Vernalis — Update 6 April 2016

Vernalis launched Tuzistra XR, its first prescription-only, extended-release, reformulated cough cold medicine, into the US market in September 2015. This launch represents the first step in Vernalis’s transition into a commercial-stage speciality pharma company, targeting a $3.5bn market opportunity (at brand pricing). Management has emphasised that year one of commercialisation is less about hitting a target sales level and more about establishing the platform for future sales growth of Tuzistra XR, and of its developmental-stage cough cold products once they reach the market. However, the financial performance of this franchise, in particular during its second year on the market, could have an important bearing on whether Vernalis will need to raise additional funds in the near term. We discuss this later in the report, after presenting a SWOT analysis for the cough cold portfolio in Exhibit 1 and examining some of the early launch trends overleaf.

H116 results provided the first update on launch progress. Trade distribution began in August 2015, with active promotion of Tuzistra XR beginning in September. Net sales (based on deliveries to wholesalers minus any rebates or discounts) to the end of December 2015 stood at £0.6m.

As with any product targeting the primary care market, there remains a degree of uncertainty at such an early stage in the launch regarding launch trajectory, the speed at which sales ramp up and the peak sales level that will ultimately be reached. We forecast peak sales of $240m for Tuzistra XR, which contains codeine polistirex (to suppress the cough reflex) and chlorpheniramine polistirex (an antihistamine to relieve allergic symptoms) as its active pharmaceutical ingredients (APIs). Its primary market segment is codeine plus antihistamine treatments, which is valued at $470m at current brand pricing.

We estimate aggregate peak sales of $500m across the portfolio of cough cold products, which includes an average peak sales estimate of $65m per product for the remaining four cough cold products (despite the likely variability of their peak sales potential) on the basis that the launch order and APIs are undisclosed. We intend to refine our estimates following further disclosure. At this point, our total aggregate peak sales value equates to c 14% of the $3.5bn total branded cough cold prescription market for the five products based on June 2015 prescription data using an estimated net price per scrip of $100.

Tuzistra XR’s slow launch into a mild cough cold season suggests that FY16 consensus forecasts for the product will fall as product sales are unlikely to ramp up sufficiently in the second half of the financial year. From launch to end-February 4,571 Tuzistra XR prescriptions were written; £0.6m in net sales recorded included stocking into wholesalers and pharmacies. Nevertheless, a disappointing launch from a financial perspective is offset by the solid operational progress so far, which has established a foundation for the cough cold franchise.

The commercial focus for Vernalis’s 80-strong salesforce is on (1) generating and improving awareness of Tuzistra XR so that physicians are prescribing the product, and (2) ensuring patients are able to fill their Tuzistra XR scrip. Accessibility to Tuzistra XR both physically (through being stocked at pharmacies) and financially (by gaining formulary coverage and minimising out of pocket expenses to the patient) are critical factors for facilitating the latter.

Steady progress is being made on both these fronts and encouraging trends are being seen, despite a cough cold season that is far from ideal from a new product launch perspective. As illustrated by Exhibit 2, the 2015/16 cough cold season has had a very mild start (weekly TRx down c 25% on prior year to January 2016) and is peaking later (weekly TRx down c 15% between September and February) than the typical October to February pattern. This inevitably has resulted in fewer potential patients presenting at their doctors with symptoms, and thus fewer opportunities for physicians to have Tuzistra XR and its marketing message at the front of their minds.

Vernalis has emphasised that Tuzistra XR has broad applicability across both the codeine and hydrocodone segments of the cough cold market, and Rx are seen across both. With the passage of time, the company is becoming better informed regarding traction with target audiences. Predictably, areas seeing high levels of Rx are those where there are early adopter physicians and favourable insurance coverage. Market research is ongoing to assess whether there is growth in physician awareness of Tuzistra XR over time and whether this is leading to increased market share. Further detail is expected to be shared at prelims in September.

At launch, longer-term targets of 75-80% Tier 3 formulary coverage for Tuzistra XR at brand pricing, targeting a net price per Rx of up to $100, were set out. To date, Tier 3 coverage has been achieved at c 55% of plans, with a net price per Rx of $70-75. This net price per Rx is lower than the $90 anticipated for the early launch stage in part due to a lower average volume of product per Rx. Exhibit 3 provides an anonymised reconciliation of the wholesale acquisition cost (WAC) of $177 per average 168ml Rx (lower than the $192 per 180ml Rx assumed at launch) paid by the insurer to Vernalis, to the net sale price per Rx. Patient co-pay levels are higher than had been anticipated, through the two ongoing co-pay assistance programmes comprising e-vouchers (for pharmacies) and coupon cards (distributed to the physicians). This is an area of focus for Vernalis as a critical factor in commercial success includes minimising the cost to the patient.

Vernalis’s ongoing initiatives to build physician awareness, boost pharmacy stocking and decrease the cost to patients should all help increase market share, and facilitate continued prescribing into the next cough cold season. There will also be a shift in rep training ahead of the launch of the spring allergy campaign, where the emphasis will be on cough due to allergy, as indicated in Tuzistra XR’s label. A successful campaign should ensure that Tuzistra XR Rx growth continues in the off-season as reps maintain their dialogue with physicians, albeit with a different message.

Equally importantly, the company is striving to improve formulary coverage to increase market share/minimise insurance rejections. These activities will have a longer-term outcome as formulary listings are typically multi-year. As mentioned earlier, CVS Caremark is the notable gap in current coverage, and Vernalis is working with CVS Caremark to support a formulary decision, however, the timing of such a decision is ultimately determined by priorities at the pharmacy benefit manager.

Vernalis is addressing all the major factors affecting its potential market share and rate of Tuzistra XR uptake; however the most fundamental driver of demand – the relative severity of the cough cold season – is outside of its influence. Assuming a solid foundation going into the 2016/17 cough cold season, the second year of Tuzistra XR’s launch should provide better insight into its sales potential. Critically, it will also determine whether Vernalis will need to raise additional funding.

Cash and equivalents stood at £54m at end-December 2015. The expectation when Vernalis last raised equity in 2011 (£65.9m net) was that it would have sufficient runway to reach sustainable profitability. However, this is contingent on the level of Tuzistra XR sales in FY17 and FY18 and the timing of success-based milestone payments to Tris. There is presently limited visibility on revenues, in part due to the slow and early stage of the Tuzistra XR launch. Conversely, operating costs and milestones are more apparent: we forecast operating costs of c £40m pa over the next two years (with limited room for cost savings) and estimate that $46m (c £32m) in milestone payments to Tris remain in FY17 and beyond. Our current forecasts suggest that Vernalis becomes sustainably profitable in FY18, with its cash position reaching a low point of £1.7m at end-FY18.

Four additional cough cold programmes remain in active development. The next most advanced, CCP-07 and CCP-08, are in pivotal bioequivalence studies, and are currently on track for NDA filing by end-2016. CCP-07 is the more advanced of the two, having already completed its single dose PK study. Due to the different technical challenges between different molecules, formulation work continues with CCP-05 and CCP-06, with PoC anticipated during the 2016 calendar year.

Vernalis intends to launch its recently acquired antibiotic Moxatag, a once-daily tablet formulation of amoxicillin, into the US market by mid-calendar 2016. Its marketing message is aligned with Tuzistra XR, and as such it is an ideal companion product for the salesforce. Both are unique extended release formulations with the benefit of improved patient compliance targeted for the winter cough cold season. This compliance point is especially pertinent to antibiotics.

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). A key difference, however, is that as well as having a coupon programme, Vernalis will be able to sample Moxatag. This should circumvent any issues with pharmacy stocking or reversals as a Moxatag sample will ensure a patient has a dose for the first 24 hours of treatment (a treatment course is 10 tablets over 10 days) and the pharmacy will see demand before having to routinely stock Moxatag. Vernalis estimates c 2.1 million patients are treated with amoxicillin each year by primary care physicians; these are the target audience for switching. Hence, the peak net sales potential is c $20m. Ahead of launch, we add Moxatag sales estimates to our financial forecasts and valuation.

Moxatag’s characteristics are a prime example of the type of product Vernalis is seeking to optimise its existing sales and marketing infrastructure. 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 brand-type switching message, rather than one reliant on key opinion leader influence.

As Vernalis moves into the commercialisation phase for the cough cold portfolio, the near-term sensitivities have shifted towards Tuzistra XR sales growth. Key challenges remain ensuring adequate pharmaceutical supply and distribution of Tuzistra XR; ensuring stocking at pharmacies; gaining broad Tier 3 unrestricted formulary coverage; minimising patient out of pocket expenses and the speed and efficiency of the salesforce in executing its strategy and particularly in converting prescribers from immediate release to extended release formulations.

The first two years of launch will be critical in laying the foundations for the cough cold franchise, and also in determining whether Vernalis has sufficient funds to take it through to sustainable profitability. With operating costs well understood and reasonable visibility on when milestone payments are due to Tris, the level of Tuzistra XR sales is a major sensitivity.

The cough cold development pipeline is relatively low risk compared with mainstream pharma/biotech, is lower cost and the reformulation technology is proven through market approval for Tuzistra XR. We also highlight the high barriers to entry given the difficulty in creating a liquid formulation that the FDA will approve due to the challenges in maintaining stability.

The dynamics of the cough cold market are sensitive to government policy; eg DEA rescheduling of hydrocodone has caused some shifts in the market, but we note the Vernalis is well placed to cover these shifts through the development of a range of products covering other active ingredients.

Our DCF valuation has decreased to £384m (86p per share), down from £439m, or 99p per share, using a 12.5% WACC across the development portfolio with the exception of Tuzistra XR and Frova at 10%, our standard WACC for a commercial-stage product. Our assumptions are summarised in Exhibit 4. Underlying valuation assumptions remain consistent with our November 2015 report (A player in the US prescription cough cold market), although we have made the following changes:

Vernalis’s financial results for the six months to 31 December 2015 (H116) showed increased total revenue of £6.1m (up from £5.7m in H115), which included first Tuzistra XR revenues. Net Tuzistra XR sales of £0.6m were recognised; these revenues are reported on the basis of deliveries to wholesalers net of any rebates, discounts and returns provisions. Research collaboration income was flat at £3.8m, albeit with a shift in the split between FTE income and milestones: higher FTE income in H116 was offset by reduced milestone receipts (H115: £0.4m vs £0.2m received from Servier in H116). In both H115 and H116, one Frova API shipment was made to Menarini; however, due to negative FX impact and pricing pressure royalty revenues fell slightly to £1.6m (vs £1.7m).

In H216, Vernalis has guided towards one additional Frova API shipment, although following patent expiry in December 2015, volume and pricing are likely to be lower. So far, genericisation has had an impact in some European territories but not others. The research business will remain self-financing, with guidance that collaboration income will continue at similar levels to H116. H116 sales figures and current Rx data for Tuzistra XR suggest our full-year sales expectations are ambitious; we cut these to £1.26m (previously £5.8m). Consequently, we now forecast FY16 revenue of £11.9m (vs £15.9m previously).

Total operating costs pre-exceptionals were £19m (H115: £9.9m) reflecting increased Tuzistra XR-associated costs. Following Tuzistra XR launch in September, sales and marketing costs of £10.8m have been broken out; these include circa four months of salesforce activity and include the set up and ongoing costs of the inVentiv contract salesforce as well as promotional costs. R&D spend fell to £5.6m for H116, a 22% decrease from £7.1m in H115, largely due to completion of Vernalis’s in-house investment in its NCE pipeline and non-recurring Tuzistra XR pre-launch costs incurred in the prior period. G&A pre-exceptionals stood at £2.6m in H116 (H115: £2.8m), although this was offset by an exceptional £2.6m gain due to successful settlement of an onerous lease obligation.

Vernalis had guided that annualised H116 R&D and pre-exceptional G&A spend provide a “reasonable” run rate for ongoing future annual costs, while sales and marketing spend will increase in H216 as it will relate to the full six-month period. We forecast FY16 operating costs of £40.5m (vs £41.8m previously) and £40.6m in FY17.

Operating loss before exceptionals widened to £13.5m (or £10.9m post-exceptionals) vs £4.3m in H115 due to the increased investment in US cough cold sales and marketing infrastructure. Net finance income decreased to £2.9m from £4.6m in H115, although this was primarily due to FX effects with an unrealised FX gain of £2.8m and £4.5m respectively on translation of cash and investments from US dollars. Interest earned on cash balances was flat at £0.1m for both periods. Vernalis holds 66% of its cash in US dollars and a translation loss or gain is recognised at the end of each period at the prevailing exchange rate. Normalised PBT includes net financial interest but excludes other financial income from forex gains and losses. We forecast a £30m operating loss for FY16, and normalised PBT loss of £28m.

Cash and equivalents stood at £54m at end-December 2015. On our current forecasts, we expect that Vernalis will reach sustainable profitability in FY18, with its cash position reaching a low point of £1.7m at end-FY18. However, this is contingent on Tuzistra XR sales meeting or exceeding our expectations during the next two cough cold seasons and/or Tris milestones ($46m or c £32m in aggregate) becoming due in line with, or later than, our estimates. If a slower ramp in Tuzistra XR sales than forecast is achieved, Vernalis would have a short-term funding requirement in FY18.