October 10, 2006

Vertex: A Promising Hep-C Play

Standard & Poor says the pharma company's VX-950 could not only become part of a new standard hepatitis C treatment, but also alter the treatment "paradigm"

The World Health Organization estimates that as many as 170 million people are infected with the hepatitis C virus (HCV) and that an additional 3 million to 4 million are infected each year. The American Association for the Study of Liver Disease has estimated that about 3.4 million people in the U.S. are infected with HCV and that 10,000 to 12,000 Americans die of the disease each year.

Based on preliminary clinical trial results, we believe that Vertex Pharmaceuticals' VX-950 protease inhibitor could become part of a new standard of care for the treatment of hepatitis C, and capture a large portion of an estimated $5 billion worldwide market. Additionally, we think VX-950 may have the potential to greatly improve patient compliance and may create a new paradigm in the treatment of HCV viral infection.

In our opinion, investor confidence would be boosted should forthcoming data remain positive. In turn, we think the share price would move higher. The stock carries Standard & Poor's highest investment recommendation, 5 STARS (strong buy). Vertex is a biotech company and, therefore, carries a relatively high degree of risk. We also note VX-950 is still several years away from Food & Drug Administration (FDA) approval.

"FAST TRACK" STATUS. Founded in 1989, Vertex Pharmaceuticals is a biotechnology company that is focused on discovering, developing, and commercializing small molecule drugs for the treatment of a variety of diseases. The company utilizes a drug design approach that integrates biology, biophysics, chemistry, and automation and information technologies throughout the research process, which the company believes makes the discovery process more efficient and productive. The company has an extensive pipeline of drug candidates targeting a broad array of diseases and several important industry partnerships.

Vertex's principal focus is on its VX-950 oral hepatitis protease inhibitor for the treatment of chronic hepatitis C viral infections. VX-950 is designed to inhibit NS3-4A serine protease, an enzyme needed for HCV replication. The FDA has granted "Fast-Track" designation to VX-950, because HCV infection is an unmet, life-threatening disease. VX-950 has partnered with Janssen Pharmaceutica, a Johnson & Johnson (JNJ: Strong Buy: $65) company.

The current standard of care for HCV infection is a combination of pegylated interferon and ribavirin, administered for up to 48 weeks. The regimen has significant side effects, however, including fatigue, flu-like symptoms, depression, and anemia, and most patients drop out of before completing the full course of treatment. As a result, even though HCV is a curable illness, only about 3% of diagnosed patients are actually cured. We believe there is a large market opportunity for a new drug if it can reduce treatment time and/or reduce or eliminate the side effects associated with the current standard of care.

POSITIVE TRIALS. In early 2006, Vertex reported preliminary results from a 28-day, Phase II trial of VX-950 in combination with pegylated interferon and ribavirin, which included 12 treatment-naive (i.e., not previously treated) patients infected with genotype 1 HCV (the most common type of infection in the U.S.). In the study, patients received VX-950 every eight hours for 28 days, in combination with standard pegylated interferon and ribavirin. Following the VX-950 dosing (after 28 days), all 12 patients showed undetectable viral load, with no treatment discontinuations, no serious adverse events, and no evidence of viral breakthrough.

In the second quarter of 2006, Vertex initiated the PROVE 1 (260 treatment-naive patients dosed with VX-950 compared with standard care in the U.S.) and PROVE 2 (320 patients in the EU) trials. The PROVE 1 trial is fully enrolled, and the company expects to release 12-week safety data for 80 patients by the mid- to late fourth quarter 2006. We believe that, based on prior safety data already presented, the odds favor a positive result from this trial. We think further positive results will have a favorable impact on the shares.

In the first quarter of 2007, the company expects to release three-month sustained viral response (SVR) data, which will measure the viral load 12 weeks after 12 weeks of treatment is stopped. In our view, this will be the key data for VX-950, as preliminary SVR is considered indicative of longer-term sustained response.


By mid-2007, Vertex expects to have 12-week treatment data for 180 patients and some follow-up data that it will use to design the Phase III trials. In all, the company believes that more than 1,000 patients will be enrolled in clinical trials by mid-2007.

DEVELOPMENT PIPELINE. Turning to the company's other compounds under development, VX-702 is its oral p38 MAP kinase inhibitor for the treatment of rheumatoid arthritis. Vertex is conducting a Phase II program to assess the efficacy of the drug, while its partner, Kissei Pharmaceuticals, is conducting a Phase I trial in Japan. Preliminary results from the first trial supported a second Phase II trial, which is expected to begin in late 2006.

VX-770 is an oral CFTR potentiator for the treatment of cystic fibrosis. It is a small molecule compound that targets the cystic fibrosis transmembrane regulator (CFTR) protein that is defective in patients with cystic fibrosis. The company expects to complete a proof-of-concept trial in 2007. VX-770 is being developed in conjunction with Cystic Fibrosis Therapeutics.

The company is collaborating with Merck (MRK: Buy; $37) in the development of VX-680, an aurora kinase inhibitor for the treatment of cancer. Vertex believes that VX-680 could be a "backbone" therapy as well as monotherapy in certain cancers. Anecdotal data recently published showed positive results in chronic myeloid leukemia (CML) and acute myelogenous leukemia (AML) patients who had failed standard treatment. Merck is conducting three Phase I trails of VX-680 in hematologic cancers and solid tumors.

The company also has an agreement with GlaxoSmithKline (GSK: Buy, $54) covering the development of HIV protease inhibitors. GSK currently pays Vertex a royalty on sales of Agenerase, Lexiva, and Telzir and will pay additional development milestones for the development of other candidates, including brecanavir.

FOCUSED ON R&D. Vertex receives royalties on several products marketed by its partners, but the company is still primarily engaged in research and development. In 2006, we expect Vertex to receive about $38 million in product royalties and approximately $171 million in collaborative R&D revenues and milestone payments, for total revenues of around $209 million. R&D should constitute the bulk of the company's expenses, coming in at approximately $385 million for the year. We see Vertex generating a net loss of about $239 million, or $2.14 per share for 2006. Our net loss per share forecast for 2007 is $1.88.

The company is well funded. At the end of June, 2006, the company had about $316 million in cash and marketable securities on hand. In addition, in July, Vertex received a payment of $165 million from Janssen Pharmaceutica for the development and commercialization of VX-950. Lastly, the company completed an offering of 9.1 million shares on Sept. 20, which netted an additional $281 million. Given the company's current cash burn rate, we believe that Vertex has sufficient funds for at least the next two years of operation.

We estimate peak potential sales for VX-950 in the U.S. at about $2.5 billion under the assumption that VX-950 becomes part of standard of care for HCV treatment. We derive this estimate by assigning a 25% premium to projected sales of current treatments PEG-INTRON (Schering-Plough: SGP: Buy; $22) and PEGASYS (Roche), which had combined 2005 sales of about $1.9 billion. We believe such a premium will be justified if VX-950 can produce SVR levels that are higher than those elicited by current regiments, and/or shorten duration of therapy. We estimate the global market potential for VX-950 at about $5 billion.

PROFIT PROJECTION. We see the company's first year of profitability in 2010. In that year, we expect U.S. sales of $600 million for the HCV treatment. We think total Vertex revenues could exceed $800 million in 2010, and that Vertex will report net income of $349 million and EPS of $2.88 per share.

To arrive at our 12-month target price of $42, we employ net present value analysis. We are assuming that VX-950 is launched in late 2008, and that sales reach about $1.6 billion in 2012. For 2012, we forecast that Vertex will earn $4.91 per share. We assigned a p-e multiple of 25 times to our 2012 EPS estimate and discounted this result by a 20% rate for five years. We believe a 20% discount is appropriate, given the high degree of risk inherent in the shares.


We view Vertex Pharmaceuticals' corporate-governance practices as generally sound. We view the following factors favorably. The board is controlled by a supermajority (greater than 75%) of independent outsiders, and the nominating and compensation committees are comprised solely of independent outside directors. Also, the company has a committee that oversees governance issues, a board-approved CEO succession plan is in place, and a simple majority of shareholders is required to approve a merger.

BIOTECH RISK. On the negative side, the company has a poison pill in place, and its auditors were not re-elected at the most recent annual meeting in March.

Risks to our recommendation and target price include any delay in the development timeline for VX-950, the possibility that VX-950 fails to gain FDA approval due to a lack of efficacy in larger clinical trials or other adverse developments, or any combination of these issues. Other risks include new competition in the HCV treatment market, possible need for additional financing to fund the development pipeline, and lower-than-expected sales for the company's current and prospective product candidates.

Lastly, Vertex is a biotech company and, therefore, carries a relatively high degree of risk. We also note VX-950 is still several years away from FDA approval. Additionally, while we view results from the small, preliminary clinical trial favorably, we note that outcomes from the subsequent larger trials could vary, given larger patient populations.