Vectura Group Following A Familiar Path

Investors who like Nektar Therapeutics (NASDAQ:NKTR) or Alkermes (NASDAQ:ALKS) may want to take a look at Britain’s Vectura Group plc (OTC:VEGPF) (VEC.L). Although not a household name, Vectura has established itself as a technology leader in the formulation and manufacture of inhaled drugs and devices to administer these drugs. Vectura boasts a key partnership with Novartis (NYSE:NVS) for potential blockbuster Ultibro as well as Seebri, as well as a diverse pipeline of generic and branded respiratory drugs.

Vectura Group has multiple avenues to growth. The company can continue its policy of being a partner of choice for companies that wish to enter the large (and still under-served) market for therapies for respiratory ailments like COPD and asthma, or the company can choose to start developing and commercializing drugs on its own – transitioning from earning mid-single digit to mid-teens royalties to being a more fully fledged specialty pharmaceutical company. While there are risks associated with the performance of its licensing partners, clinical development risks, and potential risks from a long-term change in strategy, I believe Vectura could be almost 50% undervalued today.

Readers considering these shares should note that the U.S. ADRs are of the “F-type” and not very liquid. The London-listed shares (VEC.L) are considerably more liquid and most major brokerages will allow clients to trade on major foreign exchanges like the LSE.

A Respiratory Specialist

Both Nektar and Alkermes got their start by applying their specialized knowledge and technologies to drug development partnerships with major pharmaceutical and biotech companies – accepting small royalties (as a percentage of sales) but taking on little-to-no R&D expense or clinical risk in the process.

Vectura has followed a similar path with its specialty in inhaled products. Vectura has the second-most patents for dry powder inhaler (or DPI) formulations and devices, behind Boehringer Ingelgeim, and is in the top overall for inhaler patents over the last 15 years. Vectura is no only able to transform drugs into dry powder formulations, the company offers devices like the Clickhaler, OmniHaler, Duohaler, and GyroHaler (the latter being similar to the Diskus inhaler used to administer Advair).

This dual drug and device focus is important, particularly when it comes to developing generic equivalents of respiratory drugs. It has been more challenging for companies like Teva (NYSE:TEVA) to copy bestselling drugs like Advair because it is not enough to prove that the underlying drug is the same, there must also be a delivery device that functions similarly to the original approved device. Device development is beyond the scope of what most generics can do, elevating Vectura as a partner of choice in developing generic respiratory drugs.

A Strong Roster Of Products

Until fairly recently, Vectura was a story about the future as approved products like Asmabec Clickhaler (marketed in Europe by Recipharm) and Meptin Clickhaler (marketed in Japan by Otsuka) weren’t all that significant. Likewise, Vectura did generate some revenue from licensing relationships outside of its respiratory focus, including a relationship with Baxter (NYSE:BAX) for ADVATE, Adept, and Extraneal.

More recently, Vectura has started seeing the benefit of significant new respiratory products. Vectura has licensed NVA237, a long-acting muscarinic receptor agonist (or LAMA) to Novartis. NVA237 has not only been developed and launched as a standalone drug in Europe (Seebri), but also as part of the Ultibro LAMA/LABA combo. Novartis has seen its U.S. FDA submission timelines slip for both drugs, but launches in 2016 are still probable and Ultibro nevertheless looks like a potential blockbuster. There will be competition, including BI’s Spiriva-Striverdi combo, GlaxoSmithKline‘s (NYSE:GSK) Anoro, and a combo from AstraZeneca (NYSE:AZN) but this is a large enough market to allow multiple winners.

Novartis (through its Sandoz subsidiary) has also licensed and launched AirFluSal Fospiro in multiple European markets. This drug is a generic form of Advair that has thus far been priced very competitively to Advair (at a roughly 15% discount) and may not have much near-term competition. The U.S. development process has taken a little longer, but a launch in 2016 or 2017 seems probable. Vectura does have a U.S. licensing partner for this drug, but the identity has not been revealed.

Beyond these, Vectura also has a generic version of Flovent (VR506) in clinical development, as well as a generic Symbicort (VR632). Glaxo has also licensed formulation IP from Vectura for its Breo, Relvar, and Anoro respiratory drugs (though royalties are capped at GBP 13M/year). Vectura has a development partnership with UCB for an inhaled biologic, as well as a 35% stake in a joint venture (Kinnovata) looking to create new branded generic DPI versions of existing respiratory drugs.

Activaero Provides New Options

Earlier this year, Vectura paid $181 million to acquire Activaero – an early-stage pharma technology company similar to Vectura in many respects. Activaero has focused on developing a proprietary nebulizer technology that matches patient breathing patterns to drug administration and allows for lower doses and shorter inhalation times.

Activaero brought with it numerous clinical development partnerships covering a range of diseases and treatments with partners like Grifols (alpha-1 antitrypsin deficiency), Ventaleon (severe influenza), Sterna Biologicals (asthma), and an undisclosed partner for pulmonary hypertension.

Activaero also has two unpartnered proprietary programs – Favolir for severe adult asthma and Scipe for severe pediatric asthma. The former is in Phase III development in the EU (Phase I in the U.S.), while the latter is in Phase II in both the EU and U.S.. Both of these compounds are inhaled forms of budesonide (a corticosteroid) and could address $400 million global opportunities (each) with just one-quarter penetration of the EU and U.S. severe asthma patients who are not well controlled with current therapies.

Time For A Change?

Activaero also may represent an opportunity for Vectura to change its business plan and become more of a true specialty pharmaceutical company than a technology developer and licensing partner. Right now, Vectura gets a a mid-single digit royalty for its branded drug partnerships and a mid-teens royalty for its generic partnerships; those numbers sound low, but then remember that the company is not taking on direct clinical risk nor funding large-scale clinical trials and the margins on that revenue are high.

Vectura is likely to become free cash flow positive this year and is looking at a revenue growth rate of over 20% over the next five and 10 years. With that, I believe you can argue that Vectura has the financial flexibility to consider keeping more products in-house, taking on the R&D/clinical risk, and keeping 100% of the profits for successful drugs. Favolir and Scipe could likely be handled with relatively smaller specialty sales forces, at least in Europe, and the addition of Activaero’s technology significantly expands the range of potential future drug development – particularly as reformulating existing compounds into dry powder formulations would not require a large primary R&D effort.

Estimating The Value

For the time being, I do not value Vectura on the assumption that it will become a true specialty pharmaceutical company. Instead, I value the company has a high-margin royalty collector well-placed to benefit from the growth of Novartis’s sales of Ultribro and Seebri as well as its generic pipeline. I am looking for long-term annual revenue growth of over 20% over the next decade, with free cash flow margins reaching the mid-to-high 40%’s. Discounted back, I arrive at a fair value of almost GBP 200p, or about $3.20/ADR. My revenue projections are risk-adjusted and could therefore increase as clinical/regulatory milestones are achieved.

As I said before, I’m valuing the company as if it will license out Favolir and Scipe as it has done with other compounds in the past. I believe these programs are worth about GBP 40p/share today, but keeping them in-house could ultimately be worth over three times as much (though at the cost of higher spending and higher risk).

The Bottom Line

Vectura’s technology makes it an attractive partner in the respiratory space, but the relatively low royalties it is owed from Novartis likely reduces the incentive that company might have to acquire Vectura. On the other hand, if Novartis (or another pharmaceutical company) wants to establish a strong IP/technology foothold in respiratory drug development, an acquisition could certainly make sense.

As it is, I think Vectura has compelling technology and is looking forward to a significant ramp of revenue, profits, and cash flow. While there is uncertainty as to whether management will shift its strategy and become more of a drug company than a drug technology company, I do see enough upside in either case to make these shares worth a closer look today.