AstraZeneca's Top-Up Opportunity

Published in Company Comment on 2 February 2012

The fall in AstraZeneca's share price -- opportunity or threat?

So AstraZeneca (LSE: AZN) is in trouble. The chickens are finally coming home to roost as the "patent cliff" looms large for the UK's second-largest pharma.

The company is slashing and burning to try and shore things up, announcing 7,300 more job cuts, and it now expects 2012 revenue decline "in the low double-digit range".

AstraZeneca says sales were $2bn down on the previous year with its final results for 2011, and says it will earn less still this year.

Clearly, then, the shares are a straight sell and it's time to find value elsewhere?

Well, not for me it isn't. At the time of writing, the share price is down over 3.4% at 2,983p. This looks like more of an opportunity than a threat.

This is because a lot of the pessimism was already in the price. But on the upside, the company's price-to-earnings (P/E) ratio is now less than 7.7 based on its own revised guidance of earnings being in the $6.00 to $6.30 range (they were $7.28 in 2011). This makes it one of the FTSE's cheapest shares on the simplest of measures, the P/E.

Also, the balance sheet is reasonably strong. This is the only FTSE 100 share with net cash. And Astra's share buy-backs have actually boosted earnings and look to be a generally wise move. Believe me -- this is a welcome rarity.

Straight shooter

The company is uniquely good at being open with us shareholders about its long-term future expectations. This is because of understandable investor concerns about falling revenues as exclusivity on various drugs comes to an end.

Specifically, AstraZeneca faces patent expiries between now and 2015 on drugs such as Seroquel and Nexium, and the loss of patent protection in the US in 2016 for its best-selling high cholesterol treatment drug, Crestor.

On Wednesday, the company reaffirmed that it expects annual revenue will be in the $28bn to $34bn range between now and 2014, but "in the lower half of the range". It also expects double-digit revenue growth in emerging markets.

The latest cost cuts announced will deliver a further $1.6bn in annual savings by the end of 2014. Its first phase of cuts from 2007-2010 delivered $2.4bn in annual savings.

Shrinking into value

The company has to do this as the expected revenues from recent drug launches aren't as optimistic as they once were. It would be great if the company was expanding like mad instead of the inverse, but it isn't. The market prefers growth to managed retreat and so the shares are lowly rated.

Also, it's difficult, if not impossible, for private investors to get a real feel for Astra's drugs pipeline and the profit possibilities thereof. In fact, nobody really knows what is possible.

There is excitement around potential blockbusters like type 2 diabetes treatment drug dapagliflozin (despite disappointing news regarding the US Food & Drug Administration's request for further clinical data), for example.

But the company remains strongly cash-generative thanks to the cuts. And it has promised to return value to shareholders through a progressive dividend policy and share buyback programme. In fact, Astra says it plans to buy back a further $4.5bn of its own shares this year after last year's $5.6bn net buy-backs and it was feeling confident enough to raise the full-year dividend by 10%.

Astra intends to increase the dividend while maintaining cover at two times (50% of underlying earnings). Just keeping it steady means the shares are yielding a very respectable 5.9%. Brokers' expectations push that figure up to 6.1% for the current year.

The combination of too high a yield, too low a P/E and the unfortunate but necessary cuts AstraZeneca is making -- coupled with the fall in price -- put the shares further into bargain territory for me. The problem, though, is the psychological one investors often face, of buying into a falling price and having to average down to make the investment make more sense.

Nevertheless, I will be doing just that on any further falls from here.

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Comments

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Conviviality 02 Feb 2012 , 12:19pm

A very good analysis David and agree with all of your points, however, i won't be topping up. My average cost is at the £28 mark so i consider it a certain hold for the medium term.

richjfool 02 Feb 2012 , 2:20pm

I'm holding.

Dozey1 02 Feb 2012 , 3:25pm

I'm not even tempted. Share buy-backs for a shrinking company are a nonsense, though they may give the illusion eps is holding up; give cash to shareholders to decide what to do with it. Where's growth coming from? There isn't going to be any., and slash and burn can only go so far. It's a big sea and there are a hell of a lot of better fish in it than AZN.

ScotsKen 02 Feb 2012 , 4:31pm

I am not tempted either. The company is facing lower profits in future as products lose patent protection, which means that the favourable P/E ratio will be hard to maintain. The only way of making up the lost earnings is to develop new products or find ways of making existing products cheaper to prevent the loss of orders to under-cutters. Yet it is getting rid of a reported 650 research and development jobs as part of the 7300 job cuts. That does not sound like a lot of sense to me.

vinchainsaw 02 Feb 2012 , 11:13pm

Seroquel is a major, major loss. Almost half of net profits because of its 90% margin.

The chances they can replicate that are very slim indeed.

fedupwithbanks 03 Feb 2012 , 12:23pm

"Seroquel is a major, major loss. Almost half of net profits because of its 90% margin.

The chances they can replicate that are very slim indeed."

Understand what you are saying, but it's not a total loss?

They will still be making it, won't they? And they will still presumably be able to make a (albeit smaller) margin on it.

vinchainsaw 03 Feb 2012 , 1:27pm

fedup,

Yup they will. But over the next couple of years the market will catch-up and the margins will fall drastically. Every other drugs company will look to get into the action with such a high GP margin. It makes up half o their bottom line. Even if the margin only comes down to say 45%, thats still 25% less profit they'll be making per year.

ScrumpyJack 06 Feb 2012 , 1:52pm

Also their 'core' earnings figure used for calculating EPS is a complete fairy tale. It excludes writing off drug development costs , legal expenses and other 'restructuring costs' (all of which happen almost every year). So the real PE is a lot more than 7.7 Presumably though directors' bonuses are calculated on 'core' eps? 4th qtr 2011 'core' eps was 161 cents. The figure before excluding all the bad stuff was 116 cents.
Yes they are still making huge profits but it would be interesting to have a 10 year forward estimate of profits taking account of known patent expiries. This is a business you cannot possibly value simply on a multiple of next years expected profit.

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