BlackJack3D
At first glance, Incyte (NASDAQ:INCY) is a great value stock that allows buying into growth at a reasonable price, GARP. 10-year revenues have clocked in a very enviable compound annual growth rate (CAGR) of 26.4% and are projected to grow over the next few years. Even though growth is expected to outpace the sector averages, the FY24 PE is 13.4x and below the sector average of 19.3x. PS is 3.3x, again below the sector average of 4.0x. Is this an excellent GARP company or a potential value trap? 70% of its total revenue is from one product, Jakafi (ruxolitinib), and this is facing a patent cliff in late 2028. We dig a little deeper to find that the company is on the right path in diversifying its product offerings and its revenue stream.
The Company
Incyte is a biopharmaceutical company that specializes in the discovery, development, and commercialization of proprietary therapeutics hematology/oncology, the treatment of cancers of the blood, and Inflammation and Autoimmunity. Incyte's pharmaceuticals such as Jakafi are used for the treatment of polycythemia vera, a type of cancer of the blood, and myelofibrosis, a bone marrow cancer that disrupters the production of blood cells. Pemazyre treats adults with bile duct cancer.
Incyte employs over 2,500 with over 1,000 involved in research and clinical development. Science magazine ranks Incyte at number 2 as the best employer in 2023.
Price Performance
The price performance of Incyte has been disappointing as it is trading 22% down compared to the same period last year, and 29% down compared to five years ago. Investors have not been rewarded for holding the shares over a longer 10-year period, as share prices are roughly at the same levels.
Financials
Incyte reported its FY23 results earlier this month, where revenues saw an increase of 9% from $3.4bn to $ 3.7bn, and non-GAAP EPS increased 27%, from $2.8 to $3.56. Its main product, Jakafi's revenues increased by 8%, Opzelura by a more impressive 162%.
Incyte FY23 Revenue Breakdown (Incyte)
If we are to exclude "milestone and contract revenues" and just look at the product and royalties revenues, they increased by a more respectable 14%. Net income margins improved significantly from 18.3% to 21.5%.
Incyte has a strong balance sheet with shareholders equity of $5.2bn, of those only $280m are intangibles. Shareholders equity has grown significantly over the last 10 years from negative $87m. As of December 2023, it has virtually no debt and a cash pile of $3.7bn. The company is also highly cash-generative and over the next 4 years, it could have at its disposal up to $5.5bn of additional retained earnings.
For pharm companies, R&D is vital in discovering new treatments, and even more vital for Incyte ahead of 2028's patent cliff for Jakafi. R&D expense for FY23 was $1.6bn, 44% of revenues. They currently have 8 approved products, 7 in the pivotal stages, and 19 with clinical proof of concept.
Revenue And Growth
Before we go on to growth, let us have a look at how Incyte's revenues have developed over the past five years.
Incyte Revenue Breakdown (Author & Incyte 10K Statements)
Apart from Jakafi, Incyte has several other revenue-generating products and revenues from royalties. We simplify this for a clearer picture of the revenue share and growth.
Incyte Revenue & Growth Analysis (Author & Incyte 10K Statements)
Jakafi accounted for 70% of total revenues in FY23, though high, this is lower than FY19's 78%. Royalties remain relatively constant and represented 14% in FY23. Other product share increased from a low base of 4% in FY19 to 15% in FY23. This is the area that has shown significant growth. In FY20 only Jakafi and Iclusig were revenue-generating products, and four new products have begun contributing to revenues. These increased from $90m in FY19 to $571m in FY23 which represents an impressive CAGR of over 45%. In FY23, other non-Jakafi product revenues increased by a breathtaking 69%, mainly from Opzelura's 162% increase. Opzelura is an inhibitor ruxolitinib for the topical treatment of nonsegmental vitiligo and mild to moderate atopic dermatitis.
With Jakafi's 2028 patent cliff approaching, management is committed to supporting growth drivers. They have plans for some promising and potentially high-impact launches by 2030. In December 2023, Incyte announced positive data for its pivotal trial of axatilimab its treatment of graft-versus-host disease, and is currently filed with the FDA for approval. Share prices reacted positively to the news and were up 17% over the next three trading sessions, from $54.7 to $64.2.
Incyte Q4 2023 Presentation (Incyte)
If Incyte can introduce new products to the market and maintain its growth trajectory in non-Jakafi-related products, the drop-off from the 2028 patent cliff may be manageable.
The greatest risk faced by Incyte is not being able to introduce and get FDA approval for new products quickly enough. The other risk is not being able to maintain revenues in its heavily dependent product, Jakafi. On the positive side, management is dedicated to diversifying revenues and they also have an existing war chest with $3.7bn of cash on their balance sheet and a potential of up to $5.5bn more over the next four years from retained earnings. This can help speed up its R&D as well as be used for acquisitions.
Valuation
Looking at the traditional valuation matrix, Incyte is trading a significant discount to the sector average on multiple fronts. It is trading at a forward PE of 13.3x compared to the sector average of 19.3x and a PS of 3.3x compared to the average of 3.96x.
We will also use a unique Cash Flow Returns on Investments based DCF perspective to identify and examine Incyte. More information on how Cash Flow Returns on Investments are calculated, including gross cash, gross assets, and returns can be found in Bartley Madden's paper "The CFROI Life Cycle". Bartley Madden is a significant contributor to the Cash Flow Returns on Investment methodology. We have used and expanded on this concept in our previous articles.
Returns On Cash Generating Assets or ROCGA uses the same methodology as Cash Flow Returns On Investments and is a measure of economic returns. Another way of looking at companies is the ratio of economic returns to the cost of capital. This should directly correspond to the value of a company. The greater the spread, the higher the share price should be. This can be represented by the spread between the EV and the assets used to generate income.
The first step involves modeling the company, back-testing the valuation for correlation with the historical share prices, and once confident, using that same model to forecast forward. Value is a function of returns a company achieves, the rate of fade of those returns to the cost of capital, and growth. The total value of the company is the present value of existing assets and the present value of growth. For mature companies, most of its value is in the existing assets, and for high-growth companies, the value is in the present value of growth assets.
The blue band below represents the share price highs and lows for the year, and the orange line is the DCF model-driven historic valuation. The green line is the forecast warranted value derived using the same model along with consensus earnings and default self-sustainable organic growth. Self-sustainable organic growth is a ratio of investable free cash to gross assets.
Default ROCGA Valuation (Chart created by the author using ROCGA Research platform)
The mean reversion theory of returns reverting to the cost of capital over time is applied. A company generates returns, and the higher the returns, in theory, the higher the valuation. The company will not be able to sustain its high returns over a prolonged period. Companies with stronger competitive advantage will maintain those returns for a little longer before the fade begins. This indicates the strength of the business. A mature company's return will fade quicker, and the earlier life cycle companies will fade at a lower rate. The model also ensures that the company is not overvalued or undervalued during different stages of business cycles.
More details of how the modeling and quantitative valuation work can be found here.
The assumptions used for this particular model are that the company returns are not cyclical, have moderate business strength (competitive advantage), and are in the early business cycle life cycle stages.
Financial Modelling Assumptions (ROCGA Research & Author)
In the valuation graph above, it is only recently that Incyte is looking cheap, and given the default mode, it has a potential 78% upside for FY24. We know that there is a patent cliff pending in 2028. Our model does not extend that far so we will assume that earnings drop in FY27 and use a conservative EPS of $2.5.
Adjusted ROCGA Valuation (Chart created by the author using ROCGA Research platform)
This gives us an adjusted warranted value of $87 in FY27.
We can also look at Incyte as separate components, the first as the highly cash-generative Jakafi. But its patent is set to expire in 2028 and we can expect a significant drop in revenues and earnings after that. We can value this part at a very basic $3.7bn in cash and $5.5bn in retained earnings over four years. The second is its non-Jakafi related products revenues which grew at a breathtaking rate of 69% in FY23. We apply a conservative 10x PS for this part giving us approximately $5.5bn. The third would be royalties-related revenues that is $0.5bn but growing moderately. A sector average of 4x PS gives us $2bn. Together they add up to $16.7bn, less than our DCF valuation above, but still a potential upside of 23%.
Conclusion
There are risks involved but given the low share prices, strong financial position, and a strong pipeline of promising products, we believe Incyte warrants to be trading at higher multiples. All valuation methodologies we used point to Incyte being undervalued. We initiate with a buy rating.
