Vertex Pharmacueticals Inc Approaching a Huge Fork in the Road

Orphan drugs are hot these days, so when an investor finds a biotech focused on orphan drugs that appears to be undervalued, it certainly merits further investigation. In the case of Vertex (NASDAQ: VRTX  ) , it all comes down to risk and a major upcoming clinical data release -- If Phase III studies reveal success for a new combination therapy for cystic fibrosis, these shares could easily head to $100 (or higher). If the trials are declared failures, though, the downside could be $25 per share or higher.

TRAFFIC and TRANSPORT nearing the end of the journey
Vertex already markets Kalydeco, a CFTR potentiator that offers the first real treatment option for cystic fibrosis patients, but only for a small subset (less than 10%) of patients. Kalydeco has blockbuster potential in its own right (by virtue of the rich prices allowed for orphan drugs), but the real opportunity seems to be in pairing the drug with CFTR correctors that could expand the potential addressable market closer to 100% of CF patients.

Vertex's first such corrector is called lumacaftor, or VX-809, and combinations of VX-809 and Kalydeco are in Phase III studies (TRAFFIC and TRANSPORT) in patients who are homozygous for the F508del mutation (roughly 50% of the CF patient population). Data from these studies is expected around midyear 2014, likely May or June.

Opinions do vary
By no means is there a unanimous opinion out there that these two Phase III studies will succeed, and at least some of that doubt ties back to the Phase II studies of the combo therapy. The Phase II studies showed an absolute benefit in improved lung function (FEV1) of around 4% to 6% depending upon the dose, and that would normally be seen as quite compelling.

The devil is in the details. In the monotherapy phase of the studies (where patients got VX-809), patients' lung function actually worsened. Second, there was not a linear relationship between lung function improvement and sweat chloride measurements, raising doubt as to just how well the drug(s) worked as advertised.

At this point, I side with the more bullish interpretations. VX-809 was not designed or intended as monotherapy, so I'm not bothered by how the drug performed on its own. I'm also not convinced that the relationship with sweat chloride is entirely relevant. It has not been established as a predictive marker for lung function, and it may be the case that this combo works differently in the lungs than it does in the sweat glands and/or expression and regulation of CFTR may be different between the lungs and sweat glands.

Pretty much a one-note company
The risk of a negative outcome in the TRAFFIC and TRANSPORT studies is magnified by the weakness of the company's business outside cystic fibrosis. The powerful efficacy of Gilead's (NASDAQ: GILD  ) Sovaldi in hepatitis C has all but relegated Vertex's Incivek to the history books, and sales are likely to drop sharply from here.

Worse still, the company's nuc (VX-135) does not look strong enough to be a viable competitor in the space. A combo study with Bristol-Myers Squibb's daclatasvir showed only a 73% SVR4 in treatment-naive GT1 patients at 100mg and 83% at 200mg (a dose still on hold due to liver toxicity issues). Those response rates are not likely competitive; comparing across trials is statistically dubious, but Gilead and AbbVie (NYSE: ABBV  ) have shown SVR12's between 95% and 100% in studies like AVIATOR, LONESTAR, ION-1, and ION-3 (though some arms showed SVR12's as low as 79% and 83%).   Considering the time-to-market lead for both Gilead and AbbVie, it's hard to see how Vertex would fit in, particularly considering that even AbbVie is now regarded as a competitor who will have to compete at least in part on price to gain meaningful share in the hepatitis C market.

Vertex also may not have all that much with its JAK3 inhibitor VX-509. While the drug showed respectable efficacy in rheumatoid arthritis, safety and tolerability are potentially problematic. Given the strength of established biologics like AbbVie's Humira and the fact that VX-509 would come to market well after Pfizer's Xeljanz and Celgene's Otezla, it would seem that Vertex has an uphill climb to convince another company to partner on this drug.

Estimating the opportunity
There are a few companies looking to enter the cystic fibrosis space with potentiators and/or correctors. Galapagos and AbbVie have partnered together to develop compounds, and a company called N30 Pharma is also in the game. It is likely to be some time before either become a true competitive concern, and there are multiple clinical milestones that have to be achieved first.

Kalydeco still has some expansion potential. A study in R117H patients technically failed, but there were signs of efficacy in older patients and the absence of other treatment alternatives may sway the FDA toward allowing a limited label expansion. All told, Kalydeco could develop into a $1 billion to $1.5 billion drug on its own, suggesting a fair value of around $22 to $23 today.

The key factor in Vertex's valuation is the success of combo therapy. I refer to "combo therapy" here and not VX-809 exclusively as Vertex does also have the corrector VX-661 in clinical development. Failure of the VX-809 combo studies could cast the entire potentiator/corrector combo concept into doubt, but VX-661 does offer another shot on goal, as well as the potential for future triple-therapies.

An assumption of 70% approval odds for combo therapy in homozygeous patients (and a market opportunity of $5 billion to $6 billion) leads to a per-share discounted value of $61 today. Adding in combo therapies for heteozygous patients, a market opportunity of potentially $3 billion to $4 billion, and approval odds of 35% adds another $15 to the fair value.

The bottom line
As is (and excluding cash), I believe Vertex's cystic fibrosis portfolio is worth about $99 today. I include no value today from either the hepatitis C or the inflammatory disease platform (which I only estimate to be worth about $3 to $5 per share). If the Phase III combo studies are successful and homozygeous combo therapy is de-risked, another $26 in fair value would appear ($125), while failure would reduce the fair value to about $50, and that's still giving some chance (35% for homozygeous, 15% for hetero) that follow-on compounds would prove more effective. Strip away all combo therapies, and Vertex would probably look to sell itself as a means of salvaging the value of Kalydeco.

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