liver toxicity, however; investors must remember, safety matters a lot.

I expect one or two of these 3-drug combos to enter Phase 3 in the first half of next year. These studies can move along relatively rapidly. Could we be looking at a 2021 or 2022 product intro, or two product intros?

The progress on T/I and on triple drug therapy each represents a potentially important corner that Vertex may be turning in its quest to corner the market on CF drugs.

Improving on Kalydeco

VRTX has recently acquired rights to what is said to be a deuterated ("heavy hydrogen") version of Kalydeco (CTP-656) from Concert Pharmaceuticals (NASDAQ:CNCE). The cost was $160 million upfront, with maximum milestones of $90 million. This is proposed to be a longer-acting drug with at least the same effectiveness and safety as Kalydeco, with the goal of allowing therapy once daily.

We will have to wait to see precisely how VRTX moves to incorporate the former CTP-656 into its development plan.

It is nice to see the company focusing on improving its products within the one narrow therapeutic area of CF. Focus and successful risk-taking have been the keys to the successes of such biopharma stars as Celgene (NASDAQ:CELG) and Gilead (NASDAQ:GILD).

VRTX profitable in Q2 - Another corner turned?

While the large profit in Q1 was greatly flattered by the sale of oncology R&D assets, Q2 was cleaner. Product revenues were $514 million; total revenues were $544 million. R&D expenses were enormous as a percentage of revenues at $289 million. Yet, the company eked out a 7 cent per share profit. With Orkambi growing rapidly, and Kalydeco growing as well and gaining an additional 600+ patients from an FDA supplemental approval per an August 1 press release, there's every chance that SG&A can begin to shrink as a percentage of revenues; the same may or may not be true for R&D.

Note: VRTX is well known for being fantastically R&D oriented; this is in its founding DNA, so to speak. The stock has been a strong performer since its 1991 IPO despite just a few profitable quarters, with a CAGR around 14% since then. Also, over the past 10 years, despite the terrible disappointment of its hepatitis C drug, Incivek, going from best new product entrant ever in 2011 to zero after the current generation of HCV drugs began reaching the market, the CAGR for VRTX over the past 10 years is around 13%.

So, I'm not certain that conventional profits are now going to be the goal of this company versus more Amazon-like (NYSE:AMN) reinvestment. Nonetheless, that it could be profitable despite huge R&D spending strikes me as another corner turned.

But I do need to note that as usual for VRTX, analysts have marked down their EPS forecasts. These were $1.66 non-GAAP and $3.12 non-GAAP for 2017 and 2018 before the earnings report, and now are looking more like $1.60 and $3.03 respectively.

Sales are forecast to be $2.68 billion for next year; I am not certain whether that is actually a product sales forecast or total revenue forecast (I think it's total revenues).

In any case, clearly this stock is being valued on earnings some years from now, or at least potential earnings if it just spends and spends on R&D.

Why VRTX may become a more conventional earnings play

There is only one Jeff Bezos, and tech is tech. Meaning, you can have a new idea and just implement it. In the case of AMZN, a leader in profit-lite stock market/business wizardry, the story is well-known and logical. The infrastructure to support AMZN's retail division, both hardware and software, was there to allow the company to offer itself out as the repository of data from other companies and individuals; voila: AWS. Profits from retail went back into global retail expansion and into AWS expansion.

This sort of scalable and unusual set of enterprises does not translate well to pharmaceuticals. Time lines are too long, regulation too intense, breakthrough ideas of uncertain safety even if therapeutically sound, etc. In other words, beyond the evolving and impressive potential to make a huge impact in an untreatable disease, CF, it is difficult to see VRTX scaling. And since the universe of CF patients can only evolve slowly, success with the T/I combo and then triple therapy should either force the company to become a free cash flow powerhouse or else get into a good deal of acquisition activity that could bring GAAP profits way down if extensive.

Thinking it through, however, given the very high valuation of VRTX, if the institutions who own the stock want new buyers to sell their stock to, it makes sense for them to pressure the company to move toward conventional behavior and show growing GAAP (and non-GAAP) profits. This occurs over and over again, with AMZN a rare exception.

My long-term investment thesis for VRTX is, for the above two reasons, that it succeeds in dominating the CF market and becomes a "GARP" (growth at a reasonable price) stock.

Risks

Anyone interested in VRTX stock should very much consider reading the Risk Factors in the 10-K and as updated in the 10-Q and elsewhere. Past performance of the shares is no guarantee and may be no indicator of any future success for anyone purchasing shares at current prices.

Certainly, the very high prices charged by VRTX for its drugs brings risk of various sorts. And even though I think the company has a solid lead against all its competitors in the fight to bring improved drugs to the market for CF patients, only time will tell how the market develops. Can it achieve clear, profound dominance by the early 2020s, as it hopes, and extend that for many years to come? The less chances it can do that, the greater the risks to investors in the stock.

Concluding thoughts - Is VRTX another CELG in the making?

When one goes back to look at the valuation metrics of CELG in the 2005-07 period, it traded as high as about 21X sales per share. The sales and EPS growth were a lot faster than the valuation shrinkage, so that all worked out. If VRTX can beat estimates next year and trade at some point at 20X revenues of, say, $2.85 billion, that would equate to a $57 billion market cap, or a 50% price increase from that seen today.

I published my last VRTX article a little over two years ago and titled it "Vertex Pharma: Well Positioned To Set New Highs." Part of the bull thesis was that the company was a takeover target. That has not happened, but maybe it would have benefited the acquirer if it had gotten control after the stock took its big dive. The stock was around $128 then versus $154 now. That would be a 20% gain - not at all bad given that a leading biotech ETF (NASDAQ:IBB) is down roughly 20% since then.

The basic case that I can see for VRTX actually being a good new money investment over time, despite being somewhat extended right now, is that it may have a hammerlock on the CF market. If the 75,000-patient population is correct, and they continue to live longer, then that number can increase. Then, one has to think of sales in countries where CF is less common but still seen, notably Mexico and South America, and China. CF is vanishingly rare in Japan, however.

Just speculating on numbers, let us say that the total addressable CF population 10 years from now is 90,000, including some from countries not included in the current 75,000 potential patient estimate. What will be the market penetration, assuming that VRTX is correct that its medicines, if approved, will then be able to treat, say, 80,000 or so patients? If it reaches 50%, then that's 40,000 patients. With Kalydeco, which is highly effective, listing for well over $300,000 per year, and with VRTX having indicated in, I think, 2015 that discounts in the EU were not all that much greater than in the US, but Orkambi less highly priced than Kalydeco, do we estimate $200,000 per patient per year? I do not know, but that would come to $8 billion per year. If that occurs, and note again these numbers are rank speculation, it is anyone's guess whether the company will proceed as CELG has, with other products and a robust pipeline, or like GILD and Amgen (NASDAQ:AMGN), with the Street looking at aging product lines and inadequate R&D productivity and valuing the stock at a relatively low price-to-sales ratio?

Lots of questions, and no answers until the future unfolds.

At this point, now focusing almost exclusively on CF, VRTX has evolved to be my favorite sort of company, namely one with an ecosystem that is tightly tied together. CELG and GILD have done that; so has Biogen (NASDAQ:BIIB). In a different field, obviously Apple (NASDAQ:AAPL) has done that amazingly well, as has Facebook (NASDAQ:FB). The first biotech stock I wrote about and praised more than 4 years ago, United Therapeutics (NASDAQ:UTHR), accomplished something similar in extraordinary fashion. These are "category killer" companies. As with GILD in HIV/AIDS, the profit stream from CF drugs at VRTX may have, in the end, greater durability than the analysts think. Line extensions, new inventions developed in-house using the company's extensive knowledge, and often a first look at new ideas developed elsewhere can be powerful advantages. In addition, once the sales force is well trained, ethical and productive, the company has the added profit ability to market or co-market products developed elsewhere, providing a bridge over sometimes troubled waters. Finally, in the case of VRTX, its experience with rare diseases could make it a preferred senior partner for a small player with a new product, should VRTX make it to become a $5 billion+ annual sales and highly profitable company.

In summary, VRTX has taken a promising lead in the development and marketing of a once-fatal disease with no specific treatment. In rebounding so quickly from the Incivek disaster, it has proven there are some second acts. With few short-sellers (only about 1.5% of the float) and strong institutional sponsorship, the company may have the right stuff to grow into its valuations and continue to reward shareholders with price appreciation. Risks are significant, however, including but not limited to product development risks and valuation risks.

Thanks for reading and sharing any comments you wish to contribute.

Disclosure: I am/we are long VRTX, BIIB, CELG, GILD, AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Not investment advice. I am not an investment adviser.

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Vertex Pharmaceuticals May Be Turning Some Major Corners - Seeking Alpha