I've recently discussed the key reasons I think Roche’s (OTCQX:RHHBY) guidance for 2017 is conservative, so in this article I will focus on a quantitative valuation of the company to show why I think Roche is an attractive investment if you believe in the ability of the company to deliver on their pipeline, especially in oncology.
DCF analysis, with inputs in line with analyst estimates, shows that Roche is trading at discount to its fair value, even on conservative assumptions on its pipeline opportunity.
I used the Excel template offered by Bloomberg, but I adjusted consensus estimates to reflect my view on Roche’s pipeline.
As discussed in my previous articles, I believe that 2017 is a key year to assess the ability of the company to deliver on its pipeline, given that the company will present the Phase III data for Perjeta in adjuvant breast cancer, ACE910 in Haemophilia and Tecentriq in 1L NSCLC, which I consider the most important assets in Roche's pipeline.
In my model, I have made the following assumptions behind these 3 key growth drivers:
- About Perjeta, Roche has recently reported positive headline data for the Aphinity trial, supporting the thesis of a clinically relevant benefit from using Perjeta in combination with Herceptin in the adjuvant breast cancer. Thus, I assume Perjeta peak sales to be around $6B.
- About ACE910, after the recent announcement of a patient death in the PIII trial in the inhibitor segment, I believe that the potential for the drug will be less than initially expected, especially in the non-inhibitor segment. It’s worth noting that the death of the patients has not been linked directly to Roche’s drug, but it seems to be the results of a rectal hemorrhage.
“It is our understanding that a patient experienced a serious rectal hemorrhage (the first reported SAE) and received bypassing agents, including repeated doses of activated prothrombin complex (APCC), after which the patient developed signs of Thrombotic Microangiopathy (TMA, the second SAE). The preliminary assessment is that the clinical and laboratory characteristics of this case of TMA are consistent with what was observed in the two previously reported cases; however, our evaluation of the available information is ongoing. The investigator concluded that the patient died as a result of the rectal hemorrhage and that Roche’s drug was not responsible.”
Despite that, I assume peak sales for ACE910 of only 2 bln $.
- About the opportunity for Roche in immunotherapy, I think there are still too many uncertainties about the outlook in this space, with Merck & Co. (NYSE:MRK), Bristol-Myers Squibb (NYSE:BMY) and AstraZeneca (OTCPK:AZNCF), which are fighting with Roche in this space and that will report their key Phase III results later this year. Thus, I assume peak sales for Roche’s I/O business of only 2.5 bln $.
Here are my key assumptions for the estimates of Sales, EBITDA Margin and FCF:
Sources: Bloomberg and My Own Valuation Model
As you can see, these estimates are approximately in line with consensus in terms of sales growth and EBIT margin over the period 2017-2021. It’s worth noting that my expectations are conservative because I’m not assuming the full potential of Roche’s pipeline in my 2022 numbers.
Sources: Consensus Comparison vs. My Own Valuation Model
To generate a DCF Analysis, I used 2 different methodologies:
- PERPETUITY GROWTH METHOD: I used fair assumptions for the perpetual growth rate and the WACC. In details, I used a perpetual growth rate of 2%, which is in line with the Bloomberg estimate and I assumed a WACC of 8%, that is in line with the peers one.
As can be seen in the table above, Roche is undervalued by about 12% based on the Perpetuity Growth Model. In addition to that, the sensitivity analysis shows significant upside (i.e. 67%); assuming more aggressive estimates for WACC (7%) and perpetual growth rate (3%).
- EBITDA MULTIPLE METHOD: This analysis reveals a similar result for Roche. The company still looks undervalued by about 14%. I assumed an EBITDA exit multiple of 11X, which is a reasonable assumption because it's in line with Roche's historical multiple, as shown by the following tables.
In terms of multiple valuation, it's worth noting that Roche is trading in line with its 5 year average historical P/E (absolute and relative valuation), as shown by the following analysis.
Roche's Current vs. 5 years average P/E (absolute analysis). Source: Bloomberg.
Roche's Current vs. 5 years average P/E (relative analysis vs. peers). Source: Bloomberg.
Lastly, a sensitivity analysis on this EBITDA Multiple Method shows that the implied perpetuity growth in my valuation of Roche is about 2.1%, which is a fair assumption for a company with one of the most exciting pipeline in the space.
Lastly, I modeled also a downside scenario. The key differences in terms of assumptions are:
- I assume low single digit revenue growth 2020-2022, which is below consensus. The key reason behind this assumption is that I consider a worst case scenario in which the opportunity of Roche in the Immunotherapy space for NSCLC will be smaller than expected and ACE910 will not be approved for its safety profile.
- I assume a limited improvement in the EBIT margin over 5 years, which is materially below consensus.
- I assume a 0% perpetuity growth rate and 9x EBITDA exit multiple, below Roche's historical multiple.
As a result of these assumptions, my estimate for 2021 revenue is 8% below consensus and my estimate for 2021 EBIT is 10% below consensus.
Sources: Consensus Comparison and My Own Valuation Model
Under this worst case scenario, Roche is overvalued by approximately 29% (Perpetuity Growth Method) and by approximately 16% (EBITDA Multiple Method), as shown by the following analysis: