Roche Delivering Leverage, But Still Needs Diversification

By Stephen D. Simpson, CFA | July 29, 2013 AAA

These remain good days for Swiss drug and diagnostics giant Roche (Nasdaq:RHHBY), as the company continues to see double-digit growth across most of its oncology franchise, with ongoing growth in diagnostics and early signs of additional operating leverage. While Roche's oncology pipeline looks solid, it's well worth asking if management has been too slow to move to bulk up other areas. Although Roche shares still look a little undervalued, M&A speculation is likely to remain in play for the foreseeable future, likely adding volatility to the shares.

Good Leverage Leads To Upside In The First Half
Although Roche's top-line results were almost exactly in line with expectations, the company still managed to beat operating assumptions by a meaningful amount due to more effective marketing leverage.

Revenue rose 5% (in constant currency) this quarter, led by 6% growth in the pharma business and 3% growth in the diagnostics business. Within drugs, Avastin and the company's HER2 franchise continue to grow at double-digit rates, while Lucentis was also up by double digits. Within diagnostics, Roche's professional business was up 6% (similar to Abbott (NYSE:ABT)), with double-digit growth in immunoassay. Tissue diagnostics was also pretty good (up 6%), while molecular diagnostics was weak and up only 1%. Roche's negative 5% performance in diabetes was poor, but at least better than Johnson & Johnson (NYSE:JNJ) as the major testing companies suffer through a harsher reimbursement environment.

SEE: Evaluating Pharmaceutical Companies

On the margin side, Roche was already a fairly strong performer. Nevertheless, marketing expense growth of just 3% allowed the company to post 10% growth in operating income (or 7% netting out pension adjustments), with pharma up 8% and diagnostics up 9%. On a margin basis, Roche outperformed the average sell-side target by 120bp.

Forget Alexion, But M&A Makes Sense
As I expected, Roche threw cold water on the notion of buying Alexion (Nasdaq: ALXN), the orphan drug specialist. While Alexion looked like a very expensive deal for Roche, and one with high execution risk and minimal synergies, the notion that Roche should and will do deals is sound.

Over 60% of the company's pharmaceutical sales come from oncology, and Roche has seen some embarrassing trial failures in areas like diabetes and cardiovascular disease in its attempts to diversify. Although there are some interesting and high-potential drugs in the pipeline (including a Glyt-1 inhibitor for schizophrenia, etrolizumab in ulcerative colitis, and crenezeumab in Alzheimer's disease), Roche would likely do well for itself by adding more heft to its non-oncology operations.

The question, though, is one of price. With the multi-year bull market in biotech having spiked valuations, there aren't many bargains left. Still, I could see Roche possibly having some interest in companies like Biogen Idec (Nasdaq: BIIB), Vertex (Nasdaq: VRTX), or other orphan drug companies were valuations to ease off over the next year or two.

An Attractive Pipeline Moving Forward
Roche still has an attractive pipeline of its own. Between Roche management and comments from Bristol-Myers (NYSE: BMY), it sounds as though the timeline for PDL-1 could be shorter, and GA101 looks well-positioned as a follow-on to Rituxan (a drug where biosimilar competition in Europe is starting to look like more of a threat).

SEE: The Value Investor's Handbook

The Bottom Line
Even with the strong performance in these shares over the past year, there still seems to be some value left. With long-term free cash flow growth in the neighborhood of 5%, a fair value in the mid-to-high $60s is reasonable. While Pfizer (NYSE: PFE) may have more upside with respect to current growth expectations, Roche remains one of the more attractive large-cap pharmaceuticals, with relatively limited patent risk and several significant pipeline/launch developments over the next 12 months.

Disclosure – As of this writing, the author owns shares of Roche.

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