The 3 Biggest Risks Facing AstraZeneca

Published in Company Comment on 28 November 2012

What should investors in AstraZeneca (LSE: AZN) be worried about?

The world's fifth-largest pharmaceutical company, with operations in more than a hundred countries worldwide, AstraZeneca (LSE: AZN) (NYSE: AZN.US) is a business with very definite attractions. A £36bn FTSE 100 (UKX) constituent, last year the company earned a pre-tax profit of $12.4bn on revenues of $34bn.

And with margins like that, it's no wonder that this defensively-positioned business is popular with many investors. Today, with its shares changing hands at 2,892p, the company is rated on a cheap-looking prospective price-to-earnings ratio (P/E) of 8, and offers income investors a very tempting forecast dividend yield of 6.4%.

But how safe is that share price? And -- of vital importance to income investors -- how safe is that dividend? In short, how could an investment in AstraZeneca adversely impact investors' wealth?

In this series, I set out to answer just these questions. My starting point: AstraZeneca's latest annual report, where the company's directors are obliged to address the issue of risk.

Risk management

One immediate thing that I'm looking for is an acknowledgement that risks do exist, and that they need managing.

The good news? As you'd expect from a business of AstraZeneca's size and calibre, the company has in place a risk management policy, a system of regular reviews, and a number of high-level committees tasked with monitoring the risks that the business has identified.

But what, precisely, are those risks that the company faces?

Read the small print, and AstraZeneca identifies no fewer than 29 risks as having a significant prospective impact on the company's financial performance. They range from delayed regulatory approvals to taxation, and from illegal trade in its products to patent litigation.

So let's take a look at three of the biggest.

Failure to meet development targets

Fairly obviously, AstraZeneca's shares are cheap -- and the prime reason for this is to do with investors' worries over its product pipeline. In short, this is seen as weak, with insufficient new products coming on stream as patents expire on old ones. As AstraZeneca puts it:

"The development of any pharmaceutical product candidate is a complex, risky and lengthy process involving significant financial, R&D and other resources, which may fail at any stage of the process due to a number of factors. A succession of negative drug project results and a failure to reduce development timelines effectively or produce new products that achieve commercial success could adversely affect the reputation of our R&D capabilities, and is likely to materially adversely affect our financial condition and results of operations."

In many ways, it was the perceived failure of former chief executive David Brennan to get to grips with this issue that led to his removal earlier this year. And there's no doubt that investors are worried: sales during the three months to the end of September slid almost 20%, thanks to the patent expiries of treatments such as the antipsychotic Seroquel. That said, new chief executive Pascal Soriot -- who joined the company from Roche -- is well aware of the problem, as is the rest of the Board.

Delay to new product launches

In the pharmaceutical business, patenting a new treatment is one thing, and bringing it to market in a timely manner quite another. As the company puts it:

"The anticipated launch dates of major new products have a significant impact on a number of areas of our business, including investment in large clinical studies, the manufacture of pre‑launch product stocks, investment in marketing materials pre‑launch, sales force training and the timing of anticipated future revenue streams from new product sales. For example, for the launch of products that are   seasonal in nature, delays in regulatory approvals or manufacturing difficulties may delay launch to the next season which, in turn, may significantly reduce the return on costs incurred in preparing for the launch for that season."

In short, execution is everything -- as the company knows too well. One slip, and the hit to revenues is almost unavoidable. AstraZeneca knows the dangers, to be sure. But can it avoid them? Time will tell.

Price controls

In many countries, healthcare costs consume an increasing amount of GDP. Consumers and legislators alike are aware of this, and in the present economic environment it's no surprise that pressures are mounting on healthcare providers, healthcare insurers and legislators to promote the use of cheaper generic drugs where possible. As AstraZeneca notes:

"Most of our key markets have experienced the implementation of various cost control or reimbursement mechanisms in respect of pharmaceutical products. For example, in the United States, realised prices are being depressed through cost‑control tools such as restricted lists and formularies, which employ 'generic first' strategies, and require physicians to obtain prior approval for the use of a branded medicine where a generic version exists."

The pressures are very real, and there's no doubt that the increasingly restrictive reimbursement policies to which AstraZeneca is subject -- together with the potential adoption of new legislation expanding the scope of permitted commercial importation of medicines into the United States -- could materially adversely affect the firm's financial performance.

What can the company do? Innovate, in short. But it's little wonder that in a 'head to head', many investors favour competitor GlaxoSmithKline (LSE: GSK) (NYSE: GSK.US) precisely because of its clutch of consumer healthcare and nutrition products -- which generate a decent 20% of sales -- and which come from such brands as Panadol, Sensodyne, Macleans, Lucozade, andHorlicks.

Risk vs. reward

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> Malcolm owns shares in AstraZeneca and GlaxoSmithKline.

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TraineeBuffett 28 Nov 2012 , 1:37pm

Good article Malcome
I have read that they have increased these R&D expenses immensely and the new CEO is buying shares. It might be a sign that a new blockbuster drug might be in sight in the near future. Moreover, they are looking into acquiring small pharmaceutical companies. I am backing AZN.

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