Fair Value Estimate: 3,305p | Uncertainty Rating: Medium | Economic Moat: Wide
Thesis (Last updated on 15/02/2011)
AstraZeneca's (AZN) leading presence in the pharma and biotech industry is built on patent-protected drugs and a developing pipeline that all add up to a wide moat. The firm's dynamic operations and an aggressive acquisition strategy create growth opportunities to offset patent losses, including the near-term expirations on respiratory drug Pulmicort and oncology drug Arimidex.
The company boasts a healthy product portfolio led by four key drugs. These growth drivers include gastrointestinal drug Nexium, antipsychotic treatment Seroquel, cholesterol reducer Crestor, and respiratory agent Symbicort. Collectively, these drugs posted more than $18 billion in sales for 2010, representing over half of the company's sales. Ongoing clinical studies are advancing the indications for these products and tapping into new patient pools for continued growth. Besides Seroquel's 2012 patent loss, the corresponding key patent expirations for the other three drugs range from 2014 to 2016, which provides ample time for pipeline products to kick in. Modified release versions of these products may also partially extend patent protection. However, given the high level of sales for these key drugs, we don't think the company's pipeline will offset the sales loss during the next decade.
Although AstraZeneca's pipeline ranks toward the bottom of its peer group, we think the company is developing several key products that hold blockbuster potential. In particular, dapagliflozin could enjoy a first-mover advantage as a new type of diabetes therapy. Another diabetes treatment, Onglyza, should compete effectively against Merck's MRK Januvia, which sold more than $3 billion in 2010. Additionally, the company's late-stage cardiovascular drug, Brilinta, could develop into a multi-billion-dollar product if doctors get comfortable using the drug with low-dose aspirin. The company also controls several late-stage cancer compounds where approval requirements tend to be lower and pricing power remains strong.
In addition to internal development, AstraZeneca aggressively pursues acquisitions with mixed results. Acquiring Cambridge Antibody Technology in 2006 added a plethora of pipeline products for a reasonable price. However, the $15.6 billion price tag paid for MedImmune in 2007 appears too high. Several of MedImmune's early-stage products need to achieve blockbuster status to warrant the acquisition price. Although the company creates growth opportunities through acquisitions, its chequered track record leaves us less confident of management's adherence to price discipline.
Valuation
Our fair value estimate for AstraZeneca is 3,305p per share based on an exchange rate of 62.4p per $1, as of Feb. 14, 2011. Although we expect operating margins to decline during the next five years because of patent losses on high-margin drugs, the company's restructuring efforts should help mitigate the margin erosion. We project a 5% average annual sales decline during the next five years as patent expirations take their toll. We estimate a cost of equity of 9.5% and cost of capital of 9.0%, which is consistent with those of pharmaceutical peers. During the next five years, all four of the company's current growth drivers lose patent protection, magnifying the importance of pipeline products. If the company fails to develop its top three pipeline products--dapagliflozin, Onglyza, and Brilinta--into blockbusters, our fair value estimate would fall by more than 620p per share.
The fair value estimate for this share class is derived using a model in the firm's reporting currency and applying the applicable exchange rate for the share. Any differences between the fair value estimate shown in the valuation section and the fair value displayed elsewhere in this report is a function of a more recent exchange rate.
Risk
AstraZeneca faces several integration risks in meshing the entrepreneurial cultures of MedImmune and CAT with the company's more secure and established culture. The company also faces the typical risks inherent in the pharmaceutical industry including patent expirations, regulatory delays, and nonapprovals, as well as increasingly aggressive generic and managed-care industries.
Management & Stewardship
In 2006, David Brennan was appointed CEO following a long tenure in the pharmaceutical industry dating back to 1975 when he started as a sales rep for Merck MRK. Perhaps learning early on from his father who was a car salesman, Brennan's successful sales ability helped position him for the top spot. Further, Brennan's strong ability to manage sales outside of his native country of the US has been shown in a previous post as the chief executive of Merck's French subsidiary Chibret in the early 1990s and then as a manager of a joint venture between Merck and Astra. His international experience should bode well for Astra's push into emerging markets. For the number two position, AstraZeneca appointed Simon Lowth to the CFO position after veteran CFO Jon Symonds departed to Goldman Sachs GS (subsequently to Novartis NVS). We remain somewhat concerned with Lowth's novice status in the pharmaceutical arena. As far as stewardship, we like the transparency of AstraZeneca's compensation policies, but we wish the firm used long-term return measures in place of earnings per share to determine executive bonuses. Compensation levels seem reasonable, given AstraZeneca's position as a global pharmaceutical firm.
Overview
Financial Health: Strong cash balances and robust cash flows provide ample fuel for acquisitions and share buybacks. The $14 billion in additional debt due to the MedImmune acquisition in 2007 still exhibits some lingering effects on the company's debt capacity.
Profile: AstraZeneca was formed in 1999 by a merger between Astra of Sweden and Zeneca Group of the United Kingdom. The company sells branded pharmaceutical products across several major therapeutic classes including gastrointestinal, cardiovascular, respiratory, cancer, neuroscience, and infectious disease. Just less than 40% of its sales are derived in the United States.
Bulls Say
-- The company is expanding its biologic presence in pipeline products. The biologics tend to carry higher pricing power and may hold off generic competition longer than typical drugs.
-- Even in the face of generic Zocor, Crestor continues to post positive gains in the highly competitive statin market, which should bode well for the late-2011 Lipitor patent loss.
-- While Astra doesn't have the largest presence in emerging markets, the company is growing the fastest in these territories, which should help offset patent losses in developed markets.
-- During the next three years, the company will likely regain full control over drugs currently marketed under a legacy joint venture with Merck, which should boost Astra's profits.
-- The FDA's approval of a new indication for Crestor in patients with high C-reactive protein opens the door to a much larger patient population and suggests Crestor could be the best-in-class statin.
Bears Say
-- AstraZeneca is developing several new pipeline products in collaboration with partners and consequently lowering the new drugs' profit potential to the company.
-- Since US doctors tend to use high-dose aspirin for cardiovascular patients, the upside for pipeline drug Brilinta could be limited as trials showed only limited benefit for the drug when used with high-dose aspirin.
-- During the next 10 years, all four of the company's growth drivers will lose patent protection, which creates big shoes to fill.
-- The high price tag of $15.6 billion for MedImmune reflects the intense competition by large pharmaceutical companies looking for acquisitions to augment their internal efforts.
-- The competitive proton-pump inhibitor class (anti-ulcer drugs) will likely mean pricing cuts for Nexium until its 2014 patent loss.
Damien Conover, CFA is an equity analyst with Morningstar.
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