We See Value in Vertex

Vertex was once best known for discovering Incivek, a blockbuster hepatitis C virus drug; however, with that drug's sales disappearing because of increased competition in the HCV market, the firm's future is now tied to its burgeoning cystic fibrosis portfolio. Approved treatments Kalydeco and Orkambi and additional pipeline assets are expected to create a dominant franchise in this lucrative rare-disease market.

With Kalydeco's successful launch in 2012, Vertex is very well positioned in cystic fibrosis, a genetic disorder affecting roughly 70,000 people worldwide that causes a progressive and deadly decline in lung function. While the number of patients is small, the potential for six-figure pricing for disease-modifying drugs in serious orphan indications makes for blockbuster market potential. Kalydeco was launched with a price close to $300,000 as a treatment for less than 10% of cystic fibrosis sufferers with certain genetic mutations. Despite this aggressive pricing, uptake has been swift, and almost all eligible patients are now on the therapy.

Vertex's pipeline strategy has been to develop drugs known as correctors that work in combination with Kalydeco, to treat other genetic subtypes that make up a larger portion of cystic fibrosis patients. The firm's most important opportunity is Orkambi (VX-809/Kalydeco combo regimen), which was recently approved to treat people with the most common cystic fibrosis mutation (F508del homozygous), representing about half of the cystic fibrosis population. We anticipate that drug will experience a quick ramp-up to $4 billion-plus in peak sales.

The firm's other cystic fibrosis pipeline drugs include VX-661 and several second-generation correctors to be used in combination with Kalydeco as more potent treatments for more difficult-to-treat subtypes. We think Vertex's comprehensive approach is poised to dramatically change the treatment of cystic fibrosis and potentially earn the firm a dominant position in this market worldwide. The market's attractiveness is heightened by the chronic nature of therapy and limited competition on the horizon. Given these positive market dynamics, we think Vertex's cystic fibrosis program could grow to over $6 billion within our forecast period.

Domination in a Lucrative Market We think Vertex merits a narrow moat based on its intangible assets, including long-lived patents for its burgeoning portfolio of disease-modifying therapies, which should allow the company to dominate the cystic fibrosis market for the foreseeable future. With Kalydeco's successful launch in 2012 and the recent approval of Orkambi (VX-809/Kalydeco combination), and other attractive assets in its pipeline, Vertex is very well positioned in this lucrative rare-disease market.

While the number of cystic fibrosis patients is small, expected six-figure pricing for Vertex's disease-modifying drugs make for megablockbuster market potential. In addition, Vertex's cystic fibrosis portfolio is experiencing a welcoming commercial and regulatory environment due to the lack of treatments for this severe affliction. The market's attractiveness is heightened by the chronic nature of therapy and limited competition on the near-term horizon. All of these elements lead us to award the company a narrow economic moat rating as it executes on its transformation into a rare-disease powerhouse.

Reliance on Cystic Fibrosis a Risk The company's future relies primarily on its emerging cystic fibrosis franchise. Given that a significant amount of Vertex's fair value hinges on Orkambi's launch in F508del homozygous patients, a negative efficacy or safety signal would curtail our positive view of the firm's growth prospects. Additionally, there is increasing competition in the cystic fibrosis development pipeline, which could threaten Vertex's current leadership position.

Our assumptions of very high pricing underpin our view of the blockbuster potential of the cystic fibrosis market. We are therefore concerned that payers, particularly austerity-strapped governments in Europe, may balk at such high prices even for a drug treating an orphan indication. On the other hand, should Kalydeco's current pricing of around $300,000 be maintained with its future combination therapies in a much larger number of patients, our estimates may prove too conservative.

The firm's risk is compounded by the early-stage nature of its remaining pipeline, which includes experimental treatments for influenza and pain and cancer.

As of year-end 2015, Vertex had $1.04 billion in cash and $300 million in debt. Like most biotechnology companies, Vertex has historically operated at a loss due to the high cost of clinical trials and research. These losses have been financed largely through offerings of equity and debt securities, collaborative research and development funding arrangements, and development milestones and royalties from partners.

More recently, with the successful launches of Orkambi and Kalydeco, the company has been able to generate significant revenue, which allowed it to build up a significant cash cushion sufficient to fund the development and commercialization of its remaining development-stage candidates. Even with Orkambi's launch still ramping up, we expect that Vertex will reach sustainable profitability in 2016 and generate significant cash flows thereafter.