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.