Shire's Vyvanse shows an impressive growth rate

We expect to modestly boost our fair value estimate for Shire following the firm's third-quarter earnings report last week. Quarterly sales of $129 million for Vyvanse already outpace our 2010 estimate for the drug. At this growth rate, it's possible for Shire to completely replace lost Adderall XR sales by 2013 with Vyvanse. The market's acceptance of Vyvanse is better than we expected, given the now widely available Adderall XR. While only a minority of attention-deficit hyperactivity disorder patients have a problem with addiction, it appears the threat of possible drug abuse is enough to make parents switch, despite the higher cost. Higher-than-expected sales will be partially offset by higher-than-expected research and selling costs.

Fair value estimate: 1,071p ¦ Fair value uncertainty: Medium ¦ Economic moat: Narrow

Thesis (last updated 11-08-2009)

Shire boasts a narrow economic moat because of its treatment lineup for central nervous system, gastrointestinal, and genetic disorders. However, its top product, Adderall XR, accounted for 40% of sales in 2008 and lost market exclusivity in April 2009. It will take time for Shire to replace this lost revenue.

Adderall XR was the most prescribed attention-deficit hyperactivity disorder treatment in the United States, with sales of $1.1 billion in 2008. Shire was in the same position of losing its top product to generic competition in 2001 with its immediate-release version of Adderall, but managed to switch patients to the extended-release version and avoid generic threats. In much the same way, Shire hopes its newly launched ADHD drugs will make Adderall XR and its generic equivalents obsolete. However, we remain sceptical that these premium-priced drugs will warrant widespread switching from generic Adderall XR or other products on the market. None are likely to become blockbusters, in our opinion.

Although we think Shire's new ADHD drugs are unlikely to reach the sales levels of Adderall XR, we recognise their merit in certain niche markets. Daytrana, approved in 2006, is a treatment patch intended for children ages 6-12. The drug looks like an attractive option for children unable to take pills. Vyvanse, which Shire acquired with its purchase of New River Pharmaceuticals and launched in the third quarter of 2007, has a unique formulation that should prevent stimulant-related abuse. Shire hopes the drug will gain rapid acceptance as a safer alternative to Adderall XR and other stimulant ADHD drugs, despite its identical Schedule II classification under the Controlled Substances Act.

Even if successful with new ADHD drugs, Shire is likely to see profits take another hit in 2010 when HIV drug lamivudine loses patent protection. The drug is sold by GlaxoSmithKline, which pays Shire a royalty. Although royalty income constitutes just 10% of Shire's total revenues, it accounts for a big chunk of its operating profits.

Still, Shire has a promising lineup of new product candidates. Shire should diversify its revenue away from ADHD therapies because new drugs Elaprase for Hunter syndrome and Lialda for a gastrointestinal disorder serve combined markets of more than $1 billion. In addition, Shire recently acquired the rights to Phase II candidate Juvista, which could tap the potentially huge market for treating postsurgical scars. We expect Shire's pipeline candidates and new products to contribute more than half of its sales by 2010.

Valuation

Our fair value estimate is 1,071p per share, based on an exchange rate factor of 60.65p per 1 US dollar as of August 10, 2009. Despite the genericisation of Adderall XR, Shire's core products are showing 20% annual growth. Post-Adderall XR gross margins were also in line with our expectations. Although we have high hopes for Shire's ADHD portfolio, we think the new drugs will fall short of completely covering Adderall XR's lost sales by 2010. We assume the new ADHD drugs, probability-weighted for uncertain approval, will generate combined sales of about $700 million by 2010, in contrast to Adderall XR's $1.1 billion of sales in 2008. Vyvanse contributes $525 million to this 2010 sales forecast. We think Shire's licensing portfolio, mainly consisting of HIV drug lamivudine, will deteriorate by 2010 as key patents are set to expire. We think the combination of these negative events will keep Shire's ongoing operating margins in the mid-20s.

Risk

Shire's ADHD drug, Adderall XR, faces generic competition in 2009, which puts 40% of the firm's sales at risk. Although the company just launched its second of two new ADHD drugs and is developing one more in late-stage clinical trials, we don't believe Shire will recoup all of its lost sales from Adderall XR by 2010. Also, Shire's license agreement with GlaxoSmithKline for HIV drug lamivudine is at risk as the drug loses patent protection in 2010.

Strategy

Shire focuses its research efforts on three distinct fields--central nervous system, human genetic therapies, and gastrointestinal disorders. Shire pursues acquisitions that build up its pipeline and add products to these existing specialties. Shire seeks drug delivery or formulation improvements to prolong the patents of its main products and lessen the impact of generic equivalents.

Management & Stewardship

Following the retirement of Matthew Emmens, Angus Russell assumed the CEO post in June 2008. Russell had served as Shire's CFO since 1999. While relinquishing day-to-day responsibilities, Emmens will now act as chairman of the board. Shire has seven independent directors out of 10, ranging from lawyers to the former CEO of MedImmune (now part of AstraZeneca). As noted, Shire separates the roles of chairman and CEO, which promotes board independence. Also, the firm has only limited takeover provisions, which often benefit management at the expense of individual shareholders. Still, Shire has some stewardship practices in need of change. CEO and CFO stock ownership in Shire is primarily in stock options. We think this does not necessarily align shareholder and executive interests, as options carry no downside risk for the holders. Instead, we would prefer to see a greater percentage of executive stock ownership in restricted stock or actual shares. Also, Shire links its executive bonuses to revenue growth. We would prefer to have bonuses tied to returns on invested capital, which cannot be manipulated through acquisitions.

Profile

Shire is a pharmaceutical firm best known for its attention-deficit hyperactivity disorder drug Adderall XR, which accounted for 40% of sales in 2008 and faces generic competition in 2009. The company has two new ADHD drugs, Vyvanse and Daytrana, and one more in late-stage clinical trials. Shire also has products in the gastrointestinal and human genetic therapy specialty markets. Shire generates 10% of total revenue from royalties on HIV drug lamivudine.

Growth

We expect Shire's revenue to start declining in 2009 as its main product, Adderall XR, faces generic competition. However, Shire has two new ADHD drugs, Vyvanse and Daytrana, and a solid pipeline that should lessen the impact of this loss in the long run.

Profitability

We think Shire's profitability will come under pressure during the next couple of years, but we think adjusted operating margins will solidify in the mid-20s, as the firm's pipeline helps offset legacy products that succumb to generic competition.

Financial Health

Most of Shire's $1.2 billion in long-term debt is convertible. Although this position may eventually convert to equity before its 2014 due date, it puts pressure on management to execute as the firm loses key product sales.

Bulls Say

1. Shire boasts a full lineup of drug candidates that should diversify future revenue.

2. Shire should still lead the ADHD drug market even after the patent expiration of Adderall XR. By the end of 2009, the firm could have four drugs on the market to treat the disorder.

3. Shire's profitable pharmaceutical business generates large amounts of free cash flow. These resources should allow the firm to pursue further acquisitions to strengthen its position.

Bears Say

1. Shire's sales are concentrated in its main product, Adderall XR. As generic equivalents start entering the market in 2009, Shire stands to lose a great deal of its revenue.

2. Shire's royalty revenue is at risk as the patent for its HIV drug lamivudine expires in 2010. Also, Shire's gross margins should deteriorate as the firm loses the high incremental profits of royalty sales.

3. Public opinion for ADHD treatments is not positive, as some believe the drugs are overprescribed and are an unnatural way to improve performance in children.

4. Shire paid a lot for New River. Although the firm gained full rights to Vyvanse, we think that incremental benefit was small relative to the price paid.