By Stephen D. Simpson, CFA
I didn't exactly win a lot of fans for myself last year when I decided it was time to jettison Johnson & Johnson (NYSE: JNJ) and turn my affections to other med-tech names – most notably Swiss giant Roche (Nasdaq: RHHBY.PK). At the time, few people seemed to like Roche. The company was under (theoretical) assault from biosimilar competition, the efficacy of major drug Avastin was in question, and the company didn't have much to offer in areas like vaccines, generics, and consumer health while investors started to drool over the supposed synergies of one-stop shops like Novartis (NYSE: NVS).
What a difference a year makes. Although J&J has done a little better than I thought it might, Roche has done about as well as I thought it would and last year's 20% gain was welcome indeed. More importantly, the situation around Roche today is one that warms the heart of many value investors – analyst sentiment has shifted and Roche has moved from a least-favored name to one of the more popular picks for 2012.
A Strong, But Very Concentrated, Business
There's no question that Roche does a few things very well. About 80% of the company's sales come from pharmaceuticals, and two-thirds of those sales come from biologics. Even more to the point, half of the company's drug sales (and about one-third of overall sales) come from just Rituxan, Avastin and Herceptin.
Fortunately, Roche is playing to its strength. Although Avastin did indeed lose its labeling for breast cancer (as it should) and recent data on ovarian cancer usage was disappointing, the company has an excellent oncology franchise. Pertuzumab could prolong the useful life of Herceptin [European patents begin to expire in 2014), while Zelboraf looks like a big winner in melanoma – even with the recent approval of Bristol-Myers Squibb's (NYSE: BMY) Yervoy]. Beyond that, the company has an intriguing pipeline of conjugated antibody products that may not have yet gotten all due notice from the Street.
But wait, there's more. Although Roche has endured some high-profile failures (like taspoglutide for diabetes), the pipeline outside of cancer looks interesting albeit risky. Aleglitazar could be a blockbuster dual-PPAR for diabetes, though this class has had safety issues. Elsewhere, dalcetrapib could be an intriguing good cholesterol booster if the efficacy data holds up and the company can deal with potential competition from Merck's (NYSE: MRK) anacetrapib.
Last and not least, can Roche maintain its status in the Hep-C world? The biotech/pharma world was underwhelmed with the company's deal for Anadys, but it did fill an obvious hole in its pipeline and IP portfolio. Roche doesn't have the buzz of Gilead (Nasdaq: GILD) after its buy of pipeline darling Pharmasset (Nasdaq: VRUS), but this portfolio of assets may yet keep Roche in the game.
Diagnostics A Valuable Crown Jewel
Roche also happens to have the largest global share of the in-vitro diagnostics business and has established itself well against JNJ, Abbott (NYSE: ABT), and Danaher's (NYSE: DHR) Beckman Coulter. Roche is not flashy with its diagnostics business – it doesn't boast as often about the growth potential of molecular diagnostics, for instance, but this is an all-around solid business that continues to produce good returns for Roche. The real question may be whether management is tempted to spike that growth by making a bigger splash in markets like diabetes or hospital-acquired infection through acquisitions.
Where Roche has lagged is in the life sciences tools arena. 454 was once a real player in sequencing, but the company just doesn't seem to be keeping up with Illumina (Nasdaq: ILMN) or Life Technologies (Nasdaq: LIFE) in the arms race. Given past criticism of frittering away money on projects with long payoff timelines, perhaps management has developed rabbit ears and is disinclined to invest the R&D to stay on the very cutting edge of the field. Then again, considering that even mighty Illumina's returns on capital aren't that compelling, maybe it's not such a bad decision after all.
The Bottom Line
Roche's heavy emphasis on cancer therapy is a risk, but the fact remains that cancer is a lucrative and still under-served market. Elsewhere, while Roche doesn't necessarily boast about its presence in in-vitro diagnostics and the potential of its businesses in diabetes care, life science research, or molecular diagnostics, these businesses are fairly strong (even though the company ceded the sequencing market). Likewise, though some may criticize Roche for not being active in generics, consumer health, or vaccines, it doesn't seem to be hurting the performance all that much.
With sentiment shifting, Roche isn't the bargain it once was. Still, assuming just low single-digit growth and slight improvements in cash flow margins, the stock is undervalued by about 25% and offers one of the better dividend yields in the sector. Like JNJ, Abbott, or Bristol-Myers, Roche ownership is not about getting rich quick, but there is solid value here for long-term investors looking for an improving name in healthcare.