Roche (RHHBY.OB) is one of the premier drug companies for the next decade, with a dominant position in cancer care and diagnostics. One of Roche's key competitive advantages is that two thirds of its products are biologics. Biologics are much harder to replicate than typical small molecule products. There has been concern within the investment community about the long-term effects of new legislation allowing for new generic biotech drugs (biosimilars). Last February, the U.S. Food and Drug Administration (FDA) published biosimilar guidelines as a follow-up to the Biologics Price Competition and Innovation Act of 2009.
The Biosimilars Act established two distinct categories of generic biologics; biosimilars and "interchangeable" biologic products. Only the "interchangeable" biologic products are required to have new clinical trials to be considered legitimate as a suitable replacement. These "interchangeable" products will account for most of the new biosimilar drugs released over the next decade.
A biosimilar product has only minor differences in active compounds, with no statistical differences in terms of efficacy or safety. An "interchangeable" product is one considered to be biosimilar and to display similar corresponding results, with a risk "no greater" than the risk of utilizing the brand-name product. For a generic manufacturer, the first filer has rights and receives six months of exclusivity. But the Biosimilars Act awards wider exclusivity to those firm seeking approval of an "interchangeable" biologic product; a full year.
The FDA finally released its guidelines this past February that describe the technical data needed for any generic firm to secure approval for a new biosimilar. The U.S. guidelines will not make it easy for these new generic manufacturers. It will be a much more difficult and expensive process to produce biosimilar products.
The first obstacle for a biosimilar manufacturer is the difficulty in replicating these drugs. Generic manufacturers do not have access to the original data, making it very onerous to copy the complex proteins that make up biological drugs. The FDA has proposed a "stepwise" approach to demonstrating biosimilarity. This is initiated with comprehensive structural characterization of the proposed and referenced new product.
Europe has demonstrated that providing low-cost biosimilar products is not as easy as the policymakers would like. Despite a favorable regulatory market, only a handful of biosimilars have made it to market in the European Union. This is due to several factors, most notably the high barrier of entry to meeting the "interchangeable definition" and the significant cost and complexity of producing biosimilars. The cost to develop a biosimilar can be $80 to $200 million in total, versus less than $10 million for a conventional generic product. For the buyers of biosimilars, the cost differential is not as stark. The discount for a biosimilar product will be approximately 25-30% of the brand name price. This is much less than your typical generic drug discount (90%).
Roche will no doubt be affected by this large transition to biosimilars. Projections by analysts are in the $2.5 billion range of lost revenue by the end of the decade for its three major products. But its products will not become obsolete. Roche will be able to reduce prices and still remain competitively priced with the new biosimilars that come on to the market. Additionally, conversion to biosimilars is highly predicated on the success of this new class of pharmaceuticals as a new "equal" treatment class. This is yet to be determined as several new biosimilar trials are under way.
As I wrote in my analysis of another promising healthcare firm Zimmer last week, any investment candidate must meet my nine key investment criteria list:
Key Selection Criteria
- A market capitalization over $10 billion.
- A leadership position within a growing industry.
- A dominant, or large, market share within its product mix.
- A strong position internationally.
- A strong balance sheet and high credit rating.
- A high free cash flow number.
- A low historical relative valuation as measured by price/sales and price/earnings ratios.
- A strong dividend growth rate.
- A catalyst of new revenue opportunities (pipeline).
Roche is also a large-cap healthcare firm, with a current capitalization of $160 billion.
Roche is the global market leader in cancer, maintaining the highest market share of 29.2% versus the other large pharmaceutical and biologic firms. Roche's position in cancer was bolstered by its acquisitions of Genentech and its increasing control of Japanese firm Chugai. Roche has the opportunity to increase its stake in Chugai this October. Roche holds a leadership position in cancer through its primary products, which include Avastin, Rituxan and Herceptin. The cancer drug market is forecast to grow at a CAGR of 9% between 2008 and 2015 to record a sales value of around $90.8 billion. Roche should be a primary beneficiary of the continued growth in the worldwide cancer market. Here is a profile of the firm's three leading products;
Avastin (16 percent of sales) is the company's largest cancer drug with approvals to treat colorectal, non-small cell lung, kidney, and glioblastoma cancers. Avastin was the first in a class of drugs developed to inhibit angiogenesis, or the formation of blood vessels, back in 2004. Avastin sales were reduced last year when the FDA revoked its conditional approval as a treatment for breast cancer. For ovarian cancer, it was approved for use in the European Union last December. Avastin is being studied in a phase III trial, AURELIA, which is examining Avastin in combination with standard chemotherapy in women suffering from ovarian cancer. Another study, ML18147, is evaluating Avastin with second-line chemotherapy for colon cancer. Roche hopes for approval for ovarian cancer from the U.K. in 2013. Sales of Avastin advanced by 3% in the first six months of 2012. By 2015, the drug is set to be the world's biggest selling cancer medicine, with annual sales of close to $9.5 billion. Avastin has protection from biosimilars until 2019 in the U.S and 2022 in the European Union, protecting this large revenue source for Roche.
MabThera/Rituxan (15% of sales), is a drug used to treat non-Hodgkin lymphoma, 1997; rheumatoid arthritis symptoms, 2006; rheumatoid arthritis, 2008; chronic lymphocytic leukemia, 2010; Wegener's granulomatosis, and microscopic polyangiitis, 2011. The drug has demonstrated continual double-digit growth, adding new conditional treatments on an ongoing basis. Rituxan's has patent expirations coming up, with Roche losing exclusivity in Europe in 2013 and 2018 in the United States. There is concern for this drug's future revenue as six biosimilars are being developed by various firms (Sandoz (NVS), Teva (TEVA), etc). Pfizer (PFE) has initiated a trial REFLECTIONS B328-01, which started in March. A total of 210 patients are enrolled and the study is expected to be completed by the end of 2013. Patients will either get the biosimilar or actual Rituxan. We have no idea at this point whether this biosimilar will prove efficacious. Remember the development is costly for the generic firms, upwards to $200 million in expenses for production and trial. If Pfizer misses on its REFLECTIONS trial, it could put a damper on the enthusiasm of other companies attempting to replicate Rituxin. Trust will be another big issue for the conversion of patients from Rituxan to biosimilars, even if the data are compelling in the trial. The soonest to expect any form of generic Rituxan would be early 2015. Additionally, Roche could easily reduce the price to compete with the new biosimilars. Although revenue would be lower, it would not drop in the same manner as typical generics (loss of up to 90%) within the drug industry.
Herceptin (16% of sales) is the primary treatment for early stage HER-2 positive breast cancer and metastatic gastric cancer. Roche estimates its market share in Europe's five largest markets is approximately 75% with similar penetration in the U.S. market. Herceptin revenue grew by 11% in the first six months of 2012. The patents on Herceptin are set to expire in the EU in July 2014, and in the U.S. in June 2019. Generics giants Hospira and Stada are working on their own biosimilar versions of Herceptin, so it looks like there will be no shortage of competition. Private firm Synthon B.V. announced in July that the firm has entered into a global licensing agreement with Amgen (AMGN) and Watson Pharmaceuticals (WPI) for the clinical development and testing of biosimilar Herceptin as an alternative to Roche's blockbuster. As the Synthon phase III trial is still not under way, a Herceptin biosimilar should not arrive on the market at least until early 2015 as well. One item to note on Herceptin is the HERA study promoted by Roche, which is examining the benefit of utilizing Herceptin for two years rather than the standard one. An opposing study, PHARE, is looking at whether patients get the same benefit from using the drug for just six months. PHARE is a small study sponsored in France. A positive HERA study would enhance the revenue prospects of Herceptin, whereas the PHARE study could wipe out a good portion of Roche's revenue. The most likely outcome is that the current standard will hold, but it is a risk to any investor in Roche.
Roche's diagnostics business is also strong. With a 20% share of the global in vitro diagnostics market, Roche solidly holds the top position in this healthcare industry over competitors such as Johnson & Johnson (JNJ) and Abbott Laboratories (ABT). Roche's diagnostic group sales advanced by 5% in the first half of 2012, including 17% growth in Asia and 13% growth in Latin America.
Roche generates 63% of its total sales from outside the United States. Within pharmaceuticals, 37% of its revenue is derived from the U.S., 25% from Europe, 12% from Japan, and 28% from emerging markets. Growth in China over the past twelve months grew by 35%. Growth in Russia and Brazil were both over 10%. Roche is 2nd in market share in Brazil, and third in both China and Russia. In diagnostics, Roche has a commanding emerging market exposure, with 47% of total sales from those high growth markets. Roche has doubled its sales force in China in the past 36 months. As the share of patients in emerging markets is substantially underrepresented, Roche can increase revenue in its primary products through its sales force. For example, in Brazil it maintains approximately 1850 patients for Herceptin. Roche has forecasted that by 2017, the number of Herceptin patients in Brazil will double.
Balance Sheet/Free Cash Flow
Today, Standard & Poor's Ratings Services raised its long-term corporate credit rating on Roche to AA from AA-. At the same time, the A-1+ short-term rating was affirmed. Standard & Poor's commented, "The upgrade reflects that Roche has transitioned into the credit metrics compatible with higher ratings. The group has achieved continuous strong free cash flow generation, based on a portfolio of mature and growing products, basically not threatened by near-time patent expirations."
Standard & Poor's was obviously impressed with Roche's financial condition. The firm did generate $5.7 billion in free cash flow in 2011 at constant currencies. Roche's free cash flow generation has averaged nearly 7% in the past three years. Roche covers its debt 13 times over. On a per share basis, its free cash flow yield continues to be above average and at the top of its peer group.
|2008 HY||2009 HY||2010 HY||2011 HY||2012 HY|
|FCF growth per share||4.81||6.78||6.43||6.86||7.17|
In part two of my analysis of Roche, I will analyze the firm's dividend history and growth potential, its relative valuation, outline my prognosis for Roche's big three cancer drugs, and lastly discuss the firm's key new revenue opportunities/pipeline of new products.
Disclosure: I am long RHHBY.OB.