Sanofi (NYSE:SNY) was supposed to be a relatively solid Big Pharma company in 2013. True, the company is going through some pressures from patent expirations and internal drug development issues have created a soft spot for growth, but Sanofi's strong emerging market exposure was supposed to help, as was the fact that about one-third of the company's revenue comes from non-branded drug businesses.
Instead, Sanofi delivered a surprisingly large miss for the second quarter, a miss that means a little more in the typically more predictable Big Pharma space. While it may be true that problems in Brazil were a large part of the reported miss, worse than expected results in ex-Brazil emerging markets, vaccines, and animal health, coupled with higher than expected SG&A spending to support new launches, has reset expectations to a lower level. Although Sanofi shares are not overvalued today and the company could demonstrate fairly quickly that Q2 results were just an aberration, it's harder to make a forceful pro-Sanofi argument today.

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A Lot Of Ugly In Q2
Sanofi's second quarter report makes for pretty ugly reading. Revenue fell 10% as reported (and 6% in constant currency), leading to a 5% miss relative to expectations – likely to be the biggest deviation (good or bad) from the average for the sector this quarter. Pharmaceutical sales (net of Genzyme) were down about 12% this quarter, though Genzyme products were up a strong 21%. Everything else was down as well – Consumer was down 1%, Generics were down 36% and 35% below expectations (though up 10% net of Brazil), Vaccines were down 3% (missing by 6%), and Animal Health was down 9% (also missing by 6%).
There wasn't much good news down the line either. Gross margin fell four and a half points, missing the average expectation by two and a half points. Operating income plunged 28% (with operating margin falling more than six points), missing estimates by more than 20%, as the company needed heavier SG&A spending to support the diabetes business and upcoming product launches.
All told, EPS ended up 15% below expectations, as a lower tax rate helped gain back some of the poor operating performance. Now it's true that a large charge in Brazil tied to channel-stuffing had a major impact on the quarter, but it doesn't explain all of the miss – emerging market growth was still only 5% excluding the Brazil problem, and that was below the double-digit target.

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A Few Bright Spots Stand Out
Assuming that the issue in Brazil really was just due to local management mistakes and perhaps a lack of observation/supervision from HQ, there were some good points to highlight in Sanofi's report.
For starters, even with serious competition from Lilly (NYSE:LLY) and Novo Nordisk (NYSE:NVO) in the insulin space, Lantus remains a star – growing 18% in constant currency and contributing more than 17% of the company's revenue. Secondly, Genzyme continues to perform quite well – revenue was up 21% this quarter, and it looks as though Sanofi/Genzyme is taking some share from Shire (Nasdaq:SHPG) in rare diseases.
The Pipeline – Underwhelming, Or Underappreciated?
Sanofi definitely needs to add some oxen to its wagon team. Although Lantus and the rare disease/Genzyme platform are growing well, the oncology business is withering away into nothing (down 49%), and it's largest drugs (Plavix, Lovenox, and Avapro) are off-patent and declining at double-digit rates.
The new MS franchise should help, as Lemtrada is expected to get FDA approval in the fourth quarter of this year and could be a $1B+ drug even with competition from Biogen Idec (Nasdaq: BIIB). Investors can also look forward to Phase III data on Sanofi's PCSK9 cholesterol drug in the third quarter (a potential multi-billion dollar drug, though facing competition from the likes of Amgen (Nasdaq:AMGN) and Pfizer (NYSE:PFE)), Phase III data on sarilumab in rheumatoid arthritis in the first half of 2013, and FDA approval of Lxymia later in 2013.
Lemtrada and '553 (the PCSK9 drug) look like solid winners, but beyond that it gets fuzzier. Sanofi does not have the same quality of pipeline as many of its Big Pharma peers (though it may well be underrated), and it hasn't been as aggressive in addressing it as, say, AstraZeneca (NYSE: AZN). With that, any disruption to the Lemtrada or cholesterol businesses could have an outsized impact, and I would imagine Sanofi would be considering partnerships or M&A if biotech valuations ease off a bit.
The Bottom Line
I've been pretty bullish on Sanofi, but the issues in Brazil and potential fraud problems in China are frankly embarrassing and run counter to the notion that Sanofi's management team has cleaned up the mistakes of the past. Although I think management has gotten a great deal more prudent and realistic about pipeline management, the reality is that Sanofi needs more depth and breadth in its branded drugs, as well as consistent solid performance from its emerging markets businesses.
I still expect Sanofi to produce long-term free cash flow growth well above average (more than 6%), but that's worth about $52 per share today. While there aren't many bargains in Big Pharma, and Sanofi is undervalued, investors considering the shares need to be patient and understand that the next couple of quarters could still be a little shaky.
At the time of writing, the author did not own shares of any company mentioned in this article.