The shares currently look undervalued ahead of further drug approval.
By Kelsey Tsai, CFA | 11-13-17 | 06:00 AM | Email Article

After  Vertex Pharmaceuticals third-quarter results showed robust uptake of cystic fibrosis drugs Orkambi and Kalydeco, we raised our fair value estimate to $175 per share from $170. Our updated 2017 sales estimates fall in line with management’s new outlook: $1.29 billion-$1.32 billion for full-year Orkambi sales (from $1.1 billion-$1.3 billion) and $810 million-$830 million for Kalydeco sales (from $770 million-$800 million). We think the company’s drug portfolio was significantly derisked following the earlier news of positive triple-combination drug data for harder-to-treat cystic fibrosis patients with heterozygous F508del mutations. We believe Vertex’s monopoly in the cystic fibrosis market merits a narrow economic moat rating, and we think the shares are currently undervalued.

Kelsey Tsai is an equity analyst for Morningstar.

Thanks to the approval of Kalydeco in children ages 2 and older in the United States with residual function mutations, the drug’s sales increased 12% quarter over quarter. Once these patients come on line, we believe Kalydeco sales will return to slow but steady growth. Phase 3 data evaluating next-generation corrector tezacaftor in combination with Kalydeco did not show an acute effect on the lung function Kalydeco patients. However, as these patients are already well served by Kalydeco, we don’t believe the finding bears any significance for our model estimates.

Orkambi, which targets patients with two copies of the F508del mutation, grew 4% over the past quarter. Approval in children ages 6-11 supported sales expansion, and we expect approval in children ages 2-5 will provide a modest tailwind in 2018. Expected approval of next-generation Orkambi (tezacaftor with ivacaftor) in the first quarter of 2018 for the U.S. and second half of 2018 for the European Union is anticipated to capture a larger share of patients with homozygous mutations. Tezacaftor with ivacaftor did not show the same bronchoconstriction side effect seen with Orkambi, which could have discouraged a modest number of patients from continuing Orkambi therapy.

Vertex’s ENaC inhibitor VX-371 was not found to add incremental improvements on top of Orkambi treatment in a phase 2 trial and prompted the company to record an impairment of the asset in the quarter. While VX-371 could have built a larger barrier of entry for pipeline competitors, the write-off of the asset does not affect our valuation.

We believe the stock price already incorporates some anticipation of approval of a triple-combination therapy in the heterozygous-minimal function (het-min) CF population. However, further confirmation of the drug cocktail’s efficacy and subsequent approval would eliminate any concern of regulatory risk, and we would expect this to provide future upside to the stock price. We assume the regimen will reach the market in our model. After the readout of additional phase 2 data testing multiple next-generation correctors in a triple regimen in early 2018, Vertex will begin pivotal testing with 1-2 combinations. The inclusion of VX-561, a once-daily version of Kalydeco (which is twice-daily) acquired from Concert Pharma, is not material to our estimate of Vertex’s het-min opportunity, but successful integration of the molecule in a triple regimen would bolster the company’s competitive position. Beyond cystic fibrosis, Vertex will need to bolster its pipeline with its next opportunity. We expect the company to make small acquisitions to protect its cystic fibrosis franchise and build a portfolio of early-stage candidates for its next era.

Cystic Fibrosis Portfolio Provides Moat
Vertex’s portfolio of disease-modifying drugs forms the basis of our narrow economic moat rating. The company is well supported by lengthy patent protection and first-mover status in the cystic fibrosis market. Kalydeco was launched in 2012, and Orkambi (VX-809/Kalydeco combination) was approved in 2015. As the only disease-modifying drugs on the market, Kalydeco and Orkambi are the backbone of cystic fibrosis therapy, and we believe Vertex will remain the leader in this rare-disease space for the foreseeable future.

Given the limited treatment options for cystic fibrosis and the chronic nature of the disease, Vertex is able to command strong pricing power over the course of a patient’s life. Kalydeco costs close to $300,000 as a treatment for less than 10% of cystic fibrosis sufferers with certain genetic mutations. Despite this aggressive pricing, uptake has been swift, with almost all eligible patients now on the therapy. Vertex’s strategy has been to develop drugs known as correctors that work in combination with Kalydeco in order to treat other genetic subtypes that make up a larger portion of cystic fibrosis patients. Orkambi treats people with the most common cystic fibrosis mutation (F508del homozygous). The drug is priced over $250,000 per year and currently targets roughly 40% of the cystic fibrosis population. Pediatric label expansion will increase the target population by approximately 12,000 patients. The company’s other cystic fibrosis pipeline drugs include tezacaftor (VX-661) and second-generation correctors VX-152, VX-440, VX-659, and VX-445 to be used in combination with Kalydeco as more potent treatments in difficult-to-treat cystic fibrosis subtypes. Approval for a triple-combination regimen using next-generation correcters would expose Vertex to its next-largest opportunity in cystic fibrosis--the het-min patients who make up nearly 30% of the total cystic fibrosis population.

Cystic fibrosis is a genetic disorder affecting roughly 75,000 people worldwide; it causes a progressive and deadly decline in lung function. While the number of patients is small, the six-figure pricing for Vertex’s disease-modifying drugs makes for megablockbuster market potential. In addition, Vertex’s portfolio is experiencing a welcoming commercial and regulatory environment because of the lack of treatments for this severe affliction. The chronic nature of therapy and limited competition on the near-term horizon heighten the market’s attractiveness. U.S. patents for Kalydeco and Orkambi extend to 2027 and 2030, respectively (2025 and 2026 in the EU), which wards off generic competition. Galapagos , in partnership with AbbVie , remains the closest pipeline threat to Vertex’s cystic fibrosis franchise, but it is still years away from reaching the market. This gives Vertex time to further entrench its current marketed therapies in the prescriber population and also potentially launch second-generation products. All of these elements lead us to award the company a narrow moat rating as it executes on its transformation into a rare-disease powerhouse.

Future Relies on Emerging Franchise
A significant amount of Vertex’s fair value hinges on the commercial success of Orkambi in the large F508del homozygous patient population. Although we expect the drug to largely capture this patient population, as there are no other disease-modifying drugs on the market, increased patient discontinuation of Orkambi due to bronchospasm side effects would curtail our positive view of the company’s growth prospects and moat trend. Additionally, there is increasing competition in the cystic fibrosis development pipeline, which could threaten Vertex’s current leadership position. Progression of Vertex’s next-generation doublet candidate, which does not display the same bronchospasm effect, helps mitigate this risk.

Our assumptions of very high pricing underpin our view of the blockbuster potential of the cystic fibrosis market. We are therefore concerned that payers, particularly austerity-strapped governments in Europe, may balk at such high prices even for a drug treating an orphan indication. The U.K. National Institute for Health and Care Excellence has initially denied reimbursement for Orkambi, acknowledging the efficacy but citing cost-effectiveness concerns. On the other hand, should Kalydeco’s current pricing of over $300,000 be maintained with its future combination therapies in a much larger number of patients, our estimates may prove too conservative. Finally, the company’s risk is compounded by the early-stage nature of its remaining pipeline, which includes experimental treatments for influenza, pain, and cancer.

Like most biotechnology companies, Vertex has historically operated at a loss because of the high cost of clinical trials and research. These losses have been financed largely through offerings of equity and debt securities, collaborative research and development funding arrangements, and development milestones and royalties from partners.

However, with the successful launches of Orkambi and Kalydeco, the company has been able to generate significant revenue, which allowed it to build up a significant cash cushion sufficient to fund the development and commercialization of its remaining development-stage candidates. Even with Orkambi’s launch still ramping up, we expect Vertex will reach sustainable profitability in 2018 and generate significant cash flows thereafter. We expect that Vertex will use its cash to build a more diversified rare-disease portfolio as it looks beyond the cystic fibrosis market.

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Kelsey Tsai, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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