2023-03-08 10:51:52 ET
Summary
- Roche has logged a few clinical successes lately, but hasn't scored the sort of big wins that change investment theses or drive lasting changes in sentiment.
- Fourth quarter pharmaceutical sales were fine, and Roche has a strong roster of $1B-plus/year drugs, but growth may be limited to around 3% to 4% over time.
- I expect mid-single-digit long-term FCF growth from Roche, and the company will continue to generate ample cash flow to fund R&D, M&A, and returns to shareholders.
- I continue to believe that Roche needs to fundamentally re-examine its approach to drug development, as pipeline productivity has been declining.
- Roche's underperformance leads to a more attractive valuation, but there is a real risk that the shares lag as a "value trap" without growth drivers that can excite the Street.
Not all that much has changed at Roche ( RHHBY ) since my last update on this Swiss pharmaceutical and diagnostics giant in November 1, 2022. I’ve been concerned for some time with a lack of R&D productivity and the risk that there are structural issues in Roche’s approach to pharmaceutical drug development, and I continue to believe that this relative dry spell is pressuring growth and could well spur new M&A. By the same token, though, pharmaceutical revenue did grow 9% in the fourth quarter and the company does still have several growth drivers.
Roche shares are down 15% since that last update, underperforming the pharmaceutical sector. Long-term revenue growth of around 3% and modest margin improvement can drive enough growth to support a low-$40’s fair value, and I believe Roche will do what it takes through M&A to maintain at least that level of growth, so I see relatively less risk in this name, but I also don’t see a lot of catalysts that are likely to change investors’ minds beyond chasing relative value.
Mixed Clinical News
Relative to my last update, there have been a few positive clinical updates. The company announced in January that the IMbrave050 study of Tecentriq and Avastin met its goal in liver cancer. Liver cancer isn’t particularly common in North America or Europe, but it is a hard-to-treat cancer, and Roche could see more meaningful opportunities in China (where it’s more common).
In February, Roche announced that the Phase III COMMODORE study of crovalimab, a subcutaneous treatment for paroxysmal nocturnal hemoglobinuria (or PNH) was successful, showing non-inferiority to AstraZeneca ’s ( AZN ) Soliris with some possible advantages in the safety/tolerability profile. AstraZeneca has been moving their PNH franchise forward, including subcutaneous Ultomiris, and dislodging established treatments isn’t often easy, but this is a large addressable market and Roche should see some meaningful contributions from this drug.
Also in February, Roche announced that Vabysmo achieved its primary endpoints in two Phase III studies in retinal vein occlusion; Vabysmo showed non-inferiority to Bayer ’s ( BAYRY ) / Regeneron ’s ( REGN ) Eylea. While Eylea slightly outperformed on the primary endpoint in both studies, Vabysmo outperformed in an exploratory endpoint of the absence of blood vessel leakage, and this will pave the way to a third approved indication (added to wet-AMD and diabetic macular edema).
Over that same time, there have been some clinical failures as well. The biggest was the Phase III failure of its Alzheimer’s drug candidate gantenerumab, which while not surprising is still disappointing and feeds into the questions I have about Roche’s drug design issues – Roche is building a track record where its entries into new drug classes (like Tecentriq) tend to underperform.
Roche also saw the failure of the CONTACT-03 study (studying Tecentriq and Exelixis ’s ( EXEL ) Cabometyx) and chose to end its collaboration with Blueprint Medicines ( BPMC ) on Gavreto.
While not a failure, February passed without an update on SKYSCRAPER-01, a phase III study of Roche’s anti-TIGIT antibody tiragolumab (meant to enhance the efficacy of other oncology drugs like PD-1-targeting antibodies). Management had indicated that there would be no update if the interim look necessitated the trial continuing to completion, and I think this argues further against the likelihood that the drug will hit its target for meaningful overall survival improvement.
A Thinner Roster Of Potential Drivers
One of my concerns about Roche is that there’s not a lot in the pipeline to generate all that much excitement. That’s admittedly a subjective call, but I don’t see a lot of would-be blockbusters queued up for read-outs in the near future.
Roche is building up its hematology franchise, and I do see some promise in its bispecific antibody programs, but there’s a lot of competition and I think competing with drugs from AbbVie ( ABBV ), Bristol-Myers ( BMY ), and Johnson & Johnson ( JNJ ) could still prove challenging. It seems more likely to me that this will develop into a roster of solid drugs that collectively generate good revenue and profits, but without any superstars.
As far as near-term Phase III opportunities, TNKase is worth watching in stroke (the TIMELESS study), but the history of thrombolytics for stroke warrants skepticism (or at least caution). Sarepta ’s ( SRPT ) gene therapy for Duchenne muscular dystrophy (or DMD) SRP-9001 is looking promising, with a Phase III read-out around year-end, but Roche’s ex-US rights limit the financial upside from this program.
Beyond this is a fairly hefty list of adjuvant studies of Tecentriq. These incremental opportunities aren’t trivial, and there’s a case to be made the Street undervalues the revenue opportunities that could come from success here, but adjuvant studies don’t typically drive a lot of investor enthusiasm.
There are, of course, many other candidates in various phases of testing, including a KRAS drug (RG6330), follow-on indications for crovalimab, and new compounds for large markets like schizophrenia and Alzheimer’s but those are some distance away and still very much at risk.
There Are Still Drivers, But Are There Enough?
Roche had a decent fourth quarter, with 9% growth in the pharmaceutical business and significant ongoing growth from Ocrevus (up 18%), Hemlibra (up 24%), Tecentriq (up 24%), Evrysdi (up 59%), and Vabysmo. Roche has four drugs annualizing at $1B-plus/quarter, and while Ronapreve will likely fall off, Perjeta is just on the cusp of joining Ocrevus, Hemlibra, and Tecentriq in that club.
I’m still bullish on the ongoing opportunities for most of these leading drugs, though I do expect Ocrevus to see slowing momentum as it makes up a larger percentage of the market. With Hemlibra I expect increased competition from newer therapies, including BioMarin ’s ( BMRN ) gene therapy Roctavian, but again I believe this business can still grow. Tecentriq could see a boost from those adjuvant studies, as well as a move to a subcutaneous formulation.
Even with those drivers, though, I believe overall growth is likely to slow to 3% to 4% range in the coming years as Roche sees further generic erosion, pressures from market penetration, and increased competition with its lead drugs. I believe this will put more pressure on management to improve the pipeline productivity and deliver new blockbusters, and that may well lead to a return to M&A. While I believe 3%-plus revenue growth can sustain respectable growth in earnings and cash flows, investors don’t get excited about “respectable” and I see a risk that Roche could languish as a value trap.
The Outlook
I expect long-term revenue growth of around 3% to 3.5% from Roche, underpinned by a strong oncology franchise (particularly in breast cancer) as well as contributions from key drugs like Ocrevus. I do actually like the breadth of Roche’s portfolio of revenue-generating drugs, but again my concerns have more to do with sentiment and the lack of “tentpole” mega-blockbusters that will excite institutional investors.
On the margin side, Roche is already an exceptionally profitable company and I see relatively limited leverage from here – I believe free cash flow margins can climb a little higher into the mid-20%’s on a sustained basis, with a few years likely to be better than that, but I don’t see a lot of operating leverage opportunities, and I think free cash flow growth is likely to be in the mid-single-digits.
Discounted back, those cash flows support a low-$40’s fair value for the ADRs, and I get a similar result with a 14.6x multiple on a normalized/adjusted FY’23 EPS estimate (adjusting for the impact of declines in COVID-19-related businesses), with the P/E driven by my three-year expected growth rate (there’s a reasonably good historical correlation between three-year growth rates and forward P/Es).
The Bottom Line
I know there will be readers who say that they don’t care about whether or not Roche has flashy drugs in the pipeline and that they’re happy to wait for the value here to be recognized over time. That’s fair enough – if double-digit declines over a period of two or three years don’t bother you and you’re content to wait for an eventual value-driven recovery, that’s valid.
Not all readers are so patient, though, and while I do believe Roche offers enough value now to bump it back up to a ”buy”, it’s a name where prospective shareholders need to be aware of the risk that the shares could languish despite that value, as the Street typically needs growth stories they can latch onto when considering their portfolio investments.
For further details see:
Roche: Ongoing Pipeline Issues Sap Growth And Increase M&A Likelihood