AstraZeneca - I Expect A Dividend Cut

| About: AstraZeneca Group (AZN)

Summary

AstraZeneca is nearing another patent cliff.

Late Stage Pipeline will take longer to deliver and investors could lose patience.

Over the last 3 years, AZN has been burning cash.

With future cash flows under pressure and a leveraged balance sheet, AZN may need to cut on dividend payout.

The next three years will be very painful for AstraZeneca (NYSE:AZN) as it will face multiple patent expiries. The new expiries will add to the pain of ongoing generic erosion of recently expired blockbusters (Nexium and Pulmicort). The company will lose patent protection across geographies on most of its cash -cows, and AstraZeneca is certainly not in a very strong position to deal with these pressures.

The balance sheet this time is leveraged and the late stage pipeline may be ripe but not enough to offset the near-term pains. For the nine months ending September 2015, AZN generated $2.8b as cash flow from operations (before capex), while it paid out $3.5b as dividends (9-month cash flow statement of AstraZeneca). There is no dividend payment scheduled for Q4-2015, hence net cash flow from operations after dividend payment for the full year 2015 for AZN would be just $300m (not accounting for capex/acquisition spend).

AZN has been consistently running a deficit for the last three years. From a net debt of $1.3b as on Dec 31, 2012, it has risen to $5.9b as on Sep 30, 2015. With the recent acquisition of Acerta and ZS Pharma, net debt position should further deteriorate (~$11b) in the coming quarters. This may not be a situation of distress, but certainly, I see the dividend payments at risk going forward.

Financial Impact of Patent Expiry

The patent expiries should cumulatively knock off 50 percent of its 2015 EBIT by 2018. The pipeline may not be immediately able to replace the loss and hence I foresee a dividend cut as a decent possibility. I foresee AZN lowering its dividend payments by 15% from current levels, which should lead to a proportionate correction in the stock price. I recommend the following position on AstraZeneca:

1) Buy Put Option - Strike Price $31.25 - Expiry January 20, 2017 - Last traded price $2.8

2) Sell Put Option - Strike Price $25 - Expiry January 20, 2017 - Last traded Price - $0.64

3) Sell Call Option - Strike Price $40 - Expiry January 20, 2017 - Last traded price - $0.75 strike price of $30 on AstraZeneca and at the same time selling AstraZeneca Put option expiring January 2017 at a strike price of $27.5

Patent Expiry Burden - 2016 to 2018

Over the next three years, approximately 40 percent of AZN 2015 estimated sales (~$24b) will be at risk of generic competition.

  • Crestor will lose patent protection across geographies (US - July 2016, EU - 2017 and Japan - 2018)
  • Nexium will lose patent protection in Japan in 2018
  • Pulmicort will lose patent protection in China in 2018
  • Symbicort generics are expected to enter the market by 2018
  • Generics for Seroquel XR will enter the US market beginning November 2016 (As per a settlement agreement).

Apart from these new patent expiries, recently expired drugs like Nexium will witness an imminent erosion in sales going forward due to entry of multiple players and the full-year effect.

Estimating the Impact of Patent Expiries on Free Cash flow (2016-18)

1) Crestor - Crestor which sells around $2.8b (Q3-2015 US sales annualized) in the US will be open to generic competition from July 2016. About 8-9 generic players (which have already received a USFDA tentative approval) are expected to enter the market as soon as the patent on Crestor expires in July 2016. With such immense generic competition, Crestor sales in the US will face a quick erosion. I expect AZN annual sales in the US to decline by approximately $1b in FY 2016. This should approximately translate into a net decline of $500m in annual net profits. In FY-17, the Crestor sales will be almost washed off in the US. The negative impact on net cash earnings in 2017 would be close to $1.4b.

In Europe, we will see entry of full generic competition in 2017 onwards. Crestor currently generates ~$900m annually in Europe and sales are currently declining 9% annually on account of existing generic competition in select geographies in Europe. Post full generic competition in Europe in 2017, sales in Europe should decline by 50 percent from current levels, affecting EBIT by $200m.

2) Seroquel XR

AstraZeneca has a settlement with four generic players (Accord, Handa, Lupin and Intellipharmaceutics) which allows them an early generic entry in the US (November 1, 2016), one year ahead of the patent expiry in November 2017. In Q3-2016, Seroquel XR generated $187m in sales. On an annualized basis, the same translates into $750m. With four generic players expected to enter in November 1, 2016, AZN should lose about $200m in 2016 and the same should be around $650m in 2017. On the bottom line, this should translate into $260m.

3) Nexium Generic Entry in Japan and Full Year Erosion in the US

The first generic Nexium (by Teva) entered the US market in early 2016. A couple of months back, the first to file exclusivity expired and about five generic players have now launched copies of Nexium. In FY 2015, Nexium sales erosion in the US was limited as for most part of the year, Nexium had a single generic competitor Teva Pharmaceutical Industries Limited (NYSE:TEVA). Nexium is expected to contribute approximately $900m to AZN's revenue in 2015. With multiple generic players now on the US market, the revenues from Nexium should decline by about 80 percent in FY-2016. This should translate into a net revenue loss of $720m and impact EBIT by $300m.

  • Nexium loses patent protection on the active ingredient in Japan in 2018. Assuming generic entry in 2018, Nexium which sells about $400m in Japan annually should also face sales erosion.

4) Pulmicort Respules - Recent Patent Invalidation and Upcoming Patent Expiry in China

AZN earns approximately $400m from Pulmicort respules from the US. Out of $400m, approximately $260m comes in as royalty from its authorised generic partner -Teva, while the rest ($140m) comes in as direct brand sales by AZN. However, in the 2H-2015, two other generic players have also launched generic copies of Pulmicort respules. Elevated generic competition would affect AZN in three ways

  • Undercut AZN direct sales from Pulmicort respules
  • Also undercut the amount of royalty AZN receives from Teva
  • According to the agreement AZN has with Teva, the royalty rate too goes down when other generics hit the market.

In FY 2016, AZN core earnings is expected to reduce by $300m in the US on account of generic competition in Pulmicort respules.

The patent for Pulmicort respules expires in 2018 in China. Currently, China is the largest market for Pulmicort sales for AZN. AZN generates approximately $470m in annual sales from Pulmicort in China. Teva, Sandoz and Actavis which are already selling generic copies of Pulmicort respules in the US should be well prepared for a China launch in 2018.

5) Symbicort Generics

Symbicort comprises approximately 15 percent of AstraZeneca annual sales. In FY 2015, Symbicort is expected to gross $3.5b in annual sales. Symbicort belongs to a class of drugs LABA/ICS, which is the largest class among respiratory drugs, contributing around 40 percent to the respiratory drugs market.

I see AZN Symbicort facing multiple threats over the next three years. The impact is likely to be slow and steady and may lead to a sustained decline until 2018, while the larger part of sales erosion is expected in 2018 when substitutable generics should hit the US market.

  • LABA/ICS class losing market share to recently approved treatment options

Fixed dose LABA/LAMA combination is an emerging treatment option for COPD patients. The sales traction of the class is encouraging. It is expected that LABA/ICS combination would lose market share to fixed dose LABA/LAMA combination. Recent clinical studies have found that fixed dose LABA/LAMA combination offer greater lung function improvement compared to LABA/ICS combination in COPD patients with infrequent exacerbations.

  • Threat from therapeutic substitution:

Symbicort competes head to head with GSK's Advair as they belong to the same class of drugs (LABA/ICS). Advair loses patent protection in 2016 and it is expected that multiple generic players will enter the market. The key players expected to launch generic Advair include - Sandoz, Teva, Cipla and Mylan (NASDAQ:MYL). These generic copies when available would adversely affect the formulary access of Symbicort. AZN may have to opt to cut prices/offer higher rebates to sustain market share/formulary access in the US. I foresee a 20 percent impact on Symbicort sales

  • Threat from non-substitutable generics

Teva, Orion, and Sandoz are developing non-substitutable generic copies of Symbicort. These non-substitutable copies have the same ingredient as Symbicort but are not a proven bioequivalent. Hence, they need to be promoted as brands which would directly compete with Symbicort.

Teva has already received approval for its non-substitutable generic (Duoresp Spiromax) version of Symbicort in Europe. Orion and Sandoz should launch their non-substitutable versions by 2017.

  • Threat from fully substitutable generics

The USFDA has given its guidance to generic companies for developing a fully substitutable generic version of Symbicort. The guidelines are more or less similar to the ones laid out for a fully substitutable version of Advair. The essential differences being:

  1. Generic companies would need to conduct three additional in-vitro which are specific to MDIs (metered dose inhalers). Advair is a DPI (Dry powder inhaler).
  2. Minor changes to the inclusion/exclusion criteria for the in-vivo studies.
  3. Lower hurdle as far as device requirement is concerned, since MDIs are less complex than DPIs.

The draft guidelines for Advair DPI have already been laid out in 2013, while the guidelines for Symbicort generics have been announced just last year. The guidelines essentially being the same as Advair (rather milder) it can be safely assumed that anybody who is developing a fully substitutable generic Advair will also be developing a generic Symbicort. Some prominent names which are in advanced stages of development of generic Advair include Sandoz, Mylan, Vectura (OTCPK:VEGPF), Teva and Cipla.

Threat of Faslodex Generics

Faslodex is an anticancer drug marketed by AstraZeneca. Faslodex sells around $700m annually. The active ingredient patent protecting Faslodex has expired and the drug is now covered by formulation patents. The drug patents have been challenged in the US by about seven generic filers. If the decision goes against AstraZeneca, we could see an earlier than expected launch of generic Faslodex. The consensus does not expect generic competition until 2021, when the pending patents on the drug expires. In the event the generic prevails in the litigation, we could see generics entering the market as early as 2017.

Conclusion

Apart from these relatively mature drugs that face patent expiry and risk of generic competition, many of AZN's growth platforms (Brilinta) etc., also do not have a very long patent life remaining. The patent on active ingredient of Brilinta expires in 2019 in majority of the geographies. About 15 generic companies have already filed a Para-IV seeking a generic launch post expiry of Brilinta NCE patent in the US. With a leveraged balance sheet, patent expiry pains casting tremendous pressure on near term cash flows, growing R&D budget and launch expenses of recently approved drugs and valuations close to sector average, I see the risk-reward as unfavorable.

AstraZeneca Relative Valuation

AstraZeneca PLC - Relative Valuation
EV/EBITDA Last EV/EBITDA(e) 2016 EV/EBITDA NTM
AstraZeneca PLC 16.32 11.73 11.73
International Peers 15.84 12.27 12.25
Pharmaceuticals 9.12 9.69 10.37
FTSE 100 11.74 10 10.13
United Kingdom 6.2 8.19 8.31

AZN Performance/Valuation metrics vs. Sector

CAGR 15-19 AZN Sector
Group Sales 0.20% 3.40%
Rx Sales 0.20% 3.50%
Net Profit 3.40% 6.30%
EPS 4.00% 6.80%
Price/Sales 3.3x 3.9

Disclosure: I/we 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.

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