AstraZeneca boss Pascal Soriot must have relished taking the opportunity this week to suggest that the EU's earlier rejection of his company's Covid-19 vaccine could now be the reason the bloc is struggling with a devastating new surge in coronavirus infections and a higher hospitalisation rate than the UK. Soriot described the contrasting numbers as "interesting" although he agreed there was no proof that his theory was correct.
Whatever the strength or otherwise of the claims, the fact remains that the drug maker's vaccine is not being used for booster shots in the UK, and while AstraZeneca has been at the forefront of Covid vaccination in the UK, one is left with the impression that this treatment, and immunology in general, is not an area that appeals to the company. However it will continue to produce the vaccine and has confirmed that it will move to a new profit pricing model for the doses it manufactures once all current orders - being produced at zero profit - have been fulfilled.
Some observers feel that AstraZeneca only became involved in Covid vaccines to act as a trial runner and commercial conduit for Oxford University’s R&D. The AstraZeneca vaccine was never approved in the US and one school of thought is even that the Covid vaccine IP, and perhaps all interest in immunology, will be sold off as they are a distraction from core oncology and ‘orphan’ treatments.
But there is a lot going on at AstraZeneca besides its detour into vaccines, and it's worth delving into its history to understand where its strengths lie.
For much of the 2010s, AstraZeneca (AZN), the Anglo-Swedish pharma giant, looked like a ship adrift with engine failure, a broken rudder and missing charts. Also like a giant ship, big pharma businesses take a long time to stop, turn and to restart when a change of direction is required. AstraZeneca was experiencing a patent expiry cliff edge with a rising number of blockbuster drugs coming off-patent after 2010. When patents expire, competitors are free to make generic versions of the blockbuster drugs that dominate big pharmas’ revenues, which then sell for substantially less than the original (because there is no R&D to recover) and steal its market share. AstraZeneca’s sales and profits would sink into long-term decline as the development pipeline struggled to bring forwards the next blockbusters.
From 2011 to 2017 group sales fell by one-third and profits by two-thirds despite the global pharmaceuticals market growing by a mid-to-high single-digit percentage each year and in the middle of this period, shareholders were denied an exit when the board rejected a bid from Pfizer at £55 a share, almost a 50 per cent premium. The AstraZeneca board convinced shareholders that its drug pipeline supported a much higher valuation despite, then, limited evidence of this. The offer price would not be topped in the market for almost 3-and-a-half years.
Figure 1: AstraZeneca sales and Ebitda (US$m)
AstraZeneca’s R&D had performed poorly with just 4 per cent of its candidate drugs moving to Phase III trial completion between 2005 and 2010, thus making them available for sale. Even where drugs were being approved, the commercial marketing to physicians who would actually prescribe them proved to be sub-standard. Then came a rescue – the '5 Rs' framework, a new approach to drug development driven by then new and still serving chief executive Pascal Soriot.
This heralded a new approach to research and development (R&D), with a focus now shifted to ensure:
- Right target – picking viable candidate drugs, in-house or with biotech companies.
- Right tissue – pharmacokinetics & pharmacodynamics – drug movement & absorption.
- Right patient – identify the most likely responding patient groups.
- Right safety – pharmacology, toxicity, drug-to-drug effects, liability issues.
- Right commercial – getting the physician and healthcare funders on side.
By 2017-18, the '5 Rs' had delivered and AstraZeneca had raised its Phase III trial success rate to 19 per cent, delivering a raft of new drugs and ushering in a change in momentum – and sales began to recover. Historically, a powerhouse in primary care medication, cardiovascular, neuroscience and gastroenterology drugs, AstraZeneca emerged from this reinvention process as a very different player, now dominated instead by oncology, the treatment of cancers. In addition to reviving sales, margins were boosted by the focus shift – primary care drugs delivered margins of c30 per cent, whereas oncology delivers returns of 50-60 per cent.
Figure 2: Simplified and restructured revenue profile
The drugs that emerged from this process now dominate the group’s revenues and have long patents, many reaching the mid-2030s. Taken with continued effective R&D under the '5 Rs' bringing through a substantial and stronger pipeline, AstraZeneca’s revenues and margins appear to be well-defended for at least the next 10 years.
|Table 1: A healthier mix|
% of sales
% of sales
|Source: AstraZeneca Report & Accounts, FactSet|
Being focused on the treatment of cancer gives far more growth potential as the disease is still not one that is well-understood and is still nowhere close to having a cure – drugs are still primarily for disease management and life prolongment. AstraZeneca is looking hard for the next big step. Cancer drugs have many more potential therapies than other areas (such as cardiovascular), many of which are known but largely underdeveloped: this includes the likes of checkpoint inhibitors that use the immune system to attack cancer, pathway inhibitors for the treatment of difficult cancers such a pancreatic, PARP-inhibitors that stop cancer cells self-repairing, Car-T treatments that are effective but very expensive and Killer-T cell therapies that directly kill the cancer cells. The field remains immense and AstraZeneca is now at the forefront of development in these key areas; this should help sustain momentum.
Working on cancer drugs also brings unexpected wins. While a drug will have typically been designed to treat a narrow and specific range of or a single cancer, they can prove effective for a wider range. For example, Infimzi, initially approved as a lung cancer drug, has proved successful in gastrointestinal and brain cancers, allowing it to far exceed expected revenue levels. The pipeline has been tweaked to try to make similar broadening of use possible in upcoming drugs, enabling treatment of the widest possible range of cancers and at differing stages of severity.
Alexion: a major step-change
However, strengthening the core of the business was not the end of the story. In 2020, AstraZeneca acquired Nasdaq-listed Alexion, a specialist in ‘orphan’ drugs, for $39bn. This is a niche area targeting rare diseases where global patient numbers may only number in the thousands: 90 per cent of rare diseases have no effective medicines. The ‘orphan’ market is worth around $180bn in a whole market worth around $1,300bn a year and while US pharma grew by 4.4 per cent in 2020, its ‘orphan’ segment rose by c7 per cent.
Was this an expensive diversion? Probably not. Getting access to good established and likely successful pipeline drugs being developed by smaller biotechnology companies is becoming harder and more expensive. That is because so many of these earlier-stage businesses have been bought by private equity (PE) investors. There is relatively little pressure on the PE houses to sell up as they are flush with cash and have little need to recycle capital. Practically, that means that the price any large pharma has to pay to buy these businesses will be high. Perhaps this means that buying larger quoted players, such as Alexion, makes more sense and offers better value.
‘Orphan’ drugs can struggle to recover their R&D, so special regulations allow for lower trial costs, longer exclusivities and tax breaks. They also allow the drugs to be priced high: Alexion’s Soliris (for rare blood disease PNH), is one of the world’s most expensive drugs, costing more than $450,000 per patient per year. In practice, this means that orphan drug sales can rival ‘blockbuster’ drugs for revenue and profitability: Soliris has revenues of more than $4bn a year, similar to AstraZeneca’s leading seller, Tagrisso.
Alexion has hitherto been skewed towards the US (but operates in 50 countries) and notably is de-minimis in China. The US pharmaceuticals market is worth c$500bn a year and China (according to Deloitte) is now worth c$220m but is growing at well above 10 per cent a year. AstraZeneca is a major player in China and growing Alexion’s ‘orphan’ portfolio is a major priority and a key growth driver.
Having it all
Investors seem now to have it all: good growth that is visible for 8-10 years; confidence that patent expiry cliffs can be avoided thanks to stronger R&D via the '5 Rs'; broad spectrum potential in oncology; new and faster growth via the ‘orphan’ segment; higher margins due to the swing away from basic primary care products; generally improved complexity leading to a lower risk of rival drug development; stronger exclusivities via the regulatory cover in ‘orphan’ drugs; scope to ramp up Alexion’s revenues in China; improved cash flow thanks to rising sales but flattish R&D, leading to debt reduction (not really a concern) and growing dividends.
In terms of reorganising and repositioning itself, AstraZeneca feels some way ahead of the likes of GlaxoSmithkline (GSK), which is struggling with its purity as a pharma business as it still has a major consumer division and an unaffordable dividend: this was AstraZeneca five-to-seven years ago. Activism by disgruntled shareholders also seems to be a recurring issue in this sector – witness the travails of GSK – but does not seem to be an issue at AstraZeneca. There were grumbles when Alexion was acquired but investors seem now to be happy enough, but doubtless only as long as the promised positives are delivered.
There are always risks, however, for pharma companies. Changing legislation (tightening on its drugs or loosening on rivals’), patient or healthcare provider litigation, key trial failures (the impressive run of success in phase III trials could simply run out of steam), rising costs in an inflationary world (general costs, R&D or the price of bought-in drugs or biotech businesses) that swallow up free cash flow with a negative impact on dividend growth, rivals’ drugs taking a foothold where AstraZeneca’s leading drugs today thrive or a failure to drive Alexion’s ‘orphan’ drugs into China. With the exception of the latter, however, these are standard risks and are already bound up in ratings for this sector – what Donald Rumsfeld would have classed as “knowns-knowns”. That said, the market will still be brutal in the event of any faux pas such as a high-profile trial failure (ie, the early failures with cancer drug Infimzi in July 2017 when AstraZeneca’s shares dropped 15 per cent overnight).
Is there money to be made here?
So, the drivers look positive but what of the valuation? Pharma is not an especially highly rated sector at present, either in the UK, EU or the US and AstraZeneca looks already to be sat towards the upper end of peer-group valuations. That said, brokers’ analysts are heavily skewed towards the positive: of 17 investment recommendations, 15 are buy, two are hold and there are no sellers. Back in 2015, of 20 brokers’ calls only nine were positive. Brokers’ price targets average £105.50 per share, almost a quarter above today’s price. That all looks well-supported given the weight of positives in the operational outlook. Historically, investment here needed back-up from an above-average yield but AstraZeneca only pays a 2.5 per cent income today. This is not really needed today as this is more of a growth story: investors can look forward to over 90 per cent revenue growth and comfortably more than doubled EPS between 2019A and 2023F, the bulk of which arises by AstraZeneca ‘making its own luck’. Growth is not only high, but feels to be good quality – on that basis, the shares still appear good value.