Fat Pitches

7 June 2017

Fat Pitch of the Month

Roche Holdings (ROG.VX)

Fat Pitch Price per Share (CHF)

Roche Holdings

We have come across one “fat pitch” with Roche stock price falling to CHF250, circa 20% below fair estimated value of CHF310. Roche reported disappointing clinical trial news of its flagship Perjeta drug, challenging cost-benefit equation of an expensive $90,000 USD/p.a. breast cancer treatment. Perjeta has estimated $4bln incremental dollar sales potential in breast cancer scenario, however much of that is now in doubt due to marginal improvement (-1.7% recurrence reduction, or 19% overall risk reduction) vs the pricey tag for the treatment.

Investment thesis

Whilst individual drugs and trials are by nature volatile given experimental nature of clinical trials, we believe that the overall thesis for Roche remains compelling. Pharma companies including Roche make their money by charging high prices on patented drugs until the competition from generics and more recently biosimilars arrives in the market. Sales of off-patent drugs tend to fall-off steeply after that. Patents have useful economic life of 10-20 years, depending on how quickly the drug was developed after it was first patented. New drugs take time to reach their peak sales potential as marketing and sales force educates the medicals staff on the benefits of the drug. Investors want to invest in pharma companies that satisfy the following criteria: large stable and high margin portfolio of existing drugs that isn’t susceptible to generics/biosimilars competition for extended period of time, pricing power for drugs due to unmet clinical needs with as little competition, ability to resist pressure by insurance companies and PBO to reduce the price in order to qualify drugs for inclusion into formulary for reimbursement, promising pipeline of early stage drugs that have multi billion potential in the area of unmet clinical needs, price that is less than conservative estimate of NPV of existing drug portfolio with minimal value assigned to pipeline (essentially investors should aim to get future pipeline for free).

Competitive advantage

Roche possesses many of these attributes. Roche has unique exposure to oncology (45-50% of 2016 to 2025 estimated pharma sales) and other specialties (15% pharma sales), where the pricing environment for new drugs is likely benign. Pricing power in oncology is sustainable in our opinion, due to unique US legislation that mandates medical professionals and insurance companies to treat and reimburse for cancer care (e.g. insurance companies cannot deny coverage); due to medical urgency in putting people on cancer treatment as soon as practical (reduces opportunity to explore alternatives / negotiate price); as well as due to high  complexity of cancer treatment regimes which offers companies the opportunity to generate evidence that differentiates their drugs from competition for the unique type of tumor/combination therapy/biomarkers/line of therapy/regime requirements.

Oncology also experienced a higher rate of innovation due to friendly regulatory environment and more recently the ability to use patients’ immune system and to tailor oncology treatment to the genetic makeup of individuals. Molecular slicing and dicing of tumor types helps make new drugs nonsubstitutable and protects pricing power. Much of the increase in drug approvals from 2012 has been oncology driven, with 45 of the 152 newly approved drugs having cancer labels. Ultimately, this will mean that expensive news drugs will be better than the old ones they are replacing. That is a good outcome for patient, doctor, payer and pharma company.

Risk

Single most important long-term risk for Roche is its ability make research & development efforts productive as measured by the new innovative treatments for unmet clinical needs and/or improved patients’ outcomes. In our opinion, industry is only just beginning to scratch the surface in deploying the potential of genomics and harnessing patients’ immune system to fight diseases such as cancer. In short, we expect industry to generate more breakthrough innovation, with aid of data analytics, big data, vast computing capacity and deeper understanding of  genetic code. It is not guaranteed that Roche will necessarily be the vanguard of such innovation, although Genentech, Roche’s subsidiary, continues to maintain cutting edge research in all of these areas.

We are further encouraged by Roche’s long-term view which is in large part influenced by the controlling vote of the founding families. We find that long-term thinking, preparedness to take risk on experimental compounds and sometimes fail, and stability for management to pursue long-term strategy without in pharma industry are all distinctive competitive advantages. Compared to many publicly quoted companies whose management has to meeting quarterly market expectations and focus R&D budgets on “quick wins”, Roche is very well positions. It is no accident that Roche is spending some CHF10 billion annually on R&D, far in excess of many of its competitors. We are highly encouraged by this business model.

More near-term risk to Roche is drug pricing pressure from US based commercial payers. We have no special insights on this subject, other the above mentioned practical barriers to exerting pricing pressure on leading oncology treatments.

Valuation

The value of pharma companies is challenging due to many variables that determine the economic value of a drug. These may include efficacy of patient outcomes, % of success of phase 3 trials, peak sales, speed of ramp-up, pricing actions by payers, generic/biosimilars competition arrival, possibility of patent extensions.

We profess to be no experts in precise modelling of such revenue streams for all Roche’s drugs in the existing portfolio as well as future pipeline as that is beyond our skills. However, we have access to credible source who do such modelling for living.

We have sighted two such calculations and both conservatively estimate Roche’s NPV per share for existing drugs and phase 3 drug candidates at between CHF258 and CHF 314 per share. Both figures are above current price of CHF248, and both estimates assume only moderate value of the pipeline at circa CHF40 per share whilst also fully costing all future R&D expenditures at CHF70+ per share. This means that investors are primarily buying revenue stream of the existing drug portfolio and conservatively assume that all that new R&D will deliver very modest future value. We consider such assumption to be overly negative in the context of high historical R&D productivity and new innovative drugs. We consider pipeline to be a major source of future stock upside that investors are not presently required to pay in the purchase of the share. Needless to say, we like such “free” optionality.

 

 

Watchlist

Stocks Approaching Margin of Safety

This month’s newsletter will focus on medical and pharma industry with many potential candidates for investments approaching their required margin of safety. As we have stated before, it is hard to forecast drug sales with any degree of precision due to large number of variables affecting the sales. These include pricing pressures, competition entry, patent expiry, number of indications, drug efficacy in trials and patients’ uptake. Any of these factor affects price, volume, duration of exclusivity and ultimate profitability of drugs.

We instead rely on conservative estimates, by experts, of NPV (net present value) generated from existing portfolio, aiming to pay little or nothing for any future pipeline of early stage medicines. We believe overall, industry will continue to innovate and the need for innovative drugs will increase as population ages and spend on healthcare increases across the world. It is difficult though to say with certainty that any individual company will be making such breakthroughs. Below is the list of the key players and our view of the value they offer to enterprising investors.

Express Scripts (ESRX)

Express Scripts

Pharmacy Benefit Management companies are rational oligopoly with combined market share of some 80%. PBMs provide clients with management of drugs prescriptions by administering the benefit plans, negotiating direct pricing with drug manufacturers and managing formularies to reduce the overall cost to the payers.

In our opinion, the demand of PBM services will increase as payers seek to contain the relentless inflation in medical costs. However, the competitive bidding will ensure that margins will remain tight and clients will continue to shop around for the least cost PBM services. Hence, we’re proposing higher margin of safety prior to committing capital.

Valuations remain unassuming with forward PE of 8, healthy cash generation of $5bln annually, ROE of 20% and manageable debt level, we continue to watch Express Scripts closely.

Stericycle (SRCL)

Stericycle

Stericycle provided specialist medical waste disposal services in highly regulated industry. Stericycle has an established network of collection, storage, handling, incinerating and autoclaving facilities. Such network faces barriers to entry due to regulatory permits, density of routes and client relationships particularly in small quantity customer segment.

In line with recent trend to outsource waste disposal and lower the cost, Stericycle continues to benefit from secular trend of tighter regulation, stricter enforcement of existing regulation and higher volume of medical waste generation as population ages and more front-line services are pushed to smaller practices. With the acquisition of Shred-it Stericycle entered paper shredding and disposal business, with far inferior competitive advantages (beyond existing truck fleet). We consider the acquisition as margin dilutive and management attention distracting, with questionable payoff.

Valuations remain relatively high at forward PE of 16 given that 50% of revenue is from low margin paper shredding business. Company continues to generate healthy cash flows in excess of $400mln annually, adjusted cash ROE of 15% and rather high debt level of almost $3bln. We’d advise investors to demand higher margin of safety to compensate for the low margin paper shredding business.

Biogen (BIIB)

Biogen

Biogen is the leading player in multiple sclerosis market and its drugs set the standard of care. Biogen’s has focused its R&D on narrow set of therapeutic areas, chiefly comprising Multiple Sclerosis (MS) and cancer. MS continues to be an area of large unmet clinical needs, with market size of $20bln annually and growing.

Biogen is facing competition from others in MS markets, however we believe that it’s pipeline remains promising. Biogen is trading at low historic multiples, with NPV per share in the range of $250 per share, based on existing portfolio with upside in the $300 per share. We remain watchful for any buying opportunity in $230 range and below.

Biogen is in excellent financial health, with almost no debt, 20% ROE, steady revenue, and over $4.2bln of annual free cashflow.

CVS Health Corp (CVS)

CVS Health Corp

Similar to Express Scripts, CVS acts as PBM and is one of the top 3 players, which control 80% of the combined market. Given its size CVS is able to negotiate meaningful discounts directly from drug manufacturers, administer plans, manage formularies and help payers reduce the overall healthcare cost.

The industry is competitive with clients constantly shopping for the best deal, which also means that investors are well advised to seek meaningful margin of safety of at least 30% from fair value estimate. Margins are tight in low single digit %.

Valuations remain unassuming with forward PE of 12, healthy cash generation of $11bln annually, ROE above 10% although with sizeable debt level of $25bln. We continue to watch CVS for meaningful discount to fair value estimate.

Pfizer (PFE)

Pfizer

Pfizer is one of the largest pharma companies with debt of existing drugs and rich and deep pipeline. Pfizer has overcome the worst of patent cliff and is showing improving R&D productivity with notable new drug launches (Ibrance in breast cancer and Xeljanz in arthritis).

Prizer hasn’t arguably lagged in the transformative innovation and has based its business model on M&A strategy and subsequent senergy extraction. We believe that although there may be a place for “industry” consolidator, the future of Pfizer rests with innovative R&D. We believe that manage has recognised this weakness and is taking steps to improve R&D productivity as well as building focus around it’s strategic R&D priorities.

NPV per value is conservatively estimated at $28-30 a share with limited value subscribed to Pfizer’s pipeline. Pfizer’s value is unassuming at forward PE of 12, debt of $12bln, stable and growing revenue, 20% ROE and annual cash generation in excess of $16bln.

CVS Health Corp (CVS)

CVS Health Corp

Similar to Express Scripts, CVS acts as PBM and is one of the top 3 players, which control 80% of the combined market. Given its size CVS is able to negotiate meaningful discounts directly from drug manufacturers, administer plans, manage formularies and help payers reduce the overall healthcare cost.

The industry is competitive with clients constantly shopping for the best deal, which also means that investors are well advised to seek meaningful margin of safety of at least 30% from fair value estimate. Margins are tight in low single digit %.

Valuations remain unassuming with forward PE of 12, healthy cash generation of $11bln annually, ROE above 10% although with sizeable debt level of $25bln. We continue to watch CVS for meaningful discount to fair value estimate.

Eli Lilly (LLY)

Eli Lilly

Lilly is a world class pharma innovator. Investors benefit from Lilly’s diverse and de-risked new product story, led by Trulicity, Jardiance, Taltz, Lartruvo, as well as abemaciclib and galcanezumab. Company has prospects for significant margin expansion opportunity, boosted by management commitment to long-term expense targets and to progressive dividend policy.
NPV per share from existing portfolio is in the range of of $80-$85 per share. Market seems to be ignoring significant value potential in the future pipeline, estimated in $10-$20 range. We remain attracted to Lilly and recommend to add to position at $80, at which levels investors are obtaining significant margin of safety.

NPV per value is conservatively estimated at $28-30 a share with limited value subscribed to Pfizer’s pipeline. Pfizer’s value is unassuming at forward PE of 12, debt of $12bln, stable and growing revenue, 20% ROE and annual cash generation in excess of $16bln.

Allergan (AGN)

Allergan

Allergan benefits from strong product growth story, led by Botox/aesthetics, Linzess/GI and eye care, and a broad and underappreciated pipeline given limited value by investors. This is somewhat offset by challenges in base business impacted stock in 2016 but expectations now more reasonable.

It can be argued that Botox remains as much a consumer product as a medical treatment. With limited competition and almost 75% of aesthetics market share, Botox will continue to power Allegan’s earnings growth for many years to come.

NPV per share is in the range of $230 per share and we look for meaningful margin of safety from this level, ideally in $220 territory and below. Sales are expected to steady grow from today’s $16bln p.a. to over $20bln by 2020. Net margin remains attractive in 35%-40% range and net income rising from $6bln p.a. today to $8bln by 2020. Allergan remains on our watchlist.

Gilead Sciences (GILD)

Gilead Sciences

Gilead remains the “dog” of the pharma industry. Gilead is a biotechnology company focused on the development and commercialization of antiviral treatments. Their products include Sovaldi and Harvoni for hepatitis C and Stribild, Complera/Eviplera, Atripla, Truvad and Viread for HIV. After stellar product introductions for Hepatitis C and surge in profits and revenue, Gilead is struggling to acquire enough new patients for it’s expensive Solvadi/Harvoni treatments as people delay treatment (not acute) or even remain undiagnosed.

Sales of Hepatitis C drugs remain hard to forecast and markets are understandably discounting such uncertainty heavily. We believe that in the worst case scenario, Gilead’s Hepatitis C and HIV businesses combined are expected to generate at least $60 of NPV per share, giving 0 value any future pipeline (in NASH) or acquisitions.

We continue to applaud management for not chasing value destroying deals despite immense pressure from the markets. Gilead is in rude financial health, with annual cash generation of $11bln in ’17 falling to $9bln by ’19, manageable debt of $13bln, and optionality on how to redeploy the incoming cash.

Fat Pitches – June 2017

Fat Pitches 7 June 2017 Roche Holdings (ROG.VX) Roche Holdings We have come across one “fat pitch” with Roche stock price falling to CHF250, circa 20% below fair estimated value of CHF310. Roche reported disappointing clinical trial news of its flagship Perjeta drug,...