MED 275: BIOPHARMACEUTICAL INNOVATION

March 9, 2010

Healthcare | Biotechnology

Liliana Chan-Hou |

Christine Kang |

Erin Parker |

Nina Wong |

Ming Yan |

Entry Price Band:$20-$30

Exit Price:$60

Fair Value Price[1]: $44.50

Stop Loss Threshold:$15

Time Horizon: 2-5 years

Introduction

Investment Thesis:We believe VRTX to be a fundamentally strong company that’s projected to corner the market and that financially outperforms its peers.

Company Profile:Vertex develops small molecule drugs principally for the treatment of hepatitis C and cystic fibrosis. Lexiva for HIV Infection is the company’s sole drug on the market. It has Telaprevir and VX-770 for HCV and cystic fibrosis, respectively, currently in Phase III development. Vertex was founded in 1989 by Josh Boger. The company owes much of its success to him. He was an outstanding fund-raiser and managed the company’s cash flow well. The company currently has a market cap of approximately $8.31 billion. Vertex was one of the first biotech companies to employ a clear strategy of rational drug design rather than combinatorial chemistry.

Markets: Pending Telaprevir’s approval, Vertex has the potential to be a market leader in both the United States and China. There are 3.2 million people in the US living with chronic Hepatitis C and 17,000 are newly infected each year. The US Hepatitis C market in projected to be worth $7.7 billion in 2013. Telaprevir is expected to capture about 40% of the market, thus generating $3.6 billion in revenue for Vertex, which holds the marketing right in North America. In addition, China is another promising potential market; currently there are 41 million people infected with HCV in China, where Hepatitis C infection is the highest in the world.

Recent News:

Vertex Issues FY 2010 Guidance Below Analyst Estimates: The company expects a GAAP net loss which includes a restructuring expense. While Vertex's GAAP net loss rose from $459.9 million for the year ended December 31, 2008 to $641.6 million for the year ended December 31, 2009, the loss comes more from increased investment than it does from falling revenues. With a cash position of approximately $1.3 billion entering 2010, Vertex is investing in key activities to support the potential launch of Telaprevir and to move the company toward its near-term and long-term business objectives. As they near completion of the Phase III development program for Telaprevir, they are increasing their investment in critical pre-launch activities, including building of product supply, the further expansion of Vertex’s commercial infrastructure and the hiring of key employees to support the implementation of commercial functions. Additionally, they plan to continue investing in research and development to support proof-of-concept clinical trials.

Vertex targets RA and epilepsy in proof-of-concept clinical trials

In a strategic move that will surely diversify its portfolio, Vertex has committed to conducting proof-of-concept clinical trials with novel compounds targeting rheumatoid arthritis and epilepsy. They expect to generate initial clinical data from these trials later in 2010, which could provide important insight into the value of these compounds to patients and to Vertex.

Company Analysis

Pipeline:

Competition: Many of Vertex's competitors, including major pharmaceutical companies such as Schering-Plough, GlaxoSmithKline, Wyeth, Pfizer, Roche, Amgen, Novartis and Johnson & Johnson possess substantially greater financial, technical, and human resources than Vertex. Telaprevir’s main competitor is Merck’s (formerly Schering-Plough) Boceprevir. Like Telaprevir, Boceprevir is also in Phase III of clinical trials. Both drugs are expected to launch in 2011 in the United States. Another rival of Telaprevir is Roche/Pharmasset's R-7128, a nucleoside polymerase inhibitor for chronic Hepatitis C in Phase IIb clinical trial.

Competitive Advantages:The current standard of care of Hepatitis C is lacking. HCV patients currently receive a combination of pegylated interferon-alfa (PEG-IFN) and ribavirin. The treatment involves once-a-week injection for 48 weeks. In addition, only 50% of the patients are responsive to the treatment[2]. Telaprevir is an oral pill that patients take in combination with the standard treatment, and shrinks the treatment duration from the current standard of 48 weeks down to 24 weeks. This is important because the treatment for HCV cause miserable side effects including flu-like symptoms. Further, Vertex’s Telaprevir was proven to have worked on 79% of the patients, including those who didn’t respond at all to prior standard treatment.

Standard / Telaprevir
Response Rate / 50% / 79%
Treatment Period / 48 Weeks / 24 Weeks
Form of medicine / Invasive / Oral

Although both Telaprevir and Boceprevir are both likely therapeutic options for future Hepatitis C treatment, Telaprevir is viewed more positively by clinicians due to its shorter treatment duration for certain patients and efficacy in treating previously nonresponsive patients. According to Decision Resources Analyst Alexandra Makarova, M.D., Ph.D, "Relative to Boceprevir, Telaprevir's potential shorter treatment duration is indeed an advantage for Telaprevir."

Vertex is competitive because of the significant commercial potential of hepatitis C virus pipeline. The launches of several agents currently in late-stage development - most notably Telaprevir, Boceprevir and Roche/Pharmasset's R-7128 - will help to expand the market dramatically from $2 billion in 2008 to nearly $7.4 billion in 2013.

Intellectual Property: Vertex has retained exclusive commercial rights to Telaprevir in North America and the firm will receive royalties on sales abroad from partners Janssen Pharmaceutica (a Johnson & Johnson JNJ company) and Mitsubishi Tanabe, should the drug gain approval. Telaprevir is pending patent approval in the US and has already received patent approval in Europe. In addition to Telaprevir, Vertex has also secured patents covering the manufacture, pharmaceutical compositions, formulations, and dosing regimens of VX-813, VX-985, and many other HCV protease inhibitors. Those patents expire in 2021 and 2025, respectively, but due to the Hatch-Waxman amendments, Vertex is eligible for patent term extension of up to five years.

Technology: Vertex's leading drug candidates were all discovered in-house, thus lending credibility to its drug discovery technology and its potential to generate additional pipeline candidates in the future. The biotechnology company uses an integrated, multidisciplinary approach - employing biophysics, computer-based modeling, and functional genomics - to speed up the discovery and development of new drugs. They have also invented some technologies, such as virtual screening and E-VIPR (electronic stimulation voltage ion probe reader), a proprietary technology which enables scientists to quickly sift through tens of thousands of compounds to find the most promising candidate molecules. This is significantly faster than a previous standard technique that assessed one compound at a time.

Partnerships:Most of its activity has been in collaboration with much larger pharmaceutical firms. The collaborations help provide financial and other resources to support research and development programs. Vertex has partnered with Janssen Pharaceutica, a Johnson & Johnson company, Mitsubishi Tanabe and Eli Lilly for the development and commercialization of Telaprevir. By partnering with these companies, Vertex can share its drug development costs, gain validation for their drug, obtain undiluted capital and minimze financial risk.

Regulatory Environment:Telaprevir and VX-770 have received Fast Track designation by the FDA, meaning they have more FDA guidance through the process but does not necessarily leads to priority review or accelerated approval by the FDA.

Reimbursement:Vertex anticipates that third-party payers will reimburse for drugs if they are successful at obtaining marketing approval from FDA, but Vertex expects increasingly challenging cost-effective pricing of their drugs. Vertex will also be receiving royalties for drugs commercialized by their collaborators.

Evaluation of Management:

Vertex has an experienced management team and board of directors to guide the company as it prepares to launch its potential blockbuster Telaprevir. Former board chairman and founder Joshua Boger led Vertex as chief executive from 1992 until 2009. Boasting a doctorate in chemistry from Harvard, Boger deserves much of the credit for Vertex's development into a leading biotech with promising late-stage drug candidates. However, Boger retired in May 2009 and was replaced by newcomer Matthew Emmens, a current board member and former chief executive and board chairman at Shire Pharmaceuticals SHPGY. Given his extensive business background, we think Emmens is well-suited to guide Vertex as it becomes a more mature operation. While Boger has been instrumental in Vertex's success thus far, we believe the current executive team, half of whom have over 15 years of experience in the industry, are equally capable of making this a profitable company.

Matthew W. Emmens became Chairman, President, and CEO of Vertex in 2009. He has 35 years of experience in the pharmaceutical industry and previously served as CEO of Shire Pharmaceuticals Group (03-08) and EMD Pharmaceuticals (99-01). He has also held positions at Astra Merck and Merck & Co.

Ian F. Smith is the Executive Vice President & Chief Financial Officer and joined Vertex in November 2001. Before that, he served as a partner in the Life Science and Technology Practice Group of Ernst & Young LLP, an accounting firm, from 1999 to 2001.

Peter Mueller became Executive Vice President, Global Research and Development, and Chief Scientific Officer, in May 2009 though has been with Vertex since 2003. He is responsible for Vertex's R&D and regulatory affairs. He has a Ph. D. in Chemistry and his prior experience includes being Senior Vice President of R&D at Boehringer Ingelheim Pharmaceuticals, Inc.

Risks:Vertex expects to incur future losses and may never become profitable. Its profitability depends heavily on its ability to obtain approval for and successfully commercialize Telaprevir, its leading drug candidate. Should Telaprevir not succeed, Vertex's business will be materially harmed.

Furthermore, Vertex may have difficulty raising addition capital for research and clinical trials due to its large outstanding debt of $287.5 million of 4.75% convertible senior-subordinated notes due 2013. All of Vertex’s drug candidates remain subject to clinical testing and regulatory approval. If the clinical trials prolong or delay, the drugs could not be commercialized.

Finally, with two additional hepatitis C therapies in clinical development, Vertex is heavily concentrated in this increasingly competitive market. Numerous drug developers are working on hepatitis C treatments that could top Telaprevir's convenience and efficacy.With Telaprevir poised to hit the market in 2011, Schering-Plough's SGP late-stage protease inhibitor Boceprevir poses the most immediate threat. Over the long term, Vertex will have to contend with numerous other competitors--including fellow development-stage biotech InterMune ITMN--that seek to top Telaprevir's convenience and efficacy. Nonetheless, Vertex is the current market leader, with a 70% success rate in Phase III trials and the preference of clinicians for Telaprevir over Boceprevir. A recent study by Decision Resources, one of the world's leading research and advisory firms for pharmaceutical and healthcare issues,found that physicians would prescribe Telaprevir to more than 50 percent of their hepatitis C virus genotype 1-infected patients and will prescribe Schering-Plough's Boceprevir to less than 30 percent of these patients. Although surveyed physicians perceive both Telaprevir and Boceprevir as efficacious drugs, they value (among other factors) Telaprevir's shorter duration of treatment as compared to treatment duration using Boceprevir. Despite the risk from competitors developing similar protease inhibitors, Vertex is still well-positioned to corner the market.

Expected future events that will affect price: Vertex's market price could be significantly and adversely affected by announcements of results of clinical trials of its drug candidates or those of its competitors, issuance of additional shares of common stock, introduction of new drugs by competitors, government regulatory action, public concern over safety, and changes in patents and other intellectual property rights. In addition, since clinical trials of HCV drug candidates occur over two years, any new information regarding Telaprevir and its competitive drug candidates during this time can substantially affect investors' perceptions of its future prospects.

Financials and Valuation

Income Statement Analysis

Revenues have been steadily rising from $160.89mm (2005) to $175.50mm (2008)

R&D is the company's largest expense and surpasses revenues, R&D rose from $248.54mm (2005) to $516.29mm (2008), this is actually a positive signal because it indicates future growth for the company's revenue as it develops more core pipeline products

Cash Flow Statement Analysis

Company's cash from investing activities is largest use of cash, also signaling positive future growth

Cash from operating activities has been low and negative as a result of net loss

Fair Value Analysis

We referenced the Knowledge Reuters database to retrieve our fair value estimate of the company

Knowledge Reuters pools together the median of all Wall Street Research Analysts fair value models

We believe VRTX to be fair valued at $44.50

Comps Analysis

Our comps analysis enables us to see where VRTX stands relative to its competitors

Larger comps indicate market leadership, profitability, sustainability, and that an acquirer would be willing to pay more for the company because it’s worth more

VRTX has significantly larger comps relative to its competitors which signal its financial outperformance

MED 275: BIOPHARMACEUTICAL INNOVATION

March 9, 2010

[1]Reuters Knowledge Wall Street Analyst Consensus Estimate – – March 8, 2010

[2]Nature - - March 8, 2010