Sanofi's Balanced Model Looks Undervalued

| About: Sanofi (SNY)

There has always been a certain boom/bust aspect to the branded drug business, but French drug giant Sanofi (NYSE:SNY) seems to be trying a different path. Instead of a narrow focus, Sanofi has a business that is diverse both in markets and geographies served. Instead of a pipeline built around blockbuster home run stocks, Sanofi seems to be focusing on steadily banging out singles and doubles. Time will tell if this different approach will work, but the valuation certainly merits a closer look.

A Solid Close To The Year

Sanofi ended the year on a relatively strong note, with revenue growth and margin performance that was broadly clean and in line with expectations. Reported revenue rose about 9%, with better than 10% growth in pharmaceuticals, 10% growth in animal health, 13% growth in consumer, and 16% growth in generics offset an 8% revenue decline in vaccines. It should be noted, though, that "growth" in pharmaceuticals did have a great deal to do with the inclusion of Genzyme (which itself grew about 1% this quarter).

Lantus was exceptionally strong once again (up 18%, to over $1.4 billion), while Plavix held on (up 5%) and Lovenox sales dropped 14%.

As said before, profitability was more or less consistent with expectation. Gross margin dropped about a point on a reported basis (slightly worse on an adjusted basis), while reported operating income rose 11%.

2012 - The Year Of Pain

Whereas companies like Merck (NYSE:MRK), Pfizer (NYSE:PFE), and GlaxoSmithKline (NYSE:GSK) are mostly past their points of pain with respect to revenues lost to patent expiration, Sanofi is in the middle of it. Lovenox, Plavix, and Avapro have gone (or about to go) off patent, and account for more than 12% of company revenue at present.

The good news for Sanofi is that it does not look as though sales are going to immediately crash, but rather experience a more prolonged decline. That's still going to do a number on 2012 earnings, sending them down more than 10%, but that's better than many other pharmaceutical companies have experienced.

A Pipeline With Few Primadonnas

Under new management, Sanofi has changed a lot over the years. Sanofi used to be a company that hung on too long to low-potential drugs and built itself around high-risk/high-reward compounds. Now the strategy seems be targeted less at finding the Snow Whites as it is finding seven dwarves. In other words, Sanofi seems to be developing a pipeline that will produce relatively few blockbusters, but a fairly respectable number of drugs with $400 million to $800 million in sales potential.

Arguably the most important drug in the pipeline is a reformulated version of Lantus - Sanofi's blockbuster insulin product. This is an exceptionally important product to Sanofi (and part of the lucrative trioply it shares with Lilly (NYSE:LLY) and Novo Nordisk (NYSE:NVO), but patents begin expiring in 2014 and competition is on the way from Novo's degludec and compounds in development at Pfizer and Lilly.

Outside of a new version of Lantus, most analysts are only looking for today's late-stage pipeline to add about 10-15% of trailing sales to Sanofi's 2016 revenue. The most important drugs are arguably Lemtrada for multiple sclerosis (where it will compete with Novartis's (NYSE:NVS) Gilenya and likely Biogen Idec's (NASDAQ:BIIB) BG-12) and '353 for hyperlipidemia.

Behind these are 14 other late-stage products, including mipomersen [co-developed with Isis Pharmaceuticals (ISIS)] for hypercholesterolemia, several cancer drugs, a dengue fever vaccine, and Lyxumia - a GLP-1 drug that is not all that exciting on its own, but could be interesting as a combination therapy with Lantus.

Will A Different Model Produce Better Results?

In addition to the previously discussed pipeline, Sanofi has re-crafted its business in other interesting ways. Over the last few years, Sanofi has been active in overseas M&A (including buying Brazil's Medley) and the end result is that the company is one of the most exposed Big Pharma names to emerging markets - about one-third of the company's revenue comes from these areas.

Sanofi has also embraced a more diverse mix of target markets. Branded drugs are still the lion's share of the revenue base, but vaccines, consumer health, animal health, and generics come close to 30% of total sales.

In theory this should smooth out some of the ups and downs that go with the branded business. Management still has to prove that it can pay off at the bottom line; Sanofi's free cash flow conversion rate is well below other major drug companies.

The Bottom Line

Sanofi management has accomplished a lot in a relatively short period of time and has thus far done a good job of addressing the operational issues that ultimately led Genzyme to sell out. Despite that, and a better than average revenue growth outlook over the next five years, Sanofi shares still look too cheap. Should Sanofi manage to couple low-to-mid single-digit revenue growth with some modest improvements in free cash flow conversion, these shares could be every bit the bargain that Merck or Pfizer is today.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.