Lundbeck, Like The Dude, Will Try To Abide

About: H. Lundbeck A/S (HLUYY)
by: Stephen Simpson, CFA

Lundbeck technically beat expectations for the first quarter, but its growth portfolio disappointed and management spooked investors on near-term gross margin guidance.

The Abide deal looks interesting, but the only asset is early stage and targeting tough-to-treat conditions.

Lundbeck looks fairly valued now, but management is actively looking for licensing and M&A deals.

Danish pharmaceutical company H. Lundbeck’s (OTCPK:HLUYY) (LUN.KO) first quarter is likely to be pretty much par for the course for the near term – double-digit growth from its portfolio of newer offsets that can’t offset the generic erosion of its old portfolio, with investors hoping for updates on pipeline-building deals.

The multiple misses in the growth portfolio were disappointing, but not entirely surprising given the track record here. The deal for Abide looks somewhat promising, but Lundbeck needs to do quite a bit more to replenish its portfolio, and the clock is ticking with respect to patent coverage on Northera (2021/22) and Trintellix (2026). Given where the shares are, and the risks involved in recharging the portfolio, it’s hard to make a compelling must-own case for these shares.

Q1 Beats In Theory, But Not So Much In Practice

Although Lundbeck’s first quarter results were better than expected as far as the numbers go, it was a low-quality beat that will do little-to-nothing to boost confidence in the name.

Revenue fell 6% in constant currency, beating expectations by 4%. Three of the four growth drivers missed expectations, though, and the beat was driven by contract manufacturing. Gross margin declined 150bp yoy, missing by about a half point. Core operating income fell 22%, but did beat by 2% largely due to the size of the revenue beat.

Within revenue, the growth portfolio delivered 19% year-over-year growth which, in isolation, isn’t so bad. Relative to expectations, though, it was another disappointing result on balance. Abilify Maintena grew 24% (with its share climbing to 17% against drugs from Johnson & Johnson (JNJ) and Alkermes (ALKS) ), beating expectations by 12%. Rexulti revenue rose 22%, but missed by 7%, while Trintellix sales rose 27% and missed by 2%. Northera sales rose only 3%, missing by 7%.

Although management lifted the bottom end of the revenue guidance range, the sell-side was already lodged on the high side of the range, so it won’t help sentiment much, if at all. Management also reiterated guidance for 2019 EBIT, but spooked analysts and investors with its gross margin commentary, as the loss of lucrative legacy drug sales is likely to pressure gross margins back down to the 80%-82% level for a few years before recovering toward the mid-80%’s.

The Pipeline Still Needs Help

Lundbeck’s biggest announcement regarding the pipeline (apart from the Abide deal, which I’ll discuss in a moment) was that it is ending development of Lu AF20513 – its Phase I anti-beta-amyloid vaccine for Alzheimer’s disease. Based upon management’s commentary, it seems like questions about the real potency of the vaccine and the validity of the entire beta amyloid hypothesis led to the termination, though the company is working on what it described as more potent vaccines in preclinical work.

This is at worst only a mild disappointment. It’s never wise to assume much from any Alzheimer’s drug candidate, and this one was particularly risky. Given that the working principle of a vaccine like this is to activate the immune system, you have to strike a very careful balance between sufficient activation to do the job, but not so much that it damages the organ involved (in this case, the brain).

There wasn’t much beyond this. The enrollment in the foliglurax study is progressing slowly, which is a moderate disappointment, and data won’t be available until very late in 2019 or in 2020.

Lundbeck Abides

A few days prior to the earnings release, Lundbeck announced the acquisition of private U.S. biotech Abide Therapeutics. Abide has focused on serine hydrolase inhibitors (a wide class of drugs), and Lundbeck is most interested in the possible CNS applications of this drug class. Lundbeck paid $250 million upfront and up to $150 million in future milestones and earn-outs.

Abide’s lead drug is ABX-1431, which was once partnered to Celgene (CELG) (which is how I came to know about Abide in the first place), and is in clinical development for Tourette’s and neuropathic pain. A small Phase I study in adults indicated statistically significant improvement in motor function (tic frequency and severity), and the drug is now in Phase IIa testing. An effective drug for adult Tourette’s could be worth around $750 million (maybe more if the efficacy were really good), but the big market is pediatrics, where the opportunity is about four times larger. It remains to be seen if Lundbeck will initiate pediatric studies of ABX-1431.

Further down the line, I can see a range of potential drugs from this deal, including applications in pain, movement disorders, and certain forms of epilepsy. Still, $250 million isn't a particularly big price tag, and I believe that reflects the comparative lack of clinic-ready assets and the elevated risks of the Tourette's program.

The Outlook

Apart from some housekeeping adjustments, not much really changes in my model, and I think Lundbeck shares are trading more or less around fair value. That fair value does not include future contributions from further M&A/licensing additions to the pipeline. ABX-1431 could add about $1.50/ADR to my fair value, even at a heavy risk weighting, but I’m reluctant to add this into the model now without at least some Phase II data, as Tourette’s has proven to be a difficult indication.

Clearly there’s still a lot of work for Lundbeck to do in replenishing its pipeline, and management has expressed a willingness to leave few stones unturned, including pursuing regional licensing deals that would take advantage of its existing sales force. With about $700 million in cash on hand, about $700 million a year in free cash flow generation potential, and the capacity to borrow at least $1 billion, Lundbeck certainly has options to pursue additional deals – my preference would be to see the company a later-stage, somewhat “niche” CNS drug or two, but also bulk up the early-stage portfolio through licensing and/or M&A (I know, I know … you can’t have everything you want).

The Bottom Line

I’ve held on to these shares more out of habit and stubbornness than true conviction. That’s not great portfolio management practice, I’ll grant, but I’m not going to start lying to readers. Maybe Lundbeck will find a diamond in the rough in its M&A/licensing search, but the shares are fairly valued on the assets that we know about and I don’t put any value on what the company could buy. At this point, I look at Lundbeck as a source of funds for better ideas, but I’m not in a rush.

Disclosure: I am/we are long 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.