The Year 2016 In Review: Roche’s Investors Remained Cautious Despite Improving Business

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The year 2016 was a mixed one for Swiss pharmaceutical giant Roche (NASDAQ:RHHBY). While the overall business improved on the back of the launch of new products and growth in the HER2+ drug franchise, the stock fell as investors remained cautious regarding broader industry factors. Overall, there was no change in the company’s strategy and Roche still remains a research-focused firm. There were no major M&A deals and the capital was primarily deployed towards developing and accelerating the drug pipeline. This can be thought of as a response to the changing pharmaceutical landscape, as the industry has to brace against the impact of upcoming biosimilars. Roche stands to lose the most because of its focus on biologics. Nevertheless, we believe the management is capable of navigating the course by smartly expanding into adjuvant and combination therapies, apart from launching new products based on sheer strength of its R&D.

Our price estimate of $38.50 for Roche is nearly 30% above the market.

Roche’s Revenue Growth Improved In 2016

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Roche’s revenue grew nearly 6% in the first 9 months of 2016 (in Swiss Francs) compared to less than 1.5% growth observed last year. It was a significant improvement, and was driven by both pharma and diagnostics businesses. However, considering that the diagnostics business constitutes just 16% of Roche’s gross profits, it becomes imperative to focus on pharma business. This segment saw nearly 4% growth driven by the HER2+ franchise, and autoimmune drugs including Xolair and Esbriet. (Note: HER2 is a protein called human epidermal growth factor receptor 2 that promotes the growth of breast cancer cells, a protein against which Roche has a number of effective treatments.)

So what changed this year? First, the decline in the Rituxan/MabThera revenue abated this year due to expansion in rheumatoid arthritis and vasculitis. Second, the ramp up in sales of Perjeta, Esbriet and Kadcyla continued with meaningful contribution from Herceptin. Strong demand due to neoadjuvant setting and metastatic breast cancer uptake in the EU for Perjeta, along with higher volumes for Herceptin due to longer treatment duration, helped. Third, a new oncology drug Tecentriq, with peak sales potential of $7-$8 billion, was approved by the FDA. Fourth, Actemra saw a significant growth this year, unlike 2015.

Despite The Improved Revenue Growth, The Market Cap Fell Nearly 20%

Although Roche’s revenue growth improved, the stock still lost nearly 20% this year. This suggests that the market had already priced in the expected drug launches, but succumbed to macro pressure and growing concerns over drug pricing and biosimilar competition.

If we compare Roche’s stock trajectory to S&P pharmaceutical index, we find a striking similarity. Both the stock, and the index, show similar graph and are down more than 20% this year. This suggests that Roche’s investors are concerned about the overall sector. Here is what we note:

  1. The stock fell in the beginning of the year when the entire market was down due to concerns over China’s economic growth.
  2. However, the gradual decline continued in the latter months despite no Roche-specific surprises. The concerns over pharmaceutical sector can be partially attributed to passing of tax inversion related laws that reduced the incentive for M&A deals, thus limiting growth opportunities. However, we think that its relevance to Roche is limited as the company is based in Switzerland and the market wasn’t really expecting a potential bid for it.
  3. Additionally, the increased approvals of biosimilars put Roche’s future growth under scrutiny. We think that this concern has grown over time, and appears to be weighing on potential benefits of new drug launches. After all, more than $20 billion of Roche’s sales could be under pressure in the next couple of years.
  4. Another factor that could explain the stock decline is the general concern over drug pricing and its relevance to the recently concluded presidential elections. For the most part, we think that the market expected Hillary Clinton to win, and she has openly criticized high prices of drugs.

Silver Lining: Roche’s Drug Pipeline Beat Our Expectations

We expected four new regulatory filings in 2016. One of them, Lebrikizumab , is still in Phase 3. For the remaining 3 filings, Roche beat our expectations with Tecentriq and Venetoclax getting accelerated approval, and Ocrelizumab getting breakthrough therapy designation. These drugs have a combined peak sales potential of $15 billion.

In the diagnostics business, Roche launched 12 new products with 5 of them being from the Cobas franchise. The company continues to remain strong in this segment. However, its relevance to Roche’s valuation is limited due to relatively low profit contribution.

Overall, we think that Roche’s strength in R&D is being undervalued by the market. We believe that the company can navigate through unfavorable market conditions over the next one to two years.

We will follow up this analysis with the expectations for 2017, and how our valuation fits in that. Meanwhile, please let us know your views by commenting in the box below.

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