Vertex's Price Pop by the Numbers: Does It Fly?

U.S. stocks finished lower on Tuesday, with the benchmark S&P 500 closing down 0.6%, while the narrower Dow Jones Industrial Average (DJINDICES: ^DJI  ) lost 0.7%. The technology-heavy Nasdaq Composite Index (NASDAQINDEX: ^IXIC  ) fell 0.1%. One Nasdaq component had a banner day, however, as shares of Vertex Pharmaceuticals (NASDAQ: VRTX  ) exploded higher, hitting a new 52-week high and closing up 40.4%, as the company announced that it will seek regulatory approval for an experimental cystic fibrosis drug later this year.

Source: Wikipedia.

Vertex Phamaceuticals' annoucement follows positive results in two studies that looked at the efficacy of Vertex's experimental drug lumacaftor in combination with its currently approved therapy ivacaftor (brand name: Kalydeco), in cystic-fibrosis patients with two copies of a rare genetic mutation.

Cystic fibrosis is a rare disease to begin with, but add to that this genetic mutation, and Vertex estimates that the target market for the combination therapy is just 22,000 across North America, Europe and Australia. (While there is no single definition of a rare disease, in the U.S., the Rare Diseases Act of 2002 as "any disease or condition that affects less than 200,000 people in the United States" – a rate of approximately 1 in 1,500.)

Nevertheless, while the target market is very narrow, the price of treatment is very high. In this case, analysts are forecasting a cost of roughly $150,000 per annum. As such, Citigroup analyst Yaron Werber expects peak sales of $3.1 billion in 2015.

Now consider that the market added some $6.4 billion to Vertex's market capitalization today. If this combination therapy had been kept entirely secret until today, instead of being highly anticipated, and its approval were now a certainty, today's increase in market value would amount to "paying" roughly two times forward revenue for the new therapy – an absolute bargain! (That $6.4 billion is approximately two times Citigroup's 2015 sales estimate of $3.1 billion.)

But not so fast. Werber wrote today that the new results only increase "the likelihood for approval from 65% to 80%" but concedes "that it might be conservative." Using those figures, the increase in Vertex's market value is now equivalent to paying nearly 14 times forward revenue (or 6.4/ (3.1*0.15)), which starts to look a bit pricey, even compared with the often optimistic valuations prevalent across the biotechnology sector. Note that as of yesterday's close, Vertex itself was trading at 11.2 times the consensus revenue estimate for 2015.

On the other hand, if we assume instead that the odds of regulatory approval just went from two-thirds to certainty, the revenue multiple is above 6 -- a relative bargain.

Bottom line: If you believe that Vertex was fairly valued yesterday, then today's jump in the share price looks like it's roughly in line with prevailing valuations. But those levels could well carry some risk, particularly since they are being goosed by furious merger-and-acquisition activity in the pharmaceutical sector. In valuing Vertex in the current environment, investors may well be drawing some of their inspiration from AbbVie's (NYSE: ABBV  ) pursuit of Shire (NASDAQ: SHPG  ) , for example, as Shire has a strong franchise in rare diseases.

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