Description

Oldyeller wrote up the development side of Theravance, Theravance Biopharma, as a long back in December. I believe the writeup did a good job of highlighting the bull case for the development company. Equally interesting, although from the short side, is Theravance Inc, the royalty spin of Theravance.  Theravance Inc provided Theravance Biopharma with $400 million in cash during the spin-off. As of June 30, 2015, Theravance Inc has $229 million of cash plus equivalents and $738 million of debt.

Theravance Inc’s two primary drugs are Breo and Anoro. Originally both were for the treatment of chronic obstructive pulmonary disease (COPD). Breo combines a corticosteroid, fluticasone furoate, with a bronciodilator, vilanterol, in a single delivery system.  Vilanterol is a Long-Acting Beta2 Adrenergic agonist, LABA for short. In the body, beta2 receptors control smooth muscle relaxation and bronchodilation.

Anoro is a combination of umeclidinium (an anticholinergic, which blocks acetycholine and the production of mucus) and vilanterol. GlaxoSmithKline (GSK) is in charge of selling Breo and Anoro. Sales have been sluggish to say the least as insurers have been reluctant to cover Breo. The table below shows Breo/Anoro sales over the past 12 months and the royalty received.

Table 1. Breo sales, Anero Sales, and Theravance Royalty. Source: Theravance SEC filings

Theravance pays out a $1/yr dividend. With 115.3 million shares outstanding and TTM royalties of $38.5 million, it’s not hard to figure out that the dividend isn’t sustainable. The table below shows the basic expenses for Theravance on an annualized basis based on Q2 2015 numbers.

Table 1. Theravance Expenses Source: June 30, 2015 THRX Financial Report

Just to cover operating and interest expense, sales of Breo/Anoro would need to double. To cover the dividend, royalties received would need to increase by 5x and principal payments would still need to be deferred. GSK debuted Breo/Anoro into a competitive COPD market. Anoro is basically dead in the water and the German Institute for Quality and Efficiency in Health Care has stated there is no difference between Anoro and Spiriva (tiotropium). Theravance bulls placed a lot of hope into GSK’s Breo, which has been dubbed the “son of Advair.”

To help prove Breo’s superiority, GSK enrolled 16,500 patients into their SUMMIT trial. The results came back and they were not positive. With no statistical significance over a placebo, Breo will likely have trouble gaining acceptance from insurers and doctors. I believe the increase in Breo sales during 2015 is largely due to Express Scripts including Breo on their formulary, as Breo was excluded in 2014. With generic Advair hitting the United States sometime in 2016, Breo faces a tough uphill battle for any sort of market share. Advair has already been losing market share to other lung drugs.

The overall failure of GSK sales might have been due to GSK shifting their sales practices to the “Patient First” model, which eliminated individual quotas. While this may have contributed to some of the sales slack, increased competition from other companies (like Symbicort) likely dampened enthusiasm for Breo/Anoro.

Outside of Breo/Anoro, Theravance Inc also has a 15% stake in Theravance Respiratory Company (TRC). Theravance Inc is entitled to 15% of any future payments made by GSK that relate to two separate development programs. The first is a Bifunctional Muscarinic Antagonist-Beta 2 Agonist, or MABA, program. The MABA program is for an investigational bronchodilator drug GSK961081. The MABA program is also being studied in conjunction with fluticasone furoate (FF). The MABA program is at least three years away from commercialization and, therefore, I have assigned no value to the drug.

The other program in TRC is the “Closed Triple Therapy” (The Triple). The Triple combines the drugs in Theravance Inc’s Anoro and Breo. The Triple is discussed in Oldyeller’s report and I will let readers check that writeup for background. Handicapping the value of the Triple is difficult given the lack of success with Breo and Anoro (the Triple simply combines the two). However, we can get an idea for the impact that the Triple will have to Theravance’s financial success/failure.

Internally, I have been modeling the Triple as though it will achieve peak sales in 2020 with 3.8 million patients. By my estimates, this would generate $65-80 million of royalties for THRX. Via a DCF I believe that the Triple has a value of $200-$300 million to Theravance. The actual cash flows are unlikely to materialize until 2018 at the earliest, and Theravance has three years to go before cash flows (potentially) hit their bottom line. Three long cash burning years.

There are more problems. First, if the Triple is as effective as everyone thinks it is - what good is Breo or Anoro? If the Triple becomes the de facto treatment, Breo and Anoro sales will likely drop. Second, there is no guarantee that the Triple will be any better than Breo or Anoro. GSK has had tremendous difficulty getting Breo/Anoro off the launch pad and the Triple is simply a reformulation of the two.

Debt

Theravance has a lot of debt thanks to the spin. As of June 30, 2015 they have $255.1 million of convertible notes. The strike price is $21.32/share. I believe these notes will be redeemed for cash when they mature in 2023. Currently these notes cost 2.125% annually.  

Theravance has $483.3 million of non-recourse notes that come due in 2029.  These notes are secured by a 40% interest in Breo/Anoro sales. Prior to May 15, 2016 Theravance can choose to make up for any interest payment shortfall by increasing principal. So far, this is what they’ve had to do. Otherwise, these notes are gifts to Theravance and are covenant lite. While there will be few triggers of default, Theravance will devote almost all excess FCF to paying down these notes. If Breo/Anoro sales really tank, Theravance can obviously just ignore these notes.

Valuation

I will present three scenarios to value Theravance. There are admittedly crude estimates but it’s not hard to figure out that there are few ways out for Theravance bulls. In my bear scenario I have increased royalties for Breo/Anoro by 25% per year until 2020, after which (due to the Triple and other COPD drugs) royalties decrease by 10% per year. I assumed no sales after 2025 giving Anoro/Breo an 11 year life. The Triple is valued under the assumption that peak sales hit $4.5 billion by 2020.

In the Base scenario I have increased royalties for Breo/Anoro by 50% each year until 2020, after which royalties decline 10% per year. The Triple was valued with peak sales approaching $7.6 billion by 2020.

In the Bull scenario I increased royalties of Anoro/Breo by 50% per year and kept sales flat until 2025. The Triple was assigned the same value as the Base scenario.

Table 2. Potential Valuation for Theravance

In all scenarios, the equity takes a significant haircut from current market values. Growth rates in excess of 25% are rare, even in the pharmaceutical space. Without sounding bombastic, I believe the Base scenario is very likely and Breo/Anoro will fail to ever achieve meaningful sales. If the Triple has trouble gaining traction with doctors, there is likely zero value to Theravance’s equity even in a period of robust growth from Anoro/Breo sales. There are a number of ways for Theravance shares to drop at least 50%, and likely a lot more than that.

Risks

As always, there are a number of risks. Theravance could lever up and acquire other royalty streams. Based on my conversations with royalty financing groups, this space is richly valued right now, especially in areas that Theravance would be looking for. I believe it is unlikely, although not impossible, that Theravance could source and execute another royalty deal.

GSK could also get their act together and sales of Breo/Anoro could dramatically increase. My research suggests that GSK is looking towards the future and putting all their effort towards the Triple. The results of the SUMMIT study cast doubt on just how much of a blockbuster the Triple could be. Even if you assume that it replaces Advair dollar for dollar, Theravance Inc is still an attractive short.

Finally, the MABA candidate could be worth a material amount and perhaps prove to be a blockbuster. I have not explored this given the drug is still several years out.

Conclusion

Theravance has a very tough battle going forward. Their two royalty streams, Anoro and Breo, have failed to gain traction in a crowded COPD/asthma market. Insurers and doctors have looked elsewhere. Meanwhile, Theravance has more than $700 million of debt and pays out more than $115 million per year in dividends. I believe the dividend is unsustainable and will be cut in the next 6-12 months. Even with the drop in share price over the past month, shares fail to account for the low likelihood of Breo/Anoro sales improvement. I believe there is more than 60% downside in a bullish case. Should the Triple not be approved, or have trouble gaining traction, Theravance shares are likely worthless.  

Catalyst

Dividend Cut