Description

Business Overview / Background:

Shire is a leading biotech and specialty pharma company with a focus on rare (“orphan”) diseases. As a standalone business, it operated through four core therapeutic categories: (i) Rare Diseases, (ii) Gastrointestinal (GI), (iii) Neuroscience and (iv) Ophthalmology. In 2015, Shire generated $6.5B in net revenues and $2.9B in adjusted EBITDA (~45% margin). Of this $6.5B, almost half was at risk of generics competition and patent expiry:

• Vyvanse (ADHD): the largest franchise, which accounts for $1.7B, is facing a patent cliff in 2023;

• Lialda: the second largest franchise, which accounts for ~$680M, is facing generic competition in 2020; and

• Pentasa: which accounts for $300M and is at risk of generics competition.

When the current CEO, Flemming Ornskov, joined the firm in 2013 he initiated and spearheaded the “One Shire” program which repositioned Shire. As part of this program, Ornskov (i) cut down the number of R&D projects as well as R&D roles, (ii) reorganized / streamlined operations into two global hubs and (iii) decreased corporate expenses. These actions, together with growth, drove an increase in EBITDA margins from 32% to 44% during the 2012-2014 period. Furthermore, during this same period, Ornskov made number of acquisitions to high-grade the pipeline, building the “deepest and most valuable pipeline in Shire’s history.” This positioned Shire for robust growth through the end of the decade and thereafter. As a result, in the summer of 2014, Shire set an ambitious plan of achieving $10B in revenue by 2020, of which $3B+ would come from new products / pipeline. A majority of products that Shire acquired were molecules/small companies in development stages with varying potentials such as Lifitegrast ($400M purchase price; $1B+ peak sales potential; recently approved), ROP ($150M purchase price; $1B peak sales potential; primary endpoints were not met but secondary endpoints showed some promise), Pink Eye solution ($300M purchase price; large potential; P3 ready), Dyax ($6B purchase price; $2B+ peak sales potential; P3 ongoing with really strong efficacy data in P2), etc. Shire also made strategic acquisitions of companies that have commercially ready products, but lack the scale such as ViroPharma ($4B or 6.4x sales; Cynrize + pipeline optionality) and NPS pharma ($5B; Natpara early in commercialization and Gattex recently approved, but each have $500M+ peak sales potential, + pipeline potential). Last year, Shire acquired Baxalta (“BXLT”), in a transformational acquisition, to create the leading rare diseases platform.  Similar to Shire, BXLT is a rare diseases biotech company with a focus on complementary therapeutic areas: (i) Hemophilia, (ii) Immunology, and (iii) Oncology. In 2015, BXLT generated $6.2B in revenues and $1.9B in adj. EBITDA (34% margin). The PF Company has a robust pipeline that should drive DD growth through the end of the decade. As such, Shire doubled its “$10B by 2020” plan to “$20B by 2020”. For more info on the company I would point you to the BXLT M&A transcript/presentation, as well as Shire’s 2Q2016 earnings transcript/presentation.

Initial Investor Reaction to Baxalta Transaction

Shire traded down following the initial hostile offer for BXLT in August 2015 for number of reasons. The primary and lingering concern for investors was that Shire over-paid for the BXLT transaction. Pro forma for $500M of synergies (revised up to $700M synergies recently), Shire acquired BXLT for 13x 2016 EBITDA and 11x 2017 EBITDA which yielded an IRR “in excess of 10%.” Once the transaction was agreed on in January 2016 the return profile of the acquisition was revised to “ROIC in excess of cost of capital by 2020”, which was ambiguous and perceived by some to be lower than the initial 10% IRR. The other concern was (and still is) the likely revenue erosion arising from ACE910, which raises concerns around BXLT’s durability. Also, high leverage (in excess of 4.0x) was another concern. Lastly, rare disease drugs are priced highly thus the concern around “price gauging” / bad actor pharma companies.

Business Quality

Rare diseases business model is still relatively new in pharma and as such it appears to be underappreciated. This model enjoys few unusually attractive characteristics. First, rare diseases don’t generate multi-billion dollar franchises and, as such, are typically not the target of big pharma – thus eliminating much of the competition. Second, orphan drugs enjoy the accelerated development process due to priority review and phase-skipping, which tends to decrease the development costs and accelerates time-to-market. Third, an orphan drug company needs resources and scale to be successful, which goes beyond just discovering effective drugs / therapies. Most orphan diseases are still underdiagnosed creating a need to developed new markets, which takes time and resources – an orphan drug company must (i) train and educate doctors, (ii) identify patients, (iii) educate patients, (iv) get products on formulary, etc. As a result, big pharma tends to avoid spending R&D dollars on smaller patient populations so a lot of R&D is done by smaller “single-product” biopharma companies. These “single-product” biopharma companies might develop great products / solutions but they lack the resources to commercialize and bring-to-market these products, and, as such, tend to become targets of companies that have those capabilities (commercial and R&D) and that want to develop an orphan disease platform (such as Shire). In fact, thus far Shire has been capable of acquiring many drugs in development stages for attractive prices – Lifitegrast being the best example; other acquisitions had varying levels of success, but on average their R&D and M&A teams have been able to identify, assess and acquire attractive molecules in various stages of development for attractive valuations. And this will most likely continue into at least the next decade, as most of new drug development (by number) is happening in orphan disease space. Lastly, what continues to be really attractive in rare diseases space is that its markets are under-diagnosed and under-treated, creating long runways for healthy organic growth as markets continue to develop – I’m referring to Rx growth, before any benefits of pricing. So a rare disease platform (such as Shire) faces strong tailwinds from both organic and inorganic growth opportunities.

Shire standalone branded drug products are well protected through the patent cliff. As discussed, there are number of key products coming off patent in 2020 and thereafter. In the meantime, Shire claims that its patents are really strong as has been validated recently in the Lialda challenge which Shire won, thereby delaying potential early generic entrance. To offset patent cliff concern, Shire has number of products in late stage development or early commercial stages, that should contribute significantly to the growth, such as Lifitegrast ($1B peak sales potential; recently approved), DX-2930 ($2B; in development but strong positive early data), Natpara ($500M+; already approved), Gattex ($500M+; already approved), etc. Furthermore, Shire has shown strong success in expanding existing drug indications which not only grows TAM but also extends the exclusivity/patent lives. One good example of this is ADHD franchise, where Shire continues to expand indications into: (i) BED, (ii) adult ADHD, (iii) children and adolescents and (iv) potential extended-life ADHD. So on the whole, Shire business is durable through the patent cliff with significant optionality coming from commercialization of new products and, to lesser extent from, indication expansion of existing products.

BXLT standalone products are predominately biologics which are durable beyond the patent cliff. I’m not familiar with any biosimilars in clinical trials that would challenge BXLT products. The biosimilar approval process is more complex than the generics process: FDA requires biosimilars to run trials to generate data to demonstrate similarity, which is costly and time consuming (unlike bioequivalence studies for generics). Since BXLT’s biologics serve small populations, it’s often not feasible to create biosimilars in the same way that biosimilars are going after large multi-billion dollar biologics. That could change over time, but one would have good foresight of new potential entrants through clinical trials. Having said that, BXLT’s products are not insulated from competition. The largest threat to BXLT Hemophilia A franchise is Roche’s ACE910 which is a once monthly inhibitor therapy currently in P3 trials that could enter the market in 2018. If successful, ACE910 would be a disruptor to current inhibitor therapies that administered weekly and biweekly. In the worst case scenario, Shire estimates that ACE910 would erode 50% of inhibitor sales ($790M) which comes out to $395M revenue erosion (~6% of total BXLT sales). Moreover, ACE910 could potentially impact Factor VIII (“FVIII”) replacement therapies. Having said that, current ACE910 P3 trials are focused on inhibitor therapies, not FVIII. However, if Roche decides to target FVIII market, Shire estimates that they could lose 20% of sales in the worst case, which comes out to ~$450M in sales (~7% of BXLT sales). There are number of arguments for and against ACE910, but it’s prudent to assume that Roche will at least disrupt the inhibitor therapies. The other potential disruptor to BXLT’s hemophilia business could be BioMarin’s gene therapy; however, it is still early in development and early results are derived from a small data set. In both cases, Shire management likes to highlight that the transition to new therapies would be slow as the long-term safety and efficacy is unknown compared to the existing therapies, but that’s not a prudent assumption for an investor. The other concern is that BXLT’s plasma-derived products are somewhat interchangeable (commoditized), though views differ on this subject. Concern is that the plasma-derived capacity growth will outpace the demand thus putting pressure on pricing and margins of BXLT’s Immunoglobulin therapies, if in they’re in fact interchangeable. Currently, Immunoglobulin therapies account for 30% of BXLT sales.

Short Thesis / Key Concerns

The key component of the short thesis is that Shire overpaid for BXLT. As discussed, one of the concerns around BXLT business is the competitive threat coming from ACE910. The other concern is that BXLT could face overcapacity in the coming 3-4 years, which should impact pricing and margin profile of IG therapies, which account for 30% of BXLT sales and ~13% of PF Shire sales. The second component of the short thesis is that Ornskov is starting to build an empire and thus is not focused on shareholder value creation – as is evidenced by low return profile of BXLT. The third component of the short thesis is the general laundry list assigned to spec pharma faces including: (i) price gauging, (ii) high leverage and (iii) dependence on M&A to drive growth.

Mitigants: BXLT purchase multiple does seem too high on a 2016 basis, but BXLT is a strategic acquisition for Shire. It diversifies away from the upcoming patent cliff into durable biologics business (with the exception of pending ACE910 threat) that offers stability and cash flows to fund future R&D and M&A. Also, I must point out that BXLT has a strong pipeline growth potential which buys down the multiple 3+ years out, implying an attractive valuation when considering the growth potential (and durability of biologics franchises). With the recent increases in cost synergy expectations (from $500M to $700M), Shire has bought down the PF multiple to 12x 2016 EBITDA, down from 13x at announcement, so today’s investor would buying into a more favorable deal. Second, while the returns are low, the acquisition provides significant stability and cash flows for future R&D and M&A, which create a base for future value creation. With respect to “spec pharma” laundry list, Shire doesn’t really fit the “bad actor” profile. While Shire drug prices are high, they’ve seen modest pricing increases historically (in MSD range) – which is much different from sudden, enormous and often criticized pricing increases. Furthermore, the expensive pricing is justified by big R&D spending that Shire engages in, especially since it targets orphan diseases which are largely ignored by big pharma. I believe that its high leverage is just a result of efficient use of a balance sheet and a non-issue since Shire enjoys very strong organic growth – it should de-lever to 2-3x by 2017-end. Lastly, Shire doesn’t depend on M&A for growth, its growth is driven by pipeline products, which are occasionally replenished through M&A. In fact, pro forma for BXLT acquisition, Shire has over 40 pipeline products in clinical development with 75% in rare diseases space. Also, Shire has grown through indication expansions for existing products and will continue to going forward.

Long Thesis

Shire is a high quality business, run by a very capable CEO, that should generate DD CAGR top line growth through 2020, low-to-mid-teens EPS growth, which, when coupled with expanding multiple, should result in 20%+ IRR for next 3 years. At current share price (~$198), Shire is trading at 12.5x 2017 PF EPS with ~4.1x leverage which is expected to decrease to 2.7x by 2017-end. This is very compelling valuation considering Shire’s growth profile, especially with the Lifitegrast de-risking, as well as the increased optionality coming from 40 products in development (of which >20 are in P3 or registration phase) as well as incremental optionality that Shire will gain as it de-levers. I expect a multiple re-rating as (i) growth is de-risked through product approvals / positive trail data, (ii) BXLT integration is complete and (iii) the business de-levers. Simplified 3 yr IRR bride: ~11% top line growth ⇒ >15% EPS growth (margin expansion and debt de-levering) + NTM EPS multiple expansion to 15x ⇒ 20% IRR. Upside to my numbers, would come from incremental M&A which is a “free”/inexpensive option at current valuation.

When evaluating a downside case scenario, I perform a run-off analysis to take into account the patent cliff. Also, in this downside scenario I assume significant erosion of hemophilia business due to ACE910 entrance; I include risk-adjusted high probability pipeline (largest of which is Dyax) and modest returns on R&D (10% pre-tax) thereafter; I assume 10% discount rate, which results in a DCF value of $160, a 20% discount to current Shire share price. Probability-wise, I don’t assign much to this scenario as I don’t believe Shire will stand still (as is the case in my run-off math), but I still like to understand the bad scenario math. So in summary, on the low end you stand to lose 20% while in the upside case you’re generating 25+% IRR. Based on my probability weighted outcomes, I come out at mid-teens IRR over next 3 years.

Conclusion

Shire is a high quality business with a strong management team and an attractive growth profile that is currently underappreciated by investors. To appreciate Shire, one must believe in Ornskov and his team. And while I like Ornskov, I must point out that Shire pursues a more risky strategy than what some investors are comfortable with. The anchor drugs, Vyvanse and Liald, are coming off patent in 2023 and 2020, so the future hinges on successful R&D and astute M&A (beyond current pipeline). Shire is guiding to new product launches (pipeline) generating $5B of revenues by 2020-end which sell-side has not fully bought in, but with 40+ products in development Shire has a lot of “shots on goal.” Some of the pipeline has already been de-risked by recent product approvals (Lifitegrast being the largest), but there are still several significant approvals ahead. And when I look beyond the current pipeline, I’m betting on Shire to continue to identify and acquire products in development stages with promising growth profiles. It’s no secret that Shire’s M&A strategy is different than big pharma – it’s typically early stage and pre-revenue. Given the early success with Lifitegrast and NPS pharma (among other ones), I have developed confidence in Shire’s ability to identify promising compounds and to develop and commercialize them. But to be fair Shire’s M&A track record hasn’t been perfect. Shire acquired ViroPharma (Cinryze) for $4B which was the best solution until Dyax showed impressive results in clinical trials, which Shire subsequently acquired for ~$6B (to defend its position in the market) - Dyax is expected to cannibalize ~20% of Cinrzye sales. Dyax standalone acquisition should be a great investment, but coupled with Viropharma acquisition it should generate more modest returns. So bottom line is that today’s investor in Shire is placing a lot of trust in Ornskov and his team.

Valuation

Based on my projections, which are modestly below Shire LT goals, below are the trading multiples. Note that 2016 only includes BXLT financials from June 3, 2016, which distorts ’16-’20 CAGRS.

No reliance, no update and use of information. You may not rely on the information set forth in the above write­up as the basis upon which you make an investment decision. To the extent that you rely on such information, you do so at your own risk. The write­up does not purport to be complete on the topic addressed, and we do not intend to update the information contained therein, even in the event that the information becomes materially inaccurate. Certain information contained in the write­up includes calculations or projections that been prepared internally; use of a different method for preparing such calculations or projections may lead to different results and such differences may be material.

Catalyst

De-risking of growth through pipeline product approvals and positive data from trials + Baxalta intergration