2024-01-22 07:13:56 ET
Summary
- Royalty Pharma is a unique pharmaceutical company that diversifies investments in market-leading or late-stage development therapies.
- RPRX has a dominant position in the pharmaceutical royalty market and shares in the profits of successful pharmaceutical development projects.
- The outlook is getting better driven by strong industry tailwinds like new technologies in developing drugs and treatments, and biopharma turning to royalty deals as an alternative financing strategy.
Introduction
Unlike traditional pharmaceutical companies that go through the painstaking and often financially risky process of investing throughout the multiple stages of drug development, Royalty Pharma ( RPRX ), as the name might imply, takes a royalty-like approach , diversifying investments in a variety of either market-leading or late stage development therapies that have a high likelihood of being commercialized.
With a 60% share of the pharmaceutical royalty market, Royalty Pharma has become one of the foremost providers of capital to these life sciences projects. It's a great business because it's essentially a partnership model with the pharmaceutical development companies, sharing in the profits if they do well. As a company, Royalty Pharma reduces its risk by investing in several of these royalties and compounds shareholder capital by reinvesting those royalties back into the business to acquire more streams of cash flow.
My investment thesis is predicated on three main points: (1) Royalty Pharma has a track record of compounding value, (2) the company has a durable competitive advantage in the biopharma royalty space, and (3) the future outlook for the company's growth is looking better driven by strong industry tailwinds.
Track Record Of Delivering Consistent Returns
Despite only being a public company since its IPO in 2020, Royalty Pharma has been operating since 1996. Since that time, it has been able to capture a 60% market share while steadily growing its adjusted cash receipts ($1.05 billion in 2012 to $2.13 billion in 2023) and its total capital deployed. In royalty deals larger than $0.5 billion, the company has an 84% market share, indicating it is the go-to provider of capital for life science royalty funding.
As you can see from the chart below, the capital deployed at Royalty Pharma has increased substantially to over $20 billion in the last decade with a substantial amount being invested in just the last 5 years.
While taking market share and deploying capital is great, the really impressive trait in my view is that Royalty Pharma has been able to deliver a 13% CAGR from 2010-2020 on its adjusted cash receipts, indicating that the company is getting very good returns on the funds it invests into royalties. It is very similar to an evergreen structure, where cash flows from royalties are reinvested back into new ones.
This strategy has really been driven by the company's focus on generating consistent cash flows from their royalties. As we can see from the graph below, 'consistent' is the keyword here. In an environment where investors are concerned about recessionary risks and inflationary pressures, these royalties look all the more attractive given that they can be generated in all market environments.
Because demand for approved therapies in many cases is both predictable and price insensitive, this has led to unlevered returns between 12-15%, but when we add the leverage (which is financed at a very low cost of debt below 3%), the returns can be in the high teens even into the low 20s range. So all in all, this strategy seems to be working well.
While Royalty Pharma does use leverage to juice up some of those returns, the unlevered returns on their own are pretty impressive and they have been consistent over time. In addition, I don't view the leverage to be an issue because the company has been very prudent with its balance sheet , where it only funds a third of the cost of these royalties using debt, which we can see translate over to the company's overall books.
At quarter end, the company had $6.13 billion in long-term debt with $1 billion due in each of 2025 and 2027, and the remaining amount due thereafter. Most of their debt was taken out during 2020, which was a time when U.S. interest rates were extremely low, so while the cost of debt is cheap right now, we should expect interest expenses to increase if the company takes on new debt. That said, most of the debt is locked in at fixed rates and there is limited near-term need to refinance so I don't view this to be an issue. Moreover, all of its debt is investment grade with an average rating of BBB.
Competitive Moat In Biopharma Royalties
The next part of my investment thesis is Royalty Pharma's competitive moat in the biopharmaceutical royalties space. We've mentioned the company's 60% market share which is a testament to this, but what I find impressive is the way the company differentiates itself from other pharma royalty companies.
For example, unlike traditional royalty deals that are serial fund structures, Royalty Pharma opts to engage in long-term royalties with its partners. This has the advantage of being aligned as long-term stakeholders in the royalty process. Unlike other royalties structured by private equity, Royalty Pharma can leverage its position as a publicly traded company to access equity and debt markets very easily. Private equity debt is also a lot more expensive than the 2-3% Royalty Pharma pays so in cases where you might want to leverage a long-duration royalty, a low cost of capital doesn't eat away at your returns if the interest rate is very low.
Finally, Royalty Pharma has a portfolio of 45 products, going after some of the largest royalties too; royalties that might be too large to be funded by other smaller, royalty peers. This diversification has a strong structural advantage over smaller, concentrated portfolios of royalties as they can spread out the risk in case one goes wrong, but also structure them in an evergreen way where they reinvest their streams of cash flow into new royalties. This diversification of risk and reinvestment simply wouldn't be possible if Royalty Pharma was smaller.
One factor I think is underappreciated (and isn't even mentioned in the investor presentation) is that Royalty Pharma does all this with its gigantic market share with just 16 people at the company (source: S&P Capital IQ). With strong EBITDA margins above 90%, there isn't a lot of risk on the expense side of the income statement. This also speaks to the scalability of the business model, in that it can remain highly efficient while keeping expenses to a bare minimum.
Outlook For Future Growth Looking Better
The last part of my investment thesis outlines the case for why I believe the outlook for Royalty Pharma has never looked better.
Back in 2020, at its IPO 2020, Royalty Pharma was projecting a 6-9% CAGR in its adjusted royalty receipts five years out to 2025. With a few years having passed since then, that number is looking more like 11-14% now according to management, and 10%+ top-line growth from 2025 to 2030.
A lot of this growth is also due to the overall growth rate in the healthcare and biopharmaceutical market. For example, according to Mordor Intelligence, the biopharmaceutical market is expected to grow at an 8.07% CAGR from 2024-2029, indicating above-average growth for the industry compared to the general market.
Driven by strong industry trends like an aging population, new developments in technology to treat previously untreatable diseases, and a growing trend by biopharma companies to seek out royalties as an alternative method of funding with an often lower cost of capital, Royalty Pharma is poised to benefit from these secular tailwinds.
Specific to the portfolio, there are a number of reasons to be optimistic about the company's future outlook. For example, in August last year, the company acquired 5.1% from Ferring on the U.S. sales of their Adstiladrin (approved for bladder cancer) for $500 million. With the royalty expected to increase to 8% in 2025, this represents the first gene therapy drug in Royalty Pharma's portfolio, which speaks to a market that hasn't yet been tapped by Royalty Pharma.
In September , the company also bought a royalty on Skytrofa (a weekly growth hormone therapy) from Ascendis which is the first FDA-approved hormone therapy of its kind, addressing an unmet need in pediatrics. At 9.15% for $150 million, this seems like a great deal when we consider that the sales forecast will be about $450 million by 2030. Based on this, management is now guiding for adjusted cash receipts to be in the range of $2.95 billion to $3 billion.
Valuation
Based on the 4 sell-side analysts covering Royalty Pharma's stock, all 4 analysts have a buy rating with an average target price of $46.75, with a high estimate of $56.00 and a low estimate of $40.00. From the current price to the average price of $46.75 one year out, this implies a potential upside of 60.8%, not including the 2.9% dividend yield, which was just raised this month by 5%. This suggests the sell-side is very bullish on the company's near-term outlook.
As you can probably guess, I share this view as well. But unlike with other companies where one can use the P/E multiple or EV/EBITDA figure to value a company, I don't think EBITDA does a good job of capturing the earnings power of the business and would rather use the company's reported adjusted cash receipts figure to put a multiple on the business. With adjusted cash receipts of $2.95 billion on the low-end of guidance for the year, a market capitalization of $12.93 billion, cash of $937 million, and long-term debt of $6.13 billion, we can an EV to Adjusted Cash Receipts multiple of about 6.1x, which is extremely cheap for a royalty company.
While there aren't any publicly traded royalty companies in the biopharma space that would be suitable comparables, the multiple of 6.1x on its own should tell you that the stock is very underpriced here.
In terms of the risks to the investment thesis here, the largest risk would be the company's financing strategy. While the stock has been punished with the rest of the biopharma and healthcare stocks relative to the broader markets, one possible headwind the company may face is that its interest rates on new debt will almost certainly be higher when it comes time to refinance. While I think that's a risk that's more than priced in at the current share price, a 200 basis point increase would double the interest expense Royalty Pharma pays by about $122 million.
The second risk is the concentration of the portfolio. While Royalty Pharma is fairly diversified with over 40 different drugs and treatments it has royalties on, the company is fairly concentrated in its cystic fibrosis franchise. This was a pretty significant deal size well over $3 billion for Royalty Pharma, and so based on their track record, I don't think they would have made the deal unless they were confident in the future outlook for Vertex's drug. So far, net cash from the franchise has been very consistent but I would nevertheless watch for indications if this changes.
Conclusion
In summary, Royalty Pharma stands out as a unique player in the pharmaceutical industry, adopting a royalty-like approach that sets it apart from traditional pharmaceutical companies. With a dominant 60% share of the pharmaceutical royalty market, the company has demonstrated a track record of compounding value, maintaining consistent returns through a prudent and efficient business model. Its competitive moat in biopharmaceutical royalties, marked by long-term partnerships and a diversified portfolio of 45 products, positions it for continued success. Looking ahead, I believe Royalty Pharma's future growth appears promising given the strong industry tailwinds. At the current EV to Adjusted Cash Receipts multiple of about 6.1x, I believe shares look very cheap at the current price. While there are risks to consider like the cost of capital increasing in the future and the current portfolio concentration in the cystic fibrosis franchise, I feel good about the current outlook for Royalty Pharma and rate shares as a 'buy'.
For further details see:
Royalty Pharma: One Of The Best Names In Pharmaceuticals