ASTRA ZENECA (AZN) - cheap or not?

BACKGROUND

AstraZeneca is one of the world's largest pharmaceutical companies, with 2008 sales of $31.6 billion and $6.1 billion in profits. 2009 sales are expected to top $32 billion.


It is interesting to note Astra Zeneca's (AZN) relatively low forward price/earnings ratio (around 8 for 2010 and 2011) versus its peer group and healthy dividend (4.1%). This appears to make it attractive versus other companies in the pharmaceutical space who generally trade on p/e ratio's above 10.  But before buying the stock "hand over fist" it is worth considering that the company formed from the merger of Astra of Sweden and Zeneca of the U.K. in 1999 has experienced a run of failures of drugs in late-stage clinical trials which makes the earnings picture hazy from 2014 onwards. Despite substantial R&D investment, the company's development pipeline has failed to produce a strong stream of future blockbuster drugs. Phase III clinical trial failures over the last 5 years include Galida for diabetes, Exanta to prevent thrombosis (blood clots), NXY-059 for stroke, Iressa for lung cancer, and AGI-1067 for prevention of atherosclerosis (hardening of the arteries).


After this long run of failed late-stage clinical trials, in order to boost its pipeline, AstraZeneca completed the acquisition of vaccine maker MedImmune in June 2007, paying $15.2 billion, a significant price premium to what analysts considered a good buy. Subsequently, AstraZeneca consolidated its biologics portfolio in MedImmune having also acquired Cambridge Antibody Technology (CAT) in 2007 again at a premium price.


AstraZeneca has eleven blockbuster drugs (with $1 billion or more in annual sales) in five different therapeutic categories. The strong performance of these drugs has driven earnings growth in recent years. These are (based on 2008 sales):

• Nexium $5.2 bn- gastro intestinal
• Seroquel $4.2 bn - anti psychotic
• Crestor $3.6 bn - cholesterol lowering
• Symbicort $2.0 bn - respiratory
• Arimidex $1.8 bn - cancer
• Pulmicort $1.5 bn - respiratory
• Atacand $1.5 bn - cardiovascular
• Casodex $1.3bn - cancer
• Synagis $1.2 bn - infection
• Zoladex $1.1 bn - cancer
• Prilosec $1.0 bn - gastrointestinal

POTENTIAL NEGATIVE DRIVERS
Litigation
AstraZeneca's most successful drug for the treatment of psychiatric disorders is Seroquel. Seroquel competes in the antipsychotic drug market, and can be used to treat  conditions such as schizophrenia.  However, the drug may significantly increase the risk of diabetes and the company is facing several thousand lawsuits involving 15,000 patients alleging that the company knowingly downplayed weight gain and diabetes risks. In mid 2008, AstraZeneca won a U.S. patent battle against generics manufacturers, securing its exclusivity to Seroquel until at least 2011.Sales of the drug were $4.45 billion in 2008.


Patent Expiry
Patent expiry issues are the largest drag on AZ's earnings outlook. Pharmaceutical patents generally last about 20 years during which a pharmaceutical company has an exclusive right to manufacture a particular drug (it can take well over 10 years to bring a new drug to market from discovery). After the patent expires, generic versions of the product can be produced and sold by competitors. Generic medication is cheaper than brand medication, undercutting the pricing power of the original pharmaceutical producer. Generally speaking the loss of patent protection for brand named drugs may reduce sales by close to 90%.


Eight patents on drugs that represent 60 percent of Astra Zeneca's current sales are due to expire by 2016. The company also has eight products near the end of its product pipeline and launch. However, it is not clear whether all of these drugs will receive regulatory approval or whether they can replace sales lost to generics.

AstraZeneca's Pulmicort was the subject of a patent infringement settlement in late 2008. Israel-based Teva Pharmaceutical Industries had released and been selling a generic version of the drug in the United States, but AstraZeneca threatened with a law suit and successfully forced a settlement. Teva will cease sales of the drug until December 2009, when it will pay AstraZeneca royalties.Nexium, which treats stomach ulcers and heartburn, is one of the world's biggest selling prescription medicines with annual sales of around 2.6 billion pounds. AZ has reached an agreement with Ranbaxy to produce a generic version from May 2014, delaying introduction of competition by several years.

POTENTIAL POSITIVE DRIVERS

New drug indications
AstraZeneca's anti-cholesterol drug, Crestor had $3.6 billion in sales in 2008 with its patent due to expire in 2016.. In December 2009, the U.S. FDA panel backed an expansion of Crestor's labelling to treat patients with relatively low cholesterol levels who are otherwise at risk for heart disease. This expansion could open the market for Crestor significantly, the FDA estimates by an additional 6.5 million patients, and 2012 projections for the drug now reach $6.75 billion, almost double 2008 sales.


New products

One promising drug for AstraZeneca is Brilinta, a late-stage development drug which thins blood and helps prevent complications after surgery or in those patients at risk from stroke or heart disease. The drug, also known as ticagrelor, has been shown in a study to have lower death rates than competitor Bristol-Myers Squibb Company (BMY)'s Plavix.

During 2009, data from the PLATO trial of 18,600 patients with acute coronary syndromes (ACS) demonstrated a 16% relative risk reduction in death from cardiovascular causes, myocardial infarction (MI) or stroke and a 22% risk reduction of death from any cause, compared to current market leader,Sanofi Aventis' Plavix.The extent of this benefit in favour of Brilinta was at the top end of analyst expectations' and even outshone Effient in terms of efficacy, Eli Lilly’s (LLY) antiplatelet agent which received regulatory approval in 2009.. However, while Effient’s improved efficacy over Plavix comes at a significant cost of an increased risk of major bleeding, the Plato data showed no overall difference between Brilinta and Plavix in major bleeding rates.

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There were some concerning safety and efficacy signals from the PLATO data. Although Brilinta was similar to Plavix looking at the risk of major bleeding events, AstraZeneca's drug did cause significantly higher rates of minor bleeding, as well as showing a trend for increased intracranial bleeding and strokes, although these were not statistically significant. In addition, Brilinta caused a higher rate of breathlessness and increased blood levels of uric acid and creatinine, side-effects that have not previously been observed with either Plavix or Effient. However, most analysts and experts do not expect these more minor safety issues to be a barrier to approval, although clearly they will attract particular regulator scrutiny and will be part of any post-approval risk management programme. What was attracting slightly more concern was sub-group analysis which revealed an anomaly in the U.S., the biggest commercial market for Brilinta. The Plato trial was divided into 66 sub-groups, 33 covering safety and 33 over efficacy. Of the 33 efficacy sub-groups, 30 were consistent with the overall trial results, however two groups in North America showed no benefit with Brilinta with a trend towards a worse outcome. Trial investigators are so far at a loss to explain this anomaly, having already re-examined the data for clues. The negative result could be down to regional differences in patient populations or practice patterns, or just a “statistical fluke”.

Whilst clearly a risk, and of specific concern for FDA approval, given the overwhelming nature of the overall positive data, the drug is likely to be approved, but the regulators may well request  additional studies in the U.S.  which may put back approval 12 months or more.

One of AstraZeneca's largest new products is Onglyza (saxagliptin), a diabetes drug co-developed with Bristol-Myers Squibb and approved in the U.S. in mid-2009. However, even before its launch in 2009, competitor Novartis has developed a drug called Galvus. The two drugs share significantly similarities in chemical structure and pharmaceutical action, so it is unclear how Onglyza will perform in the market


Dividend Yield
Astra Zeneca has a commitment to paying a good dividend. Currently the stock is yielding 4.2%.


SUMMARY
The firm faces many challenges in the mid to long term.  AstraZeneca's prospects after the year 2010 are unclear. Despite a 28% increase in research and development spending in 2007 to $5 Bn and another $5 Bn in 2008, it has failed to produce any truly ground breaking drugs to complement its portfolio largely due to bad luck with late stage clinical trial failures. Brilinta is a vital component of AZ's patent expiry protection plan.


BUY OR AVOID?
Positive news on Crestor and Brilinta is a solid start to cover the $20 billion plus of patent expiries due over the next 5 years. But much remains to be done in terms of new products and as the company knows only too well, commercialisation of drug discovery doesn't always go to plan.


AZ is purely focused on pharmaceuticals unlike competitors like GlaxoSmithkline, Johnson and Johnson and Novartis which means that drug failures have a disproportionate impact on future earnings growth. In addition the patent expiry situation will hit earnings hard if new products of a signficant size are not delivered consistently.

The company may also embark on another round of acquisitions to strengthen the R&D pipeline and they have a history of paying top prices. On the other hand, AZ itself may be target of a takeover but at close to £46 billion market capitalisation, it would be difficult particularly in this environment where bank funding of debt is still not normalised. A friendly merger, perhaps with the likes of Novartis is a more likely scenario.


Although the company is not expensive based on classical valuation metrics, the risk appears signficant that things may not go to plan due to the usual uncertainty with clinical trial success and regulatory scrutiny. I am avoiding Astra Zeneca for now, especially with price going over £30 with the pharmeceutical sector being upgraded over the last few days. AZ seems a share to buy on a set back rather than now after its very strong run from close to £27 at the end of 2009 to its current £31 (52 week range £21.47-£31.08). Amgen remains a favourite for Contrarian Investor in this sector.