The last few months have been interesting for Roche (OTCQX:RHHBY) and the pharmaceutical space in general. While the COVID-19 pandemic isn’t gone, the impact on pharmaceutical businesses is lessening, and second half results should reflect more of that return to normalcy. The bigger item, though, has been the highly controversial approval of Biogen’s (BIIB) Aduhelm (aducanumab) for Alzheimer’s and the prospect that antibodies that looked marginal at best, including Roche’s gantenerumab could have a renewed opportunity courtesy of a change in standards and practices at the FDA.
While I don’t agree with the FDA’s decision in re Aduhelm, the situation is what it is and Roche will have an opportunity to enter the market if and when the Phase III program (GRADUATE) for gantenerumab (scheduled to read out in the second half of 2022) shows adequate efficacy and safety. In the meantime, Roche has other drivers like the ongoing growth of Ocrevus, Hemlibra, Tecentriq, and Evrysdi and important clinical read-outs for Polivy, giredestrant (an oral SERD drug), tiragolumab (anti-TIGIT), and Tecentriq in adjuvant settings.
As there’s now a credible path forward for Roche in Alzheimer’s, and the company’s core markets are recovering, my revenue and FCF estimates head higher, as does my fair value. Up about 20% since my last update, modestly better than the sector, I still see Roche priced for high single-digit annualized returns, which I think argues for nothing worse than holding the shares.
Mixed Notes In Q2, But Better Sales Momentum Is An Important Takeaway
Roche’s second quarter earnings didn’t make everyone happy (it’s rare that a large company does), but there were more positive takeaways than negative. While Roche did miss on margins in the Pharma business, guidance on the impact of COVID-19 on Diagnostics left ambiguity, and management tempered some expectations on gantenerumab, first half revenue and operating income beat expectations, and revenue was stronger than expected in both businesses in the second quarter.
Revenue rose 14% on an adjusted basis, with CHF 15,783M beating expectations by about 5%. Pharma sales improved 4% from the year-ago level and similarly from the first quarter, beating by 3%, and Diagnostics sales rose 48%, beating by 10%.
For the first half of the year (Roche only reports detailed financials twice a year), gross margin declined 230bp from the year-ago period (to 74.4%), while core operating income rose 4%, with margin down 230bp to 37.9%.
I didn’t see many surprises in the Pharma results. The old Big Three (Avastin, Herceptin, and Rituxan) continue to take big hits from biosimilars, falling 40%, 35%, and 34% respectively, but still contributing almost 20% of total Pharma sales. Ocrevus was strong, up 31% and beating by 2%, with patient switches now back to pre-pandemic levels. Hemlibra was up 58%, beating by 7%, and has almost 30% share in the U.S. (and is gaining about 150bp per quarter). Tecentriq sales rose 31%, matching expectations. Evrysdi brought in $163M in revenue and management sees upside to the 20% or so share it currently has.
Diagnostics Will Likely See Less Lift From COVID-19
Some analysts appeared frustrated that Roche management didn’t give more granular guidance on the Diagnostics business, but given the significant unknowns in the real world, particularly as the delta variant leads to renewed outbreaks in the U.S. and vaccination rates are still sub-optimal in much of the world, I’m not sure how much more they could reasonably say.
COVID-19 contributed about CHF 1.3B to second quarter sales in the diagnostics business, up from CHF 1.2B in the first quarter, while the base business saw 31% growth (helped in part by the inclusion of GenMark). Management said that despite a sharp decline in PCR-based testing in the U.S. (90% if I heard right), their PCR testing business had remained “resilient”. As medical procedure volumes continue to recover, I expect the base hospital business to continue to recover as well.
I do expect COVID-19 to fade as a contributor to diagnostics sales going forward. Clearly, the virus is not going to disappear anytime soon, and there will be an ongoing need for surveillance testing, but I do expect those wider drops in testing volumes to hit Roche more significantly in the second half and into 2022. Partially offsetting that are growth opportunities like GenMark, where Roche has the resources to significantly accelerate test panel menu development.
Alzheimer’s - Roche Management Seems To Be Taking The Right Approach With A Delicate Issue
The FDA’s decision to approve Biogen’s Aduhelm has been controversial, to say the least, and I’m not going to wade into the debate any further than to say I don’t believe the data supported approval. In any case, the FDA has established a new bar for efficacy, and it’s one that other companies with amyloid beta-targeting antibodies may now be able to meet, including Roche.
While some sell-side analysts have gotten quite aggressive talking up the potential of early filing and approval (and possibly even breakthrough therapy designation) for gantenerumab, Roche management tried to tamp that down. Most importantly, I think, was management pledging not to launch the drug without a “significant benefit” on cognition from the Phase III trial program (GRADUATE). It is possible, though, that the company may begin the filing process early, so as to be able to move quickly if and when there are compelling data to support approval and launch.
An effective Alzheimer’s drug is an almost-certain multibillion-dollar blockbuster, and it remains to be seen whether gantenerumab will meet the bar for efficacy and if Roche management will stand by their stated principle of not launching without a “significant benefit”. Even a 10% chance of success for a potential $5B-plus drug makes an impact on the Roche model, so I do have some concerns that this could be a set up for disappointment later in 2022.
The Outlook
With Roche looking for the oncology business to be back at “95% of normal” in the second half of 2021, I believe the business is back on track. Moreover, the pipeline remains robust, including 12 Phase III studies started in the first half of the year and four new drugs entering the pipeline.
In the near term, watch for POLARIX results in the third quarter, as approval for Polivy in first-line DLBCL could be a CHF 2B opportunity. Data on neo-adjuvant use of giredestrant, and adjuvant use of Tecentriq is also coming later in the year, as is more data on the anti-TIGIT antibody tiragolumab. All of these would be potential CHF 1B-plus incremental opportunities.
With a small chance of gantenerumab approval now in my model, as well as some other revisions, my long-term revenue growth rate moves up slightly from “around 3%” to closer to 3.5% (or 2.5% from pre-pandemic levels). My margin assumptions aren’t all that different, though the launch of a multibillion-dollar drug like gantenerumab would have a positive effect. All told, I’m looking for mid-single-digit FCF growth, or around 3% on a pre-pandemic normalized basis.
I also use a EPS-driven model for valuation in addition to discounted cash flow, and I expect around 7% EPS growth from 2020 to 2025.
The Bottom Line
Based on my models, I believe Roche is still priced for an annualized return in the high single-digits. That’s enough for me to be happy continuing to hold the shares, but investors should of course shop around and do their own due diligence. With a strong pipeline and healthy FCF that can fund not only dividends but also tuck-in/add-on deals, I continue to believe Roche fits the bill as a potential core holding for investors who can take on some risk but don’t want the risk of biotech.
