Where Does Lundbeck Go After A Brutal Round Trip?

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

Lundbeck shares have been pummeled by a combination of late-stage pipeline failure, looming generics-driven pressure, and disappointing contributions from newer assets.

A strategic review is welcome (and necessary), but M&A and in-licensing are only a part of the potential solution.

Lundbeck shares look undervalued again, but it will take time to rebuild trust and find/develop assets to reignite exciting earnings momentum.

I had suggested investors lighten up on Danish drugmaker H. Lundbeck A/S (OTCPK:HLUYY) (LUN.KO) earlier this year, and I wish I had fully followed my own advice and sold out my position, rather than just meaningfully reducing it. Between ongoing disappointments in the performance of its new drug portfolio and the crushing disappointment of its only novel late-stage asset, Lundbeck shares have plunged almost 50% from the mid-year high and now sit down about 10% for trailing 12 months (and back where it was at in late 2016).

At this point I think there is an argument that Lundbeck shares are undervalued, but that will be a tough argument to sell to the Street given the company’s virtually empty late-stage cupboard and the ongoing challenges in its portfolio of recently-approved drugs. On the plus side, Lundbeck has a clean balance sheet and should generate significant cash flow in the coming years, giving management a better set of options to boost the portfolio and near-term performance.

DAYBREAK Shatters

Expectations are a funny thing, and the reaction to the failure of Lundbeck’s Lu AF35700 in treatment-resistant schizophrenia (the pivotal DAYBREAK study) is a case in point. Most sell-side analysts were treating this trial as a toss-up and either significantly discounting the future revenue contributions or excluding them from models altogether. Investors were taking a different approach, though, and the failure of this late-stage asset send the stock down sharply in late October.

That ‘35700 failed is not so shocking. Treatment-resistant schizophrenia is not only a horrible condition, it’s beastly hard to treat. While Lundbeck designed the study in such a way that it should have favored a positive outcome, management hasn’t tried to “polish the turd”; management was clear that while there’s a very slim chance of finding a worthwhile indication, there’s no real path forward they see in treatment-resistant schizophrenia.

Although the reaction to this trial failure was outsized, I also understand the disappointment. This was really the only exciting asset in Lundbeck’s late-stage pipeline and the only asset that seemed likely to offset generics-driven revenue contraction in drugs like Onfi, Sabril, and (eventually) Northera. While there are some worthwhile follow-in indications being pursued for brexpiprazole (Rexulti), this was a chance at a legitimate blockbuster for the company and one that was apparently more key to sentiment than I’d realized.

Third Quarter Earnings Reflect Some Looming Challenges

Lundbeck reported another modest beat-and-raise quarter with its third quarter earnings release, but the results also highlight some meaningful upcoming challenges for management and the business.

Revenue was up 9% in local currency, which was a nice result, but it was driven in no small part by the ongoing success of Onfi (up 21%), the company’s largest drug at close to 20% of sales and one with looming generic competition. Lexapro and Sabril continue to hang on (contributing close to 20% of revenue combined), but the company’s portfolio of new drugs (Abilify Maintena, Trintellix, Northera, and Rexulti) once again disappointed, coming in 5% below expectations on a big miss from Northera.

Abilify Maintena revenue grew 23% in the quarter, but the drug added only a little more than a point of market share in the U.S. long-acting antipsychotic market versus the year-ago level. It’s a credible drug in a growing market, but the company really isn’t chipping away at Johnson & Johnson’s (JNJ) share very significantly. Trintellix and Rexulti were both up more than 30% (33% and 38%, respectively), but Trintellix once again missed expectations in the U.S. as the company struggles to gain volume share in the depression market due to significant resistance from payors, despite a much more cooperative FDA (Lundbeck recently secured an expanded labeling claim that includes better performance with respect to sexual dysfunction side-effects).

Last and not least, Northera was surprisingly weak. Sales dropped 6% on some inventory issues and what management described as challenges due to high out-of-pocket costs for the drug. Most of the issues hitting the results this quarter weren’t new per se, but I don’t feel that management had a particularly compelling or convincing explanation for why they hit results as hard this time around.

Gross margin was once again quite strong; up almost three points to just under 81%. Unfortunately, this line item could be under pressure soon. Management is expecting severe generic competition for Onfi starting this quarter (Q4’18), with four generics already launching at prices about 95% below Onfi’s list price. Think about the margins for Onfi must be if generic competitors can launch at such a huge discount and still earn what they regard as a worthwhile margin, and you can see why I’m concerned about gross margin pressure coming from declining Onfi sales.

Operating expenses remain well-controlled, helping drive 14% core EBIT growth despite a noticeable increase in R&D spending.

What Will Come Of The Strategic Review?

With a new CEO in place and the failure of ‘35700, Lundbeck management is initiating a strategic review and will present its conclusions with fourth quarter earnings in early February of 2019. The process has only just begun, but I think increased spending on R&D is a given, as is a more active position towards in-licensing and/or M&A. I’d also note the company just announced the retirement of its head of R&D.

Management did also suggest a willingness to broaden its R&D focus from just depression, schizophrenia, Parkinson’s, and Alzheimer’s – a decision I applaud, as I never liked this narrowed focus. Lundbeck’s CEO also seemed to acknowledge that such a strong focus on depression really isn’t logical at this point, given how hard it is for a new branded drug to break into the market. That doesn’t mean that there aren’t niche opportunities (like the post-partum depression opportunity being explored by Sage (SAGE) and Marinus (MRNS) ), but it does mean that new depression drugs really have to be special in some way.

The Opportunity

Lundbeck has the cash and the cash flow to “do something” with respect to in-licensing and/or acquisitions and add some heft to its later-stage pipeline (and/or commercialized assets). Obviously there are limits (Lundbeck and Neurocrine (NBIX) are virtually the same size in market cap terms, while Sage is about 40% smaller), but I do believe there are assets out there for the company to consider – particularly in more niche/specialized areas, but that would/could still leverage the existing sales force infrastructure.

Given the ongoing disappointments in the new drug portfolio, I’ve trimmed my revenue expectations once again, and am now looking for basically flat long-term revenue performance. This does not include any contributions from the company’s earlier-stage pipeline of Parkinson’s and Alzheimer’s assets. While I do see a little more pressure on margins now, I expect that Lundbeck can/will maintain long-term FCF margins in the low-to-mid 20%’s, and possibly higher if one or more pipeline assets really pops. Discounting those cash flows back, I believe fair value for the ADRs is in the mid-$40’s today.

The Bottom Line

The market seems to have overreacted to Lundbeck’s disappointments and challenges, but by the same token it’s hard to identify any strong near-term positive catalysts. Any clinical updates are likely to be tempered by “… it’s only a Phase I result”, while negative results could further pressure the stock by hammering home the lack of any promising novel late-stage assets. Likewise, while I would favor a more aggressive stance from management regarding in-licensing and M&A, in-the-moment reactions to deals may not be so favorable. All told, while I think Lundbeck is undervalued again, management is once again looking at some significant near-term generics- and pipeline-driven challenges.

Disclosure: I am/we are long NBIX, LUN.KO. 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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