Vectura VEC LN
December 27, 2007 - 5:18pm EST by
2007 2008
Price: 53.75 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 340 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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It is unusual to suggest a biotech – especially one at a relatively early stage on VIC. There are a number of reasons for this – (1) they are high risk (2) there is a high scientific barrier to understanding (3) it is difficult to project very long term for them

Notwithstanding all of that I would like to suggest a particular biotech to VIC members. I believe that it has three shots at goal and success on any one of them will justify the investment. I hope to address all three issues above to some degree in this writeup. I am going to make a lot of references to Wikipedia pages for those interested in more details but I hope to cover the essential points in this writeup.

One of the key tenets of value investing is ‘margin of safety’ – regarding early stage biotech companies I translate that into using conservative market penetration rates and royalty rates and then see if the present valuation is justified by that. I also tend to ignore all but the three or so lead projects thus having optionality on anything else in the pipeline.

Vectura (VEC LN) is a UK listed and based biotech that is hardly covered (only Canaccord really covers it).

Its market cap is £170m (at 53.75p – which is roughly $340m). Currently there is £71m of cash on the balance sheet and a liability to Paul Capital (to be paid over three years) of £15m. The fiscal year is to March – the company is likely to generate some cash in the second half (probably £4m net) so by March 2008 the position will be £75m cash; a debt of £15m leading to a EV of £110m.

The three key value drivers are (1) an inhaler device (2) a generic inhaled asthma combination therapy (3) a novel new asthma compound.

Before going into detail with the key products it is probably worth spending a moment discussing the asthma and COPD markets.

The following numbers are from Wikipedia and I would recommend the article there on asthma as a backgrounder for anyone trying to understand this disease. The key points are (1) more that 6% of US children have been diagnosed with asthma (2) the condition usually persists into adulthood (3) there are lots of different possible treatments – but generally not curative (with the exception of desensitization for allergy induced asthma) (4) the final ‘Expert Panel Report 3’ report on asthma management in the US was published by the National Institutes of Health on 29 August 2007. This is important as the previous report was from 1997 and arguably the US was historically slow to adopt steroids and combination inhalers for asthma compared to other Western countries.

Similarly I would refer readers to the Wikipedia page for chronic obstructive pulmonary disease (COPD). In comparison to asthma this is a disease typically of the elderly with over 80 million sufferers worldwide. In many ways COPD tends to be overlooked and considered less ‘glamorous’ than asthma even though the impact on sufferers can be just as severe.

A lot of the same drugs and delivery systems (ie inhalers) that are used for the treatment of asthma are used for the treatment of COPD.

The inhaler device - Gyrohaler

Since both asthma and COPD affect the lungs a lot of drugs are delivered via inhalers. The traditional type of inhaler is the metered dose inhaler (MDI). Historically these used chloroflurocarbons (CFCs), which due to the damage to the ozone layer, are being phased out. Another problem is that many patients find it difficult to synchronize taking a deep breath with pressing the canister to release a dose of medication.

As a result breath actuated dry powder inhalers (DPI) are delivering more and more respiratory drugs.

However given that these are devices that deliver what can be life saving medication it is important that they deliver a standard measured dose each and every time and that variation between doses is limited. A typical (disposable) device might be required to deliver upto 60 doses over the course of a month; and be exposed to saliva and the deposition of drug from a previous dosing. And all in conditions where drug contained in the device is not subject to contamination. It is also important to recognize that an inhaler does not exist in a vacuum but has to be tailored to a specific drug. Part of this involves formulating the drug with suitable carriers so that particle sizes are of the correct size to pass in the breath to the correct part of the lung (one of the problems with poor synchronization of MDIs is that a lot of the dose ends up in the back of the throat rather than in the smaller airways of the lung).

The reason I highlight this is that even large companies such as AstraZeneca have in the past had difficulty in getting approval from the US FDA (Food and Drug Administration – the US drug regulator) for an inhaler.

It is important to recognize that inhaler technology is a patent minefield – thus there is real value in having freedom to operate.

Vectura has a dry powder inhaler (Gyrohaler) that it claims meets FDA standards (final approval has to be for an inhaler with a specific drug by a company seeking approval for that combination). Key differentiators of the Vectura device are that it is a multidose device (holding upto 60 doses) and the drug is stored internally in foil-sealed blister packs to maintain sterility.

Whenever a company claims to have a new technology or device I am usually fairly skeptical – especially when even big players in the area have failed.

What has caught my attention however is that Vectura has partnered with a German company Boehringer Ingelheim to develop the Gyrohaler for a proprietary respiratory molecule.

It is worth taking a slight detour at this point to discuss the background of this deal. Boehringer Ingelheim (privately owned) is one of the largest pharmaceutical companies globally (in the top 20 – with sales of over €10bn). It is a major player in respiratory medicine. Its major drug in this area is Spiriva which is co-promoted by Pfizer (the global number 1 drug company). In 2007 analysts estimate that Spiriva will have sales of over $2.38bn. However there are two issues with Spiriva – (1) the current inhaler used to deliver the product (the Handihaler) has to be loaded for each dose separately; it is worth remembering at this point that the major market for Spiriva is the COPD market which usually means elderly patients who have difficulties loading the device (indeed it is claimed that upto 1% of patients misunderstand completely, failing to put the drug into the device at all and instead swallow the drug which of course is then ineffective and potentially dangerous) (2) the patents on the drug expire in the US in 2014 (2015 in Europe) – however a generic company has to show that whatever device it uses has equivalent drug delivery as that of the patent holder – hence drug companies with respiratory drugs seek to raise additional barriers to generics by improving their devices in terms of quality of experience, accuracy and convenience.

Though it is speculative it is generally believed amongst biotech analysts that Boehringer Ingelheim has partnered with Vectura to develop a derivative of the Gyrohaler for delivery of Spiriva. It is said that Boehringer Ingelheim looked at 39 other inhalers and spent 18 months before choosing the Gyrohaler. This to me is the most important point about the Vectura inhaler – that it is validated by a major industry player with a lot on the table. Boehringer has paid milestones and indeed invested in the equity of Vectura (admittedly not large amounts - €5m cash and €10m equity on signing; and a recent milestone of €10m cash plus €5m in equity).

The key point however is what royalty rate Boehringer Ingelheim will pay if a successful inhaler is developed which improves Spiriva’s sales or protects from patent challenges. Canaccord are estimating a 5% royalty rate, a 20% chance of success, a 2010 launch date and sales of $800m of the underlying drug. For my modeling I have a different view, I am assuming a much higher chance of success as I believe that both Boehringer Ingelheim and Pfizer will be keen to increase the competitive barriers and the differentiation of Spiriva, however I am using a 3% royalty rate and that if it is successful then over time (say by 2014) the Gyrohaler will have been rolled out to the majority of the Spiriva franchise (which itself will have increased by that date). Further a successful launch will protect the Spiriva franchise beyond 2014.

Using a 60% adoption rate for the Gyrohaler derived device, with Spiriva sales of $3bn, a 3% royalty rate and a USD / GBP exchange rate of 2 it is possible to have royalty income to Vectura of £27m.

It should be noted that some analysts are expecting peak global sales of Spiriva of over $5bn (eg Lehmans).

I appreciate that there is a probability of success and a discount rate that need to be applied but based on the above I feel that the Boehringer Ingelheim project alone justifies the current valuation of the company. (Ultimately I cannot see why a 100% of the Spiriva franchise would not be switched to the new device; further the potential for Spiriva is certainly too low due to the potential of combination products and the asthma market (see later)).


VR315 – Asthma

The second key value driver for Vectura is an inhaled combination asthma product using the Gyrohaler that the company has licensed out to an undisclosed generic company in the US and a (? different) partner in Europe.

Since a greater proportion of the intellectual property in this case is from Vectura and the US deal includes cost and profit sharing analysts are anticipating a much greater percentage of the profits being attributable to Vectura. (The company is guiding to a 1/3 of the profits in the US will be attributable to Vectura – in exchange for it investing $30m in the project).

The company has not disclosed the product it is working on but the general belief amongst pharmaceutical analysts is that the company has a generic version of Glaxo’s Advair (also known as Seretide – different name in different regions). This has expected peak sales of over $6-8bn globally in the asthma and COPD markets and is expected to go off patent in 2010 in the US and 2013 in Europe.

Traditionally when a drug goes off patent there is a six month period when one generic company has sole rights to launch a generic version of the product (generic exclusivity) before a free-for-all (at the start of the free-for-all prices in some cases have fallen over 95%).

In the case of the respiratory market due to the need to show that a generic inhaler device delivers the equivalent amount of drug and that it does not infringe device patents it is expected that the number of generic entrants will be limited.

Because of the above it is hard to make a guess at how many players, pricing and profits for a generic Advair launch. In the case of Vectura it also depends on who its partner is. On this issue the company is tightlipped. However given that the incumbent (ie Glaxo) is a serious global player and respiratory medicine is a highly complex area I believe Vectura has a significant partner.

On this assumption I think it reasonable to model that Vectura can capture 10% of the US sales in 2010 and 10% of the ex-US sales from 2013. Roughly that would mean about $300m in sales from 2010 and the same again from 2013.  Assuming a 30% margin for the US jv and a 1/3 profit share with an exchange rate as above (ie 2) computes to £14.85m of profits from the jv coming to Vectura (I suspect this is an underestimate given that the company is investing in this jv).

The European deal involves a 15% royalty rate. Though the patent expiry is later it is likely that in the interim Glaxo will have grown sales of Seretide in Europe. Even assuming Vectura and its partner capture $300m of sales in Europe and have a 15% royalty gives £22.5m of royalty income in Europe.

On this basis I think it reasonable to model that VR315 could be worth over £30m per year in profit share and royalty income to Vectura. Note that in this I have ignored any milestones attributable to Vectura (the US deal has $63m and the European has €22.5m of milestone and development fees).

I am unable to find any comments in the company presentation regarding addressing the Japanese market – my impression is that the company will license out the Japanese rights at a future date.

As will be seen from the above there is a lot of ‘back of the envelope’ to my calculations. This is partially due to the nature of the respiratory market and it being difficult to know which generic companies will have non-infringing devices in the market that will also be bioequivalent (ie deliver the same amount of active drug to the correct place in the airways) to Glaxo’s inhalers. Because of these complexities and the validation by Boehringer Ingelheim (in the previously described project) I think Vectura has a more than reasonable chance of success. If it does succeed then, dependent on the competitive landscape at the time, it is possible that I could have grossly underestimated the market share of Vectura. Secondly the six month exclusivity period may be less relevant in this market as prices will not fall if the number of generic players are limited. It is also worth considering that Glaxo has spent years developing intellectual property and patents covering inhalers so the validation by Boehringer Ingelheim of the intellectual property around the Gyrohaler is important.


NVA237 & QVA149 – Innovative Medicines for COPD

The third target at goal is one that has high potential value for the company but which potentially has higher risk – this is a new innovative molecule NVA237 which is a long acting muscarinic antagonist for COPD. This may sound complex but in essence this is the same type of drug as Spiriva mentioned earlier but possibly with faster onset and better coverage over 24 hours. This product has been licensed out to Novartis (one of the global top 5 drug companies). As well as a standalone compound Novartis is also investigating the use of this compound in combination with QAB149 (a long acting beta agonist that Novartis has in development – the combination being know as QVA149).  So far Novartis has paid $15m upto date but total potential milestones are estimated to be $172.5m (of this about half ie $85m are expected over the next 4 years). The first drug is expected to reach the market in late 2010 or 2011. The net royalty to Vectura is anticipated by analysts to be 5-6%.

Analysts, noting that this drug is in phase 2b with phase 3 trials starting in 2008 ascribe a high value to it. The maths that is typically used is $2bn of peak sales (for NVA237 and the combination product) with a 6% royalty giving $120m per year or £60m. (Note the company claims that it will get a similar royalty on the combination drug as on NVA237 standalone).

I am slightly more cautious on this compound because (1) it is an innovative compound and therefore higher risk (2) for the full potential of NVA237 to be recognized the combination needs to be successful as well (ie QVA149) (3) though the company will not give exact details on the royalty rate it appears that the percentage will start low and rise with sales (4) as far as I can tell (still investigating this) Novartis is using the Monohaler (which is a single dose device) – thus given that we have already discussed that Boehringer Ingelheim is developing a derivative of the Gyrohaler which will be more convenient (upto 60 doses stored inside it) I wonder if by the time of launch Novartis will need to have a more competitive device. (5) Since it will be launching in essence three compounds – QAB149, NVA237 and QVA149 it will take Novartis time to educate physicians. (6) I have heard some unconfirmed reports that Novartis has had difficulties with its inhaler and may be looking to modify or replace it (or modify the drug formulation) which may lead to delays. However if it meant that they licensed the Vectura Gyrohaler that would be positive for Vectura. 

Ironically in some ways Vectura is an arms dealer - providing product to both sides (Boehringer Ingelheim plus Pfizer on one side and Novartis on the other).

Again using my back of an envelope I think £40m of royalties by 2013 is an reasonable estimate for the Novartis collaboration – I accept however that I could be too low or too early in my timeline.

Am I being too cautious?

I started this note mentioning both asthma and COPD. What is striking with both Spiriva and NVA237 is that they are targeting COPD. It is very clear that both drugs must have potential in asthma – and that the relevant drug companies will be assessing these markets. In addition Boehringer Ingelheim has clearly been working on Spiriva combinations with other drugs (much of the COPD and asthma market involved combination drugs). Because of this my calculations above may be grossly low because combination products for Spiriva will increase the duration of patented sales and sales potential; similarly accessing the asthma market will increase the value NVA237; and for the generic product there is potential for Vectura and its partners to capture more than 10% of the market.

What has been happening to the share price.

As far as I can discern a hedge fund, which is closing down, has been selling down a significant holding in Vectura – this I believe provides the opportunity for investors. This together with the lack of coverage has led to the stock price falling.

Putting it all together

I have not covered the earlier stage products in this company’s pipeline.

In two of the three cases with respect to the three projects described above the key technology is the device rather than an innovative drug  - I believe as a result that in many ways the risk profile is lower than for a traditional biotech. Further the partners (where they have been revealed) are high quality partners and validate the company’s technology.

What I have not covered is the existing business of Vectura. The key point to make is that Vectura acquired Innovata at the end of 2006 – and as a result receives royalties, which offset a significant part of the corporate R&D expenses (some of the cashflows are allocated to pay the liability to Paul Capital).

Thus it is likely that the combination of milestones on the three projects above, the Innovata revenues, the payments to Paul Capital and general cash burn will utilize roughly half the cash pile before the company reaches profitability. To be cautious I am assuming that the whole of the cash pile will be used and that the company is unable to sign any more deals.

Despite this I still find that any one of the three key projects being successful will more than justify the present valuation (indeed significantly above the present price) and two being successful could be a home run (ie more than double the share price) over the next three years. Of course two projects being successful still means that one will be unsuccessful and so this will lead to volatility and timing (ie if a project success occurs before a project failure or vice versa) could affect the path from now to then. I appreciate that this may not whet the appetite of many investors but I think in this case (the derisked approach ie devices, generics and innvovative compounds, credible partners, and a stock price that has been under selling pressure) make this an interesting investment and the potential upside make it worth considering even for traditional value investors.


Between now and 2010 I believe data releases, announcements and regulatory filings from Novartis and Boehringer Ingelheim /Pfizer will lead to interest in the company and a positive impact on the share price.
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