Earlier this month Vanda Pharmaceuticals produced the biggest pharmaceutical sector surprise of 2009 when the FDA approved for marketing its atypical antipsychotic drug iloperidone (Fanapt).

Fanapt has had the most circuitous path towards FDA approval of any compound we know save for perhaps Celgene’s Thalomid. Iloperidone started as a molecule discovered by Hoechst Marion Roussel before it merged with Aventis and later became Sanofi-Aventis. Hoechst Marion Roussel gave up on the compound and out-licensed it to Titan Pharmaceuticals (OTC: TTPN) on the last day of 1996.

Titan didn’t keep iloperidone to itself for very long before out-licensing it that same year to Novartis, which then pushed it into phase 3 testing. Novartis tested iloperidone in three short-term phase 3 studies and three long-term studies in over 2,000 patients but then gave up on the drug after it failed to show superiority to currently marketed atypical antipsychotics in reducing prolongation of the QT interval (a potentially dangerous heart condition). This is where Vanda stepped in.

Novartis iloperidone short-term phase III studies

Vanda Pharmaceuticals’ (Nasdaq: VNDA) whole existence is a result of iloperidone. A onetime executive of Novartis, Mihael Polymeropoulos, saw that iloperidone would be languishing at Novartis, quit his job at Novartis, raised a bunch of cash (including some from MedImmune which is now owned by AstraZeneca), and founded Vanda to in-license iloperidone and continue development of the drug in 2004.

Vanda in-licensed iloperidone from Novartis in exchange for $500,000 in upfront cash, potential milestone payments worth “less than $100 million” (mostly based on Fanapt reaching certain sales levels), and an approximate 25% royalty on any sales of iloperidone.

Vanda pushed Fanapt into another large phase 3 study and eventually filed for its FDA marketing approval in 2007. In 2008 the FDA issued a non-approvable letter for Fanapt and requested additional studies comparing it to already approved atypical antipsychotics like Zyprexa or Risperdal (invoking memories of Neurocrine’s unprecedented FDA issues striking once again).

Vanda ignored the FDA’s requests for comparative studies (Fanapt had already been tested against another atypical antipsychotic, Geodon) and submitted its approvable letter response later in 2008. With Vanda’s shares trading at less than the value of its net cash up until May 7, it’s safe to say that the market wasn’t ascribing much value to Vanda’s pipeline or Fanapt.

We all know the unlikely conclusion to the iloperidone/Fanapt story: after getting marketing approval for the drug earlier this month, Vanda’s share price has risen an incredible 1205% and Vanda is now sporting a $375 million market capitalization (as of June 01). Now that Vanda has gone from a drug development story to a drug commercialization one, the question is how strong will iloperidone sales be?

No Way Fanapt Gets To $1 Billion In Sales

The first point that we want to make is that there is no way that Fanapt will get to $1 billion in sales if Vanda is marketing it only in the U.S. with approval to treat schizophrenia. Fanapt is going to be the seventh atypical antipsychotic on the market in the U.S. with several more potentially on their way.

Let’s first flesh out the schizophrenia market opportunity that Fanapt is facing:

The branded and generic atypical antipsychotic drug category is a crowded one with six main branded compounds, their derivatives like extended release formulations and depot injections, and several generic atypical antipsychotic drugs as well.

Despite the fact that there are so many atypical antipsychotics on the market (not to mention the multiple genericized “typical” antipsychotics as well), the market opportunity for atypical antipsychotics worldwide was upwards of $20 billion in 2008 according to IMS Health. Atypical antipsychotic compounds like Eli Lilly’s (NYSE: LLY) Zyprexa and AstraZeneca’s (NYSE: AZN) Seroquel generated worldwide sales of $5.0 and $5.4 billion respectively last year.

The reality of the matter is that the market opportunity for Fanapt at this point in time is actually much smaller than $20 billion. First of all Fanapt is only approved in the U.S. and the U.S. market opportunity for atypical antipsychotics was approximately $12.8 billion in 2008.

Secondly, all of the other atypical antipsychotics are approved for marketing in multiple CNS disorders like the bipolar disorders or depression. At this point in time, iloperidone is only approved for use in schizophrenia. Cowen and Company estimate that schizophrenia accounts for “approximately 50%” of the broader antipsychotic market (atypical and typical antipsychotic agents).

Off-label usage of Fanapt in bipolar and the other CNS disorders is likely to some small extent but Fanapt’s current label indicating it only for  second-line schizophrenia cuts down the on-label market opportunity to $6.4 billion if the usage of atypical antipsychotics in schizophrenia is at roughly the same 50% rate as the usage of all antipsychotics in schizophrenia. (source: Cowen and Company)

Vanda has indicated in the past that Fanapt will be competing among the 50% of atypical antipsychotic users that end up switching their therapy due to ineffectiveness or side effect issues like weight gain. If this second-line schizophrenia indication represents 50% of the atypical antipsychotic market opportunity in the U.S. as Vanda suggests then that means that the market potential for Fanapt in the U.S. will be $6.4b*0.50= $3.2 billion.

Vanda 2006 corporate presentation showing iloperidone target market

Now that we’ve shown that the on-label schizophrenia market for iloperidone is much smaller than it looks at first blush, it’s also important to realize that Vanda will only have marketing exclusivity for iloperidone until late 2016 in the U.S. and 2015 in Europe assuming it receives the standard six-months extra of marketing exclusivity for running pediatric studies with Fanapt.

This short marketing window probably means that iloperidone is dead in the European Union. Vanda hasn’t even filed a marketing application for it over there yet and from marketing application date to drug approval (assuming no hiccups along the way) it will take Vanda or its potential partner at least 15 months and then up to a year to work out reimbursement issues in many EU countries. The reference pricing reimbursement systems in effect in many European countries like France also means that Vanda’s marketing partner also won’t likely be achieving very favorable margins on sales of Fanapt considering that nearly all the atypical antipsychotic compounds with be genericized in Europe in the next couple of years.

Now back to the U.S.: The main reason why iloperidone won’t get to $1 billion in sales is that it has taken Fanapt’s closest competitor, Geodon, eight years to eclipse the $1 billion sales mark. Since Fanapt will primarily be used as a second-line atypical antipsychotic like Geodon, we can’t compare other recently approved antipsychotics like Abilify to Fanapt.

Geodon was approved for marketing February 2001 and only last year reached $1.07 billion in worldwide sales by Pfizer. With Fanapt losing marketing exclusivity in 2016 and being launched later this year, Vanda will have roughly eight total years of generic free competition for Fanapt in the U.S.

Add in the facts that Pfizer’s sales resources are much greater than Vanda’s, Geodon has been approved in many more markets than Fanapt has been, Geodon has been approved for bipolar disorder as well (LEK Consulting estimates 20% of atypical antipsychotic prescriptions are for bipolar disorder), and that Fanapt will be facing a much more genericized atypical antipsychotic market and it is hard to see how Fanapt’s sales will be able to ramp up fast enough to get above $1 billion in sales by the time its marketing exclusivity runs out in 2016 even accounting for Fanapt’s efficacy and safety profile.

Is Fanapt Unique?

Vanda is going to have a hard time convincing psychiatrists to start prescribing Fanapt with six oral atypical antipsychotics compounds on the market and the fact that all the others have been a part of the large CATIE study whereas Fanapt is the only oral antipsychotic to not have been a part of that study.

We know this is all very basic but it’s worth mentioning that different pharmaceuticals in the same class of therapy differentiate themselves from their competition through these variables:

1. Efficacy
2. Safety
3. Ease of use
4. Cost

While Fanapt does have some attractive traits, in no category is it going to be a leader. Nor does Vanda have much time to start running large expensive studies to start differentiating Fanapt’s profile from the other atypicals on the market. Below is a chart comparing the top-selling antipsychotic drugs on the market and Fanapt according to their drug labels:

Keeping in mind that the clinical trials that this data is derived from are not directly comparable against each other and that the CATIE study does a good job of evaluating most of the above compounds, where in the above chart does Fanapt differentiate itself against the competition (especially Geodon)?

Is Vanda A Buy?

All that being said, Vanda is by no means horribly overvalued at its $335 million enterprise value (as of June 01) and there is nothing particularly special about whether it will hit that blockbuster $1 billion in sales status.

A $3.2 billion near-term market opportunity for Fanapt is nothing to sneeze at even if Vanda is only going to be keeping around 75% of all Fanapt sales. We’ll also point out that Fanapt will have a very low cost of goods sold, likely no more than 12% because it is an easy to manufacture small molecule drug.

Vanda doesn’t meet our investing criteria at this point in time but if Vanda watches its expenses, particularly its R&D expenses which many young drug developers seem to lose track of after getting a compound on the market, is able to effectively get the Fanapt marketing message out there, and focuses on increasing shareholder value then it could easily be a valid investment prospect for certain investors even if Fanapt only brings in a couple hundred million dollars annually.

If Titan Pharmaceuticals wasn’t such a bottomless money pit run by executives set out to capture any shareholder value created by the company then we’d recommend investors consider a “pairs trade” by going long on Titan and short on Vanda. The premise behind this type of trade would have been that Titan, valued at less than a fourth of Vanda’s valuation but potentially achieving operating margins of more than one-fourth that Vanda will achieve from Fanapt, would be a better investment than Vanda. This is not a valid strategy though, because after Fanapt was approved for marketing, Titan threw its recently enacted cash preservation strategy out the window and rehired its former executive team back at exorbitant compensation packages.

Vanda Pharmaceuticals (Nasdaq: VNDA) May 07, 2009 Fanapt FDA marketing approval conference call transcript with analyst question and answer session:

Mihael Polymeropoulos (Vanda CEO and founder) Prepared Remarks

MP: We are excited to discuss with you the approval of Fanapt for treatment of schizophrenia. Vanda announced yesterday that the U.S. FDA had granted marketing approval to Fanapt/iloperidone for the acute treatment of adult patients with schizophrenia.

The approval of Fanapt by the FDA represents many years of tireless efforts by countless former colleagues, many investigators, and thousands of patients that participated in the development of this new treatment for schizophrenia.

I would like first to extend my gratitude to all those who contributed and reaffirmed the commitment of Vanda Pharmaceuticals to the discovery and development of medicines for those in need.

The approval was supported by two placebo-controlled phase 3 clinical studies comparing Fanapt to placebo and active control in patients with schizophrenia as well as safety data for more than 3,000 patients. Fanapt is a mixed dopamine D2 / serotonin 5HT2A receptor antagonist and belongs to the class of atypical antipsychotics.

The efficacy of Fanapt for the treatment of schizophrenia was supported by two placebo-controlled short term four and six week trials. Both trials enrolled patients who met the DSM-III/IV criteria schizophrenia and Fanapt was shown to be superior to placebo in controlling symptoms of schizophrenia across doses of 12-24 mgs per day.

The recommended target dose range for Fanapt is 12 mg to 24 mg per day. Titration to a target dose of 12 mg per day can be achieved in as little as four days.

In a little more detail; In the four week placebo-controlled study involving one fixed dose of Fanapt 24 mg per day compared to placebo and an active control (Geodon), the 24 mg per day of Fanapt was superior to placebo in the Positive and Negative Symptom Scale (PANSS) total score.

Similarly, in the six week placebo controlled trial, enrolled in two dose ranges of Fanapt, 12-16 (mg) and 20-24 mgs per day, compared to placebo and an active control (Risperdal), both doses of Fanapt were superior to placebo on the Brief Psychiatric Rating Scale (BPRS) total score.

While it is not known for how long patients treated with Fanapt should be maintained on treatment, it is generally recommended that responding patients be continued beyond the acute response. Patients should be periodically reassessed to determine the need for maintenance treatment.

Fanapt was generally well tolerated and the most commonly observed adverse reactions (incidence >=5% and two-fold greater than placebo) were dizziness, dry mouth, fatigue, nasal congestion, orthostatic hypotension, somnolence, tachycardia, and weight increase.

Weight gain was mild and the overall mean weight increase in short and long term 52 week studies was 2.1 kg. Fanapt was not associated with any medically important elevations in glucose, triglycerides, or cholesterol.

Fanapt was also associated with only modest elevations of prolactin as compared to larger elevations seen with some other drugs in this class.

Fanapt has a low incidence of extrapyramidal symptoms (these are movement disorders and tremors) and a placebo-like rate of akathisia. This is restlessness and an ability to sit still, which are adverse events that are often associated with some other drugs in the class of atypical antipsychotics leading to discontinuation of treatment.

Similarly to some other drugs in this class, Fanapt may affect heart rhythm parameters and specifically the QTc interval, which may lead physicians to consider prescribing Fanapt after other antipsychotics have been tried first.

Vanda plans to make Fanapt available in pharmacies later this year. Again, we’re very excited and we’re very appreciative that the FDA reviewed all the information in the data and found Fanapt to be a compelling treatment for schizophrenia with efficacy equal to other atypical antipsychotics and a compelling safety profile with significant advantages, especially in (inaudible) patients and physicians.

(Q&A instructions…)

Questions from COREY DAVIS of Natexis Bleichroeder (7:48 mark)

DAVIS: What was it, if there was one thing that really changed the FDA’s mind in what you had submitted for your response?

MP: Let me first suggest something that usually gets unrecognized, which is the quality of the team that we have at Vanda. That was a critical factor. The second is the way that Vanda has operated, and Corey you know that very well, is to be very true to the science and the facts.

The third aspect is that the FDA decides (inaudible) so that they are open-minded to good scientific arguments so all along there was one lingering detail that goes into approval; Is this drug inferior to other antipsychotics and we have answered the FDA that this is not the case and they approved the drug.

DAVIS: I think a lot of people out there that are thinking whether or not to buy your stock right now are asking probably the biggest question which is, are you going to sell it yourself or are you going to try and partner this thing. How do you balance thinking about those two things?

MP: First of all lets talk about what is the value proposition to patients and physicians and then lets (discuss) what is the value to physicians for the products. The profile of the product and the label is up for inspection at www.fanapt.com (and) is actually pretty convincing that this is probably one of the most compelling labels of all the atypical antipsychotics. This is not just (because) of the similar efficacy (to) other antipsychotics but actually the compelling safety profile, as I said before, on extrapyramidal symptoms, akathisia, weight gain, and metabolic which is all of them relatively mild and very competitive to other drugs in the class.

Now lets talk a little bit about what happens to patients with schizophrenia. First of all, this is a debilitating disease affecting 1% of the world’s population and these are patients very dear to me since as a psychiatrist I have treated them for many years.

Despite the availability of several treatments for patients with schizophrenia, still there remains a tremendous medical need. 50% of the patients with schizophrenia switch drugs in any given year. They do that because of dissatisfaction with current treatments. Most of the dropouts in treatment happen because of lack of tolerability from side effects. The two key categories of side effects are movement disorders and metabolic (disorders); both areas that Fanapt offers to be a very good alternative. We feel that there is a significant place for Fanapt to be used for patients with schizophrenia.

If you are trying to think what’s the value position, all I can tell you is that the class of atypical antipsychotics is one of the largest classes of therapeutics today in the U.S. and the world; commanding about $15 billion in the U.S., $20 billion worldwide. The lowest selling product today is Pfizer’s Geodon and that is $1 billion (in 2008 worldwide sales).

The second proposal (the next step) with Fanapt, (even though) we just got approval for the oral formulation, is actually the commitment of Vanda to continue to develop the once-a-month injectable formulation, which will offer a unique placement of the drug to address compliance issues.

Unlike the oral formulations where there are a few drugs available, the only atypical antipsychotic today available in the market for patients is Risperdal Consta, which has been, as you may know, immensely successful, commanding $1.3 billion in revenues last year. Of course there is a lot of development work (with the iloperidone depot formulation) to do. So that’s how we think about the (iloperidone) value proposition.

DAVIS: There are so many different things that I can think of that you can do to bolster the clinical trial…Basically you have a limited amount of cash to do so. You already mentioned the injectable form but how would you prioritize new studies or new spending? I’m thinking of things like the dossier for Europe, the (subcutaneous) form, maybe some bipolar studies. Is that all still going to be on hold until you set up more of a commercial infrastructure or can you start thinking about those types of things right now?

MP: Corey, it is too early to (start thinking) about any specific direction of your suggestions. All I can say is that it is clear, not only because of the size of the market but (because of) the profile of the product that this is a competitive position and Vanda will have a number of options but you spoke to commercialization (so) let me give you a number of thoughts: So what makes Fanapt competitive? We fit the (efficacy or safety?) profile, we said the market size, there are a couple of very specific things that make it even more competitive.

One is the concentrated prescribing base of physicians. There are 5,000 out of the 25,000 psychiatrists, 20% of them, that prescribe 60% of the atypical antipsychotics in the U.S. and you can see that this is addressable with a targeted sales effort.

The other piece of the puzzle is reimbursement. Again, there is some great news here. There are no formulated restrictions for patients with schizophrenia. 90% of them belong to either the Medicaid or Medicare Part D class. All antipsychotics are (part of) this protected class and they cannot be excluded from the formularies.

These are the characteristics: the large market, the competitive profile of Fanapt, the small prescribing base, and the access to the formularies that make Fanapt a very attractive asset to a number of potential (Fanapt marketing) candidates: big pharma, mid pharma, and even Vanda.

DAVIS: So not to put words in your mouth but you’re open to all options right now?

MP: Absolutely and I think there are many (options).

DAVIS: Last question, the second drug in your pipeline, the forgotten one, VEC-162, did this (Fanapt’s approval) in any way change your plans for the development of that one and what can you start now that you got (Fanapt approval) under your belt?

MP: So let me tell you what the ongoing plan is and we can update you. Tasimelteon or VEC-162 is a novel melatonin agonist that we have shown now in two phase 3 and one phase 2 studies compelling results in improving sleep onset and sleep maintenance, especially under conditions of a circadian dysregulation.

Circadian rhythm (disruption) shows up in a number of conditions that we all understand very well (like) jet lag, delayed sleep phase disorder, and shift work sleep disorder.

We are in the process now of finding a meeting which will happen with the FDA (an end of phase 2 meeting) late in Q2 which will clarify the entire path to a NDA (New Drug Application) filing.

As preliminary work on the market analysis (of) the jet lag application suggests, this is a large untapped market where tasimelteon would be extremely differentiated. We are also evaluating another very large potential market, which is the delayed sleep phase disorder area, where again tasimelteon could also potentially be a very differentiated and unique proposition.

DAVIS: You pay at a 25% royalty stacked to Novartis but is there a milestone payment due to Novartis based on this approval.

MP: Yes, $12 million.

Questions from ELEMER PIROS of Rodman and Renshaw (18:45 mark)

PIROS: Do you or is it Novartis who actually owes some royalties to Titan Pharmaceuticals?

MP: We only pay royalties to Novartis and Novartis distributes to Titan after that.

PIROS: So the mid-20% range royalties, that’s your only obligation?

MP: That is our only obligation, yes.

PIROS: If you could please help us understand the intellectual property. I understand that the patents on the oral formulation would expire in 2011 and then you would get an additional five years if I’m not mistaken. What is the situation with the injectable please?

MP: On the oral formulation the (new chemical entity) patent expires end of 2011 but of course we would be getting the five year Hatch-Waxman Extension making (marketing exclusivity) to late 2016. We are already in the process of applying for that extension and Vanda would qualify for an even larger number than five but unfortunately it is capped at five.

Now on the depot formulation the patent expires in early 2020.

PIROS: 2020. What do you think of the regulatory path for developing the injectable formulation would be? I understand that Novartis had some early phase 1/2 trials conducted.

MP: Correct. Back in history a little bit: Yes, Novartis has taken the depot formulation into patients in a phase 2 study and shown it to be very well tolerated. The path that we suspect we will have to take but we have not yet confirmed with the FDA is manufacturing our clinical supplies of the depot formulation, performing short pharmacokinetic studies to understand the profile and to choose the final formulation, and then conduct a phase 3 study, usually it is a 12 week study, which would be the pivotal and only study necessary for filing (for marketing approval). So we will have to try and file this with the FDA but it is possible that this program could be completed in the next three or four years.

PIROS: Excellent. Thank you very much.

(Conference call concluding remarks)