Astra's plan comes at too high a price

Total third-quarter revenues of $5.3bn exceeded expectations after product sales grew by 8 per cent. And core operating profits of $1.4bn, albeit down by over a quarter year on year, also beat brokers' predictions, helped by lower research and development (R&D) costs. But for the remainder of the year, sales and general administrative costs will increase to support new product launches. And while broker Shore Capital updated 2018 forecasts to reflect greater positivity on those new launches – specifically cancer drugs Tagrisso, Lynparza and Imfinzi and respiratory biologic Fasenra – their EPS estimate only nudged up slightly to $3.34 from $3.32, a conservative prediction relative to company guidance.

The first phase of Astra’s plan has focused on building the group’s drug development pipeline in the face of a well-publicised ‘patent cliff’. As several high-earning drugs – including ‘blockbuster’ cholesterol drug Crestor, which still accounted for 7 per cent of third-quarter sales – lose exclusivity rights, cheaper copies flood the market. This has hurt sales in the past year or two, as well as profits, with more money diverted towards R&D. Now, those costs are expected to decline as money is put behind new product launches, but debt has already piled up, with the company progressively moving from a small net cash position in 2012 to net debt of $16.2bn at the end of September this year.

The spending has yet to show through as improving return on capital. Indeed, return on average capital employed (ROCE) – excluding 'other operating income' which mainly represents proceeds from drug disposals – dropped to just 3.7 per cent last year, which compares with 6.8 per cent the year before. The drop followed a generic drug approval of Crestor by Watson Pharmaceuticals in mid-2016. Bulls might argue that a declining ROCE simply reflects Astra’s decision to pour more money into its business in the pursuit of long-term growth (and arguably long-term returns). But we nevertheless feel concerned that net debt has risen quite so high and that ROCE has got quite so low.

Investors shouldn’t underestimate the risk associated with drug pipelines either. In fact, just last week Astra disappointed the market by revealing that its Imfinzi (durvalumab) drug failed to improve survival rates for patients with the most advanced form of lung cancer in a phase III trial.

Others would argue Astra is a secure income play thanks to its consistent dividend. But while management confirmed it remains committed to a progressive dividend policy at the third-quarter update, analysts at Shore Capital don’t expect dividend payments to be covered by more than 1.5 times earnings until FY2020.