AstraZeneca reported strong third-quarter results that slightly exceeded our expectations. However, we don't anticipate any changes to our fair value estimate on the basis of the minor outperformance, particularly as the bulk of it was due to unsustainable gains. Astra reported robust operational sales growth of 10% year over year. On the bottom line, the company posted surprising growth of 27% versus the prior-year period. The strong results led management to raise its full-year earnings per share outlook by about 7% to $6.20-$6.40, which we expect the company will probably exceed.
While Astra reported strong top-line sales growth, we believe unsustainable factors accounted for half of the expansion. Generic manufacturing capacity constraints allowed Astra to continue to sell cardiovascular drug Toprol-XL at a branded-price level, which added 300 basis points to total growth. We believe generic manufacturers are close to resolving the manufacturing problems and Toprol-XL sales will probably fall dramatically in 2010. Additionally, the company sold $152 million of H1N1 vaccine in the quarter, which added 200 basis points to total growth. While we expect more than $300 million in additional H1N1 vaccine sales in the fourth quarter, we believe long-term demand for the vaccine will wane next year, as we are not likely to see the resurgence of the swine flu to the same degree as this year.
For the company's core drugs, the majority of results matched our expectations. However, cholesterol-lowering drug Crestor posted better-than-expected operational growth of 30% versus the prior year period. We believe the drug's leading efficacy has enabled it to continue to take market share from other statins. Further, we think doctors have become very comfortable with the drug's rare side effect of muscle toxicity. Astra is making good strides on the pipeline front. The company recently launched diabetes drug Onglyza and filed a new cardiovascular drug, Brilinta. We expect both drugs will become blockbusters. While these drugs should partly offset Astra's massive patent losses over the next 10 years, we believe the company still needs to expand its pipeline to fully offset expected generic competition. We rank Astra's patent cliff as the second worst in the pharmaceutical industry.
Because of upcoming patent losses, in our opinion, Astra remains very focused on reducing its expenses. As a percentage of total sales, operating expenses fell a surprising 850 basis points year over year. While the company has classified all of these cost cuts as normal, we would allocate more than 200 basis points of the improvement to one-time events, including a resolution to supply contracts and lower charges for intangible asset impairments. Nevertheless, Astra is rapidly cutting costs, which should help mitigate the massive patent losses coming over the next several years.
Fair value estimate: 3,169p ¦ Fair value uncertainty: Medium ¦ Economic moat: Wide
Thesis
(Last updated 31-07-2009)
AstraZeneca's 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. [Read this article to understand how Morningstar measures moats.] The firm's dynamic operations and an aggressive acquisition strategy create growth opportunities to offset patent losses, including the near-term expiration on cardiovascular drug Toprol.
The company boasts a healthy product portfolio led by five key drugs. These growth drivers include gastrointestinal drug Nexium, antipsychotic treatment Seroquel, cholesterol reducer Crestor, and respiratory agent Symbicort. Collectively, these drugs posted $15 billion in sales for 2008, representing 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. Also, the corresponding patent expirations range from 2010 to 2016, which provides ample time for pipeline products to kick in. Modified release versions of these products may also partially extend patent protection.
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 Januvia, which is on track to sell more than $2 billion for 2009. Additionally, the company's late-stage cardiovascular drug, Brilinta, could develop into a multi-billion-dollar product, if the drug's side effect profile holds up in late-stage trials. 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 and biotechnology 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
We're slightly raising our fair value estimate to 3,169p per share based
on stronger-than-expected cost-containment efforts. Although we expect
operating margins to decline during the next 10 years because of patent
losses on high-margin drugs, the company's restructuring efforts should
help mitigate the margin erosion. We project a 3% average annual sales
decline during the next 10 years as patent expirations take their toll.
We estimate a cost of equity of 9.5% and cost of capital of 8.9%, which
is consistent with those of pharmaceutical peers. The company faces
limited patent exposure in the near term; over the next 10 years, all
four of the company's current growth drivers lose patent protection,
magnifying the importance of pipeline products. If the company failed to
receive approval for its top two pipeline products, dapagliflozin and
saxagliptin, our fair value estimate would fall by 300p. Also, given the
uncertainty surrounding the patents for Nexium, we have baked in a 25%
probability that generic drug firms would embark on an at-risk launch.
If at-risk generic launch occurred in 2009, we would decrease our fair
value by 180p.
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.
Strategy
AstraZeneca focuses on the high-margin pharmaceutical business, and it
has divested unrelated business lines. The company manufactures and
markets drugs for major therapeutic areas such as cancer,
gastrointestinal, cardiovascular, and respiratory diseases. The firm
aggressively pursues external collaborations and acquisitions to
supplement its internal efforts. Over the long term, it aims to expand
its biotechnology platform to balance out its small-molecule drugs.
Management & Stewardship
In 2006, David Brennan was appointed CEO following a long tenure in the
pharmaceutical industry dating back to 1975. Brennan worked up the ranks
at AstraZeneca and Merck and previously headed AstraZeneca's North
American operations. With the departure of veteran CFO Jon Symonds to Goldman
Sachs, AstraZeneca appointed Simon Lowth to the CFO vacancy. We
remain somewhat concerned with Lowth's novice status in the
pharmaceutical arena. 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
large, global pharmaceutical firm. We're pleased Brennan increased his
ownership of AstraZeneca shares by more than 50% in 2005.
Profile
AstraZeneca was formed in 1999 by 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 half of its sales
are derived in the United States.
Growth
We project 3% annual sales decline during the next 10 years as patent
expirations weigh on the company's growth rate.
Profitability
We project a decline in operating margin of approximately 200 basis
points during the next 10 years, as patent losses on high-margin
pharmaceuticals are partly offset by restructuring efforts.
Financial Health
Strong cash balances and robust cash flows provide ample fuel for
acquisitions, as well as large share buybacks. However, the $14 billion
in additional debt stemming from the MedImmune acquisition in 2007 still
has some lingering effect on the company's debt capacity.
Bulls Say
1. The company is expanding its biologic presence in both pipeline
products and manufacturing capacity. The biologics tend to carry higher
pricing power and may hold off generic competition longer than typical
drugs.
2. Even in the face of generic Zocor, Crestor continues to post positive gains in the highly competitive statin market.
3. Concerns over the safety of COX-2 inhibitors, such as Vioxx and Celebrex, could help stimulate increased sales of proton pump inhibitors such as Nexium. PPIs are often recommended in conjunction with traditional painkillers such as aspirin and ibuprofen, which can cause stomach ulcers over time.
3. During the next four years, the company will likely regain full control over drugs currently marketed under a legacy joint venture with Merck. The full control should boost sales.
4. The negative ENHANCE trial results should propel Crestor sales as doctors look for an alternative to cholesterol-lowering drugs Vytorin and Zetia.
Bears Say
1. AstraZeneca is developing several new pipeline products in
collaboration with partners and consequently lowering the new drugs'
profit potential to the company.
2. Multiple generics of Johnson & Johnson's antipsychotic Risperdal launched in 2008 are creating tough competitors for Seroquel.
3. During the next 10 years, all four of the company's growth drivers will lose patent protection, which sets up big shoes to fill.
4. The high price tag of $15.6 billion for MedImmune shows the intense competition by large pharmaceutical companies looking for acquisitions to augment their internal efforts, which might decrease the opportunities for value-enhancing acquisitions.
5. The lack of major differentiation between Nexium and its predecessor drug Prilosec increases the probability of an at-risk generic launch by Teva or Ranbaxy.
