Interactive Investor

Stockwatch: a defensive play for worrying times

22nd February 2022 12:04

Edmond Jackson from interactive investor

Our shares analyst explains why he prefers this big pharma stock to US large-cap tech companies, especially when interest rates are rising.

It is timely to review my buy” case a year ago at £71, as global pharmaceutical group AstraZeneca (LSE:AZN) has declared annual results and just lately made a flurry of announcements on positive progress with cancer treatments especially.  

It’s also worth doing because I think the stock exemplifies the kind of defensive earner to offer comfort as a holding through the Ukraine crisis, while a foundation in essential drugs should help it pass on higher costs in an inflationary environment.  

The company’s decision to double its net debt to make a substantial acquisition in the treatment of rare disorders – hence end-2021 net gearing of 62% – was not ideally timed ahead of monetary policy tightening. Yet Alexion is potentially transformational for AstraZeneca, and central banks are limited in their scope for interest rate rises. 

In a jittery period ahead over Ukraine, I think AstraZeneca is the kind of building-block share to have on buy” lists for a portfolio. For a start, around a third of group revenues are in US dollars, which will benefit as a haven currency. Crucially, however, Astra now shows good progress in drugs for the more challenging cancers. 

A long-term bull trend under the CEO since 2012 

Unlike enough big-cap US tech, Astra does not have the kind of parabolic chart that is exposed to mean reversion of price/earnings (PE) multiples. 

While its bull trend goes back to the 2008 crisis, it broke out of its range in late 2013 at around £30, as the market began to pay attention to the initiatives of Pascal Soriot, who took up the post of CEO in October 2012. 

After reaching an all-time high of £94.30 early last November, the stock fell to £82, but has recovered near £91 in the last fortnight. It is currently £90.

The 12-month forward PE multiple is around 17x, which admittedly is at the upper end of global pharma stock valuations. This is in line with expected ‘normalised’ earnings per share (EPS growth of 17%, though it will likely benefit from the acquisition of Alexion – after which growth is projected to ease to 6% in 2023.  

Management did guide 2022 ‘core' EPS in a mid to high 20% range at the recent preliminary annual results, although analystssense appears to be that the initial financial benefit of the combination will ease in 2023. The medium-term earnings trajectory is possibly more speculative than, say, Alphabet or Microsoft, but Astra stock does not have their risky high ratings.  

A 2.5% prospective yield looks scant compared to tobacco stocks. You could therefore say that Astra is in no-mans land between conviction growth and so-called ‘value’ plays offering superior yields. 

But unless this CEO falls under the proverbial bus, I think Astras overall ‘buy’ case is keeping up with the stocks modest advance.  

Moving on from Covid-19 vaccine controversies   

A year ago, the stock was partly under a cloud amid concern that it had promised to sell Covid vaccine at cost, in contrast to US companies profiting. Despite Astra initially gaining pole position in the global vaccines line-up, controversy followed. Initially this involved wrangling among European governments over supply, then controversy over blood clots – an area where Astras vaccine has been substantially withdrawn even in the UK.  

This episode was a distraction from Astras overall drugs development, both for top management and for investors, though I noted a turning point was apparent. Over half its revenues derived from faster-growing new medicines, in particular harder-to-treat cancers. 

Recent narrative is encouraging in both these respects. Evusheld, a Covid monoclonal antibody treatment with 83% efficacy should start to contribute to profit this year. 2021 saw encouraging product trials in relation to breast and prostate cancer, and Lynparza, a breast cancer treatment, achieved £1.7 billion equivalent sales, up 32% on 2020.  

In the second half of this month, Astra has declared further positive progress in phase three trials partly including Lynparz. It has also received EU approval for Saphnelo, the only new medicine in over a decade for patients with systemic lupus erythematosus”, and positive high-level results for Enhertu, another breast cancer treatment. 

Showing how positive news flow on new drugs is key to stock sentiment, Astra has risen 9% from £84 over the last fortnight.    

Acquisition of Alexion Inc looks strategically intelligent 

This acquisition was completed last July for £29 billion equivalent, relative to Astras current £136 billion market cap. 

Alexion provides treatments for rare disorders, an area that involves less competition and hence scope to raise margins. It’s worth pointing out that although Astras operating margin slumped last year to just 2.8% at the reported level, this related to exceptional costs (including goodwill) of the takeover going through the income statement. It means a rather frustrating differential between reported and core” numbers as some $2 billion of integration costs affect the income statement until 2025. 

The 2021 core operating margin was quoted at a respectable 26.5% after a 74.2% gross profit margin.  Another dilemma of this takeover has been net debt rising to over $24 billion just when interest rates are set to rise.  

But the two companies look well-matched, with potential synergies from Astra’s capacity to extend Alexions reach beyond the US and Europe to emerging markets. 

This takeover was followed last September by the near $1 billion acquisition of Caelum, another rare disease specialist, whose treatments include a candidate in the fight against AL amyloidosis, a life-threatening disease that damages the heart and kidneys.   

Some failures are inevitable, of course. Trials were abandoned for an amyotrophic lateral sclerosis drug after it failed to show efficacy.  Yet this CEO looks to have positioned Astra well to generate net-positive news on drug development. 

AstraZeneca - financial summary
Year ended 31 Dec

  2016 2017 2018 2019 2020 2021
Turnover - $ million 23,002 22,465 22,090 24,384 26,617 37,417
Operating margin - % 21.3 16.4 15.3 12.0 19.4 2.8
Operating profit - $m 4,902 3,677 3,387 2,924 5,162 1,056
Net profit - $m 3,499 3,001 2,155 1,335 3,196 112
Reported EPS - cents 276 188 170 103 243 8
Normalised EPS - cents 252 137 85.4 149 189 277
Cash flow/share - cents 327 282 207 228 365 418
Capex/share - cents 183 128 108 189 198 154
Free cash flow/share - cents 145 155 98.4 39 167 264
Dividend/share - cents 270 274 275 289 283 284
Earnings cover - x 1.0 0.7 0.6 0.4 0.9 0.0
Return on capital - % 10.4 7.8 7.6 6.8 11.1 1.3
Cash - $m 5,902 4,554 5,680 6,218 7,992 6,398
Net debt - $m 10,906 13,253 13,433 12,009 12,388 24,383
Net assets/share - cents 1,174 1,181 984 1,000 1,190 2,534

Source: histroric company REFS and company accounts

2021 annual results reflected strong underlying progress 

Total revenue was up 41%, or 38% at constant exchange rates, and core” EPS was up 32%, in a year of exceptional commercial delivery and product pipeline development.  

While these numbers benefited from the purchase of Alexion, double-digit growth was proclaimed in all major regions, despite some headwinds in China affecting emerging markets. 

2022 revenue was guided at a high teens annual percentage, with a mid-to-high twenties percentage increase in core EPS. Time will tell exactly how organic this proves, but for capital protection and growth I would far rather hold Astra on a 17x forward PE than US big cap tech – typically rated twice that – amid rising interest rates. 

Managements confidence in growth also extends to cash flow, although the dividend increase was only a very slight 10 cents to $2.90 a share (annualised).    

It has translated into consensus for 2022 EPS of $6.66 rising to $7.86 in 2023, equivalent to £4.90 and £5.80 respectively; so with the stock around £90 that equates to a PE of 18.4x easing to 15.5x. 

A heavy stock price bears no implication for value  

A highly experienced private investor I used to know would baulk at considering a stock once it traded over £10. Yet a heavy price simply implies a modest number of shares issued relative to earning power – a good sign because the company has managed to grow without materially diluting investors’ holdings. 

Some companies still initiate stock splits to bring the price down to a more ‘acceptable’ level, from which it then typically rises because enough people think it has become cheap. 

Such folly could happen and provide a flourish here. But I think the long-term case for AstraZeneca remains anyway, to accumulate in jittery times. Buy.  

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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