It is a challenging environment today for biotechnology and drug companies. This is an industry beset with problems ranging from patent cliffs to increased competition from generics to fundamental regulatory reform. AstraZeneca plc (AZN) is a London, U.K.-based global biopharmaceutical company facing the same challenges as other global companies. The company sells branded pharmaceutical products across several major therapeutic classes including gastrointestinal, cardiovascular, respiratory, cancer, neuroscience, and infectious disease. Just less than 40% of its sales are derived in the United States.
Direct competition from generics is a permanent overhang for the company. It is estimated that generics is responsible for $2-$3 billion in lost revenues from 2011 to 2012. This is a trend that will accelerate as more and more drugs come off patent over the next several years. AZN also faces stiff competition on its branded drugs such as Crestor and Nexium.
AstraZeneca appears to have a two prong strategy for getting back on track. It is building up a pipeline of new drugs by being actively acquisitive and by establishing partnerships with other drug companies. Earlier this year, AZN acquired Ardea Biosciences, a company with a product for the gout market. Co-development deals are now commonplace for the drug industry. AstraZeneca now has a deal for arch competitor Pfizer (PFE).
A growing source of new revenue for AstraZeneca is emerging countries. Regulatory and pricing pressures in both the U.S. and the EU make developing countries are prime target. The faster growing countries, such as China and Brazil, offer the best opportunities. The growing middle classes in these countries, among others, are demanding better medical care to address diseases that were not prevalent not too long ago. With more wealth, diets in these growing economies are becoming more like the diets found in the developed countries leading to new diseases.
The company recently announced that it suspended its $4.5 billion share buyback program after purchasing $2.3 billion of its stock. Is this suspension just a prudent review by the new CEO, Pascal Soriot? There are also rumors that AZN has targeted Questcor Pharmaceuticals (QCOR), a $344 million (sales) company or Amarin Corp. plc (AMRN), a company with expertise in lipid science and no sales.
The question that comes to my mind is, can AstraZeneca get back to its former glory?
In the second quarter of 2012, sales dropped to $6.66 billion or by 21.0% from $8.43 billion in 2Q11. In the first six months of 2012, sales dropped by 16.0% compared to the prior year. On a trailing twelve month basis, sales dropped by 7.1%. Analysts estimate that sales for calendar year 2012 will range from $27.6 billion to $29.072 billion. The average estimate is $28.18 billion. They see further decreases in 2013 with estimates ranging from a low of $26.433 billion to a high of $27.955 billion. The average estimate is $27.366 billion. The average 2012 revenue estimate is about 19% less that revenues reported for 2011.
Earnings dropped by 16.4% to $1.27 per ADR when compared to $1.52 per ADR in 2Q11. For the first six months of 2012, EPS per ADR dropped by 29%. However, for the trailing twelve month period, EPS per ADR actually grew by 7.6% to $6.24 from $5.79. Analyst forecasts for the full 2012 fiscal year ending December range from $5.99 to $6.14 and average $6.08. The company reaffirmed guidance for a range of $6.00 to $6.30. In fiscal 2013, analysts estimate that EPS will range from $5.58 to $6.20 with an average estimate of $5.90.
Only two analysts polled by Thomson Reuters provide 3-5 year EPS growth estimates. These estimates range from -3.0% to 2.0% and average -.50%. In comparison, the historical five year growth rate is 13.7%.
The company is a strong cash flow generator. For the last twelve months, it generated $2.31 in free cash net of dividends paid.
Margin analysis can give us some insight to how well AZN may do in the future even on lower revenue. The current gross margin is reported as 81.1% compared to a five year average of 81.3%. The operating margin is 33.9%. The five year average operating margin is 32.82% suggesting that AZN is doing a good job of managing its expenses inn the face of decreasing revenue. The net profit margin is 26.6% compared to the average of 23.0%. These margins are down from FY11 levels reflecting increased pressure.
AstraZeneca has, in my opinion, a strong balance sheet. Cash and short term investments stand at $9.190 billion whereas long term debt is $7.31 billion. Long term debt as a percentage is about 2.5X free cash flow and represents about 147% of working capital. The debt ratios suggest long term debt an issue. Long term debt to total capital is 24.9% and long term debt to equity is 33.2%. Long term debt has steadily decreased from 2007 when it stood at $10.876 billion.
Profitability can be measured in several ways. Return on Equity (ROE) gives us one aspect. AZN reported ROE of 36.2% as of June 2012. This down from the 43.0% reported for 2011 and down from the five year average of 39.56%. However, the industry median ROE is negative. A more comprehensive view of profitability can be seen when looking at Return on Invested Capital. AstraZeneca has a five year average ROIC of 25.5%. Last fiscal year, the ROIC was 32.10%. I estimate that ROIC for the trailing twelve month period rose to 35.65%.
I verify the quality of the earnings based ROIC by looking at the Cash Return on Invested Capital (CFROI). AZN is a strong generator of free cash. Its CFROI is 22.76% whereas the industry median is about half tat level at 12.13%.
AstraZeneca is shareholder friendly in that it returns capital to its shareholders in the form of dividends and share buybacks. The company has an indicated dividend of $2.85 per ADR which provides a current yield of 6.0%. The payout ratio is about 45.6% of earnings and about 54.0% of free cash flow. Dividends have grown in each of the last seven fiscal years from $1.30 per ADR to the current level. The payout ratio has remained fairly consistent over the years and the dividend has grown about 10% per year, a little less than the EPS growth rate. If earnings should remain depressed for an extended period, we may see the dividend frozen or even decline.
The company has in place a $4.5 billion share buyback program. As reported above, this initiative was suspended after the company expended $2.3 billion in 2012. The average number of shares outstanding has decreased about 15% since 2007; about five percent from FY2010 to FY2011 and about 7% in the first six months of 2012.
Valuation is always in the eye of the beholder. With a trailing PE of 7.7X and a forward PE of 7.9X, the company looks undervalued relative to the market. The industry median PE is currently 16.6X and the median forward PE is 17.5X. The prospect of negative growth is reflected in these values. Other common metrics include Price to Sales and Price to Book, both of which are shown above and compared with the respective industry median. On a relative basis, PSR and PB also suggest undervaluation.
I prefer to use the Enterprise Value based multiples as these include net debt in the valuation. At 2.02X, EV/Sales is about half the valuation given to the industry median. Since AZN is free cash flow positive whereas the industry median company is not, the comparison is not really relevant. However, an EV to Free Cash ratio of 9.33X is not normally considered especially high. A very popular measure of value is Enterprise Value to Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). I estimate that AZN has an EV/EBITDA ratio of 4.96X, well below the industry median of 10.38X.
AstraZeneca, just as other companies in this space, is facing formidable challenges. The next several years be difficult for it as it builds it drug pipeline and moves more aggressively into new markets. However, I think AZN offers a compelling opportunity for the patient investor. AZN is not dependent on any single drug and is not dependent on any single market. It has there wherewithal to invest in new drugs either in-house or through acquisition and the ability to exploit its global presence. In the mean time, the company pays a hefty dividend and may resume share buybacks.