Given the premium that Novo Nordisk (NYSE:NVO) enjoys for its very strong position within diabetes care, you might think that a company with strong positions in two significant pharmaceutical areas would enjoy an even bigger premium. That's not the case for Shire (NASDAQ:SHPG), though, and investors may have an opportunity here to take advantage of one of the few bargains in the pharma space. Moreover, with Big Pharma likely on the prowl for add-on deals, Shire's relative value may make it an appealing target.
Decent Growth, Okay Margins
Admittedly, Shire didn't have the sort of fourth quarter that would make investors pile into the stock. It was okay, mind you, but not spectacular.
Total revenue rose 5% (matching estimates), with reported product revenue up 5%. Product revenue would have been up 10% excluding the generic-related revenue decline in Adderall XR, but I'm not a big advocate of just looking past such matters with pharmaceutical companies. Within its roster of products, Vyvanse was up a very solid 18% (making up more than 20% of revenue), while Elaprase was up 12% and Lialda was up 16%. Of the major patent-protected drugs, Replagal was the notable decliner as sales dropped 2% (though the much smaller Dermagraft was down significantly relative to last year and expectations).
Shire's margin performance was, well, marginal. Gross margin declined more than one point as reported, though product margin remain unchanged (Shire saw a lower mix of royalty revenue). The company does continue to spend aggressively on pipeline development (nearly 20% of sales on an adjusted basis), and the company's adjusted operating income was essentially flat for the fourth quarter. Even so, the high level of R&D spending hasn't prevented Shire from posting a pretty solid operating margin.
Challenges Early In The Year, Data Later On
Part of the investment issue with Shire is the convoluted patent and litigation situation at the company. Shire has been quite savvy in managing the expiration of its Adderall XR patent estate through settlements and authorized generics and management seems to think that it can maintain strong share, but there are risks of companies like Novartis (NYSE:NVS) playing hardball with the company. Elsewhere, the company has litigation underway regarding its drug Intuniv, and most analysts seem to be taking an initially bearish stand with the outcomes here.
As the year goes on, though, I would think the story should move from patent/litigation challenges to data. Strong Phase III data on Vyvanse as an adjunctive therapy for refractive depression (MDD) could add several hundred million (if not $1 billion) to the sales potential for Shire's largest drug, and a head-to-head study with Johnson & Johnson's (NYSE:JNJ) Concerta (which is available as a generic) could possibly drive some share gains if the efficacy data is significantly superior. Shire should also be in a position to present data on SPD557 in GERD; expectations here are very modest given the availability of generics and OTC drugs, but surprisingly good efficacy could bring some additional revenue into the model.
Turmoil At The Top - Growing Pains, Or A Growing Pain?
Shire has had to absorb more than a little senior management turmoil in recent months. It goes to the very top, where Flemming Ornskov has come over from Bayer to take on the role of Shire's CEO. Additionally, the company has seen the heads of Specialty Pharma and Business Development leave, and the earnings report last week also brought news that Sylvie Gregoire, head of Human Genetic Therapies, is leaving the company.
Turnover is a normal part of corporate life, but this is a lot of change to see all at once. Perhaps some of it is motivated by the change in CEO, with disappointed executives who saw themselves as candidates choosing to move on. In any case, companies like Sanofi (NYSE:SNY) and AstraZeneca (NYSE:AZN) have demonstrated all too well that management quality and depth to make a difference at pharmaceutical companies, and investors are right to be at least a little troubled by these changes. Said differently, if you accept the idea that there is a limited number of quality executives and believe that Shire has been managed well in recent years, the odds don't favor these changes as being for the better.
A One-Two Punch, With A Deep Bench
Shire has established itself as a meaningful player in two different categories - it has the largest share of the ADHD drug market (with major drugs like Adderall XR and Vyvanse) and it has a strong position in the rare disease/orphan drug market. These strong market positions have allowed the company to not only produce strong revenue growth, but also develop a sales and R&D infrastructure that leads to more effective drug development and revenue leverage.
On the ADHD side, Shire management thinks that it will hold close to one-quarter market share in the near term with Adderall XR (as mentioned above, the extent to which this holds true is a major bull/bear point of debate). At the same time, Vyvanse continues to show substantial share growth in a growing market. While the pediatric ADHD market is probably around 80% penetrated, growing use in adults is producing high single-digit category sales growth.
If I have a concern about Shire's ADHD business, it's with the next act. As companies like AstraZeneca and Glaxo (NYSE:GSK) have shown in their COPD businesses, it can be difficult to develop follow-on blockbusters when the efficacy of generic drugs is quite good. While a decade of patent coverage on Vyvanse mitigates this risk to some extent, I think it's worth asking if Shire can develop successively better drugs in this category.
On the rare/orphan disease side, I think Shire has a lot to look forward to in the coming years. Patent expirations for significant drugs like Elaprase and Replagal are on the distant horizon, and data on oral elglustat from Sanofi's Genzyme business could put a meaningful amount of share in the treatment of Gaucher's disease back up for grabs.
Still, the company has a very strong early-stage pipeline, as well as later-stage compounds targeting diseases like Sanfilippo syndrome and Krabbe disease. Investors in companies like Alexion (NASDAQ:ALXN), BioMarin (NASDAQ:BMRN), and Genzyme know all too well the benefits of investing R&D resources into these treatments. Not only are the trials usually pretty small and quick (at least in comparison to trials for oncology or cardiovascular drugs), but the reimbursement environment is still exceptionally positive.
And Shire isn't just about ADHD and rare disease, although they do make up about two-thirds of sales. Shire has been more than willing to build up its GI treatment franchise (and Resolor may be an under-appreciated asset there), and spent $750 million on Advanced BioHealing back in 2011. Here too, this is likely to be a business that develops slowly over time, but with significant long-term potential (upwards of $3 billion for diabetic foot ulcers alone).
Modest Growth Forecasts Could Prove Conservative
In forecasting Shire's long-term revenue growth, a key issue is the uncertain outcomes of its rare disease pipeline. Alexion, BioMarin, and Genzyme have all shown that it doesn't take a large number of approvals to generate significant revenue, and likewise that the market potential of many of these diseases is underestimated by the Street. Likewise, nobody really knows yet what the decline curve is going to be when biosimilars enter the picture.
I do expect Shire to ride products like Vyvanse, Elaprase, and Lialda to solid high single-digit revenue growth for the next few years. Longer term, I see Shire growing its revenue at a little more than 4% (on a CAGR basis), well below Novo Nordisk, but well above the Big Pharma group. What's more, I would say that there's definite upside potential to those numbers, as more distant revenue numbers include substantial probability-weighted components.
On the margin/cash flow side, I see somewhat less potential if only because Shire is already a very good operator. Even so, I believe Shire can better leverage its marketing infrastructure and R&D investments and gradually grow its free cash flow margin into the high 20%s and maybe higher - adding another 2% or so to the long-term growth rate.
The Bottom Line
At roughly 6% estimated long-term free cash flow growth, Shire seems undervalued below $111 or so. It's worth noting, though, that Shire could be worth even more to a Big Pharma acquirer, as there would be opportunities to strip out redundant G&A expenses, streamline sales even further, and perhaps drive incremental manufacturing efficiencies. Accordingly, while I don't think investors should pay much more than $111, a pharmaceutical company like AstraZeneca could pay meaningfully more and still generate solid returns on the deal.
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.