Description

Investment Case:

Roche is a world-leading pharmaceutical and diagnostic company and has always had a reputation in the healthcare industry as one of the best-in-class businesses. Its product portfolio is well diversified in disease areas as well as technology modalities. In particular, it is especially strong in oncology, HIV, inflammatory and autoimmune diseases on the drug side and in almost all areas on the diagnostic side.

Core to their strength are two transformational acquisitions: Boehringer Mannheim in 1997 and Genetech in 2009. Both acquisitions have long been well integrated.

Since about 2015 (last 5 years), the share price of Roche has been mostly rangebound between CHF 250 and 300, while the business has been transforming rather significantly. In particular one reason why share prices have not been rising along with the rest of the market has been the patent expiry issues related to some of the largest blockbuster drugs of Roche.

I believe there we are now coming to an end of the negative effects of the patent expiries and there is significant potential for accelerating growth for the next 5+ years. Paired with what I consider a rather unassuming valuation, I believe Roche is a great long-term investment candidate.

Why do i believe Roche is over the patent expiry hump?

Let's take a look at Roche's core business. Out of a total of CHF 63.8 bn in net sales in 2019, roughly CHF 48.1 bn comes from Roche's pharma division. CHF 6.3 bn from Chugai and CHF 13.1bn from diagnostics. 

For the drug business, where Roche has a suite of strong franchises, here is roughly how it breaks down by disease franchises:

                                                                                      2019 Revenue              % Drug Revenue

i)     HER2 franchise (Herceptin, Perjeta, Kadcyla)   CHF 11bn                                  23%

ii)    Avastin                                                                CHF 7 bn                                   15%

iii)     Hematology (Rituxan)                                        CHF 6 bn                                   13%

iv)    Other Oncology (Tecentriq, Alecensa)                CHF 4 bn                                   8%

v)    Immunology                                                        CHF 8 bn                                   16%

vi)      Neuroscience (Ocrevus)                                     CHF 4 bn                                   8%

vii)     Other (Tarceva, Hemophelia, etc.)                     CHF 8 bn                                   16%

Total                                                                CHF 48 bn                                  100%

Note that these numbers are rough estimates projected for the year. 

Here are two slides from Roche. 

As you can see, while biosimilar issues still face the leading drugs Herceptin, Avastin, and Rituxan, they are now at a scale where new drugs are already at the point of roughly being able to make up for the large declines. 

A bit more detail:

Herceptin and Avastin are two of the absolute leading cancer drugs of our time. Herceptin is for breast cancer including HER2+. Avastin is used as chemotherapy for several cancers including colon and lung cancer. Both use monoclonal antibodies. Avastin utilizes the VGEF mechanism. A biosimilar was approved in the US vs. Herceptin in 2018. Herceptin revenues have dropped significantly but are mostly made up by Perjeta and Kadcyla. In total the Her2 franchise revenue was down about 5%.

Rituxan down 5%, but made up by revenues in the area of combo therapies. 

The other area where i believe growth that will compensate the patent expiry franchises will come from is diagnostics. In 2019, this was already a business with CHF 13.0 bn of revenues. While for Roche, the largest part of this is in immunodiagnostics, which is growing at roughly 7% yoy, molecular diagnostics as well as companion diagnostics are growing significantly more than this. 

I do not intend to go into detail about this in this write-up, but i believe that Roche due to its strong current presence in all of diagnostics and its ability to act as a partner of choice has a signficant potential in developing this in the future. This is especially because i believe diagnostics and therapeutics to become ever more integrated and Roche is strong in both areas. 

An example would be developing companion diagnostics in oncology i.e. BRCA2 breast cancer for example. 

Why Roche is a good long-term compounder?

1. Consistent structural growth:

The company was founded in 1896 by Fritz Hoffmann-La Roche. They were making Vitamin C in the 1930’s. Today, their main business is about 3/4 drugs/therapeutics and 1/4 diagnostics.

In the last years, what has driven their growth has been:

(1)   Continued growth in drug franchise

Roche has been able to growth their key drug pipeline and sales in the drug division by about 9% CAGR over the last 20 years. (see slide in the later section). Between 2011 and 2020, Roche Pharma grew its revenues from CHF 31.2 billion CHF 48.2 bn i.e. about 5% over last 10 years. With operating income growing from CHF 11.7bn to CHF 16.2bn (3.5% p.a.).

Below is a chart of the growth in the Pharma devision since 1998 based on major drug launches.

(2)   Growth in diagnostics

Diagnostics has grown roughly 3% p.a. from CHF 9.9 bn to CHF 13.0 bn between 2011 and 2020. Part of this growth comes from molecular diagnostics as well as specific parts of lab diagnostics like immunodiagnostics. Regionally Asia and Latin America are the growing regions.  

2. Proven track record of accretive capital management

Roche has had a TSR over the last 10 years as follows:

a)     Share price appreciation from CHF 160 to CHF 330 = 7%

b)     Dividend yield of 2.5%

Total of around 10% p.a in the last 10 years; more before then. The share price appreciation is in line with their growth of earnings. Net income grew from CHF 8.7bn to circa CHF 15.0 bn (5.5%) suggesting an almost stable PER ratio just below 20x.  In 2019, growth has accelerated to 9% top line and over 10% bottom line.

Risks:

-        Competition: Roche is competing directly in several drug areas with multiple other pharmaceutical companies. This includes Novartis, JnJ, Merck, AstraZeneca, GsK, etc. in areas ranging from oncology, to CMS, to Hemophelia. Roche, as was the case in 2019 with Herceptin also faces competition from biosimilars. On the diagnostic front, they also compete with the likes of BioRad, Siemens, and Ortho.

-        Technological innovation. Especially on the drug side, traditional monoclonal antibody therapies may give way to targeted immunotherapy or other novel technologies over time.

-        Drug pricing: as with other drug companies, drug pricing has become increasingly difficult in the U.S., which is the largest market for advanced therapeutics.

 All in all, at a valuation of about 16x EPS, i believe Roche to be a very good investment candidate. 

Catalyst

A return to mid-single digit top line growth in the next 3 years.