Despite Incremental News, Roche Still Largely In A Holding Pattern

| About: Roche Holding (RHHBY)
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Roche is likely stuck in a 4% to 6% growth range as mature drugs like Avastin, Herceptin, and Rituxan dominate the revenue line.

Biosimilars are a credible threat to Roche's key franchises, and Roche may have to strike gold with its numerous immuno-oncology combo candidates to continue growing through that generic competition.

I expect Roche to have enough success within oncology and outside of oncology to maintain mid single-digit revenue and high single-digit FCF growth, supporting a mid-$30s fair value.

Roche (OTCQX:RHHBY) has gone basically nowhere over the last three months, continuing a lingering trend of underperformance relative to Bristol-Myers (NYSE:BMY), Merck (NYSE:MRK), and AstraZeneca (NYSE:AZN) over the past year. Nothing has gone dramatically wrong for Roche, but concerns over biosimilars weigh much more heavily on Roche than on Bristol-Myers or Merck and the company is only just getting its toe in the water with immuno-oncology drugs.

The shares continue to look like a good, but not great, investment candidate. Roche has had some recent success in its non-oncology pipeline, but there's more work to do and a real concern for some investors that the company will suffer a "growth gap" in the time where biosimilar competition to Avastin, Herceptin, and Rituxan chews into revenue ahead of expected ramps of new drugs in oncology, hematology, and autoimmune disease. I believe there's alpha to be generated buying Roche in the low $30s (or below) and selling in the high $30s, but it will be some time yet before Roche can really break out of this dull stretch.

Pretty Ho-Hum Second Quarter Results

Roche's second quarter/first half earnings weren't bad, but there was nothing in the numbers to make an investor really change their outlook on the company or the shares.

Constant currency revenue growth of 6% in the second quarter was a little better than expected, with pharma (up 5%) and diagnostics (up 8%) slightly ahead of expectations. Within those numbers, a familiar trend continues.

New drugs like Perjeta, Actemra, Kadcyla, Esbriet, and Gazyva are all growing nicely on a year-over-year basis, but all of those drugs combined are worth only about three-quarters of Herceptin's quarterly sales. The three biggest drugs - Rituxan, Avastin, and Herceptin, are growing at mid single-digit rates (5%, 4%, and 5%) and account for more than half of pharmaceutical sales and over 40% of total company sales. A similar phenomenon applies to diagnostics, where Roche's business is performing better than rivals like Abbott (NYSE:ABT), Danaher (NYSE:DHR), and Becton Dickinson (NYSE:BDX), but it contributes a quarter of the company's revenue and can only swing the needle so far.

On the margin side, it's largely more of the same. Reported operating income for the first half of the year was up 5%, and margin expanded about 20bp, and while that beat expectations, it was boosted by a one-time benefit (related to its pension plan) that I'd argue doesn't belong in "core" earnings. Gross margin was a little weaker on a year-over-year basis (down about 75bp) and marketing and R&D expenses were higher as the company continues to "invest" in its expanding immuno-oncology business.

Attempts At Shoring Up The Business Continue To Produce Mixed Results

Avastin, Herceptin, and Rituxan have been warhorses for Roche for a long time, but companies like Amgen (NASDAQ:AMGN) are making progress with biosimilars and it is largely just a matter of time before there's competition here. I don't think Amgen et al are going to be able to price these drugs at huge discounts, but losing even a third of the business to pricing and market share loss is going to hurt Roche.

Roche has been hoping to protect these businesses with new drugs like Gazyva, Perjeta, and Kadcyla, but the results so far have been mixed. The MARIANNE study of Kadcyla failed, the GOYA study of Gazyva failed, and there are definitely some risks with the upcoming results of the APHINITY study of Herceptin and Perjeta in breast cancer. On the other hand, the CLEOPATRA study of Perjeta was positive, the GALLIUM study of Gazyva was positive, and Kadcyla is doing well in second-line use.

As a result, the bottom line impact to Roche is likely to be manageable. Only an extreme (and perhaps irrational) bull would have counted on all of these studies to go Roche's way, so a lot of the damage is already reflected in future sales estimates.

Immuno-Oncology Remains A "Hurry Up And Wait" Proposition

Roughly, 25% of the abstracts at this year's ASCO meeting were related to immuno-oncology, and this is now the dominant theme in oncology. Since my last update, Roche secured its first IO approval, with the FDA approving Tecentriq - Roche's PD-L1 antibody - for advanced bladder cancer. This could be a $1 billion-plus opportunity for Roche, but you can expect that Bristol-Myers, Merck, and other PD-1/PD-L1 players will look to secure approvals here in time.

Immuno-oncology drugs can work astoundingly well in patients when they work, but response rates remain objectively low and difficult to predict. With that, there is huge interest in combination therapies, and Roche has an extremely deep pipeline of combination agents - most of which it owns.

Not all of these combos are going to be homeruns, though. Roche's early-stage results of Tecentriq and Cotellic in metastatic colorectal cancer weren't eye-popping to me, and neither were the very early-stage results of its combo of Tecentriq and anti-OX40 antibody. Roche's Tecentriq-Abraxane combo was more exciting, though, with a 38% response rate in a difficult-to-treat patient group (triple-neg breast cancer).

I believe Roche's clinical trial strategy today reflects the reality that not much is known about how these drug combos will work in practice. With that, I'd say Roche is taking the approach of throwing nearly everything against the wall and seeing what sticks. Just with Tecentriq, the company is looking at combos with anti-CD40, anti-CEA, anti-FAP, anti-OX40, and anti-IDO, and that's not even a full run-down of the combos (for instance, the company is looking at Tecentriq and its BRAF-MEK combo in melanoma).

Tecentriq looks as though it will be a strong drug for non-small cell lung cancer, bladder cancer, and possibly breast cancer, with other indications likely more dependent on combos. That's a good starting point, but it is going to take several years for these opportunities to scale up to meaningful revenue and there are no guarantees that Roche's combos will prove superior to those at Bristol-Myers, Merck, AstraZeneca, and/or other would-be IO players like Celgene (NASDAQ:CELG).

Little Change To Core Value

Roche isn't just an IO story, as ocrelizumab (Ocrevus) looks like a major potential winner in multiple sclerosis and emicizumab (formerly ACE910) has shown some exciting results in hemophilia. Moreover, Roche has a deep pipeline of Phase I and pre-clinical candidates, so it is certainly possible that the biggest contributor to 2025 earnings doesn't even have a name yet. Such is the nature of drug development.

I model Roche on the basis of success in IO and non-IO oncology preserving the company's strong market position and continuing to support mid single-digit revenue growth. I'm looking for long-term revenue growth of around 5%, with the possibility that a true breakthrough combo or unique new entity could drive higher growth. As a very large player, though, and one that has been highly focused on oncology, it's worth remembering that it takes a lot to move the needle here relative to a company like Bristol-Myers or Celgene.

On the other hand, Roche is a big player in cancer and yet doesn't have much of a presence in areas like prostate cancer, so there is still room to grow, let alone considering underserved diseases outside of cancer.

With a long-term revenue growth estimate of 5% and a FCF growth estimate in the high-single digits predicated on leveraging internally-developed and wholly-owned drugs, I still come up with a fair value of around $35.50.

The Bottom Line

Roche isn't undervalued enough to call it a sure-fire must buy, but I continue to believe it is a high-quality company with a deep pipeline. In the low $30s and below, I think this is a stock to consider, but I would consider lightening up in the high $30s or into the $40s. It's also worth noting that there's a solid dividend here and that the company has a deep pipeline that can help support future growth.

Disclosure: I am/we are long RHHBY.

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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