Sanofi Shakes Off Patent Losses

In tandem with its research and development update,  Sanofi (SNY) announced optimistic pipeline guidance along with flat to slightly growing guidance for diabetes sales through 2018. While the diabetes outlook matches our projections, the pipeline guidance runs above our expectations. We don't expect any changes to our fair value estimate based on the pipeline outlook, as we need to see more clinical data from earlier-stage drugs before increasing our projections. However, the improving pipeline reinforces our conviction in Sanofi's wide economic moat, as the company's drug division carries the strongest margins and the next generation of drugs looks more secure as the pipeline has improved over the past two years.

On the pipeline, Sanofi provided aggressive guidance of EUR 30 billion in five-year cumulative non-risk-adjusted sales from new launches from 2014 to 2020. The expectation runs above our corresponding expectation of EUR 22 billion and consensus expectations of EUR 25 billion. We believe the company is more bullish on pipeline drugs with less public clinical data, such as dupilumab for dermatitis and asthma. Further, a big unknown is the pricing for pipeline products, and Sanofi might be expecting pricing above our expectations for new drugs--in particular, cholesterol-lowering drug Praluent.

Sanofi's outlook for flat to slight growth in diabetes sales through 2018 largely matches our expectations. We project the segment to grow 1% annually through 2018. Our expectations conservatively assume declining pricing power of Lantus in the United States and relatively stable U.S. pricing for the next-generation basal insulins, including Sanofi's Toujeo. However, we believe competition from Eli Lilly (LLY) and Novo Nordisk (NVO) in the next-generation basal insulin market will be largely rational, which suggests stronger pricing power could return to the important U.S. insulin market over the longer term.

Robust Pipeline Produces Strong Cash Flows
Sanofi's wide lineup of branded drugs and vaccines and robust pipeline create strong cash flows and a wide economic moat. Growth of existing products and new product launches should help offset weakening pricing in the insulin market.

Sanofi's existing product line boasts several top-tier drugs, including long-acting insulin Lantus. The drug's ability to work well for an entire day sets Lantus apart from other insulins. Further, given the complexity in marketing and manufacturing insulin, we don't expect major generic competition following the drug's 2015 patent loss. However, increasing branded competition and a deteriorating pricing environment will probably lead to sales declines for Lantus over the long term. Offsetting the Lantus weakness, Sanofi's vaccines, consumer products, and animal health treatments should continue to post strong growth as these products are less susceptible to patent losses.

Sanofi has compiled a robust group of late-stage pipeline products that complement its existing lineup and should help mitigate patent losses. We expect continued strength in the multiple sclerosis area with potential blockbusters Aubagio and Lemtrada emerging from the late-stage pipeline. In addition, diabetes drug Lyxumia looks to be a strong complement to the company's entrenched diabetes franchise.

Sanofi also harnesses its research and development group to bring new drugs to emerging markets. While pricing in emerging markets is not usually as strong as in developed markets, the company can still leverage its investment in developing new drugs for developed markets by bringing the drugs to emerging markets. The rapid economic growth in emerging markets has created new geographic markets for Sanofi's drugs.

A history of acquisitions and robust cash flow from operations means Sanofi could take advantage of further growth opportunities through external collaborations. While its acquisitions are likely to slow in the near term following the Genzyme deal, we expect that over the long term Sanofi will continue to make acquisitions in the branded pharmaceutical and biotechnology market.

Entrenched in Insulin
Patents, a powerful distribution network, economies of scale, and diverse operations support Sanofi's wide Morningstar Economic Moat Rating. Patent protection keeps Sanofi's competitors at bay for several years while the company charges prices that enable returns on invested capital significantly above its cost of capital. A powerful salesforce gives Sanofi access to drugs developed externally, as smaller companies typically need a partner to help market the new drug. Also, Sanofi's unique entrenched position in the insulin market further reduces the threat of generic competition even after patents expire due to the high up-front costs needed to achieve the economies of scale for low-cost insulin production. The company's diverse operations in vaccines and consumer health care add two moaty segments that are supported by low-cost production and branding power, respectively. Also, Sanofi's large geographic exposure to many countries (including emerging markets) provides a wide safety net compared with the peer group.

CEO Departure Creates Uncertainty
Sanofi faces the standard risks in the pharmaceutical industry, including delayed approvals or nonapprovals from regulatory agencies, an increasingly tough managed-care environment, and patent losses. In addition, since a large percentage of sales come from Lantus, the company faces additional product specific risks from upcoming competitive launches from Eli Lilly and Novo Nordisk.

In late October, Sanofi's board of directors abruptly removed Chris Viehbacher as CEO, leading to a lowering of our stewardship rating to standard from exemplary. Based on concerns about Viehbacher's lack of communication with the board and missteps in 2013 (Brazilian mismanagement of inventories, poor animal health performance, and sales strategy concerns about Lantus), the board started a succession process for the CEO in the summer of 2014, which was accelerated following the leakage of the plans to the press. Chairman Serge Weinberg will take over CEO responsibilities as the search for a permanent CEO replacement is likely to take several months.

Despite the increased uncertainty created by the CEO departure, we believe the core units at Sanofi will still drive high returns even in the short period of transition at the top leadership position. Sanofi's entrenched position in emerging markets, vaccines, insulins, consumer, animal health, and rare-disease drugs should all lead to operating margins approaching 30%. Longer term, the ability to redeploy capital in a profitable manner is likely to be directed by the new CEO. However, the board of directors has not signaled any major changes in the firm's overall strategic direction.

The abrupt replacement of the CEO increases our concerns about Sanofi's board of directors. We are concerned that the board's actions didn't fully incorporate many of the positive strategic decisions made under Viehbacher's tenure. From an acquisition standpoint, Viehbacher executed several acquisitions (such as Merial and Genzyme) to create favorable returns on the capital deployed. Nevertheless, the board's continued commitment to Sanofi's current diversified pharmaceutical strategy alleviates some of our concerns.