Updating My Bullish Views On Vertex Pharmaceuticals – Seeking Alpha

This post was originally published on this site

Background

Over the past 5 years contributing to Seeking Alpha, I have put in three prior articles on Vertex (VRTX) – in 2014, in 2015 and last summer. Each time, the theme was positive, with awareness of significant downside risk due to high valuations of the stock and, in 2014 and 2015, of the biotech sector (IBB). Last August, my “take” was that this was emerging to be a more mature company, hence the title: Vertex Pharmaceuticals May Be Turning Some Major Corners. This is now behind a PRO firewall. The stock was at $153.78 when the article ran, and it has underperformed a rising market, something I am looking for with the Fed taking the “punch bowl” away. The three key bullet points of that article were, in order, with my comments today:

  • Vertex stock has had a strong run lately, and in the short term may be ahead of itself.

The message of that point: this was a trading opportunity, either to flip quickly or look for a better entry point.

  • However, it is being supported at a high valuation by institutional investors who may be seeing value creation coming soon.

What I was trying to get at was that, to my surprise, VRTX was heavily owned by institutions, with little retail interest. This was a positive for me.

  • The analogy to CELG 10-12 years ago is raised.

In other words, while VRTX appeared expensive by several metrics, so did Celgene (CELG) following the Tech Wreck, but it more than grew into its valuation.

Now there is an increased chance that VRTX is seasoned enough, is an attractive enough takeover candidate, and has enough intrinsic value plus speculative value that it is more of a solid growth stock, while also offering very nice short term or swing trading opportunities.

This article provides an update of the company and the stock.

Introduction to VRTX

Because all my VRTX articles are behind PRO firewalls, here’s an extremely brief review of VRTX. This is an historically innovative company in the field of rational drug design. Its breakout product, Incivek for hepatitis C, became the best-selling first-year drug ever. By a simple and very cruel twist of fate, much better drugs soon arrived from Gilead (GILD) and others, and Incivek was withdrawn from the market. Undeterred, VRTX had also licensed patents from the Cystic Fibrosis Foundation, and has now brought a series of them to the market, most recently this week. These are Kalydeco, which is a single-agent drug, and two combinations, Orkambi and the recently-approved Symdeko.

Earnings in Q4 represented upside surprises on sales as well as non-GAAP earnings, and a $500 MM share repurchase program was announced, though this is basically to sterilize stock-based compensation. VRTX has previously been criticized for high management comp. It has also been criticized by many for very high R&D and SG&A spending, and it clearly has gotten religion at least on the SG&A part. Given a growing number of drugs with approvals now to treat most of the CF population, and with two very promising 3-drug combos poised to enter Phase 3 for one of the last remaining large group of CF patients not treatable by any of VRTX’s products, the path toward large and growing sales and profits is clear. There is no real competition in CF and none expected for years, if ever.

Consensus Street forecasts

This shows why VRTX may be interesting for new money. There may be lots of sales growth ahead and lots of EPS leverage. Using E-Trade’s consensus numbers, these are 2018 and 2021 consensus:

  • 2018: sales $2.8 B, non-GAAP EPS $3.05
  • 2021: sales $5.3 B, non-GAAP EPS $9.28.

So the projection is that expenses are going to grow much more slowly than revenues. Currently, VRTX spends such a high percentage of revenues on R&D that current GAAP or non-GAAP earnings are not the point, but eventually they will be, and I think that there is upside to the above numbers.

I’m not convinced of that, but overall, since its IPO, which appears to have been in July 1991 around $4.50 per share adjusted for any splits, VRTX has grown its share price around 14% per year, which is quite good. So, it has been satisfying Wall Street. The CEO is both a cardiologist and has experience in the financial industry. So even though I would expect VRTX to spend plenty on deals and internally generated R&D, I would also expect that if sales ramp as expected, the Street will be comfortable with greater investment back into the business and thus lower booked earnings than consensus expects.

They key here is that lots of positive operational leverage appears to lie ahead.

Next I want to give the two basic reasons I am finally willing to think of VRTX primarily as a long term hold rather than primarily a stock to flip.

What has changed at VRTX

1. The company has under-promised and over-delivered on earnings. Its Yahoo! Finance earnings web page shows that it has beaten non-GAAP EPS forecasts at least 4 quarters in a row, and estimates have been rising for the current quarter and Q2. That’s a sign of a maturing business.

2. Other good things are happening with VRTX’s products. A drug, VX-787 (pimodivir), that Johnson & Johnson (NYSE:JNJ) had in-licensed, has moved into a pivotal Phase 3 trial. And this week, VRTX announced a successful Phase 2 study in acute pain for VX-150. The data looked strong. VX-150 has had a prior Phase 2 study in chronic pain, with borderline positive results. A third Phase 3 study in neuropathic pain is under way. The company also has an earlier stage candidate, VX-128, which it thinks may be superior to VX-150. This grouping of two candidates addresses a large and needy market, that of non-opioids for pain.

Thus, while there are no guarantees, these and other possibilities mean that VRTX continues to impress with product development.

Overall, I see VRTX as growing in good directions.

Valuing VRTX

Here is where the risk is. There are various patent expirations, such as with the primary patent expiration date for Kalydeco arriving in 2027. But another patent may extend exclusivity. The combos have later expirations. So that is one issue; these drugs are oral, small molecules. Unlike proteins, they will go generic and sales will drop toward zero suddenly, so there will be a patent cliff and that will be that. Valuing the CF franchise requires estimating peak sales and time to get there. Morningstar projects enormous peak sales for the current group of CF drugs of $8.5 B. We shall see about that.

My own rough guesstimate is as follows.

I assume average CF sales, including discounting for present value, of $6 B per year through 2030. That gives $72 B in sales. 10% goes to royalties. That leaves $65 B. I then assume that if this were the only business, and there were no R&D or other extraneous expenses, that the rest of the business operated at a 55% after-tax profit margin. That gets the value to $36 B, slightly below VRTX’s market cap around $39 B.

There is a potential very big kicker, beyond the possibility of much longer patent life. That is next-gen drugs. VRTX is rapidly locking up a large percentage of CF patients in the developed world. Once happy on a VRTX drug, they may be interested in joining a clinical trial only if it is a VRTX trial. VRTX also knows more about CF and CF trials than any other company. So between its own internal drug development and being shown ideas developed elsewhere, it looks to be in the pole position for next-gen drugs. It also has an effort in CF and other diseases with CRISPR Therapeutics (CRSP), so it may “be there” with genetic therapies.

Other opportunities include potential milestones and royalties from the oncology candidates it out-licensed to the “German Merck,” properly known as Merck KGaA (OTCPK:MKKGY).

Overall, my guess is that VRTX is mildly undervalued given its other products, know-how and track record, but as always with biotech, the range of possible ways to value the stock is wide.

Risks

I would think this is a non-dividend-payer for many years to come, even if profits grow nicely. The risks from competition, imposed price stringencies, patent expirations ahead of schedule, and others as detailed in VRTX’s regulatory filings are considerable. This stock is for risk-tolerant traders or long term investors, and permanent loss of capital is a real possibility.

Concluding points, and summary

VRTX is an institutional favorite with a strong track record of innovation and evidence of a growing maturity in operations. I believe that the stock offers interesting trading opportunities, and may reward long term holders with similar low double digit annual returns as it has returned since going public.

Also, VRTX strikes me as an ideal takeover candidate, with all the “usual suspects” in Big Pharma as possible bidders. Having a strong pulmonary franchise, as GSK (GSK) and others do, would help, as would a strong presence in rare diseases.

Long VRTX for both trading and long term investment goals.

Thanks for reading and sharing any comments you wish to contribute.

Disclosure: I am/we are long VRTX,GILD,CELG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Not investment advice. I am not an investment adviser.