Vernalis — Operational initiatives in place, execution is key

Vernalis is a revenue-generating UK speciality pharma company focused on the development and marketing of prescription-only (Rx) cough cold medicines for the US market. The company has two marketed cough cold products: Tuzistra XR (extended release, prescription-only codeine cough syrup launched in 2015/16 cough/cold season) and Moxatag (once-a-day, oral formulation of amoxicillin for tonsillitis and pharyngitis caused by Streptococcus pyogenes), and full promotion has begun. Royalty income from frovatriptan (acute migraine) is in decline from peak following patent expiry in 2015. The cough cold development pipeline, in partnership with privately owned Tris Pharma, consists of four extended-release products: CCP-07 and CCP-08 were issued complete response letters following the respective April and August PDUFA dates, while CCP-05 and CCP-06 are in development. Vernalis also has a legacy portfolio of early- to mid-stage development projects in cancer, CNS and inflammation (to be developed exclusively through partners), and significant expertise in fragment and structure-based drug discovery. Under existing management, who joined in 2009, Vernalis has raised c £155m net in four fund-raisings (2009, 2010, 2012 and 2016). The March 2012 fund-raise of £65.9m (net) enabled the company to strike the collaboration with Tris Pharma. A further £38.9m (net) was raised in May 2016. Vernalis employs 90 staff at UK sites in Winnersh and Cambridge, with 20 employees at its US head office in Berwyn, Pennsylvania and 110 salesforce field operatives in the US (this includes regional sales directors).

Our updated valuation reflects lower anticipated net sales of Tuzistra XR in FY18, peak sales reduced to $220m (from $240m) and the launch of CCP-07 and CCP-08 pushed back to the 2018/19 cough cold season following receipt of the CRLs. We apply an rNPV approach to the US cough cold and NCE pipelines, explicitly model costs (R&D, SG&A, capex) and include cash; we assume an NPV of zero for the research business (offsetting FTE income with R&D spend). Milestone receipts represent pure upside. Our valuation incorporates a 12.5% WACC (10% for launched products), with a revised 18% (from 21%) UK corporate tax rate after 2021 applied to cough cold cash flows (reflecting accumulated tax losses). Further upside would come from portfolio progress, launches and upgrades to cough cold sales expectations.

Key sensitivities relate to Tuzistra XR sales growth drivers; ensuring supply and distribution of Tuzistra XR; maintaining existing formulary coverage; and the speed and efficiency of the salesforce in executing its strategy and converting prescribers from immediate release to ER formulations. Addressing barriers to increased prescribing will determine the trajectory of Tuzistra XR uptake and both the level of and the timeframe over which it can achieve peak sales. The timing and outcome of the CCP-07 and CCP-08 NDA resubmission (partner Tris is responsible for refiling both post the CRL) is critical for investor sentiment towards the cough/cold portfolio.

Our new forecast for Tuzistra XR is for FY18 net sales of $5.7m (previously $18m) to reflect the combined impact of coupons and pharmacy stocking incentives and the slower than expected sales ramp up. FY18 cost guidance is at the similar run rate to 2016/17 and this could be higher if sterling weakens. Our new FY18 EBITDA loss is £34.0m (vs £34.5m previously). We expect sustainable profitability in FY21. However, this is contingent on sales of Tuzistra XR meeting or exceeding our expectations during the next two cough cold seasons and FY18 launches of CCP-07 and CCP-08. Net cash of £61m provides sufficient runway into FY19. We estimate a funding gap in FY19 and include an illustrative £30m financing, nominally attributed to debt, in our FY19 forecasts.

Two years on from the launch of Tuzistra XR into the US prescription cough cold market, prescriptions are starting to ramp up after a modest maiden year. During the 2016/17 cough cold season Vernalis reviewed its operations and addressed all the major factors affecting potential market share and the rate of Tuzistra XR uptake. This led to a threefold increase in prescriptions vs the prior year. FY17/18 Tuzistra XR should benefit from the 25% expansion of the salesforce (all reps have been brought in-house), patient access and brand awareness initiatives providing better insight into its longer-term sales potential. Near term, execution is critical; successful operational execution in FY18 will lay important foundations for subsequent launches from its extended release (ER) prescription only (Rx) cough cold pipeline, enabling Vernalis to successfully build a speciality franchise. Our updated forecasts reflect a delay to CCP-07 and CCP-08 launch by one year coupled with lower Tuzistra XR revenues due to a slower than anticipated sales trajectory in the near term.

The operational initiatives to address barriers to prescribing and uptake (Exhibit 1) are starting to bear fruit. Increased momentum in Tuzistra XR Rx has been supported by the refined commercial plan and a moderately severe season. This has resulted in material growth in Rx rates to 35,000 in FY17 (vs 12,000 in FY16) with a peak run rate of 55,000 prescriptions. However, Rx growth has not been matched by revenue growth as highlighted previously; for FY17 (year end 30 June), Tuzistra XR net revenues (on a delivered-to-wholesaler basis) were £2.1m (vs £1.1m for FY16). This is due to pharmacy/wholesaler stocking versus underlying demand. The third year of Tuzistra XR’s launch should see the impact of the expansion of the salesforce to 100 sales reps (all of whom are now in-house – converted from inVentiv to Vernalis in July 2017), patient access and brand awareness initiatives, providing better insight into its longer-term sales potential. Management is targeting a threefold increase in Rx during the 2017/18 financial year (guided to total Rx of ~105,000-115,000). Longer term, the average target price is expected to reach $80/Rx.

Commercial execution is a critical driver of Tuzistra XR performance and Exhibit 2 illustrates both the overall steady progress throughout the 2016/17 cough cold season and also the sensitivity of weekly Rx rates to active promotion. Vernalis’s strategy is validated by the presence of high performing sales reps in all US regions; the aim is to improve performance across the 71% of territories that have an annualised run rate <600/Rx. A more established and effective salesforce should also benefit the launches of CCP-07 and CCP-08, which we now forecast for 2018/19 following on from the CRL issuances by FDA.

12-hourly dosing with XR cough cold medicines offers greater convenience over immediate-release counterparts (requiring four to six doses daily) with deemed equivalent efficacy based on bioequivalence data. 12-hourly dosing means patients can rely on one dose through the night and one dose through the day allowing the potential for improved patient compliance. Tussionex (chlorpheniramine/hydrocodone) is the only other commercialised liquid ER product available in the US Rx market. Three Tussionex generics (one based on legacy UCB formulation technology, one on Tris’s technology and one on Neos Therapeutics’) are also available. DEA reclassification of hydrocodone may mean that hydrocodone prescribers find it easier and less costly and restrictive to prescribe Tuzistra XR than Tussionex. Physician market research conducted by Vernalis’s partners suggests there is willingness to prescribe Tuzistra XR among prescribers in the broader $1.6bn narcotics segment (which also includes codeine plus expectorants, as well as the hydrocodone segment), albeit at lower penetration in the hydrocodone segment than in the primary market.

The 25% expansion of the field force from 80 reps to 100, coupled with refined physician targeting and marketing tactics (including sampling) should improve brand awareness and usage of Tuzistra XR. Sampling of cough cold products, in particular of controlled substances such as codeine, is not standard practice. Nevertheless, Vernalis will offer samples to enable physicians to provide the first 24-hour dose, providing a bridge to pharmacy stocking and increasing physician confidence that the patient will be able to obtain a course of Tuzistra XR. Vernalis is offering continued incentives for pharmacy stocking and exploring contracting with pharmacy chains directly. The intention is to ensure that Tuzistra XR scrips can be filled when presented at a pharmacy rather than abandoned due to lack of, or a delay in, stocking. This is especially important so that the investment into enhanced promotion to drive Rx will result in increased sales. Exhibit 3 highlights how these incentives have translated successfully into higher patient consumption percentages (73%), an expansion of pharmacy stocking to 29% and consistent wholesaler levels.

The net $/Rx for Tuzistra XR will be affected by discounts offered to pharmacies, as well as ongoing coupon programmes. Coupons are being offered to improve out-of-pocket costs for cash patients, while efforts are being made to improve formulary coverage. Vernalis has achieved its formulary coverage goals of 75% Tier 3 unrestricted coverage two years post launch. Expansion of formulary coverage should increase market share/minimise insurance rejections and have a longer-term effect as formulary listings are typically multi-year.

Longer term, Vernalis is targeting a net $/Rx of $80 and achieved c $60 at end June 2017. Net $/Rx should rise in future years as insurance coverage improves and brand awareness and physician loyalty is more established, although the pace at which this normalises (and the average net $/Rx achieved) will depend on the relative payer mix (cash vs commercial insurance). We have moderated our peak sales potential to $220m from $240m given the slower than anticipated initial take up.

Moxatag (once a day, extended release, oral formulation of amoxicillin for tonsillitis and pharyngitis) was launched in September 2016, albeit in a limited number of regions due to the need to secure a new supplier. Net revenues in the first four months of its US launch were £0.1m, reflecting the drug’s restricted promotion due to supply constraints. Vernalis has made progress qualifying a new supplier and intends to re-establish manufacture of Moxatag in 2018, consequently the whole salesforce resumed full promotion of Moxatag nationwide in the US market in September 2017. High decile paediatricians have been added to the territory call plan for this season – Moxatag is approved for adults and also for children above the age of 12 years. Currently held inventories (good inventory levels from the original 2016 launch) will be utilised to meet near-term demand. Moxatag enables the company to leverage its existing fixed commercial infrastructure and relationships (with physicians, pharmacies, wholesalers and payers). As a result, we expect modest Moxatag sales in FY18 with an uptick in sales from FY19 when supply constraints are lifted and manufacturing resumes.

Vernalis is targeting a similar WAC to Tuzistra XR in the long term and a similar level of insurance coverage (Tier 3 unrestricted at 75-80% of commercial plans). The ability to sample Moxatag once routine supply is re-established should circumvent issues with pharmacy stocking or reversals by ensuring that a patient has a dose for the first 24 hours of treatment (a treatment course is 10 tablets over 10 days) and allowing the pharmacy to see demand before routine stocking. Vernalis estimates that each year c 2.1m patients are treated with amoxicillin by primary care physicians; these are the target audience for switching to an ER antibiotic. Peak net sales potential is c $20m.

Vernalis’s pipeline of ER reformulated cough cold medicines offers greater convenience and patient compliance than the immediate release (IR) counterparts and is being developed in collaboration with licensee Tris Pharma. Tris’s patented LiquiXR sustained-release liquid reformulation technology is a key factor in creating high barriers to entry given the difficulty in creating a liquid formula that the FDA will approve. From the Vernalis collaboration with Tris, Tuzistra XR is the first product to be launched and Exhibit 4 summarises the status of the other four products in development covered by this collaboration.

FDA has issued two complete response letters (CRL) to CCP-07 NDA (following its April PDUFA date) and CCP-08 NDA (following its August PDUFA date), outlining questions that need to be addressed in an NDA resubmission for potential FDA approval. While we continue to expect CCP-07 and CCP-08 to be approved, given the limited disclosure regarding possible timelines for dealing with these questions (partner Tris is responsible for the resubmission) and the probable class of resubmission, we conservatively push back our CCP-07 and CCP-08 approval assumptions by one year, delaying launch into the 2018/19 cough cold season. We are expecting a six-month FDA review cycle.

Regulatory approval will trigger the disclosure of the active pharmaceutical ingredient(s) (API) in CCP-07 and CCP-08, which will reveal which market segment each drug will target and enable a more meaningful peak sales assessment to be made. We currently forecast peak sales of $65m for each asset in Exhibit 4. Trends in the overall prescription cough cold market for 2016-17 highlight a continual shift towards non-narcotic treatments; a key beneficiary are the benzonatate class of drugs. Vernalis does not disclose the identity of the active pharmaceutical ingredients in its cough cold products ahead of approval. Tuzistra XR, a codeine/chlorpheniramine combination, targets the narcotic segment of the market; the remainder of the portfolio is understood to cover the other API market segments including a benzonatate but excluding dextromethorphan (which would be an over-the-counter product).

Overall, the 2016/17 season had 3.0% higher Rx written vs 2015/16 (34.5m vs 33.5m); however, this masked a change in the weighting of the various segments. The narcotic segment (codeine and hydrocodone products) is in decline as the impact of the general concerns of the use of prescription opiate abuse stemming from use in the pain setting spills over to the cough-cold segment. Despite the decline in narcotic market share to 44% of TRx (14.1m), the codeine segment – which Tuzistra XR addresses – is now the second largest segment with 30% of TRx (10.4m). The main beneficiary has been the non-narcotic segment, in particular benzonatate (36% market share in 2016/17, up from 31% market share in 2015/16), and as such Vernalis’s ER benzonatate is likely to be the largest product alongside Tuzistra XR.

CCP-05 and CCP-06 remain in active development, in the formulation stage; proof of concept is now targeted before the end of 2017/18 (FY18) rather than before the end of December 2017 (CY17).

In addition to commercialising its cough cold portfolio, Vernalis also aims to realise value from its NCE (new chemical entity) pipeline of eight assets focused on CNS, cancer and inflammation. Five of the NCE programmes are partnered (Exhibit 5) and Vernalis is seeking to out-license the remaining three assets (Exhibit 6) as it does not intend to invest further in the pipeline. Development timelines and newsflow are subject to partner decisions and disclosures for the partnered assets; however, Vernalis is eligible for downstream economics on development, regulatory and commercial success without incurring any financial cost. Deal terms are largely undisclosed, but could include meaningful milestones.

FY17 benefited from a strong contribution in research collaboration income with Vernalis booking £12m in FY17 versus £8.0m in FY16. The partnered pipeline has made steady progress over the course of FY17, with several noteworthy developments including:

Vernalis’s Cambridge-based research business leverages its extensive experience in fragment- and structure-based drug design in target-agnostic research collaborations. These collaborations enable the division to be self-financing. Currently, there are three collaboration partners and six active collaborations, while business development activities are ongoing to secure further collaborations.

Collaborations not only contribute to the staff costs (FTE funding) during the research phases, but also include milestones and future royalties if the compounds succeed through the development and regulatory phases. The early nature of these collaborations means sizeable economics only accrue when (and if) the compounds progress successfully through development and approach the market. Progress during FY17 was evidenced by the receipt of milestones totalling £2.4m.

Vernalis’s transition to commercialisation has shifted the key near-term sensitivities away from development risk towards execution risk for the cough cold portfolio, particularly in relation to initiatives to support Tuzistra XR sales growth. The company is making significant additional investment in initiatives to support patient access (pharmacy stocking) and affordability (supporting coupons to minimise out-of-pocket expenses), and brand awareness to grow prescription levels. Addressing barriers to increased prescribing will determine average net $/Rx, the trajectory of Tuzistra XR uptake and both the level of and the timeframe over which it can achieve peak sales. Optimising salesforce effectiveness is therefore a key sensitivity. The third year post-Tuzistra XR launch will also lay the foundations for the cough cold franchise ahead of the potential launch of CCP-07 and CCP-08 into the 2018/19 cough cold season. The timing and outcome of the CCP-07 and CCP-08 NDA resubmission (partner Tris is responsible for refiling both post the CRL) is critical for investor sentiment towards the cough/cold portfolio.

The SWOT analysis presented in Exhibit 7 (overleaf) highlights the dynamics of the US cough cold market, Vernalis’s opportunity and the key challenges to be addressed.

We have updated our financial model and valuation, which results in a lower DCF valuation of £358.5m or 68p/share (previously £399m or 76p/share). Our underlying valuation assumptions are summarised in Exhibit 8, with the following adjustments made since our last note:

We continue to apply a DCF-based rNPV approach to the US cough cold and NCE pipelines, explicitly model costs (R&D, SG&A, capex) and include cash. We do not explicitly value the research business, instead netting off collaborative FTE funding against R&D spending (research remained self-financing in FY16); thus any milestones received from research partners represent pure upside. We also highlight that unpartnered assets in the NCE pipeline, as well as V2006 (partnered with Juno/Redox) are not included in our current valuation; deal(s) for the former, or clarity on development timelines and strategy for the latter, would unlock potential valuation upside.

We apply a 12.5% WACC across the R&D portfolio with the exception of the launched products (Tuzistra XR, Moxatag and Frova) where we use 10%, our standard WACC for a commercial-stage product. We also apply an 18% (from 21%) UK corporate tax rate after 2021 to cough cold cash flows only, reflecting accumulated tax losses. Cash flows from the NCE pipeline are untaxed, based on our assumption that these will benefit from the UK patent box, as well as tax loss offset.

Vernalis’s FY17 revenues (12 months to 30 June 2017) were £20.8m vs £12.0m for the 12 months to 30 June. The company reported increased US commercial sales of £2.1m (FY16 £1.1m), higher research collaboration income and higher Frova income in the prior year. US commercial net revenues include sales of Tuzistra XR (£2.0m) and Moxatag (£0.1m) and are reported on the basis of deliverable to wholesalers net of any rebates, discounts and returns provisions.

Research collaboration income grew 50% to £12.4m (FY16: £8.0m) largely due to milestone payments of £5m in the year vs £0.6m from Servier in FY16 and £7m of FTE income vs £7.4m in 2016. Other collaboration income was reported as £2.4m in FY17 (vs zero in FY16). Following frovatriptan composition of matter patent expiry in December 2015, generic competition has affected Menarini’s in-market sales in both volume and price terms. Frova royalties booked by Vernalis correspond to API supply; in FY17 three12.5kg API batches were delivered (£4.3m in royalties) vs two 12.5kg batches (royalties of £2.9m) during FY16. Management has guided for two 12.5kg batches for FY18.

US commercial infrastructure costs drove the 23% increase in operating costs to £45.2m (FY16: £36.9m pre-exceptional; £34.0m including the £2.65m gain on settlement of an onerous lease obligation). Sales and marketing costs showed the most significant increase (£28.6m vs £20.4m) reflecting salesforce expansion during FY17 and only ten months of salesforce activity in FY16 (following recruitment in August). Broadly flat R&D costs of £11.1m (FY16: £10.9m) were mainly associated with internal R&D, while G&A increased modestly to £5.5m (FY16: £5.3m).

Increased investment in US commercial infrastructure was offset by an increase in revenue thus the operating loss for the year was similar to the prior year £26.4m (FY16: loss of £26.2m pre-exceptional, £23.6m post exceptional gain). Net loss of £21.64m (FY16: pre-exceptional loss of £17.9m) again benefitted from unrealised FX gains on cash and equivalents (£2.2m) and tax credits (mainly connected to the CCP-07 and CCP-08 regulatory filing milestones). At 30 June 2017, cash and equivalents stood at £61.3m (£84m at end-June 2016). Cash and equivalents of £84m at end-June 2016 benefited from 15% £/US$ weakening post the Brexit vote; c 73% of cash is held in US$ to hedge against US costs and future milestones to Tris. A translation loss or gain is recognised at the end of each period at the prevailing exchange rate.

For FY18, Vernalis has guided towards lower research collaboration income as FY17 benefited from milestones which are lumpy by nature. Two Frova API batches are projected by Menarini, with one in each half-year period. We lower Tuzistra XR FY18 net sales to $5.65m (£4.4m), previously $18m (£14m) to reflect a slower than anticipated ramp up. We have delayed our launch expectation for CCP-07 and CCP-08 by one year to 2018/19. The net impact is that our new revenue forecasts are £13.9m for FY18 (previously £25.8m) and £26.9m for FY19.

Management’s operating cost guidance for FY18 is for a similar run rate to 2016/17. The increase in these US$-denominated costs is magnified when translated back into sterling given the impact of US$ strengthening vs sterling. We forecast S&M costs of £35.7m for FY18 (but broadly maintain our R&D and G&A expectations). FY19 SG&A costs rise as expected to support the launch of CCP-07 and CCP-08 (contingent on approval); we forecast £40.0m.

On our updated forecasts (Exhibit 10), we expect Vernalis to reach sustainable profitability in FY21. However, this is contingent on Tuzistra XR sales meeting or exceeding our expectations during the next two cough cold seasons and FY19 launches of CCP-07 and CCP-08. Net cash of £61m provides sufficient runway into FY19. We estimate a funding gap in 2019 and include an illustrative £30m financing, nominally attributed to debt, in our FY19 forecasts.