Lundbeck Looks Largely Played Out

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About: H. Lundbeck A/S ADR (HLUYY), Includes: OTSKY, SAGE
by: Stephen Simpson, CFA
Summary

Lundbeck's fourth quarter was a rare miss, and there's not much in the clinic to get excited about in the near term.

The board is still looking for its new CEO, but the company's recent comments suggest more flexibility when it comes to M&A and targeting adjacent CNS markets.

Today's price appears to offer high single-digit stock returns on the basis of low-to-mid single-digit growth, making Lundbeck a decent hold but one without many obvious drivers.

I’m often sloth-like when it comes to selling positions in good companies, but it looks to me like the time to part company with H. Lundbeck A/S (OTCPK:HLUYY) (LUN.CO) may be close at hand. Despite concerted efforts to differentiate its new product portfolio, Lundbeck is struggling to gain much headway versus generics in the U.S., while generic competition continues to threaten lucrative profit centers in the mature portfolio. What’s more, the cupboards are pretty bare when it comes to the pipeline, and though management seems more positive on M&A than it has in the past, early-stage assets aren’t likely to garner much enthusiasm.

Lundbeck shares are trading around my fair value, suggesting a total return potential in the high-single digits – which really isn’t too bad today (and part of the reason I’ve been slow to sell). The announcement of a new CEO could also be a stock-moving event (in either direction), as he or she will likely have a vision for Lundbeck that offers at least some change from today. I don’t believe my low single-digit growth expectations are all that aggressive, but these shares are looking pretty “meh” after a strong run driven by new launches and rigorous cost restructuring.

For Q4, “Meh” Seems Like The Right Word

Lundbeck’s fourth quarter results weren’t so great, but they weren’t a disaster either – hence, “meh.”

Revenue rose 11% (in constant currency), coming in just shy of the Bloomberg consensus. The company’s four horsemen of growth (Abilify Maintena, Trintellix, Northera, and Rexulti) delivered 30% growth, slightly below expectations, with strong growth in Trintellix (up 47%, a slight beat) and Northera (up 56%, a 7% beat), mixed results for Rexulti (up 32% but 10% shy of estimates) and weak results for Abilify Maintena (up 12%, 9% short of expectations). The company’s mature portfolio saw 8% revenue erosion, with the four old horsemen delivering mixed results – Cipralex down 14%, Sabril down 10%, Xenazine down 41%, but Onfi up 27%.

Gross margin improved three points for the year, and core operating income rose 15% (with over two points of margin improvement), but reported EBIT came in about 13% lower than expected on higher spending. That’s a pretty sharp reversal relative to recent experience, but COGS were a little higher on seasonal variability and higher than expected R&D isn’t a huge problem at this point.

Management did announce a decent return of cash to shareholders, with a DKK 8/share dividend that works out to a 2.7% yield.

The Cupboard Is Bare And The Cost-Cutting Has Played Out

Relative to where Lundbeck was a few years ago, the company has made quite a lot of progress. In addition to launching Trintellix and Rexulti, the company has successfully shifted a lot of its business toward the U.S., with North American sales up 17% this quarter and around 60% of the total. The company has also done a great job of managing generic competition and managing the life cycle of aging drugs, including maximizing the profitability of the highly profitable epilepsy drug Onfi.

Even more significant has been the expense restructuring. Though helped in part by new launches, gross margin is over eight points higher than it was in 2014 and likely heading higher still. R&D spending has dropped about 5% as a percentage of sales and the company has significantly tightened up its spending on SG&A (from around 48% to under 38% of sales).

But the question I have is “now what?” While higher revenue would allow for more/better expense leverage, I don’t think there’s much room to cut further – when Onfi goes generic late this year there will be an opportunity to reduce some sales headcount, but there aren’t significant cost-cutting opportunities that I can see.

Adding to that is the company’s weak pipeline. Lundbeck has a promising, but very risky, drug in Phase III testing for treatment-resistant schizophrenia. This could be a blockbuster, but won’t even be filed with the FDA for a couple of more years. Lundbeck also has an interesting vaccine for Alzheimer’s, but this is in Phase I and data won’t be available until late this year or early next, as management has elected to take a very slow, methodical approach. A new Phase III study of Rexulti in Alzheimer’s-related agitation is promising, but again not likely a contributor for a couple of years at best.

And…?

Lundbeck is still looking for a new CEO to replace Kare Schultz, the man who led those major changes and improvements. I don’t mind the board taking its time, and the company has said they want somebody with a solid science background. A blockbuster hire seems unlikely, but then I was surprised when they announced Schultz’s hiring too.

Once a new CEO is on board, I would expect a new vision for how Lundbeck will go forward. I don’t think it will be a radical departure, but management’s recent comments suggest more receptiveness to M&A and a willingness to stretch beyond the prior narrow focus on depression, schizophrenia, Parkinson’s and Alzheimer’s.

I think both of those moves are/will be essential. Markets like depression, schizophrenia, and epilepsy are very large in terms of the number of prescriptions written each year, but they’re dominated by generics and it is very difficult to develop new drugs with enough advantages in efficacy/safety to coax insurers to pay for them (as seen with both Trintellix and Rexulti, where prescribing/reimbursement have been challenging despite proven advantages over generics).

I also believe more M&A is necessary. Truth be told, Lundbeck’s internal R&D program hasn’t been all that productive. Rexulti and Abilify Maintena were discovered/developed by Lundbeck’s partner Otsuka (OTCPK:OTSKY), while Northera was acquired in the 2014 Chelsea Therapeutics deal. Only Trintellix has come out of Lundbeck’s labs recently (Onfi was also acquired), and that’s not a very encouraging track record.

For all of Lundbeck’s talk about looking to discover/design/develop drugs that more precisely target various receptors, the R&D productivity has been lacking – this at a time when companies like Sage (SAGE) have shown that there are still pathways to innovation in the CNS market.

I don’t expect Lundbeck to look to do large, flashy deals, as Lundbeck itself isn’t that big of a company (about 50% larger than Sage in market cap). With that, most deals will likely be for earlier-stage assets. Along similar lines, I really wouldn’t object to Lundbeck sniffing around for early-stage/venture-stage CNS companies with potential platform technologies/approaches that could create a more dynamic long-term R&D engine.

The Opportunity

For all of that, I do still see growth in Lundbeck’s future. Generic competition will squeeze harder on drugs like Sabril, and Onfi too will soon see generic competition. That’s a tough blow, given that Onfi is now Lundbeck’s largest drug (and one of its most profitable), and adoption of newer drugs like Abilify Maintena and Trintellix has been disappointing.

I am looking for long-term revenue growth of around 2%, with drugs like Abilify Maintena, Trintellix, Rexulti, and Northera doing the heavy lifting. I do expect Rexulti to get approval for use in AD agitation, and I also currently model a risk-weighted contribution from the company’s experimental ‘357000 schizophrenia drug. I do not model any contribution from the Alzheimer’s vaccine.

I also model some ongoing margin improvements; I believe operating margins will remain in the mid-20%s for a while, but could head toward 30% over time if the pipeline delivers. That all fuels a FCF growth rate of around 4%, which discounts back to a fair value around $48.50 today.

The Bottom Line

I realize this article is fairly critical of Lundbeck, but I think there’s an important difference between the great things the company has accomplished and its near- to medium-term outlook. I believe Lundbeck’s underinvestment in R&D and M&A is going to create another pinch/choke point in growth and I think it is difficult to see many exciting drivers today. The share price/valuation isn’t bad, though, so I can understand why investors want to wait to see the newer drugs continue to develop and see what the board does in terms of finding a new CEO (and what that person wants to do with the company in the future).

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.