AstraZeneca Wounded But Definitely Not Out

| About: AstraZeneca Group (AZN)

There is no way around it; AstraZeneca (NYSE:AZN) announced dreadful first-quarter results earlier this week.

First-quarter revenue came in well below market expectations, falling 11 percent to $7.35bn, short of consensus forecasts of $7.95 billion - the average of 21 estimates compiled by Bloomberg.

Pre-tax profits fell a massive 38 per cent to $2.05bn, with earnings per share also down 38 per cent from $2.08 to $1.28.

The company highlighted challenging market conditions together with the anticipated impact from the loss of exclusivity on several brands behind the fall, which is exactly what many analysts have been fearing for a while as the benefits of some patents have come to an end, whereas there is currently nothing much to counter this.

Outgoing Chief Executive David Brennan worded it as follows:

The anticipated impact from the loss of exclusivity on several brands has made for a difficult start to the year in revenue terms.

Loss of exclusivity on several key brands accounted for eight percentage points of the revenue decline

Delivery on our restructuring plans and continued discipline on operating costs, together with the benefits from a lower tax rate, will only partially mitigate the revenue pressures.

Where is near-term growth going to come from?

Ten years ago, AZN was a top-rated stock in European pharmaceuticals, with future blockbusters such as cholesterol-fighter, Crestor, coming through the pipeline.

A decade and a string of drug failures later, AZN is in desperate need to find new sources of growth as multiple blockbuster drug patents are about to expire, while its valuation is one of the lowest in the sector.

In fact, drugs that account for approximately 40 per cent of sales will lose patent protection by the end of 2014.

Breast cancer drug Arimidex has already lost patent protection and sales halved last year, while its second-best-selling drug, Seroquel for schizophrenia, lost U.S. patent protection earlier in March.

The patent on Nexium for ulcers, AZN's third-biggest seller, expires in 2014. Seroquel and Nexium generated $5.3 billion and $5 billion in sales last year, respectively.

Crestor, AZN's top-selling heart drug with $5.7 billion in 2011 sales, will lose its patent in 2016. However since November, it is already facing increasing competition from Lipitor manufactured by Pfizer (NYSE:PFE).

While two years ago, AZN revealed a new strategy aimed at revitalizing its discovery efforts it still has precious few new potential 'blockbuster' drugs in development to replace these big sellers. However, sales of AZN new blood-thinning drug, Bri­linta, have been slow on the off take.

Expect more licensing-in and acquisitions

Recently AZN has stepped up the pace of deal making, to bring in more promising new drugs from other companies.

Earlier this month, AZN signed a deal with Amgen Inc (NASDAQ:AMGN), to jointly develop and sell five biotech drugs while agreeing to buy U.S. company Ardea Biosciences Inc (NASDAQ:RDEA) for $1.26 billion, giving it access to an experimental gout drug called Lesinurad that is in final-stage Phase III clinical tests.

AstraZeneca has also been mentioned as a potential bidder for Amylin Pharmaceuticals Inc (AMLN), which has rejected a $3.5 billion takeover bid from Bristol-Myers Squibb (NYSE:BMY).

AZN's research head Martin Mackay told Reuters last month that he was looking at some acquisitions in the "low billions" of dollars.

In the meantime, AZN has created a series of "innovative medicines units" - or iMeds - that source the most promising science inside and outside AZN.

AZN's Shaun Grady, who heads up strategic partnering and business development, confirmed:

We partner, in-licence and acquire because we firmly believe that we don't have all the answers internally in our labs, we don't necessarily have the best science in our labs, so we're absolutely committed to this balance between what we originate and develop internally and pro­jects and programmes that come from outside the company.

This isn't a short-term fix to plug gaps in our present pipeline; this is how we're going to generate products for patients going forward.

It is good to note that Astra already gets some 40 percent of its pipeline from external collaborations and its late-stage pipeline comprises assets licensed in over the last three years.

The focus is now on to finding later-stage assets or products that are already on the market but require another commercial partner. Expect more such deals as well as partnerships in emerging markets, according to Grady.

Management shake-up!

Chief Executive David Brennan will retire in June and chief financial officer Simon Lowth will act as interim chief executive until a permanent replacement is found

Facing the challenges of shrinking revenue, job losses and replenishing its drugs pipeline after a number of setbacks, the appointment of Leif Johansson as non-exec chairman, three months earlier than planned - to oversee the selection of a new CEO while also creating the kind of board stability needed for not only management change and a change in strategy - can't come early enough.

It is clearly time for someone to reinvigorate the pipeline with more licensing deals and medium-sized acquisitions, rather than risk a single high-risk multi-billion transaction.

We still remember AZN's 2007 acquisition of MedImmune for $15.6 billion - a transaction that was slammed by both investors and analyst alike, at the time, and has consistently failed to deliver any significant new drugs.

Johansson is currently Chairman of telecoms group LM Ericsson and former CEO of AB Volvo and home appliances maker Electrolux. Importantly, from 1998 to 2011 he was also a non-executive director of Bristol-Myers Squibb.

Johansson will take over the non-executive post from Louis Schweitzer on June 1. Schweitzer said earlier in March:

I am delighted that we are able to announce the board's decision to propose Leif Johansson to shareholders for election to the board at the AGM in April and to appoint him to succeed me as Chairman.

Leif is an outstanding businessman with a first-class track record leading multinational companies, as well as previous experience of the pharmaceutical industry.


With the main hit from the loss of multi-billion sales of Seroquel and Crestor yet to come the need to find new sources of growth as multiple drug patents expire is now all-important.

Until now, AZN has suffered repeated drug development setbacks, stoking fears about its long-term prospects given its complete reliance on prescription medicines at a time when rivals have diversified.

For private investors it is near impossible to get a real feel for Astra's drugs pipeline and the profit possibilities thereof. So far though: disappointment reigns!

AZN's sales during the next few years are likely to be down. The first-quarter cut in profits is unlikely to be the last. Nevertheless, AZN remains strongly cash-generative thanks to its multi-year cuts strategy. It also has promised to return value to shareholders through a progressive dividend policy and share buyback programme.

Importantly, for us as dividend income investors, AZN has not cancelled its intention to increase the dividend while maintaining cover at two times (50% of underlying earnings). Dividend payouts are covered by earnings, while the company is one of few FTSE100 listed companies with substantial net cash.

Finally, with AZNs "dramatic" slide in valuation, trading now at around seven times this year's expected earnings - the lowest multiple for any major international drug company - a potential suitor may well emerge, with a buyer unlocking value by closing down the company's research and development. However, it remains to be seen whether any of the big drug companies will really want to put the patient out of its misery.

In the meantime, new chairman Leif Johansson's search for a new CEO to turn around the group is yet to commence.

Disclosure: I am long AZN.

Additional disclosure: Following the Q1 results announcement our Dividend Income Portfolio has purchased an initial shareholding. At current levels, AZN is nearing historically undervalued levels as per our valuation methodology.