Vernalis — Update 21 October 2016

Vernalis is a revenue-generating UK speciality pharma company focused on the development and marketing of prescription-only (Rx) liquid cough cold medicines for the US market. The commercialisation of five extended-release products, in-licensed for development from Tris Pharma in 2012, is expected to drive Vernalis to sustainable profitability from FY19. Tuzistra XR, the first product, was launched into the 2015/16 cough cold season; and the second, CCP-007 has a PDUFA date of 20 April 2017. Vernalis also has an FDA-approved extended release antibiotic Moxatag, 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. Royalty income from frovatriptan (acute migraine) is declining following patent expiry in 2015. 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 it to strike the collaboration with Tris Pharma, while the £38.9m (net) raised in May 2016 provides working capital through to sustainable profitability. Vernalis employs 90 staff at UK sites in Winnersh and Cambridge, with 10 employees at its US head office in Berwyn, Pennsylvania.

Our updated valuation reflects increased investment in sales and marketing (S&M), lower anticipated net sales of Tuzistra XR in FY17 and more modest Moxatag sales in FY17. This is largely offset by the weaker sterling vs US$ and a higher CCP-07 probability of success post-NDA acceptance. 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 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.

Our new forecast Tuzistra XR FY17 net sales of £3.7m (previously £7m) reflect the combined impact of coupons and pharmacy stocking incentives. FY17 cost guidance is for increased US S&M spend reflecting the full-year impact of costs, 25% salesforce expansion and Tuzistra XR sampling; this is magnified by weaker sterling. Our new FY17 EBITDA loss is £37.6m (vs £24.5m previously). We expect sustainable profitability in FY19 and the cash position reaching a low point of £8.3m at end-FY18. However, this is contingent on Tuzistra XR sales meeting or exceeding our expectations during the next two cough cold seasons; FY18 launches of CCP-07 and CCP-08 and/or Tris milestones becoming due in line with, or later than, our estimates.

Vernalis’s transition to commercialisation has shifted sensitivities away from development towards execution risk, particularly in relation to initiatives to support Tuzistra XR sales growth. Key drivers are ensuring supply and distribution of Tuzistra XR; broadening Tier 3 unrestricted formulary coverage; and the speed and efficiency of the salesforce in executing its strategy and converting prescribers from immediate release to ER formulations. Vernalis is investing in FY17 to support patient access and affordability, and raise brand awareness to grow Rx levels. 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 second year post-Tuzistra XR launch will also lay the foundations for the cough cold franchise ahead of the potential launch of CCP-07.

One year on from launch of Tuzistra XR into the 2015/16 cough cold season, Vernalis has made the transition to a commercial stage speciality pharma company. However, sales of Tuzistra XR in its maiden year were modest, reflecting the early stage of its launch. Vernalis has reviewed its operations over the FY16 period and is addressing all the major factors affecting potential market share and rate of Tuzistra XR uptake. The second year of Tuzistra XR’s launch should see the impact of the 25% expansion of the salesforce, and patient access and brand awareness initiatives, providing better insight into its longer-term sales potential. Successful operational execution in FY17 will also lay important foundations for subsequent launches from its extended release (ER) prescription-only (Rx) cough cold pipeline, enabling Vernalis to build a speciality franchise. Our updated forecasts reflect increased investment in sales and marketing in FY17, coupled with lower Tuzistra XR revenues on account of a lower net $/Rx in FY17.

Tuzistra XR, an ER adult codeine-based treatment, was launched in September 2015. The 2015/16 cough cold season was an overall moderate season with 33.5m total prescriptions (TRx); however, compared with prior years it had a very mild start (Rx down 25% through to January) and a later peak (in March vs December/January typically). Net sales of Tuzistra XR to end-June 2016 were £1.1m (on a delivered-to-wholesaler basis), with c10,000 TRx. At interim results in March, management emphasised that year one of commercialisation was a transition year, and therefore less about hitting a target sales level and more about establishing the platform for future sales growth of Tuzistra XR and further cough cold pipeline products once approved.

On this basis, Vernalis has made significant progress in establishing its US commercial infrastructure, putting an 80-strong cough cold focused primary care salesforce in place and hiring an experienced president and chief operating officer for the US business, who joined in May. Other important achievements over FY16 include:

Vernalis has identified a number of areas for improvement and the equity raise in May provides additional funds to enable it to focus on the execution of its operational plan. The salesforce is focused on improving physician awareness of Tuzistra XR to drive accelerated Rx growth, as well as ensuring patients can fill their Tuzistra XR scrip. Patient accessibility to Tuzistra XR both physically (through pharmacy stocking) and financially (by gaining formulary coverage and minimising out-of-pocket expenses) are critical factors. Improvements here should help Vernalis increase market share and facilitate continued prescribing of Tuzistra XR into the next cough cold season.

2016/17: A year for commercial execution

Execution of Vernalis’s plan to build physician awareness, boost pharmacy stocking and minimise the cost to patients should help increase market share and increase momentum in the growth in Tuzistra XR TRx. Challenges for FY17 and beyond include ensuring continued pharmaceutical supply and distribution of Tuzistra XR, broadening stocking at pharmacies, broadening the Tier 3 unrestricted formulary coverage by addressing the CVS Caremark gap, minimising patient out-of-pocket expenses and boosting the speed and efficiency of the salesforce in executing its strategy, and particularly in converting prescribers from immediate release to ER formulations.

In the first 52 weeks of launch, c 12,000 Tuzistra XR Rx have been written by a total of 2,350 physicians, with a c 28k weighted annualised run rate calculated in September. A key task for the salesforce is to increase the conversion rate of physicians trialling Tuzistra XR to consistent prescribing. 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.

At present, Tuzistra XR is stocked at approximately 3,000 of 18,000 pharmacies in the territories where Vernalis has a sales rep presence. The goal for FY17 is to build and leverage relationships with pharmacies. Vernalis is offering an atypical second year of 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 results in increased sales. At this stage, it is unknown how long it will take for pharmacy stocking to normalise, and therefore how quickly and to what extent discounts can be decreased.

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 made to improve formulary coverage. Expansion of formulary coverage should increase market share/minimise insurance rejections and have a longer-term effect as formulary listings are typically multi-year. CVS Caremark remains the notable gap to hitting the target of c 75-80% Tier 3 unrestricted coverage two years post launch; Vernalis is continuing to work with CVS Caremark to support an unrestricted formulary decision (Tuzistra XR is only covered on open CVS formularies). The timing of such a decision will ultimately be determined by priorities at the pharmacy benefit manager.

Longer term, Vernalis is targeting a net $/Rx of $80 and achieved c $65 at end-June 2016; however, a lower net $/Rx is expected in FY17, reflecting the above initiatives. 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).

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. Exhibit 1 summarises the status of the five products covered by this collaboration; our collective peak sales estimate across this portfolio is $500m by 2024.

The second of Vernalis’s cough cold programmes, CCP-07, has been assigned a PDUFA date of 20 April 2017; if approved, it will be launched into the 2017/18 cough cold season. The next most advanced, CCP-08, is expected to launch into the same season although this is contingent on the timing of NDA filing and acceptance. Two remaining cough cold programmes remain in active development; due to the different technical challenges between different molecules, formulation work continues with CCP-05 and CCP-06, with the guidance window for achievement of POC widened to FY17 (ie late 2016/early 2017) from the 2016 calendar year.

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, excluding dextromethorphan (which would be an over-the-counter product).

Overall, the 2015/16 season had 3.5% lower TRx written vs 2014/15 (33.5m vs 34.7m); however, this masked a change in the weighting of the various segments, eg the narcotic segment (codeine and hydrocodone products) fell 12% as the impact of the rescheduling of hydrocodone in 2014 continues to be felt. Despite the decline in narcotic market share to 42% of TRx (14.1m), the codeine segment – which Tuzistra XR addresses – remains the largest single segment with 33% of TRx (11.1m). The main beneficiary of hydrocodone rescheduling has been the non-narcotic segment, in particular benzonatate (31% market share in 2015/16, up from 25% in 2013/14), and as such Vernalis’s ER benzonatate is likely to be the next largest product alongside Tuzistra XR.

Vernalis’s market research has identified how best to position its individual products post-launch, given the structure of the cough cold market and the various market segments within it. Due to the inevitable overlap between some of these segments, we expect there to be some degree of cannibalisation with subsequent launches. Nevertheless, following the next wave of product launches, Vernalis will have a cough cold franchise that has a greater market potential than Tuzistra XR alone. This portfolio of differentiated products targeting different symptoms will enable greater patient stratification (as some products will be more suitable for some patients than others), albeit with a consistent marketing message of a 12-hour effect for ‘all day, all night’ cough relief.

The coming years represent a critical period for Vernalis. The salesforce is detailing two products (Tuzistra XR and Moxatag, a once-daily tablet amoxicillin formulation, launched on a restricted basis in September), with potentially two new product launches next year (CCP-07 and CCP-08). These products underpin the potential for marked revenue growth and, on our current forecasts, indicate that sustainable profitability will be achieved from FY19. Nevertheless, there remains an opportunity for future operational leverage though the acquisition of additional products to optimise the existing sales and marketing infrastructure.

Moxatag, in-licensed in 2015, is a prime example of the type of product sought. It is a relatively low-risk, add-on product that is potentially highly complementary to Tuzistra XR, as it leverages a primary care salesforce that operates in a competitively attractive space with little counter detailing and is not reliant on key opinion leader influence. Its marketing message is aligned with Tuzistra XR: both are unique ER formulations with the benefit of improved patient compliance targeted for the winter cough cold season.

Vernalis launched Moxatag into the US market in September. However, due to supply constraints, the initial launch is focused on building brand awareness and sales in a limited number of regions. Launch stocks were secured in April; in May the sole source supplier Suir Pharma went into liquidation. Vernalis is in the process of securing a manufacturing partner to restore routine supply. A new supplier has been identified, and technology transfer is underway. Management expects that the process to obtain approval under the Moxatag NDA will complete in 18-24 months, suggesting routine supply will be restored in 2019. As a result, we expect modest Moxatag sales in FY17 and FY18, with an uptick in sales from FY19 when supply constraints are lifted and promotion 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.

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 2) and Vernalis is seeking to out-license the remaining three assets (Exhibit 3) 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. The partnered pipeline has made steady progress over the course of 2016, 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 and allow Vernalis to continue with balanced investment into research activities. Currently, there are three collaboration partners, with six active collaborations, and 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 FY16 was evidenced by the receipt of milestones totalling £0.6m from Servier.

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 the trajectory of Tuzistra XR uptake and both the level of and the timeframe over which it can achieve peak sales. The second year post-Tuzistra XR launch will also lay the foundations for the cough cold franchise ahead of the potential launch of CCP-07 into the 2017/18 cough cold season.

The SWOT analysis presented in Exhibit 4 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 £371m or 71p/share (previously £393m or 75p/share). Our underlying valuation assumptions are summarised in Exhibit 5, 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 a 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 FY16 revenues (12 months to 30 June 2016) were £12.0m vs £19.9m for the18 months to 30 June 2015 (18M15) and £13.7m for the 12 months to 30 June 2015 (12M15). The change in financial year end (from 31 December to 30 June) was made to be better aligned with the inherent seasonality of the US cough cold market. FY16 revenues included the first year of Tuzistra XR sales, with net sales of £1.1m recognised. Tuzistra XR revenues are reported on the basis of deliveries to wholesalers net of any rebates, discounts and returns provisions. Research collaboration income was flat at £8.0m (18M15: £8.8m; 12M15: £7.9m), albeit with a shift towards higher FTE income in FY16 offset by reduced milestone receipts (12M15: £1.1m vs £0.6m from Servier 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 FY16 two 12.5kg API batches were delivered (£2.9m in royalties) vs three 12.5kg batches (royalties of £4.9m) during 12M15.

FY16 pre-exceptional operating costs increased to £36.6m (12M15: £30.8m) due to higher Tuzistra XR-associated costs. As FY16 was the launch year of Tuzistra XR, it is the first year that sales and marketing (S&M) costs are broken out: spend of £20.4m included 10 months of salesforce activity, the set-up and ongoing costs of the contract salesforce and promotional expenses. Conversely, R&D costs fell to £10.9m (12M15: £15.7m; 18M15: £22.6m), following the completion of in-house NCE pipeline investment and non-recurring Tuzistra XR pre-launch costs incurred in 2015. G&A pre-exceptionals was £5.3m (12M15: £6m; 18M15: £8.6m); however, a £2.65m exceptional gain was booked in FY16 (18M15: £243k) following settlement of an onerous lease obligation.

Operating loss pre-exceptionals widened to £26.2m in FY16 (or £23.6m post-exceptionals) vs 12M15: £8.2m (18M15: £12.1m) due to the increased investment in US sales and marketing infrastructure. Net finance income was again largely derived from FX gains on cash, with the FY16 figure of £8.3m (18M15: £2.7m) boosted by an £8m unrealised FX gain. 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 FY17, in the absence of new collaborations, Vernalis has guided towards lower research collaboration income as the FTE income from the Asahi Kasei collaboration has ended. Active business development dialogue is ongoing with the aim of maintaining a self-financing research business. Two Frova API batches are projected by Menarini, with one in each half-year period. We lower Tuzistra XR FY17 net sales to £3.7m (previously £7m) to reflect a lower net price due to the combined impact of patient coupons and pharmacy stocking incentives. Management’s update on the timeline for bringing a new supplier on line prompts us to moderate Moxatag sales expectations for FY17 and FY18. We now expect routine supply to be re-established in FY19. Our new revenue forecasts are £12.9m for FY17 (previously £17.3m) and £40.7m for FY18 (previously £41.9m).

Management’s operating cost guidance for FY17 is for increased US S&M spend reflecting the full-year impact of costs (vs 10 months in the prior period), the salesforce expansion and sampling of Tuzistra XR. The increase in these US$-denominated costs is magnified when translated back into sterling given the impact of US$ strengthening vs GBP. We increase forecast S&M costs to £33.1m for FY17 (previously £22.3m), but broadly maintain R&D and G&A expectations. Our new forecast operating cost is £49.7m for FY17 (vs £40.6m previously). Exhibit 6 shows changes to estimates.

On our updated forecasts (Exhibit 7), we expect Vernalis to reach sustainable profitability in FY19, with its cash position reaching a low point of £8.3m at end-FY18. However, this assumes Tuzistra XR sales meet or exceed our expectations during the next two cough cold seasons, CCP-07 and CCP-08 launch in FY18 and/or Tris milestones (totalling $46m or c £36m) become due in line with, or later than, our estimates.