The market has punished Vertex Pharmaceuticals (NASDAQ:VRTX) immediately following the company announcing it was discontinuing its Phase 2 study of VX-814, in patients with alpha-1 antitrypsin (AAT) deficiency, based upon safety and pharmacokinetic data.
Based on this safety profile observed, Vertex actually decided to discontinue development of VX-814. The reasons cited were elevated liver enzymes, which unfortunately were observed in several patients within the study population. Alarmingly, in at least four patients, these elevations reached more than 8 times the upper limit of what would be considered normal and safe. Based on this data, Vertex concluded that it would not be feasible to safely reach targeted exposure levels, and thus the study was stopped.
There were no significant costs outlined within the scope of the pulled study. Being in a Phase 2 research phase, which is an efficacy and safety phase, the size of the population remained relatively small (50 patients in this case), therefore no meaningful loss was made from large sampling costs or dosage production. Whilst the company has pulled this study for now, the AAT research plan continues for VRTX, and the company hopes to advance at least one additional molecule in its multiple small molecule correctors regime into 2021, as reported by Carmen Bozic, Executive Vice President and Chief Medical Officer at Vertex:
“We are grateful to the AATD patients and investigators who participated in the VX-814 studies and we remain committed to transforming the treatment of this disease. We look forward to continuing clinical study of VX-864 and other molecules targeting the underlying cause of AATD."
Almost immediately following the announcement on the 14th of October, VRTX has given away -20.81%, to $215.28 per share, at the time of writing. Back in July, we have covered VRTX with a bullish stance which the market seemed to agree, with shareholders having gained over 67% in YoY returns up until that point. Impressively, VRTX presents with many tailwinds, including CAGR revenue growth of 33.65% over the 3-year period to June on healthy gross margins of 48.57% without the margin pressure from debt or high variable costs. The inventor of the cystic fibrosis wonder drug Trikafta also positions itself well with FCF of $1.3 billion, on a margin of 27.6%, with operating cash flow of just over $2 billion up to this same time period, and an OCF margin of around 43%.
Further, the company generates high return on assets (measured from net income in this case) of 13.34%, and generates an asset turnover of $0.62 for every dollar invested into the asset base. Positive trends exist in return on capital employed of 33%, which has shown a stellar CAGR of 38.95% over the last 3 years.
So what happened? Surely, the market hasn't lost its love for this return-generating powerhouse. We are firm believers that companies that elicit the kind of returns on invested and employed capital, alongside asset return that VRTX has displayed, are generally rewarded with stellar returns in equities. We've seen it time and time again. However, another point to remember is that markets have a tendency to overreact to both good and bad news. In this light, it could be argued that this is exactly what is driving VRTX's latest sharp pullback. This potential overcorrection may provide investors with an excellent and exciting entry point for VRTX considering the tailwinds outlined in our previous analysis and also earlier in this article.
At the time of writing this article, pre-market US time, it looks like an all-out war is about to begin to test support and resistance at the new level of $215. As of yesterday, 15th October 2020, the bears had it, but with this large and potential overcorrection, participants may see the upside at the current entry point. We also see the shares as potentially oversold, having breached the RSI 30 line where bullish sentiment may garner support especially if a large herd of investors look for an entry at the beginning of today's play.
We see an exciting entry point on a stock that may run back up towards its 52-week high of around $300 a share should this pan out. Markets have a tendency to overreact to news of this kind, as mentioned. Empirical evidence supports this notion to the core, but we need to see that support at the current level in order to really bolster the case for an immediate entry. Based on the timing of this article, more market activity will need to occur in order to provide the data which can be used to make an informed decision in the immediate term.
Prior to this, support for VRTX has been relatively strong, with the stock rebounding off a relatively flat support line 4 to 5 times up until the 8th of October, where the bulls finally had it. From there, we saw an ascending pattern with the uptick in price, with price migrating north back towards the 52-week high. Volatility had been low, with downside risk contained within the range of 4-6%, which we were quite happy with.
Market sentiment really doesn't drastically change as much as this overnight, so the panic sellers that have contributed to the huge dip we've seen most recently, only fill half of the picture. So short and immediate term, the picture is blurry, but with today being Friday, and the weekend for everyone to settle down and for portfolio managers to rebalance their positions, the next week of play will be a huge test for VRTX. From here, we are anticipating the bulls to hopefully take back control, and longer-term investors realising the opportunity for reallocation of capital which is in front of them.
Building on the mid to longer term, there is a fantastic opportunity at the current level, based on the fundamental perspective for the company. In terms of health, the balance sheet is flawless; VRTX holds no long-term debt, meaning debt ratios and debt to equity are non-applicable to the analysis of the company. From a short-term solvency perspective, VRTX easily passes our scoring system, with a current ratio of 3.27x in July.
Additionally, the absence of leverage to finance operations fits the narrative that the company generates superior return on capital allocation, and receives generous return on any cash that is spent to grow operations. By this measure, VRTX is a high-quality company. With earnings season upon us, we are eagerly waiting for VRTX's Q3 filing, so that we are able to update our modelling and make the most informed decisions on the recommendations of the stock. If results are positive and above our expectations, this will provide a large driver in the run-up back towards $270-$300, should the market view the same.
On this note, investors may want to protect themselves from any further drastic movements south. By purchasing in the money November put options, with a strike of $260- $270, this limits exposure to the downside, in the event the stock does not make the run back north within this time frame. Investors would realise a decent premium on this setup, although implied volatility is difficult to estimate at this point in time. As the stock moves further south, investors have more and more opportunity to exercise the put, so the value of these options would increase further in the event of this playing out, adding additional protection via return potential for the holder.
What's also exciting for investors is the effect this sharp pullback may have on the valuation. We've assigned a terminal growth rate as we are accustomed to, with the PRAT model of DuPont, alongside the discount rate of opportunity cost between a risk-free treasury and the risk premium we've identified with equities in the S&P 500 total return. We feel this represents a fair comparison of the additional risk that would be involved with investing in most equities, over and above the risk-less asset in the treasury security. As the company holds no debt, it may be argued that the cost of equity for the company may be an appropriate measure for the appropriate discount factor, however, we would also argue the opportunity cost of holding the index is an equally suitable proxy.
With these implied inputs, it is clear that in order to maximise on the recent downturn in price, that VRTX would need to grow revenues and FCF by about 10-12% to fit the story of an undervalued or cheap stock. In our base case, the stock still seems expensive, and with the uncertainty at play, may not justify the case for immediate entry for deep value players. What does offset this point, however, is the likelihood that the market will continue to view VRTX's fundamentals in the same positive light they have been doing so, up until this point.
Therefore, with any further movements south, this may provide an exciting opportunity for these value players, who would seek an entry with a contrarian viewpoint to the market. We are also in favour of this viewpoint, and believe that there is potential for the scenario to play out.
At this point, we don't feel it necessary to explore the many ratios that could be applied to the company, such as P/E, PEG, P/FCF and so on, particularly due to this most recent large overcorrection. Doing so would be futile, because it wouldn't reflect the long-term sentiment of the company, nor the markets position, and only a very short-term view. We aren't traders, we are investors, so the day-to-day doesn't apply to us. Additionally, further evidence of the data is required over the coming days and weeks to establish a firm position on valuation from the ratio analysis.
At this point in time, the biggest risk is that the market continues to punish the stock and it continues to be traded down, perhaps breaching the $200 per share mark, and shareholders continue to forgo large return potential beyond this point. This would gain some attention from many contrarian players, who might relish the dislocation in market pricing and the fundamentals, as we most certainly currently do. However, the risk lies in the panic that has been created by this large dip, where support needs to be regained at the current level to drive the price back to its happy territory, around $270 and above.
Furthermore, with these massive downturns in price, investors may not realise the compensation for the exposure for the downside. Investors should therefore consider the options strategy outlined above, considering the November put options with the higher price. Should the stock continue south drastically, the value increase in these contracts would further offset the capital losses, should these be realised in the case of an investor exiting their position.
Additionally, any further bad news that comes out for VRTX would be truly painful, and shareholders would be the ones feeling that pain. For the company, their operational trajectory remains largely unchanged, so it would be investors who bear the brunt of the bad news, and management for that matter.
Otherwise, the risks seem to be purely market-related, not credit-related or company-related. Once VRTX is able to continue the study, solve the pharmacokinetic issues surrounding the efficacy of the compound, then the market may choose to overreact and give the support the company arguably deserves.
This recent drop may provide investors with the entry point they have been seeking with VRTX, albeit with the uncertainty around valuation. Without the market data to provide the most sound reasoning possible, speculation rules the decision-making on immediate entry. The coming days and weeks will be the real test for the company, particularly as we approach earnings season, and should the company beat ours and the Street's estimates there, investor sentiment is likely to return to positive once again.
We would advocate to consider the options-hedging strategy outlined, and keep a close eye on the stock, with any support gained at this new level as a good indicator the run-up may be on its way. Look for a break from support at the current level, and look for the bulls to regain control and drive the ship back up towards $250-270. We are confident that's where this stock belongs, for now.