H.Lundbeck (OTCPK:HLUYY) isn't going to be an especially familiar name for many readers, as this Danish pharmaceutical company has largely sold through licensing partners in the United States. That said, this CNS specialist was the brains behind Forest Labs' (NYSE:FRX) highly successful depression drug Lexapro, and the company has some particularly interesting drugs in its pipeline. While the company's go-to-market strategy is still a work in progress and patent expirations are likely going to cut deeply into cash flows in the short term, this looks like a potentially undervalued name to consider.
Q4 Shows The High Price Of Transition
Lundbeck had an interesting fourth quarter, and one that got worse as you worked down the income statement. Revenue was flat with last year on a reported basis (and down 1% in local currencies), which was a decent beat relative to analyst expectations - particularly as the beat seemed to come from drugs that still have some patent life left. It's also worth noting that the company's biggest revenue generator, Cipralex (the European brand name for Lexapro), saw a 3% decline in revenue and made up almost 40% of the total.
Lundbeck also did pretty well on the gross margin line, as profits improved about a half-point and slightly beat expectation on improving mix. Operating income was the big issue, though. Lundbeck is spending aggressively to support new drug launches (both in the US and abroad), which led to higher marketing and administrative expenses, and new drug development, which led to higher R&D costs.
A sizable year-on-year decline in income (tied to the decline in Lexapro payments from Forest Labs) led to a big drop in free cash flow, but the company ended the year with more than 10 kroner per share in cash against a 90 kroner stock price.
… And It's Going To Get Worse Before It Gets Better
Lundbeck had a rough second half of 2012 at a time when most drug companies were doing reasonably well. That was punctuated with a steep drop near the end of the year, as management guided analysts toward much lower 2014 trough profits on more aggressive erosion expectations for Cipralex and Ebixa (better known to Americans as Forest's Namenda).
While Cipralex is already off patent in the U.S., it goes off in Europe in 2014. Lundbeck still has many years of revenue from Japan to look forward to, but it won't be enough to offset the losses. With Ebixa going off patent soon and Azilect going in 2015, about 50% of reported revenue is potentially at risk over the next couple of years.
The Cavalry Should Start Showing Up
The reason I'm positive on Lundbeck is similar to my argument for Forest Labs - the Street has been too aggressive in assuming that the company cannot replace past blockbusters with new drugs coming out of the pipeline. While CNS drugs can be difficult to develop, Lundbeck has a good record and a deep pipeline.
Lundbeck has a February 28 PDUFA date for Abilify IM - a long-acting depot formulation of successful antipsychotic Abilify. Although this is a near-term opportunity, I have modest expectations. While it is true that Abilify has been quite successful and drug compliance is a major problem with anti-psychotics (a fact that a long-acting formula would help resolve), the economic split with Otsuka Pharmaceutical is not all that favorable to Lundbeck, and Alkermes (NASDAQ:ALKS) could be a threat with its own PIII once-monthly version of Abilify. While I think peak sales of this drug could approach $1 billion, I think the odds of reaching that peak are relatively low - but it would still represent profitable revenue that will ease some pressure from patent losses.
The bigger 2013 launch/approval opportunity is from Brintellix (vortioxetine), an interesting new antidepressant with a PDUFA date in October. Somewhat similar to Viibryd (which is marketed by Forest Labs in the U.S.), this drug has a complex and synergistic mechanism of action - working as a neurotransmitter enhancer, receptor agonist and antagonist, and reputake inhibitor. The clinical data has been much less than perfect (a prior U.S. Phase III study failed), but that's not uncommon in antidepressant drug development.
All told, Brintellix seems to work at least as well as Viibryd and Pfizer's (NYSE:PFE) Pristiq, but has a more favorable side effect profile. Takeda has partnership rights to this drug in the U.S., and it could be a multi-billion dollar drug. Odds are that it won't be a first-line treatment (there are too many good generics for that), but there's ample room for success even as "only" as a second-line drug.
Two other drugs in the Phase III pipeline, brexpiprazole and desmoteplase, also have sizable long-shot potential. The former is an antipsychotic with billion-dollar potential and a potentially better/easier side effect profile, while the latter is a drug derived from vampire bat saliva that can break down the clots that cause ischemic stroke (but with a substantially longer half-life than tPA).
The biggest unknown in the pipeline is Lu AE58054 ('504), a selective 5-HT6 antagonist for Alzheimer's disease. Investors at Johnson & Johnson (NYSE:JNJ), Pfizer, Elan (NYSE:ELN), and Lilly (NYSE:LLY) know all too well how hard it is to develop an effective Alzheimer's drug and how easily hope can build. Lundbeck management has said that '504 met its Phase II primary endpoint with "clinically meaningful" results, but we won't see detailed data until the summer of 2013. That doesn't sound like the sort of data mining that companies have done recently to string along its Alzheimer's hopes, but we'll have to see the data to know.
Lundbeck has already indicated that it intends to pursue phase III development on its own if need be, but is open to partnership. This drug is meant to be given in addition to Aricept, but even an effective add-on treatment is a potential multi-billion dollar blockbuster.
The Strategy Needs Refinement, But The Growth Potential Is There
Lundbeck is a company in transition. While it has previously relied upon companies like Forest Labs to handle U.S. marketing, the company bought a U.S. company in 2009 (Ovation) and now has a specialty U.S. sales force. Even so, the company recently sold off its slow-growth legacy U.S. assets and would probably be perfectly willing to partner '504 if the right deal came around. As time goes on, I expect the company to look to build its emerging market marketing capabilities and rely less on U.S. partners, but that may well require an expansion beyond its core CNS focus to create a more leveragable base.
I include no expectations from '504 in my model, as I think the odds against Alzheimer's drug development make it too aggressive to do so. Even without that drug's potential contributions and the upcoming patent-related revenue losses, I see Lundbeck growing its revenue at a long-term rate of 2% to 3% (and that's with a potential 15% decline from 2012 to 2015/16).
Lundbeck has historically managed mid-teens free cash flow margins, but I don't think the company will manage that again until 2017/2018 as the company invests heavily into marketing and R&D. Longer term, though, I believe the company can boost that margin into the high teens. That leads to a steep-looking compound free cash flow growth rate of over 20%, a growth rate inflated by the low base created by 2012's results.
The Bottom Line
Even with a two-point premium in the discount rate to established Big Pharma companies like Pfizer, Lundbeck looks meaningfully undervalued today. That free cash flow looks to be worth upwards of $24 per share today, though clearly a lot is riding on Brintellix and to a lesser extent drugs like monthly aripiprazole, Selincro (for alcohol dependence), and brexpiprazole. Investors should note, though, that while the company established a sponsored ADR program in 2012, these shares are still not especially liquid in the U.S. - there is ample liquidity, though, in the European shares.
I realize that Lundbeck may seem too risky, too remote, or too unusual to attract many pharmaceutical investors, but this is what investors have to do if they want to find real bargains today. For investors willing to go where others won't, and willing to accept the twin risks of steeper patent-related revenue declines and pipeline/launch failures, Lundbeck could be an underappreciated name worth checking out.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.