Lundbeck Continues To Rebuild Its Reputation

| About: H. Lundbeck (HLUYY)
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Lundbeck once again outperformed on the top line and across multiple expense categories.

A lot of the revenue outperformance was driven by drug franchises in long-term decline, but the company's new generation of drugs did outperform and continue to grow strongly.

Driving an interesting fair value requires factoring in some contributions from the high-risk clinical program, but success in schizophrenia, Alzheimer's, and/or Parkinson's could add significant value down the line.

It may be good advice to not look a gift horse in the mouth, but it's also a pretty good idea to not get overly excited about unreliable financial performance drivers. I'm still generally bullish on Denmark's H. Lundbeck A/S (OTCPK:HLUYY, LUN.CO) (or "Lundbeck"), but my enthusiasm is tempered by revenue beats that are coming largely from declining businesses, difficult marketing environments for key drugs, and a pipeline that may be hard-pressed to drive a lot of near-term pop.

I want to make it clear that I'm talking about the difference between tapping the brakes and diving out of the car entirely. I still think Lundbeck is a worthwhile idea as a long-term holding, but I think the sentiment has shifted from unduly (if not absurdly) negative a year or so ago to perhaps a little too positive in the near term. I still believe $38-42 is a reasonable fair value range for the ADRs, with potential upside from high-risk clinical programs where the value is presently heavily discounted, but I'm a little less excited about the near-term outperformance potential from the core drug business.

A Good First Quarter… Mostly

Lundbeck reported 6% revenue growth for the first quarter, with U.S. sales up 32% in local currency (the company's reporting currency is the Danish krone), international sales up 4%, and European sales down 22%. That total revenue figure was about 5% better than expected, continuing a strong run of better-than-expected sales results.

There are some quibbles with how they got there. Cipralex sales (up 2%) were about DKK 173 million better than expected (versus a total revenue outperformance of DKK 188 million), and given the patent status of this drug, that cannot be sustainable on a long-term basis. Xenazine was also stronger than expected (down 16%, beating by about 3%, or DKK 12 million), as generic competition from Sun Pharma (OTCPK:SMPQY) and Valeant (NYSE:VRX) is proving less disruptive than feared. Given that about a third of Lundbeck's revenue still comes from these two declining (long-term) franchises, I think outperformance here has to be discounted a bit.

Now, on a much more positive note, sales from the company's new generation of lead drugs were up 103% in local currencies and grew to about 36% of total revenue, beating expectations by about 6%. Abilify Maintena (up 110%), Northera (up 346%), Rexulti (yoy comps not meaningful) and Onfi (up 33%) were all stronger than expected, while Brintellix (up 152%) was a small disappointment once again.

Gross margin was better than expected, up about five points and more than a half-point ahead of expectations, on an improving mix. "Core" operating income rose 247% and came in almost 50% ahead of expectations with higher sales and better gross margin, combined with ongoing reductions in operating expenses (sales expense down 10%, administrative expenses down 16%).

Importantly, management increased its full-year revenue guidance by more than the amount of the first-quarter beat - suggesting (to me, at least) that the underlying business is fundamentally stronger than previously expected.

Brintellix/Trintellix - A Disappointing Setback, But Some Positive Notes

While Lundbeck was hoping to get the FDA's okay to highlight the cognitive benefits of its depression drug, Brintellix, on the label, I had long been skeptical that the agency would ultimately go along with this, as the precedent was against the company. Despite a strong 8-2 panel vote in the company's favor, the FDA refused Lundbeck's labeling request in late March.

This is definitely a setback, as such a labeling claim was seen as a critical step in getting better reimbursement coverage of the drug (which is considerably more expensive than generic alternatives) and in getting more attention within the primary care physician community targeted by marketing partner Takeda (OTCPK:TKPYY). (Lundbeck is focusing on the psychiatric community.) That said, this is not necessarily "game over" - Lundbeck will be meeting with FDA at a later date to go over the type of data it needs to potentially file a response to the agency's complete response letter, and the company does have four trials underway designed to generate more data on the cognitive benefits of Brintellix, all of which finish in 2016. I'd also note that the company had previously budgeted for a post-marketing study to support cognition claims, so such a study wouldn't disrupt its spending/margin plans.

Time will tell if the FDA relents; I think Lundbeck has a strong case, but the agency can be surprisingly stubborn about these things. In the meantime, while Brintellix continues to see an adoption curve about two-thirds the pace of Viibryd (the last branded depression drug of note to launch), it's worth noting that Lundbeck's drug is about 40% more expensive and is outperforming the launches of Latuda and Fetzima. What's more, the company has grabbed good share (20%-plus) of new branded prescriptions and isn't flattening off at this point like Viibryd did - suggesting, maybe, a slower start but a decent eventual ramp.

In terms of other bits and pieces, the company has changed the U.S. name of the product to Trintellix, because apparently there was some brand confusion with AstraZeneca's (NYSE:AZN) Brilinta. It's also worth noting that the launch in Germany has not gone well due to reimbursement issues.

Exulting In Rexulti

In contrast to Brintellix, Rexulti continues to perform pretty well, with the launch thus far outperforming Latuda. The drug now has about 8% share of new scrips, and the company is still hopeful that follow-on indications like agitation in Alzheimer's and PTSD (despite the need to start over with Phase III testing) can expand the opportunity. Given Lundbeck's higher share of Rexulti (partnered with Otsuka) relative to Brintellix, success here is actually more meaningful to the bottom line.

The Pipeline Can Add Value, But It Will Take Time And There Are Ample Risks

Like most drug companies, Lundbeck is simultaneously working to develop new indications for existing approved drugs and also move new compounds through clinical development. On the former, the company is hoping that clinical results support the aforementioned new indications for Rexulti, but is also looking forward to data on Brintellix in ADHD. Management also announced with first-quarter results that a study of Abilify Maintena met its primary endpoint in bipolar I disorder (with data to come later in the year).

In terms of new compounds, AF357000 looks like the best risk-adjusted candidate, as this oral drug for treatment-resistant schizophrenia is already in Phase III testing. Importantly, a large percentage of existing drugs for this indication, as well as compounds in clinical trials target D2, while Lundbeck's drug targets D1, 5-HT2A, and 5-HT6 - setting the stage for potential differentiation in efficacy and tolerability.

Idalopirdine is also in Phase III studies, but I believe investors have to be extremely skeptical about any Alzheimer's drug, and particularly those with mixed Phase II data. The fact that the entire 5-HT6 class of drugs has largely flamed out likewise cannot/should not be ignored. Lundbeck's other shot on goal in Alzheimer's, AF20513, is even further back, as the company's Phase I dose-ranging study is moving slowly. It now looks as though there won't be data available in 2016, but I'm cautiously optimistic about this unusual approach (anti-beta amyloid vaccine) to the disease.

It is also apparent now that the company has rejuvenated development of AE04621 for Parkinson's. This drug was originally added to the pipeline back in 2010, but development was suspended for some time. Now there is a Phase I study underway. I wish I had more to say about this drug other than that it is a dopamine modulator that works on the D1 and D2 receptors.

Not Much Changes For Now

Lundbeck's first quarter was a little better than I'd expected, but I'm not making any fundamental changes to my model at this time. I do think older drugs like Cipralex may outperform my initial 2016 expectations, but I don't expect that to have an enduring influence on the long-term numbers. To make more substantial changes to my numbers, I need to see more strength in the new generation of drugs and/or more clinical developments.

To that end, my model previously excluded contributions from unapproved drugs. The anti-psychotic AF357000 could easily be worth more than a $1 billion a year in revenue, but there's no data on it so far (other than what the company has seen, which is enough to move it quickly into Phase III). A 50/50 chance of success for this drug would add about $4/ADR to my fair value today, with a $1.5 billion peak revenue figure. The Alzheimer's programs could be worth at least as much, with the much lower odds of success offset by higher revenue potential, and an effective differentiated Parkinson's drug should likewise be worth at least $4/ADR.

I realize this is a pretty unscientific approach, but I'm going to start factoring in just under $4/share from the AF357000 program. I'm assuming $1.5 billion in peak sales, I'm assuming that Otsuka elects to partner (they have a right of first refusal), and I'm assigning 50/50 approval odds with margins in line with the company average. While overall Phase III success rates are higher than 50/50, I haven't seen data on this drug and the atypical anti-psychotic market is crowded, which increases the risk and the need for truly differentiated data. I'm still leaving out the Alzheimer's and Parkinson's programs, but will again acknowledge that success could add meaningful per-share value down the line.

The Bottom Line

Adding in '357000 boosts my fair value from a little under $38 to a little over $41.50 and suggests the shares are about 15% undervalued today. The FDA's rejection of expanded Brintellix labeling was definitely a setback, but investors should be encouraged by the progress seen with other new drugs. If the company can continue to deliver good sales growth and ongoing margin improvements, the shares should do alright. I am a little concerned, though, by the lack of near-term performance catalysts, so I can't call this a "must-buy" right now.

Disclosure: I am/we are long LUN.CO.

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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