Rare-Disease Portfolio Digs Shire a Moat

Through several acquisitions,

Shire relies on acquisitions to supplement its portfolio, and while we remain skeptical of the Baxalta acquisition given serious competitive threats in hemophilia, other recent deals (ViroPharma/Cinryze, SARcode/Xiidra, Dyax/lanadelumab) have been beneficial to the firm’s growth and competitive advantages.

Following the Baxalta acquisition, 16% of Shire’s top line stems from the attention deficit hyperactivity disorder market, with Vyvanse benefiting from strong U.S. market growth and broad indications. Vyvanse was approved in binge-eating disorder in 2015, and while this is a new market for pharmaceutical treatment, we think the drug will be successful in this indication.

ADHD products could also see sales growth in Europe (the Vyvanse launch began in 2013) and Japan (Vyvanse and Intuniv are launching in 2018), but we caution that these markets are much smaller and reimbursement may not be as favorable.

Shire’s acquisition of Transkaryotic Therapies in 2005 was the foundation for its human genetic therapies, and both Elaprase and Replagal are core products in Shire’s portfolio. Shire was able to capitalize on Genzyme’s (now Sanofi’s SNY) manufacturing woes, gaining approval for Gaucher disease drug Vpriv in early 2010 and expanding Replagal’s international share. The company continues to build critical mass in the attractive rare-disease space with the synergistic addition of lanadelumab and Cinryze to its Firazyr franchise and internal medicine products Gattex and Natpara (via the NPS Pharmaceuticals acquisition).

Baxalta’s dominant hemophilia franchise and plasma-derived proteins--particularly immunoglobulins for rare immunological and neurological disorders--also build on Shire’s rare-disease portfolio, and while Shire is realizing more synergies from the deal than we had anticipated, we remain concerned about hemophilia competition from Roche’s RHHBY Hemlibra and future gene therapies from firms such as BioMarin BMRN and Spark ONCE.

Intellectual Property Makes a Moat The intellectual property underlying Shire's specialty pharma business (in ADHD and gastrointestinal disorders) and its rare-disease business form the basis of its narrow economic moat. The company is best known for its ADHD franchises, which make up about 16% of its revenue following the Baxalta acquisition. However, through multiple acquisitions and in-house development, the company has built up a diverse portfolio of small-molecule and biologic products focused generally on niche markets. This diversity allows the company to better withstand specific product risks while using a specialist-focused salesforce to penetrate markets, keep operating expenses down, and produce strong operating margins. Sales of Adderall XR represented 36% of Shire's total revenue in 2008, yet when its patent expired in 2009 and sales of the drug fell more than 40%, the rest of Shire's portfolio was able to prevent overall sales from shrinking.

Shire’s current lineup includes newer ADHD drug Vyvanse, ulcerative colitis therapy Lialda, rare-disease therapies Elaprase, Replagal, Vpriv, Cinryze, and Firazyr, and recently acquired Gattex and Natpara. Vyvanse, the company’s only blockbuster drug, has patent protection until 2023; however, as a small molecule it will quickly be genericized when its exclusivity ends.

In recent years, the firm has increased its focus on rare diseases. We like this direction as these markets often have characteristics amenable to achieving efficient scale, a strong basis for moat creation. However, the company’s reliance on acquisitions for growth, as well as an uneven M&A record, makes this an uncertain strategy, as increasing competition for promising products and high valuations for smaller drug-development companies make successful acquisitions increasingly challenging and expensive, weighing on returns on invested capital.

Competition Still a Risk Sales of Shire's leading ADHD drug Adderall XR plummeted in 2009 in the face of generic competition, and several of Shire's other specialty pharma products are also vulnerable to generic competition in the near future. ADHD drug Intuniv became generic in 2014, patent challenges have resulted in Lialda generic entry in 2017, and Vyvanse goes generic in 2023. Shire could struggle to expand its ADHD franchise in Europe if regulators choose to reimburse its products in the same class as generic alternatives. Shire's growth of human genetic therapies Vpriv and Replagal could falter as Sanofi competes with similar products and a new oral Gaucher disease treatment. CSL's new hereditary angioedema drug could pull patients away from Cinryze and Firazyr, and lanadelumab's launch may not allow Shire to regain lost patient share. Roche's new hemophilia drug Hemlibra is poised to erode sales of Shire's Feiba and Advate, and declines of Shire's drugs could be more rapid than expected if patients strongly value the improved convenience. With significant cuts to operating expenses, Shire could be underinvesting in its pipeline, making it more reliant on acquisitions to fuel growth. Previous business development missteps, like Advanced BioHealing and Movetis, reduce our confidence in this strategy.

Shire ended 2016 with $23 billion in debt and roughly $500 million in cash, as it is now heavily leveraged following the close of the 2016 acquisition of Baxalta. We expect Shire to steadily reduce its debt burden as cash flows from its business allow the company to repay debt annually. Following an expected lowering in capital expenditure demands (tied to Baxalta’s plasma business) in 2019, we expect annual free cash flows of roughly $6 billion. Non-GAAP net debt is still poised to shrink below 3 times non-GAAP EBITDA by the end of 2017.