Buy Vectura (VEC) at 44.25p

Says James Faulkner of specialist small cap website WatsHot.com

Investors in inhaled drugs specialist Vectura have been left gasping for breath of late, as the firm's shares took a hammering in March when its partner Sandoz announced it was handing back the US rights to VR315, a generic respiratory drug widely believed to be a generic version of GSK's hugely successful Advair. Given that this only affects the US and not Europe, and given that VR315 is only part of Vectura's exciting portfolio, it seems that this savage sell-off has been overplayed. Moreover, EU regulatory submissions for VR315 are underway, which could result in significant upside. As with all biotech companies, there is considerable risk, but this is partially mitigated by the lowly valuation and the large net cash position. The free red hot penny share tip is a Speculative buy.

The Business

Vectura is a UK-based speciality pharmaceuticals company focused on the development of inhaled drugs mainly for respiratory diseases - a market which is anticipated to grow from c.$23 billion to c.$47 billion during the next four years. The group currently has eight products marketed by its partners and a portfolio of drugs in clinical and pre-clinical development, some of which have been licensed to major pharmaceutical companies.

The Pipeline

The main driver for Vectura's business is its relatively diverse R&D pipeline, centred on inhaled drug therapeutics. In terms of revenue generating potential, the main focus for investors are four compounds: NVA237, QVA149, VR315 and VR632. The first two are licensed to Novartis and in development for chronic obstructive pulmonary disease (COPD), while the latter two (excluding the US rights to VR315) are both licensed with Novartis' generics division, Sandoz, and in development for both COPD and asthma. In addition to these drugs, Vectura possesses a host of other compounds - for the treatment of Parkinson's disease, cystic fibrosis and erectile dysfunction to name but a few - that have yet to find licensing partners.

VR315

VR315, believed to be a generic version of GSK's Advair, is what has been causing all the fuss around the share price lately. I will attempt to explain why I believe this fuss has been overdone.

Firstly, this does not preclude Advair going ahead in the US. Vectura has regained the US rights to VR315, along with a $9.5 million non-refundable payment. Sandoz retains a right of first negotiation option to the programme, and has provided a ring-fenced $25 million five-year loan to fund continued development of VR315 in the US. The additional cost to Vectura of going it alone with VR315 has been estimated at $17 million, which isn't all that much considering the potential royalties involved.

Secondly, The EU rights to VR315, still held by Sandoz, remain unaffected. EU regulatory submissions for VR315 are underway, which could result in significant upside for Vectura. As observed by broker finnCap: "Vectura receives a EURO1.5m milestone on approval in each of the EU5 and a 15% royalty on sales. GSK's sales of Advair in Europe last year were GBP1.6bn. Conservatively if Sandoz achieves GBP400m sales this results in GBP60m royalties to Vectura at nil cost, i.e. all profit."

Thirdly, Sandoz also holds the European rights to VR632, widely assumed to be a generic version of AstraZeneca's Symbicort. However, Vectura retains rights to the US, where it could be sold as a branded product (as no Symbicort DPI is approved in US). The potential for this drug is also significant, as Symbicort is another blockbuster drug.

Finally, the market has lost sight of where the majority of the value lays...

NVA237 & QVA149

NVA237 and QVA149, both of which are both patent-protected, branded products with regulatory filing due in 2011, are bronchodilators which work through expanding the airways to the lungs. Thus far, test data indicate that both drugs are superior to the competition and it is hoped that QVA149, a combined therapy of NVA237 and Novartis' Indaceterol, will come to dominate the market for COPD. While this would be the ideal outcome, rejection of the combined therapy would not affect the chances of NVA237 making it alone. The COPD market is forecast to be worth $10 billion in 2010. QVA149 entered Phase III trials in 2010, triggering a $7.5 million milestone payment to Vectura from Novartis.

Upon the commencement of Phase III tirals, Vectura CEO Chris Blackwell commented: "The data from the two Phase II QVA149 studies presented at the annual congress of the European Respiratory Society in Vienna in September 2009 were very encouraging and demonstrated the benefit of combining two potent bronchodilators in a convenient once-daily therapy with an attractive efficacy and safety profile. This is the first once-daily LAMA/LABA combination product to enter Phase III trials and, with an anticipated filing date of 2012, could provide an important future addition to the available treatment options for COPD."

Meanwhile, Phase III trials on NVA237 commenced in June 2009 and Novartis has stated that it expects to file for approval in 2011. Crucially, neither of these two drugs are affected by recent asthma-related concerns at the US regulator, the FDA, which apparently prompted Sandoz to hand back the US rights to VR315.

According to broker FinnCap, Novartis' commitment to NVA237 and QVA149 is "beyond doubt". Vectura stands to receive $70 million in milestones from these two products between now and regulatory approval, and an estimated 5% royalty on sales thereafter.

Existing royalty revenues

The firm currently generates annual royalties to the tune of around GBP15 million per annum. These include products for the treatment of asthma, renal failure and haemophilia.

Valuation & Recommendation

In the words of broker FinnCap, there is "clearly a disconnect" between the market's reaction to recent events and the reality of the overall situation for Vectura. The company has a well diversified and highly attractive pipeline of products, many of which hold significant upside potential for the shares should they come to market. VR315 is by no means a write-off and is but one of these products; indeed, it is the branded products - NVA237 & QVA149 - that are likely to be the main revenue drivers in the future. A near-50% drop in the share price since the US rights to VR315 were handed back to the company therefore seems unjustified.

And now for the tricky part...

There is no sure-fire method for valuing loss-making biotech stocks. Researcher Edison has a risk-adjusted net present value of GBP290 million (more than double the current market cap), but this only takes into account the four key inhaled drug programmes, net cash and existing royalty revenues. There could be further upside in the event of Vectura securing a development partner(s) for any of its earlier stage projects. Alternatively, FinnCap values the firm at net cash (GBP64 million) plus 2x revenues (low for a pharma), which suggests a core valuation of GBP144 million. However, it points out that the current valuation (GBP123 million) leaves no room for the potential near-term royalty from VR315. Conservatively, if we assume sales of GBP400 million in Europe for VR315, this would result in GBP60 million royalties to Vectura at nil cost. Ceteris paribus, valuing the business on the same metric (cash + 2x revenues) would suggest a 1-year target valuation of GBP225 million. Speculative buy.

Key Data

EPIC: VEC
Market: AIM
Spread: 44p - 44.5p (1.12%)

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