Although Roche (OTCQX:RHHBY) hasn't been a terrible stock over the last three years, it's hard not to look at the performance of companies like Bristol-Myers (NYSE:BMY), Merck (NYSE:MRK), and Amgen (NASDAQ:AMGN) with some envy. In the case of the first two peers, Roche has been slower to get into the immuno-oncology game, as both Bristol-Myers and Merck have seen good initial successes with their PD-1 antibodies (and, in the case of Bristol-Myers, its CTLA-4 antibody as well). Roche has also had to withstand more than a little concern and skepticism regarding the company's ability to defend its lucrative oncology franchise from impending biosimilar competition and growing worries about pricing.
I do continue to believe, though, that Roche has an attractive future. While the company was somewhat late to the game in immuno-oncology, the company is bringing a lot to bear in terms of numerous combo therapy candidates. The company is also seeing some traction in its non-oncology franchise, with encouraging results in multiple sclerosis and hemophilia. Biosimilar competition and price resistance remain real risk factors, but I believe Roche's pipeline can support long-term free cash flow growth in the high single digits and a fair value in the mid-$30s.
A Decent Start To The Year
Roche regrettably reports detailed earnings only twice a year, so the first- and third-quarter updates are really more about sales trends and incremental information on the pipeline. To that extent, Roche's quarter was fine but not really exciting.
Revenue rose 5% as reported and about 4% in constant currency for the first quarter. Pharmaceutical sales were up 4% (again, constant currency), with key oncology drugs like Rituxan, Herceptin, and Avastin growing between 4.4% and 5.4%. Relative newcomer Perjeta continues to grow nicely, with sales up about 36% this quarter, and Gazyva was up 73%. Outside of oncology, Esbriet sales were up almost 100%, but still a little shy of expectations.
Roche's diagnostics business saw 5% growth in the first quarter. Strong sales in molecular diagnostics (up 11%) helped offset an 11% decline in diabetes, while tissue was up 13% and professional (nearly 60% of the segment) was up 7%. As a reminder, Roche has been reconfiguring its diagnostics efforts to be less focused on markets like diabetes and more leveraged to companion diagnostics for new drugs.
… And The Wait Goes On
Bristol-Myers' Opdivo (its PD-1 drug nivolumab) exited the fourth quarter at close to a $2 billion annual run-rate and Merck's Keytruda was running about half that rate (over $850 million). You can rest assured that Roche would love to have another drug on the market generating $1 billion or more in sales, but Roche was slower to get into the immuno-oncology game.
There's a cliché that "it's not how you start, it's how you finish" and that could prove true in the case of Roche. As I have written on multiple occasions, Roche's PD-L1 antibody atezolizumab looks like a very strong contender, and the company's slower path to market likely won't matter much five years from now. What's more, Roche has a very strong pipeline of "atezo-plus" combos, and I am a firm believer that combo therapy is the future of oncology for the next 10 years.
We'll hear more about Roche's oncology pipeline at ASCO in June. Roche will be presenting data on combos like atezo-and-aOX40 in solid tumors, atezo-and-abraxane in triple-neg breast cancer, and atezo (monotherapy) in bladder and lung. I could probably write multiple articles on all of the various potential combos Roche is pursuing, and many of them will fail, but I believe Roche will compensate for its slow start by bringing a lot of horsepower to the market over the next five years.
Roche experienced a setback to its non-oncology ambitions back in February with mixed Phase III results from lebrikizumab, the company's experimental drug for asthma (among other indications). While the LAVOLTA I study met its primary endpoint, it was less effective than in Phase II and the LAVOLTA II study did not meet its endpoint. Perhaps the performance problems were caused by a change in the manufacturing process (which would be odd, as the change was designed to create a purer product), but enrollment criteria could have played a role as well.
This is disappointing, but not thesis-changing. I have long thought that lebri was a riskier project, particularly given the high level of competition in the market (from the likes of GlaxoSmithKline (NYSE:GSK), Sanofi (NYSE:SNY), and AstraZeneca (NYSE:AZN)). As I only saw a 50/50 shot of the drug generating $750 million in long-term sales (though there was a chance of $1 billion-plus), the net impact to valuation isn't that significant. More significant could be that this is another mark against Roche's biomarker-based drug development efforts outside oncology, where it seems as though Roche's approach is giving the green light to compounds that don't perform well in Phase III.
On a happier note, ocrelizumab looks like the real deal in multiple sclerosis, and the company secured a breakthrough therapy designation from the FDA.
The Look Ahead
My bullishness on Roche has, for a while now, been predicated on the company's eventual success in immuno-oncology and the company's ability to leverage that into ongoing leadership in oncology. Recent efforts (most notably in Europe) to fight back on escalating drug pricing is a concern, and it will make it increasingly important for companies like Roche, Bristol-Myers, and Merck to demonstrate significant benefits to new drugs to justify their prices. While early results are promising - Bristol-Myers recently reported that the five-year survival rate for melanoma patients treated with nivolumab is a previously unimaginable 34% and the nivo-ipi combo will likely be even better - the bar is going to get higher and higher as time goes on.
I'm still looking for Roche to generate long-term revenue growth of around 5%. The introduction of biosimilars (likely 2016/2017) will be a headwind, but one that the company can overcome if the data on atezo combos are strong.
I would also expect Roche to at least kick the tires on biopharma M&A outside of oncology, if only to balance the portfolio and better leverage existing sales and marketing infrastructure. It is also worth mentioning again that Roche has been developing a lot of companion diagnostic tests to complement its drug development efforts, and this is an opportunity to "double-dip" and generate some lucrative margins on the diagnostics side.
Such leverage is built into my model as well, and I'm looking for free cash flow growth of around 8% for the long term. That's not a conservative estimate in my opinion, but it does support a fair value of more than $35.
The Bottom Line
The sell-side is about 10% more optimistic on Roche's value than I am, but I think 10% undervaluation for a solid non-cyclical dividend-payer like Roche makes it worth a look for more conservative investors. Prospective buyers certainly need to understand the risks that go with clinical development, pricing, and generic/biosimilar competition, but Roche's pipeline looks strong and I think Roche is poised to do well over the next three years.
Disclosure: I am/we are long RHHBY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.