Description

Investment thesis:

VPHM is a classic example of a big negative event causing investors to look in the rear view mirror, rather than forward. VPHM has fallen from $13 to $4, based upon a failed Phase III trial  for Miravabir, but the story is really about two APPROVED drugs that they own. The current enterprise value of the company is less than they paid in December for LEVP and it's drug Cinryze. Disappointed investors who owned the stock for Miravabir are now dumping the stock indiscriminately, rather than doing the work to learn Cinryze. There are 3 ways to win (Generic competition for Vancocin could be delayed, the initial Cinryze sales could suprrise to the upside, and Cinryze could get approval for the smaller acute indication on 6/3 when the FDA will reply) on this that could occur this year. Our research leads up to believe that each of the are 50%+ likihoods.

 Given the low sentiment around the stock, we have two individual ways to win big (100%+ upside) and could win both (200%+ upside). 

How we win:

1) Vancocin could keep patents off the market for a few more years, earning 100-120m in FCF a year growing 15% a year, or

2) Cinryze could just meet LT expectations and Vancocin could go generic at the end of this year, as the street already expects. 

On the other hand we have only one way to lose; Vancocin goes generic this year and Cinryze severely disappoints, in which case the downside is limited to ~ 40% on a DCF basis, but there is a good chance they beat the 2009 & 2010 street expectations in even the worst scenarios, so the near term downside is likely overstated by our DCF methodology and could be zero.  We think Cinryze sales are progressing well ahead of expectations and this mitigates a lot of downside.

Due to a recent failed drug trial that caught investors by surprise & low disclosure around the recently acquired drug Cinryze, which makes up most of the future value, VPHM is being discounted too severely by the market and is trading with a good margin of safety, numerous free options, low economic sensitivity, and has a savvy management team with a track record of adding value. We think over the next 2-3 quarters VPHM can beat expectations and win back the market's confidence; shifting focus onto the newly acquired drug Cinryze & away from Miravabir. 

We think VPHM could be trading for 3.5x 09 earnings, 2x 10', and 1.5x 2011 if they can keep a generic off market till 2012, and if a generic does enter in the Q4 09 and erode Vancocin profitability the earnings stream looks more like 4x 09, 10x 2010 - as we wait for Cinryze sales to ramp, and 3.5 to 3x 2011earnings as Cinryze sales begin to reach full penetration.  We are buying VPHM at what they paid for Cinryze and we get the value from Vancocin for free. 

Business description:

Viropharma (VPHM) is a small drug company that generates all of its profits from two drugs: Vancocin & Cinryze.  Vancocin is a branded, off-patent but not yet generic, antibiotic that treat infectious diarrhea (CDAD), a life threatening infection for which there is no other effective treatment.  Cinryze is a replacement therapy for the orphan disease Hereditary Angiodema, which is a genetic disorder that causes severe swelling of body parts brought on by random, unknown triggers.  Cinryze was approved for commercial use in October 2008 and has a 7 year exclusivity on the market under orphan drug designation.  It just began selling into the market.  VPHM has three other drug compounds: one that recently failed a Phase III trial called Miravabir and will likely be wound down, NTCD in pre-clinical studies for treatment of C dificile, and Antiviral discovery in pre-clinical studies.  We ascribe no value to these.  Lastly,

Cinryze was purchased from Lev Pharmaceuticals (LEVP.OB), which was written by member Stanley339 in the past.  Please refer to this write-up for more background on the drug and disease.  It will help explain the meaning of acute and prophylactic markets and the history behind treatment.      

Misperception:

• 1) Glass half full, or half empty? Street is overly focused on fact that Vancocin could go away rather than the fact that it earns 100-120m FCF each year it sticks around & growing
• 2) Cinryze is a difficult drug to research given the orphan size population and limited doctor experience. Mgmt won't give guidance.
• 3) Easy to discount management team given they have egg on their face from the recent Miravabir phase III miss.
• 4) Tough to model a business in extreme transition. Street assumptions are likely too low for 2009 and 2010 even in our worst case scenario, barring major cost over runs. The Street is simply too low on sales of each product generic comes on the market over the next few months, so downside near term is mitigated by this factor.

Investment pros:

• 1) Generics consultant thinks it could be 2 + years before a generic Vancocin hits market.
• 2) Cinryze potential not appreciated in market due to complexity and Miravabir miss but we think demand is robust
• 3) Mgmt team has a history of value creation. May buy back debt at 60 cents on the dollar. Would create 100m of value.
• 4) 6 insiders recently bought shares between $4 and $5 in last 2 wks ($120k to $10k worth)
• 5) Potential to reduce cost structure if needed, but not a priority and not expected

Investment cons:

• 1) CSL Behring is behind in the race but still competing for acute. If they win before us could off-label win up to 50% of market
• 2) FDA could legally approve a generic whenever they want. VPHM has to argue the risks are too high without new trials
• 3) Fate of company still tied to two main drugs. Rest of pipeline 2-3 years away from having meaningful phase III results
• 4) Obama is targeting expensive healthcare and could put pressure on space. 400-350k annual drug cost raises alarm bells.
• 5) Cinryze is a new drug and predicting patient usage patterns / response to drug is extremely difficult given the disease traits

Research indicates it could be 2 + years before a generic Vancocin hits market. THIS IS  A HIGHLY VARIANT PERCEPTION.

• While the OGD (office of generic drugs) / FDA is free to do whatever they want - we feel there are 75% odds + Vancocin can keep a generic off the market for 2 more years, or more.
• The market has anticipating a generic version of Vancoin each year for the last 2 years but Viropharma has managed to use the natural barriers in the regulatory system to prevent this from happening, and with valid arguments.
• Vancocin is used to treat CDAD, a bacterial infection of the colon caused by the micro-organizism Clostridium Difficile
• Also known as infectious diarrhea is life threatening if left untreated. Spores lie dormant in hospitals. Patients who stay over 4 wks have a 50% likelihood of contracting the bacteria.
• Vancocin is most effective form of treatment has about 25% market share of total market and nearly 100% share of severe market. Metronidizoal is used but has a higher relapse rate and less efficacy.

•                                                   i.      Cost of treatment is about $1,000 for a 10 day course and there is less than 1/3^rd re-lapse rate. 

•                                                 ii.      New guidelines by hospitals are recommending using Vancocin as first line treatment to not take chances on relapse etc.

• Incidence of CDAD is rapidly on the rise. In 2000 38.2 out of 10,000 patients discharged were infected with CDAD. In 2005 76.9 out of 10,000 patients were infected.
• In 2008 Vancocin grew sales 14% actual and 17% if you include a 4Q shipment delay, 9% of which was price growth.
• New Vancocin hospital guidelines could take growth much higher.
• Vancocin has been off-patent key patents since 96 and has had generics seeking competition for more than 2 years.
• Generics commonly have an easy pathway to approval by demonstrating bioequivalence, which shows drugs are similar enough biologically to have the same clinical efficacy.
• Since Vancocin is a locally acting GI drug which does not dissolve in blood the standard methods of proving bioequivalence do not work, which has prevented Generics from coming on the market thus far
• In light of this issue, The OGD changed the criteria for the generic pathway, but did so without closely studying the science behind Vancocin. Viropharma took this opportunity to blast the OGD / FDA for not conducting rigorous analysis on a life saving drug and potentially allowing a less effective generic version on the market.
• With egg on their face, the OGD has been locked into deabte with VPHM and competitors since this time
• In Dec 2008 the FDA/ OGD submitted new draft guidance on generic approval pathway suggesting if generics could prove both similar active and inactive ingredient formulation, and similar dissolution curves, they would qualify for generic approval.
• According to our consultant there is 90% likelihood the current generic ANDAs on file with the FDA have only similar active ingredients but not similar inactive ingredients, which would require brand new formulations and therefore new ANDAs under the FDA new draft Guidance.
• Prior to this draft guidance there was no historical precedent for matching inactive ingredients, so it is unlikely a company foresaw this development.
• If a co. did plan their ANDA this way - it raises the possibility that the FDA / OGD tipped off the generic competitors - which would be illegal and look badly on the FDA / OGD.
• A new ANDA takes 18 to 24 months to get approval from time of submission, and creating a new ANDA could take a few months.
• On March 19^th 2008 Viropharma publicly commented on the new draft guidance for generic approval pathway and argued the following points and requesting the FDA / OGD withdraw draft guidance in light of these facts:
• OGD ignores July 2008 FDA Advisory meeting ACPS stating systemic absorption needs to be tested with Pharmacokinetic studies (PK)
• Vancocin acts differently in upper GI tract of patients with S. aureus infection FDA fails to address this only looks at lower GI tract. In addition, VPHM argues that the OGD / FDA uses healthy GI tracts in their testing whereas CDAD patients have unhealthy GI tracts. Comparing apples to oranges.
• Q1/Q2 sameness standard under current OGD is flawed. OGD /FDA regulations only allow Q1/Q2 standard for dissolving drugs not ones like Vancocin
• i. VPHM tested 6 manufacturers of a key "inactive" ingredient for Vancocin and found they were not all the same. Need to prove efficacy in a trial
• ii. Vancocin inactive ingredients are trade secrets and key to the formulation
• ANDAs filed under the old draft guidance are no longer valid b/c they claimed rapid dissolution, but the FDA has since said Vancocin does not rapidly dissolve, therefore, the ANDA claims are false and under FDA guidelines the ANDA is now void due to these false claims.
• i. Also brings up question are the generics submitting false data, sinceVancocin does not dissolve how could they say it did in their ANDA
• ii. Generics should have to submit this "dissolution" data to the OGD for review
• iii. Furthermore the OGD likely leaked data on the dissolution test to at least one generic prior to disclosing information publicly, which they still have not given actual results for
• The FDA / OGD might have to go back to the drawing board and withdraw draft guidance, which would buy us significant time.

Cinryze potential not appreciated in market due due to complexity and Miravabir miss but we think demand is robust

• We think it is likely VPHM can find 700-1200 patients and generate average revenue of $300 to 350k per patient (actual label is 2x a week at $4k a dose, or 420k annual cost but w/ ~20% of patients on Medicare effective price will go to 325K).
• Early signs are initial uptake is strong, both b/c there is no acute label product yet available and b/c sales force seems overwhelmed
• Medical Professional guidelines have wide inclusive criteria for prophylactic use - getting patients into the program will be easy
• Commentary from Medical professional in the space suggest mostly up to the patient on how they want to be treated.
• HAE organization noted VPHM has been aggressively helping to sign up anyone who wants the drug and there has been "delightful" response from insurance companies, though a 1-3 months approval delay on average.
• HAE organization has suggested patients in the trial would have done better with more frequent use of the drug, instead of just 2x weekly, to achieve complete remission of attacks. Some patients on the other hand might find they need less to avoid attacks, and these two could null each other out. It will really come down to patient preference and ease of use at the end of the day. We think at least initially patients will overuse.
• Head of HAE organization has a patient registry of 2600 patients today and is adding 35 per week, up from 13 per week before the drug was approved. Another 500 who have made contact but not signed up in the registry.
• o At least 30% of these they have been classified as severe in some surveys.
• § Assume 2600 turns into 3500 by year end = 1050 patients.
• o Could say 60% of their patients + fit the prophylactic inclusion criteria.
• § Assume 2600 turns into 3500 by year end = 2100 patients
• Using VAR from doctors, and foreign registries of patients populations we have created a market sizing table
• o Called 5 doctors who are currently prescribing and universally they felt
• § 20-25% of their patients were severe.
• Assuming the more serve patients are already in doctor care and adjusting down to 10-15% for the whole population seems appropriate.
• Further adjusting down by 25% to account for patients that get sick of infusion frequency, or don't feel enough relief and decide to stick with androgen therapy.
• Furthermore, roughly 10% of the physicians patients were already using Cinryze, and there is a 2-3 month lag for insurance to give approval.
• § Early demand indicators appear robust:
• Heard anecdotes from Doctor's that the VPHM sales reps were "overwhelmed" from the high response rate and hadn't prepared for so much initial interest - replying to insurance questions etc.
• Until an acute treatment is approved docs are writing the majority of their patients scripts for therapy - so that acute patients can have two doses on hand at their home in case of emergency.
• § Majority not having a problem with insurance reimbursement.
• But lifetime insurance caps can range from 1m to 10m so after a few years of treatment this could pose a problem. In Hemophilia typically what has happened are foundations etc. are setup to help offset the cost of medication longer term. Grants / donations etc.
• o 6 to 12k HAE patients in the US seems like the appropriate range of total patients from survey and doc calls
• Implies market ranges from ~700 to 1200 prophylactic patients under realistic assumptions:
• o 15% severe who need prophylactic, 25% reduction for compliance rates etc.
• Biggest risk for Cinryze at this point is their competitor CSL Behring who is trying to win the acute market. If they win, and under price, doctors will try to stretch labeling on scripts as much as possible to get the patient low priced drug off label.
• o The script can only be stretched so far to make a prophylactic patient look like an acute patient but insurance would condone the practice as much as possible. It could conceivably cut the market in half if CSL is able to win actue
• o Doctor's felt that Viropharma was in the lead for the acute indication.
• § CSL BLA was not approved by FDA, sent back to company for questioning
• § Biologic approval highly tied to safety of production facility.
• § FDA already likes VPHM blood manufacturing plants this give them a leg up. Easy for FDA to approve.
• § CSL shows signs of continuing to drag feet.

VPHM mgmt team has a history of value creation:

• Bought Vancocin in Oct 2004 for ~120m from Eli Lilly and has generated more than 700m in gross profit since that time, whole company did 90m in Net income in the TTM prior to Cinrzye launch alone.
• o More than doubled Vancocin product sales since ownership
• o Consistently raises prices at least 9% a yr
• o Using a small sales force / overhead of only 5 people on the drug
• o Eli Lilly saw a drug off patent with generic risk looming and decided to sell.
• o Viropharma saw a life saving, complicated drug that was being under priced and could realistically fight off generics a few more years.
• Mgmt may buy back debt outstanding for 60 cents on the dollars, currently trading at 45 cents, which would create 100m of value.
• They still feel they bought Cinrzye for a reasonable price and numerous avenues for the mgmt team to enhance value like they have with Vancocin. Price raises etc.
• We are paying ~ half of what VPHM bought Cinryze for and we get Vancocin for free. If one believes they did their homework on the drug then we are getting in at a fantastic discount

6 insiders recently bought shares between $4 and $5 in last 2 wks (only $120k to $10k worth)

• 3 directors & 3 officers have been buying
• Mgmt does not own much of the company, at less than 1%, but on the flip side they do not have overly excessive compensation
• We think more insiders will step up to accumulate shares once their restricted period ends over the coming months
• Mgmt  had a history of over promising in the past - but has learned from their old habits - no longer offering guidance

Potential to reduce cost structure if needed, but not a priority and not expected:

• VPHM could be a very lean company but has ramped spending to create new drugs in house. 
• Vancocin which was 99% of revenue in 2008 had only 5 sales reps and an EBIT of 200m
• A snap shot of overhead back in 05 vs. today shows the ramp in costs as management has focused on drug development
  • OH in 05-08 has been the follwing, 21m, 44m, 73m, and 132m. 
• If Vancocin went generic and Cinryze was a disappointment we think there are avenues for significant cost reduction, though this is not something management is currently considering

Catalysts:

• June 3^rd PDUFA date for Acute indication
• Earnings proving out Cinryze value
• Generic being kept off market longer than expectations
• Potential value creative use of cash

Enterprise Value:

Price                      4.31 

Shares                     78

Market Cap

Cash                        276

Debt                       250

EV                         

Valuation:  Scenario Tree:

Using a DCF methodology and 12% discount.  After 7- yr exclusivity Cinryze profit falls to 25% of peak.  Per share value:

• 1) $13.50 = Generic Vancocin End 2011, Cinryze 1250 patients, 350k annual pricing. Wins Acute
• 2) $10 = Generic Vancocin End 2011. Cinryze 1000 patients, 350k annual pricing. Wins Acute
• 3) $8.25 = Generic Vancocin End 2011. Cinryze 750 patients. 350k annual pricing. Wins Acute.
• 4) $5 = Generic Vancocin mid 2010. Cinryze 750 patients. 300k annual pricing. Wins Acute
• 5) $2.25 = Generic Vancocin 2H09. Cinryze 500 patients. 275k annual pricing. Loses acute.

Disclosure:

We and our affiliates are long VPHM.  We may buy / sell shares in the future.  This is not a recommendation to buy or sell shares.  Please do your own research and diligence.

Catalyst

Vancocin doesn't go generic right away, Cinryze data