Jeremy Glaser: An opportunistic pharma pick. I'm Jeremy Glaser with Morningstar.com. I am joined today by Stephen Ellis. He is an Equity Strategist here at Morningstar. He is going to pitch one of his best ideas in the pharmaceutical space right now.
Stephen, thanks for joining me.
Stephen Ellis: Thank you. Thanks for having me.
Glaser: So what's the company that you think looks really attractive today?
Ellis: The Company which has a single drug, a company called Vanda Pharmaceuticals and basically it has one single drug right now that's actually on the market, it's called Fanapt and it treats schizophrenia.
Glaser: So why is this stock looking so cheap right now? How are people reacting to this single drug?
Ellis: At Opportunistic Investor we don't try to make big calls on their approval process. So the attraction here is the drug is already on the market. It's fairly attractive market with $15 billion overall size. Over 85% of the market cap is in cash, and Vanda is only really going to burn maybe around $30 million or so of that in the next year. By the end of 2011, they can be about $170 million in cash. So you're really not paying – you're paying about $50 million, $60 million or so for the potential of this schizophrenia drug.
Glaser: How successful has the drug been so far?
Ellis: Well, the main problem is and why really the stock is so cheap is the rollout for the drug had been really quite bad. I mean what's happened is the drug was only approved last year in May and they only signed a deal with Novartis to market the drug once it got to the market in November. And so Novartis only had about six weeks or so to put together a sales force and create product awareness before the drug actually hit the market in January.
So they didn't really have enough time to put everything together and do it properly. So what's happened here is the drug launch has been really very slow and investors have been really quite disappointed with that and we think that they've been disappointed prematurely so the stock sold off quite a bit.
We think that as the prospects for the drug improve, their sales traction starts to get a little better in 2011, the stock is going to rebound and investors are going to be more enthusiastic about the drug prospects.
Glaser: This is a fairly crowded market. Is it a winner take all or this really has to displace all of the incumbent players in order to be successful?
Ellis: Well, that's one of the interesting things about the anti-psychotic market. It is just not exactly a winner take all market. What happens is, given the nature of the patient population, patients typically switch between different drugs throughout their treatment regime. So they try and find a drug that either work better for them or maybe improve what they currently have.
So what happens is, this is why even a small drug like Fanapt, which is Vanda's drug, can do quite well over time because the patient population is going to basically switch and try too much everything to be successful. So that's why we have confidence that Fanapt would continue to grow and eventually be moderately successful, which is basically where it's not being priced at this point.
Glaser: So does Vanda have a pharmaceutical pipeline as well?
Ellis: They have one drug, which basically is a drug that potentially quick treats depression or jet lag, but it didn't come online until about 2012, 2013 and that's not something that we're particularly focused on.
The real interesting thing is they have an injectable version of Fanapt. And if you think about schizophrenia being able to inject the drug and have it be active or valid for four weeks is quite attractive compared to taking a pill every day. We know that doctor can't exactly monitor a patient taking a pill everyday while they can inject the drug and have it be effective for four weeks. So that's pretty attractive.
What's very interesting is that when Vanda negotiated the deal with Novartis, they signed – they gave away commercialization rights for U.S. and Canada for Fanapt the pill form. But what they kept, they kept the European rights for the depot. In Europe, that's where the biggest market is for the injectable version. So Fanapt really had kind of an ace up its sleep there if the Fanapt was successful.
Glaser: What are some of the risks surrounding the stock?
Ellis: Well, the biggest risk, of course, is Novartis decides to walk away. I mean it's a pretty small drug, annualized in September, November did probably only around $40 million or $50 million in sales, and for Novartis this is basically a rounding error. So the deal is that's the way – if Novartis gets frustrated and says, we're not getting the traction we need, we're not making the return for it but didn't walk away.
However, all indicators to this point indicate that Novartis is moving forward and they're fully confident the drug can be successful. It's probably worth noting that the Vanda CEO came from Novartis in 2003. He left Novartis in 2003 to found Vanda. So the relationship between the companies is pretty strong.
Glaser: Let's talk about valuation for a minute. How much do you think these shares are worth and where are they trading right now?
Ellis: Well, the shares are trading for about $8 a share right now. Basically, if you think that the drug is going to be reasonably successful, which we do, cash earnings in about 2013 that would probably be about $0.50 a share. By 2012, the firm should be able to generate cash rather than burn it.
The cash flow is going to be $170 million and increasing at that point. So, we think if you apply a 50 multiple on those 2013 earnings of $0.50 a share, it's probably worth about $14, $15 and if its upside, of course, if it goes on to be, say, $1 billion drug like some of the other anti-psychotic categories, upside could be closer to $30.
Glaser: Stephen, thanks so much. Sounds like a great pick.
Ellis: Thank you very much. Thanks for having me.
Glaser: For Morningstar.com, I'm Jeremy Glaser.