|Shares Out. (in M):||263||P/E||17.5||15|
|Market Cap (in $M):||52,500||P/FCF||28||14|
|Net Debt (in $M):||-7,500||EBIT||3,900||4,400|
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We believe the recent disappointments from the failure of a development program to get past Phase II created a highly attractive and asymmetric investment opportunity. Vertex current share price trades at discount to the NPV of its highly profitable and cash generative Cystic Fibrosis franchise. Vertex’s highly promising pipeline, supported by over $1.5bn in annual R&D expenses, could create huge value for shareholders going forward, just as the past decade of R&D investment created a $50bn leading Biotechnology innovator.
The quality and vision of Vertex management is a key element of our investment thesis. After all, our bullish stance on Vertex relies on the value optionality of its drug pipeline which, in turn, partially depends on management’s ability to turn R&D dollars into profitable franchises. To date, the track record of Vertex management team has been, excluding the recent disappointments related to the AATD franchise, nothing short of extraordinary.
The key man that changed Vertex fortunes is the former CEO, now Chairman, Jeffrey Leiden. He is no longer the CEO but is as present as he has always been in the business and the new CEO, Reshma Kewalramani, was hand-picked and groomed by Leiden and is, for all intents and purposes, a natural extension of the Chairman.
When Leiden took the helm in early 2012, Vertex found itself in trouble. Following a decade of relatively unsuccessful R&D investments which led to huge losses (Vertex reported cumulative net losses of nearly $2bn in 2008-2010 with revenues coming primarily from collaborative revenues from development partners – no product revenues), it seemed to have finally caught a break with the approval by the FDA of telaprevir (Incivek) for the treatment of Hepatitis C (HCV). Launched in 2011, Incivek enjoyed the most successful launch in pharma history, earning $1.6bn in sales during its first 12 months on the market. But when Gilead’s faster acting and more effective treatment Sovaldi arrived at the end of 2013, Vertex’s drug went from hero to nearly zero overnight. Vertex shares fell 50% in six months, and it was clear the company had to pursue a plan B. The writing was already on the walls in 2012 as initial reading from Gilead were coming through. Vertex had to re-invent itself and to do so it appointed Jeffrey Leiden which was working under CEO Matthew Emmens and Vertex Founder Dr Joshua Boger. The focus slightly changed then from small molecule drugs to biologic and gene therapy treatment of serious diseases.
Leiden mapped out a long-term vision for the board that required major investments, high risks but potentially great rewards. He told the board in 2012: "the risks are huge and we're going to lose $250 million to $500 million a year trying do this.". He turned out to be right on both counts: losses between 2013 and 2016 exceeded $1bn cumulatively, but the reward was far greater. His strategy is to pursue smaller markets, like CF, which are easier to quantify and the drugs require very little sales and marketing. Vertex can reinvest the marketing saving in science, with over 70% of operating expenses going into R&D.
Leiden comes from a somewhat unusual background for large corporates CEOs, having been first a physician and an academic. He left school at age of 15 to attend the University of Chicago to study biological sciences, and by the age 25, he completed his B.A., M.D. and his Ph.D. Humira, Abbott's rheumatoid arthritis drug, came out during Leiden's tenure at Abbott as President and as COO which is regarded as an enormous success.
The decision to appoint him as the next CEO of Vertex in 2012 meant to pursue the strategy of “innovate or die” which is full of risks. As Leiden said himself: "If you're going to innovate, you're going to fail many times."
In the middle of 2012, just as he was appointed CEO, Vertex found itself at a major crossroad. Vertex could double down in hepatitis or it could put itself up for sale and let an acquirer sort out a future path. Leiden went for a 3rd path: he wanted Vertex to make a big bet on cystic fibrosis. This would mean laying off hundreds of people and losing money again, but Leiden believed a shift to developing cystic fibrosis drugs could return Vertex to profitability. At the time, CF represented some $200m in sales for Vertex with the Kalydeco drug, which could target only c. 5% of CF patients. Through an incredible process that led to the development, approval and launch of 4 different products in just 4-5 years, by 2019 Trikafta was launched and the CF franchise would eventually cover over 90% of CF patients. The franchise is now expected to generated sales in excess of $10bn in the future and is patent protected until 2037. This has been an incredible achievement through an impressively fast and efficient process. Through biomarkers with highly predictive efficacy, small clinical trials went directly into large Phase 3 studies at record speed. Vertex team earned the reputation for being the best in the market at bringing large franchises to approval through predictive lab assays and clinical biomarkers.
See below Vertex illustration of strategy and business model, which is today as relevant under CEO Kewalramani as it has been under Leiden:
We are confident that the successful playbook used by management for CF can be replicated to other franchises.
Few medicines are as effective, or as life-changing, as Trikafta. Cystic fibrosis (CF) is an inherited condition that causes sticky mucus to build up in the lungs and digestive system. Before CF treatments, life expectancy was 30 at best. Today, more than 50% of CF patients live past 40 thanks to Vertex therapies.
The basic research that led up to the moment took a generation, but development moved incredibly fast once the biology of cystic fibrosis was cracked by Vertex. Vertex was a complete game-changer for the 70-80k or so CF patients that today live with CF. The first drug launched, Kalydeco, only helped c. 5-6% of cystic fibrosis. Trikafta should cover almost 90% of CF patients. Trikafta made Vertex one of the most successful companies in biotech by any measure.
Trikafta comes not without its share of controversy. A standard Trikafta cure costs patients some $300k per year. Some countries, including Britain and France, have balked at paying for Vertex cystic fibrosis drugs. The Institute for Clinical and Economic Review, a U.S. group that analyses drug value, has concluded that Vertex’s cystic fibrosis drugs “far exceed standard cost-effectiveness levels.” For the purpose of our analysis below, we are making two basic assumptions:
· No price pressure going forward, also because there are no other available therapies in sight and Vertex did indeed spend several billions of dollars in R&D to develop the franchise
· Patent protection to 2037 with severe price and volume impact thereafter
Our analysis suggests peak sales of c. $10bn:
As basic DCF model to 2040, when we estimate to value of the CF franchise to trend to zero, yields a basic valuation of c. $190-225 per share, which is pretty much where the share price trades today:
We would note the following though. In our DCF period, Vertex will have spent over $33bn in R&D. We believe that over 90% of the R&D will be spent outside the CF franchise. We are basically implying here that there is a cumulative $30bn in R&D expenses spent for no return whatsoever, which is the crux of the thesis here – we believe the current pipeline to be valuable and that Vertex will earn a decent ROI on its pipeline investments. If we were to run the CF “for cash”, we would get a DCF value which would point to c. 30-35% upside from today’s share price. There is clear value here.
There’s been a very clear dislocation in Vertex shares in the last 9 months. Given Vertex stellar track record with the CF franchise, there was a heightened expectation in the market for a successful reading of first Phase II results for the VX-814 aimed at treating of Alpha-1 antitrypsin deficiency (AATD), a disease caused by misfolding of a mutant protein. Except for Grifols’ Prolastin, there are no real therapies for this disease. The franchise could have had up to $4bn in peak-sales, providing material upside to Vertex valuation. In October 2020, Vertex announced it would discontinue the VX-814 program due to signs of liver toxicity. On the day, Vertex shares dropped 21%, erasing c. $15bn in market value, which is arguably more than the DCF value of a derisked successful AATD franchise. While from a share price perspective the reaction should have more than factored in the complete failure of the AATD program, more bad news was in store for Vertex shareholders. In June 2021, Vertex announced it would discontinue its second AATD program, namely the VX-864, due to disappointing Phase II readings. It’s interesting to note that before the AATD debacle, the market thought Vertex could do no wrong. Even after the first failure (VX-814), so many market commentators argued the AATD was far from over. Bernstein, which initiated on the stock on November 2020, spent over 10 pages arguing why the AATD franchise will eventually be successful with VX-864. The disappointing news proved too much for many shareholders and Vertex management, from being considered the best management that could do wrong, was suddenly put in the penalty box and it appears they can do no right now. This is the only way we can justify the market attributing zero value to Vertex R&D capabilities and rich pipeline. We also note that in the period following the 2 disappointing AATD readings, Vertex lost a market cap of c. $25bn. This is probably more than either the VX-814 or VX-864 would have ever been worth. $25bn would be equal to over 6x peak sales on a derisked basis for the franchise. Vertex is only trading on c. 5x sales today so the -30% share price movement post AATD disappointment is a clear market overreaction. Hence the opportunity for us today. As a side point, while the market seems to be attributing negative value to the AATD franchise, Vertex hasn’t given up on it. The corrector mechanism showed in VX-864 works and there is no evidence for on-mechanism toxicity. Vertex will therefore apply insights from the VX-864 Phase 2 study and plan to advance novel small molecule correctors with the potential for increased clinical efficacy in 2022.
The discussion above about the quality of management is very important because Vertex aim to apply the successful experience and lessons from the CF franchise to new treatment areas:
While CF is the well understood cash cow of the group, the market seems to ignore the rich and promising pipeline outside its recent AATD failures. Vertex has been investing in cutting-edge research, using “platform technologies” such as gene editing, which can be used in a variety of potential treatment areas going forward, such as blood disorders or neuromuscular degeneration. The pipeline is rich and deep. Even after the AATD failure, there remain 5 clinical areas with promising products that in our view could add, in a best-case scenario, another $10bn of sales to the group. We are confident that management will extract some value from the below prospects, especially given their stellar track record in the past with the CF franchise.
We are not going to try and assess the probability of success for each franchise. We view the clinical development assets as pure upside optionality for which, as discussed above, we are not paying for. All we need to assess now is the potential size of such upside optionality.
Sickle Cell Disease / Beta Thalassemia
This is a very promising program. In late 2015, Vertex and CRISPR Therapeutics entered into a collaboration agreement to develop gene editing approaches for treatment of genetic diseases. The initial program coming out of that effort is CTX001, a cell therapy using CRISPR gene editing to modify cells to treat beta thalassemia and sickle cell disease, two genetic diseases caused by defects in the beta globin chain. The CTX001 study started on January 25th, 2021, and could already show results this year. We think it has a high probability of success with $1-2bn of potential peak sales.
The management of pain is complex. Opioids are generally prescribed for acute pain but are often unsuitable for chronic use. Anti-inflammatory drugs can be used for both acute and chronic pain, but their use is limited due to side effects. Beyond these approaches there are limited options and there haven’t been any major innovations in pain treatment for decades. There is a significant unmet need for new treatments that can be effective for various types of pain. Vertex’s approach is to treat pain by targeting specific sodium channels in the NaV family that have been validated by human biology. The aim is to interrupt pain signals and prevent them from traveling from the sensory nerves to the brain. This could be a huge and very attractive market. Vertex conducted Phase 2 proof-of-concept studies but is still some time away from clinical trials.
APOL1-Mediated Kidney Diseases
APOL1-mediated FSGS is a severe kidney disorder, caused by certain APOL1 genetic variants, that leads to protein loss in the blood and progressive loss of kidney function due to scarring. This can cause a number of symptoms, including high levels of protein in the urine (proteinuria), fatigue, swelling in the legs and feet and weight gain. There are currently no available treatments for the condition. Vertex approach is aimed at inhibiting variants of APOL1 through small molecule inhibitors. We are still early in its development but the franchise could reach $2-3bn in peak sales.
Type 1 Diabetes
Type 1 diabetes is clearly a huge area of treatment. Type 1 diabetes (T1D) is a metabolic, autoimmune disease where the cells in the pancreas (pancreatic islets) that produce insulin are destroyed. Insulin is a hormone that the body needs to process glucose, a key source of energy. Vertex aims at treating this by treating its underlying cause, the absence of insulin producing cells, through 2 different approaches (immunosuppression and novel immunoprotected device). The upside is huge here but we are still far from commercialisation.
Duchenne Muscular Dystrophy (DMD)
DMD is a terrible genetic disease affecting the skeletal, muscular and heart muscles. It’s typically diagnosed when children are 3-5 years old. By 12-15, most people with DMD are wheelchair-bound and life expectancy is in the 20s. Vertex is applying gene-editing technologies to alter the DNA sequence with the goal of restoring near-full length dystrophin protein. The pipeline is in Preclinical phase but the upside is very large. Sarepta, the only company in the world with a questionable and often controversial treatment of DMD, sports a market capitalisation of over $6bn.
We hope the above clearly drives the following 3 conclusions:
· The existing, derisked and highly profitable (and still growing) CF franchise more than justifies today’s share price
· The failure of the AATD franchise created a huge, exaggerated dislocation in Vertex share price
· The upside from current pipeline and R&D investments is huge, especially in light of Vertex stellar track record
While timing is uncertain, we are happy to sit and wait as the company grows and accrues value over time. Sales are expected to grow double digits in 2021 and 2022 while generating a huge amount of cash flow which will be used either in strategic investments or targeted R&D. Trading at just 15x forward earnings, Vertex trades at a large discount to other Biotech peers. We would not be surprised to see a strategic buyer jumping at the opportunity to acquire Vertex at these bargain prices. Either through M&A or through a natural rerating process combined with earning growth, we see substantial upside in the share price with minimal downside, making it a compelling asymmetric investment.
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