Should Merck, BMS Fear Roche's Drug Becoming The I-O King?

| About: Roche Holding (RHHBY)

Summary

The Swiss biotech giant Roche Holding Ltd. has reported Q4 and full-year results.

These results were judged "good" by the company, and it may be poised to overcome upcoming biosimilar competition.

The upcoming lead drug for Roche could be its immuno-oncology asset Tecentriq, a competitor to Opdivo and Keytruda.

This article reviews some aspects of Tecentriq and why I'm watching it to see if it exceeds Street expectations to perhaps become the lead drug of its class.

Other aspects of Roche's product line-up and my rationale for owning the stock are discussed, as well.

Background

Roche Holdings (OTCQX:RHHBY), the major subsidiary of which is the biotech giant Genentech, provided an informative review of operations and R&D progress in its last conference call following a report of good Q4 and full-year sales and earnings. A slide show provided good detail as well.

There are many aspects to Roche, including a sizable and growing diagnostics division, and it has a larger percentage exposure to China than most of its US peers. So, one thing this article cannot do is assess RHHBY in its totality as an investment. However, I'm long the stock and have been adding to it as part of my shift to below-average P/E stocks, which have market or better-than-market prospective growth prospects (of course, there are a couple of exceptions to the low P/E theme, but they are minor in my portfolio).

Simply put, RHHBY trades at 22.3X TTM EPS and a projected dividend yield of 3.33% as compared with the S&P 500, which at 2,365 trades at 24.4X TTM GAAP EPS for 2016 with above 86% of companies having reported as of last Friday, when S&P put out its weekly data update. So RHHBY is at a 9% discount to the market and its dividend yield is far above the 2% at which the SPY has been trading, more or less, for years.

Why might RHHBY be a little too cheap?

One reason might be a bit of Swiss reserve. How many US pharma companies would headline their investor page this way:

Roche reports good results in 2016

Huh? Good results? That's all?

These bullet points from an accompanying webpage give the investor a good very high-level overview of the company:

  • Group sales increase 4%1 at constant exchange rates, 5% in Swiss francs
  • Pharmaceuticals Division sales up 3%, mainly driven by cancer medicines Perjeta and Herceptin as well as Actemra/RoActemra
  • Diagnostics Division sales grow 7%, driven primarily by immunodiagnostic solutions
  • Successful launches of four new medicines; five US FDA breakthrough therapy designations granted
  • Emicizumab prophylaxis shows positive results in people with haemophilia A in pivotal trial
  • Successful launch of new immunochemistry instrument cobas e 801
  • Core earnings per share up 5% at constant exchange rates, 8% in Swiss francs
  • Board proposes dividend increase to CHF 8.20
  • Outlook for 2017: sales expected to grow low- to mid-single digit, at constant exchange rates. Core earnings per share targeted to grow broadly in line with sales, at constant exchange rates. Roche expects to further increase its dividend in Swiss francs.

It would be tempting to run through the financials, highlight the likely Ocrevus launch (a potential blockbuster for MS) and other new drugs that could allow good growth even as biosimilars encroach on some current blockbusters; and how diagnostics can grow indefinitely in the era of personalized medicine.

But I'll just sum up an overview of RHHBY as being by far the largest biotech company, with the broadest range of products; the largest biotech cancer company; and the biotech company with the largest pipeline. Given all that, I expect that the dividend will continue to rise, and that given interest rates in the US and Switzerland, a 3.33% dividend yield (if that's really what it will be when announced) is too high. Or, to put it another way, a trailing earnings yield of about 4.4% is also too high both for today's bond yields (looking at RHHBY as a bond equivalent) or today's SPY.

To summarize, my current view of RHHBY is that it's a sound vehicle for my savings for:

  • current yield
  • reasonable prospects for dividend growth
  • possible price appreciation either at the pace of dividend growth or faster, should Mr. Market give RHHBY more like a 25X P/E or greater, in line with its less dynamic Big Pharma comparators.

To exemplify this thinking, and to tie into the prospects both for Merck (NYSE:MRK) with its Keytruda blockbuster and BMS (NYSE:BMY) with its Opdivo blockbuster, I want to concisely make the case that RHHBY's similar immuno-oncology drug Tecentriq might surge into a permanent lead in the same space as Keytruda and Opdivo.

An investor's introduction to 'programmed death' and immuno-oncology

This is such a large and important subject, it could reasonably be the subject of one article or a multi-part article for investors interested in a deep dive into one of the major growth areas of pharmaceuticals for the years ahead.

In theory, but only theory as matters stand now, immunotherapy could be an important part of non-surgical treatment of all cancers. We're not there yet, but use is growing in more and more tumors. So the market is potentially huge. Already, BMY's Yervoy, working by one mechanism, and Opdivo and Keytruda working by the programmed cell death ("PD") mechanism, have helped spearhead a mindset change amongst pharma companies and oncologists.

Keytruda is approved, with certain limitations, for three cancers, most importantly certain types of the most common lung cancer.

Opdivo is approved, with certain limitations (which are not identical to those for Keytruda), for the same three types of cancers plus three others. These are kidney and bladder cancers plus a specific setting for Hodgkin's disease (lymphoma).

Both drugs were approved within months of each other late in 2014.

Each works by blocking the programmed cell death-1, or PD-1, protein. This protein is part of a complex system that, in normal health, functions to restrain the immune system from attacking healthy cells. However, some cancers overexpress PD-L1, to which PD-1 binds, to trick the immune system to treat them as normal healthy cells.

Tecentriq, from RHHBY is a later entrant, approved in May 2016 for urothelial (bladder) cancer. In October, it was approved for metastatic lung cancer, with limitations. It is already taking share from Opdivo in lung cancer.

Unlike Opdivo and Keytruda, Tecentriq works by a different though related mechanism. All these three drugs are antibodies, but Tecentriq blocks a protein, called a ligand, to which PD-1 binds. This protein is, somewhat confusingly but with logic, called PD-L1. Even more confusingly, PD-L1 can be found both on cancer cells and on T-lymphocytes, which all these drugs are designed to stimulate to kill cancer cells. According to Genentech, blocking PD-L1 allows blockade of an additional receptor, B7.1, on T-cells, which blocking PD-1 does not accomplish.

Genentech has an informative PDF out regarding these topics. See Slide 15 that relates to the above topics, and apologies to any specialist for any imprecision of words.

It points out that PD-L1 blockade may allow for more complete anti-cancer action than PD-1 blockade.

RHHBY has been talking Tecentriq up to the professional trade as, possibly, a superior antibody at least for some cancers. That's not proven, though.

In a Fierce Biotech article this past October, Genentech spoke with ebullience (emphasis added):

In Phase III data presented at ESMO, Tecentriq improved overall survival among previously treated non-small cell lung cancer patients by a median 4.2 months over chemo. Patients in the Tecentriq arm lived a median 13.8 months, topping a 9.6-month figure for chemo. The Tecentriq figure was "essentially unprecedented," Dan Chen, head of cancer immunotherapy development at Genentech, told FiercePharma. He added that the number "suggests that Tecentriq really does have a powerful survival effect."

So we shall see, but it's at least thinkable that PD-L1 blockade could allow superior results to PD-1 blockade, at least in some diseases. And, of course, results could be worse, as well. But since Genentech is talking tough here, and two of the three PD-acting antibodies I know of in development use the PD-L1 mechanism, others in the industry may agree with Genentech.

There are other reasons why Tecentriq may become #1 in PD-acting drugs, which was not industry consensus when that Fierce Biotech article was written. It commented on projected product sales as follows:

Bernstein's own estimates put Tecentriq at $4.9 billion by 2021. It is forecasting Opdivo at $8.1 billion and Keytruda at $6.5 billion, with AstraZeneca's (NYSE:AZN) yet-to-be-approved PD-L1 checkpoint inhibitor [durvalumab] running a distant fourth, but still a blockbuster, at $1.8 billion.

There's no way to be sure, but one of my reasons for going long RHHBY is the chance that it will beat those numbers.

Other reasons why Tecentriq might beat expectations

Just to begin with a couple of secondary points:

Tecentriq is given every three weeks, whereas Opdivo and at least one of the development-stage antibodies are given every two weeks. That's a modest but real marketing advantage.

Another potential modest advantage could be the name. The "T" in Tecentriq refers to T-lymphocyte cells, which the drug is designed to activate against cancer cells. The "-centriq" ending is good in that indeed, the drug is "T-cell-centric," and here the "-iq" ending to the name, which is done for certain other drugs, fits naturally as a permutation of the common "-centric" suffix.

In contrast, Opdivo and Keytruda suggest little to me. "Opdivo" could just as well describe a product for use on the eye, as pronounced one way, it sounds like "optical."

These may seem like small things, but drug companies spend years finding the optimal name for a branded drug, even though in theory, it should be a compound's medicinal characteristics to which the prescriber responds, not a trade name. But in the real world, subliminal things such as brand names do matter, especially as companies jockey not just for percentage points of market share, but tenths of points.

The above topics aside, what impresses me the most about Tecentriq is the enormous program that RHHBY has built around this drug. I have not seen anything like this in the industry, and it's all or almost all in-house; and the cost is being expensed, not amortized even though this represents an investment for many years of potential profits.

Genentech's immense push centered around Tecentriq

This is by far the largest division of Roche, about the same size as MRK in revenues and larger than J&J's (NYSE:JNJ) pharma division. The RHHBY website notes that the company (not only the dominant Genentech division) employed more than 17,500 people in R&D in 2014.

The oncology pipeline has 92 line items by my count, broken down this way:

  • Six filed marketing applications
  • 42 Phase 2-3 efforts
  • 44 Phase 1 efforts.

These do not by any means represent 92 different drugs, though.

For Tecentriq (atezolizumab), in addition to two lines for pending marketing applications for lung and urothelial cancers possibly in the EU, I see:

  • 10 stand-alone line items in Phase 3
  • Five stand-alone line items in Phase 1.

For this drug, in combination with one or more other drugs, I count:

  • Seven line items in Phase 3
  • 12 line items in Phase 1.

Of the total of 94 line items listed under oncology, 36 involve Tecentriq/atezolizumab, about half tested as one drug, and about half tested with at least one other Genentech drug.

This is an immense effort.

Besides attempting to become the big dog in this space with PD-1/PD-L1 therapy becoming integral to the treatment of more and more cancers, earlier and earlier in the course of treatment, there are other commercial benefits to this approach. For example, combining a young drug, Tecentriq, with an aging one, Avastin, might help Avastin resist biosimilars due to bundling sales of one with the other.

On the other end of the product age spectrum, a success combining Tecentriq with a Phase 1 drug may help move the latter along when it might not look promising as a stand-alone agent. Then, years later, if the Phase 1 candidate comes to market and is approved for use in combination with a then-aging Tecentriq, the new drug might return the favor and help Tecentriq deal with biosimilars.

Beyond those potential marketing advantages, the other companies with PD-1/PD-L1 drugs have not had the scale in oncology that Genentech has. So to extend their reach, they have had to partner with other companies. But it's easier and more economical, and more private, to do as much as possible in-house. So that's an ongoing advantage.

All things considered, my current opinion is that RHHBY is following a well-thought-out with Tecentriq. If the overall PD-L1 story pans out as RHHBY hopes, then the intrinsic strengths of the drug plus Genentech's immense R&D scale and general competence could make this drug the leader in its class in my humble opinion.

If that happens, then perhaps both BMY and MRK might gradually suffer if their drugs do not quite (or more than "quite" meet longer-term rosy scenario expectations.) Pfizer (NYSE:PFE) and Sanofi (NYSE:SNY) have partnered with smaller companies to bring their own PD-1/PD-L1 drugs to market. (There may well be other companies that are farther along in this busy field than I'm aware of.)

A caution on PD-1/PD-L1 drugs

Both as investors and, more importantly, as people, it's important to know that except for some examples of long-term remission or perhaps cure with Yervoy or a PD-1 drug, these agents are still basically palliative therapy. They also may have significant, even fatal side effects, generally related to their actions as immuno-stimulants. Unfortunately, stimulating T-cells via blockade of the PD-1/PD-L1 pathway(s) can allow T-cells to perform unwanted aggressive activity upon healthy cells, not only cancerous ones.

If you go to the Tecentriq prescribing information, pages 15-19, you can see the tables and graphs showing various percentages of different therapeutic outcomes. These are, to put it mildly, mostly not too wonderful.

The future role of immunotherapy in cancer treatment is evolving rapidly. I like RHHBY here in this field due to its broad approach to cancer, not limited by any means to Tecentriq.

Another drug to watch with RHHBY

RHHBY highlighted Ocrevus in its earnings press release second to Tecentriq, and I agree with that emphasis. Its commentary reads this way:

Additional data presented at the ECTRIMS4 congress in September showed that Roche's ocrelizumab [Ocrevus] increased disease control in both relapsing and primary progressive multiple sclerosis (RMS and PPMS). Roche is seeking regulatory approval for this medicine in RMS and PPMS in the US and the EU. The US FDA's action date for a decision is March 28, 2017.

If approved, this would be the first drug indicated for PPMS, which represents an important minority of new MS cases, and the worst type. Ocrevus works by a novel mechanism. Assuming a favorable label, and no special attention paid to a small excess of cancers reported in the Ocrevus groups during clinical trials, which could have been due to chance, my hope is that the drug gets off to a strong start. I'd expect its first major use to be in PPMS, but as potent therapy for MS, it could became an important competitor. Finally, the rapidly deteriorating stage of relapsing-remitting MS, called secondary progressive MS, might see Ocrevus attempted given no good choices.

If Ocrevus and Tecentriq grow in concert, and the rest of the company performs as management expects, I'm looking for perhaps 4%+ annual dividend increases for years to come from RHHBY.

Risks

This article is both about RHHBY and especially about Tecentriq and the PD-1/PD-L1 space. Both RHHBY and immuno-oncology are huge subjects. As an ADR, RHHBY has some intricacies that a US-based investor may well wish to know about before buying the stock. As a mega-cap stock, of course, RHHBY is well-known to portfolio managers, probably more in Europe but also in the US. Thus, some degree of efficient market action would appear to be embedded in the stock. To the extent that QE has led investors to bid up valuations of both stocks and bonds, a stock such as RHHBY could be hit simply from declining valuations, even if the company meets expectations. And, of course, success for the company is not assured. Even success for Genentech might not save the company's results if, for some reason, the diagnostics division suffered a serious profits setback.

Finally, amongst many other risks to RHHBY and all the other stocks mentioned above, one that's of interest to US investors for a foreign-based multinational such as RHHBY are the complex currency translations.

Concluding comments - technicals and a summary

RHHBY also has some interesting and perhaps promising technicals. At $30.55 for the RHHBY ADR as I write this on Wednesday, the stock is up about 40% over the past five years. It may be "trying" to break up from a 2-3 year downtrend. Success in this move up might presage further positive price action.

Adding on dividends, that's a respectable performance. It has lagged some of its US-based Big Pharma peers, but many of them, such as PFE, MRK and Lilly (NYSE:LLY) trade above 30X GAAP EPS. In contrast, RHHBY is around 22X. So the mild outperformance of some of the US-based stocks is completely due to P/E expansion. Yet, for what little it may be worth, RHHBY may be the stronger company. It has a leading presence in many sectors of biotech, and if it hits a rough patch, its high R&D spending as a percentage of revenues for such a large company could be cut back to preserve profitability.

I also like the field of high tech diagnostics, both the "connected lab" concept about which the company is talking and about the prospects for greater use of advanced diagnostic tools assuming that personalized medicine advances in utilization.

The battle between Opdivo, Keytruda and Tecentriq is in the early days. No one clinical trial can make all the difference, given the differences between the drugs and differences between the many types of cancers that are now recognized (with perhaps further splitting of cancer into even smaller, more discrete diagnostic classifications).

Whereas Tecentriq is important to RHHBY, it's more of a swing factor than the one dominant drug. As I assess BMY and MRK, though, their PD-1 drugs are relatively more important.

With conservative management that dares to announce its full-year earnings report that it merely enjoyed "good results" in 2016, RHHBY has my support and shareholder dollars. I look at it as a probable step-up bond, with possible share price appreciation a secondary goal of owning the stock. When it was a stand-alone company, Genentech always struck me as the most innovative biotech, and it may remain the industry leader for years to come.

Thanks for reading and sharing any comments you may have.

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.

Additional disclosure: Not investment advice. I am not an investment adviser.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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