VERTEX PHARMACEUTICALS INC annual report, FY2016

Vertex Pharmaceuticals Incorporated — 2016 Form 10-K

Business context and reporting period. This annual report covers the fiscal year ended December 31, 2016, with fourth-quarter results also presented. Vertex develops and commercializes specialty medicines, principally for cystic fibrosis (CF). Its marketed products were ORKAMBI (lumacaftor/ivacaftor) and KALYDECO (ivacaftor), approved for patient groups representing approximately 40% of the estimated 75,000 CF patients in North America, Europe and Australia.

Financial performance and liquidity

Revenue increased 65%; product revenue rose 68%. ORKAMBI growth, launched in 2015, was the principal driver, alongside higher KALYDECO sales. KALYDECO represented approximately 41% of total revenue. Research and development expense was $1.048 billion, up 5%; sales, general and administrative expense was $432.8 million, up 15%. Cost of product revenue was $206.8 million. Calculated product gross margin was approximately 87.7% (net product revenue less cost of product revenue); operating margin was approximately 0.6%.

Fourth quarter: Revenue was $458.7 million; operating income was $39.6 million; and net income attributable to Vertex was $32.9 million, or $0.13 per diluted share.

At year-end, current assets were $1.832 billion and current liabilities $792.5 million. The company had $300 million drawn on a $500 million revolving facility at December 31, 2016; it repaid that borrowing in February 2017. The facility matures in 2021 and is secured by substantially all company and guarantor assets, subject to exclusions. Other significant obligations include a $486.4 million construction-financing lease obligation and $54.4 million in capital lease obligations. The company reported $1.6 billion of contractual commitments and obligations, including facility leases.

Material changes versus the prior period

• ORKAMBI revenue increased by $628.9 million from 2015, when sales began midyear; KALYDECO revenue increased by $71.8 million.
• Operating cash flow shifted to positive $236.1 million from negative $365.4 million. Cash and marketable securities rose $392.1 million, primarily reflecting product receipts, partly offset by higher spending.
• The annual attributable net loss narrowed by $444.3 million. Vertex nevertheless remained unprofitable on a GAAP basis.
• Research and development spending increased $51.8 million and commercial and administrative spending increased $56.3 million. Research and development included a $20 million Moderna upfront payment and approximately $10 million for early-stage research assets.
• Vertex drew $300 million under a new revolving facility, refinanced and repaid its prior term loan, and received a $75 million Cystic Fibrosis Foundation Therapeutics (CFFT) program award recorded as a liability.

Outlook, risks and unusual items

• Management said 2017 results would depend substantially on ORKAMBI revenue. The company gave no clear numerical ORKAMBI revenue forecast; outcomes depend on reimbursement decisions, new treatment starts, persistence and adherence. KALYDECO revenue was expected to be similar to 2016. Management expected development expenses to increase in 2017.
• Vertex expected 2017 tezacaftor/ivacaftor Phase 3 data in the first half and planned an FDA application in the second half if results supported it. VX-152 and VX-440 Phase 2 data were expected in the second half of 2017; next-generation corrector and other pipeline programs remained subject to clinical results and regulatory review.
• A January 2017 oncology collaboration with Merck KGaA provides for a $230 million upfront payment, subject to regulatory clearance, plus potential royalties. Merck assumes development and commercialization costs for the licensed programs.
• Ex-U.S. ORKAMBI uptake remained constrained by reimbursement negotiations. France early-access sales generated $73.4 million of customer deposits at year-end, but no revenue was recognized because price was not fixed or determinable. A German pricing and reimbursement agreement was reached in the fourth quarter.
• Management cited ORKAMBI discontinuations and a slower-than-expected German launch. In a tezacaftor/ivacaftor trial for patients with minimal CFTR function, an interim futility analysis found the prespecified lung-function improvement was not met; the trial was stopped, with no safety concern identified. A Phase 2 VX-371 study met its safety endpoint but showed no statistically significant FEV1 or symptom changes.
• Key risks include dependence on ORKAMBI and KALYDECO, competition, clinical and regulatory uncertainty, pricing and reimbursement pressure, and reliance on third-party manufacturing. Supply includes single-source manufacturing for one ivacaftor process step and KALYDECO oral granules.
• Vertex received a U.S. Department of Justice subpoena in 2015 concerning marketed medicines, primarily good laboratory practices at a bioanalytical laboratory; it had responded and intended to cooperate. The filing reports no material contingent liabilities accrued at year-end. A shareholder class action was dismissed, and the appeal was affirmed in 2016.
• In February 2017, Vertex decided to close its Canadian research site and consolidate research locations; approximately 70 positions were affected, with estimated first-quarter 2017 restructuring expense of about $10 million.

Important facts for investors to verify

• Whether reimbursement expansions and patient starts support ORKAMBI growth, and whether patients remain on treatment.
• Upcoming tezacaftor/ivacaftor and next-generation corrector trial results, and whether they support the anticipated regulatory submissions.
• Completion and timing of the Merck KGaA upfront payment, and the impact of the French deposits if reimbursement terms are finalized.
• Cash generation and spending needs alongside lease commitments, credit-agreement covenants and any future borrowing.
• Changes in the fair value of contingent payments tied to consolidated variable-interest entities, including Parion; these estimates affected reported earnings.