Lundbeck looks like a classic recovery

Lundbeck, by contrast, is more traditional in its pharmaceutical orientation, with a product niche in central nervous system (CNS) drugs in hard-to-treat conditions such as Alzheimer’s disease and depression. The investment case for Lundbeck currently rests on the fact that it is the pharmaceutical company in Europe that looks to be the most receptive to sustained corporate action to turn its fortunes around, opening the path to profit for investors.

Cheap is no guarantee of success   

As you can see from the table below, Lundbeck is cheaply priced against earnings forecasts for 2023. In fact, it is among the cheapest large pharmaceutical stocks in Europe, a dubious honour over which it vies with Bayer, although it should be noted that Bayer’s discount is mainly due to that company’s sprawling conglomerate structure – which includes everything from veterinary medicines, speciality chemicals and football teams, as well as an after-thought pharmaceutical business.

Lundbeck’s valuation is where it is because patent erosion is cutting away at its core sales. Specifically, it is the drawdown in sales on mature products such as Northera (droxidopa) – which helps with the dizziness and nausea associated with the side-effects of Parkinson’s disease – that have weighed heavily on Lundbeck. The only real response open to the company is to throw money at the problem and refresh its drug development pipeline, but given that Lundbeck is the smallest of the big pharma companies by sales and market capitalisation, it needs to be creative in the way it does this.

Corporate actions and solutions

Accessing new funding in ways that preserves the company’s ownership structure is a priority for management. One recent corporate action that sets out to address this is a proposed share split into an ‘A’ and ‘B’ structure, with the Lundbeck Foundation – which owns 69 per cent of the current share structure – retaining control by holding ‘A’ shares. Though the company says it has no immediate plans to raise equity – the new structure will not be approved until June at the earliest – the share split would give it the option of tapping equity markets in the future, without diluting investors. Such structures, more common in Europe than the UK, also preserve dividend rights for both share classes.

The company has already capitalised its current development programme after taking on new long-term debt in 2019 to fund work on its product pipeline. Product development typically works on five-year cycles, so the earliest management would think about tapping the markets for additional funds would be next year. And judging by the state of the balance sheet, Lundbeck has around DKK6-7bn ($0.9-1bn) of headroom for acquisitions, assuming no more debt or equity is raised.

In the meantime, its own pipeline shows promise. The last annual report showed that Lundbeck spent an encouraging 23.5 per cent of sales on research and development (R&D). The general rule of thumb within the pharma industry is that companies need to commit at least a fifth of sales to R&D to maintain their pipelines, while anything over that amount indicates a considerable effort to add new products.

While Lundbeck has attracted analyst criticism for concentrating on CNS drugs, where success rates are notoriously low, the company’s specialisation makes sense from both a regulatory and development perspective.

That’s because the difficulty of obtaining measurably improved outcomes with conditions such as Parkinson’s disease or depression often results in an accelerated regulatory path for products that can show at least some benefit at treating aspects of the conditions. Additionally, specialisation is now seen as the reason that research productivity has increased in the sector in recent years, according to Deloitte. In other words, it is the sprawling pharma conglomerates with too many different products in development that have had the greatest problems with declining pipelines.

Lundbeck’s strategy, by contrast, sails closer to the advice of one of the sector’s greatest minds, Paul Janssen. When asked for the formula for successful pharmaceutical development, the Belgian physician said: “Stick with what you know and go from there.”

The next significant newsflow for Lundbeck will come in the middle of this year when the data readout for its phase III trial for Rexulti (Brexpiprazol) for patients with Alzheimer’s agitation (AAD) is reported. The research, pursued in partnership with Japanese company Otsuka, has involved various trials with Rexulti in AAD since 2017. One advantage of the approach the company takes is that Lundbeck’s drugs are targeted adjuvant therapies to treat the side-effects of the disease, rather than the disease itself – which in the case of Alzheimer’s has proved to be an exceptionally difficult therapeutic target. Overall, that makes its approach more nuanced than simply tackling hard-to-treat CNS diseases without a clear idea of the outcome.

Relying solely on in-house development is unlikely on its own to guarantee success, however, hence the debate over largescale M&A as the best shortcut to stemming losses from patent erosion. Lundbeck has traditionally been very conservative about the size of deals it does – no more than $2bn, or enough to buy it a decent CNS product in early phase III development. It helps that Lundbeck's products are in development at the point in the cycle where overall costs are falling and peak sales once approved are rising.

On the other hand, the valuations of US biotech companies, the traditional source of products for large pharma companies to restock their pipelines, have come down significantly since the summer and many analysts feel the company should go bargain-hunting on a larger scale while the conditions are favourable. A new share structure could help with that process if Lundbeck’s shares offer easier access for new potential investors, without the company compromising its ownership control. For that strategy to work, it will need a compelling narrative to take to the market before tapping funding in a systematic way, hence the importance of the Rexulti data.

In valuation terms, Lundbeck is a “no contest” share. The stock is priced at barely 10 times Berenberg’s earnings forecasts for this year, which makes it the cheapest pure-play large-cap pharmaceutical share in Europe. Positive data read-outs for Rexulti will help a rerating, but it is worth bearing in mind that the company’s future is entirely in its own hands, and with a balance sheet that is lowly geared at 29 per cent, it has the financial wiggle room to control its own destiny through sustained corporate action. Therefore, it qualifies as a recovery share in the truest sense of the phrase.