Roche Builds a Wide Moat With Dominant Oncology and Diagnostics Franchises

Following new immuno-oncology data at the ASCO meeting, we are maintaining our $33 billion estimate for annual IO drug sales by 2022 versus consensus expectations of $20 billion. While we continue to view

While we are maintaining our long-term outlook for IO drugs, the composition of our estimates is shifting as the new data slightly weakens the outlook for the lung cancer indication and strengthens the outlook in the renal cancer indication.

Company Is in a Unique Position

We think

In Roche's pharmaceutical division, blockbuster cancer biologics acquired with Genentech--including Avastin, Rituxan, and Herceptin--continue to grow quickly as they gain market share in approved indications and garner widened approval in new indications and emerging markets. The acquisition also facilitates information sharing between Genentech and Roche researchers, boosting research and development productivity and personalized medicine offerings that take advantage of Roche's diagnostic arm. For example, BRAF inhibitor Zelboraf, approved in melanoma in 2011, is among the first drugs tested in biomarker-selected patients from the start. We expect such synergies to increase as Roche's pipeline advances.

Roche's biologics focus and innovative pipeline are key to the firm's ability to maintain its wide moat and continue to achieve growth as current blockbusters mature. Three fourths of Roche's top pharmaceutical sales are from biologics, which provides a buffer against traditional generic competition. In addition, biosimilar competitors have witnessed delays and aren't likely to reach the market until at least 2017. With the launch of Perjeta in 2012 and Kadcyla in 2013, Roche is in a strong position to continue expanding its breast cancer franchise beyond Herceptin, regardless of biosimilars (which we expect as early as 2016 in Europe and 2019 in the U.S.). Gazyva, now approved in the U.S. in CLL and in testing in NHL, could also extend the longevity of the Rituxan franchise.

Roche's diagnostics business is also strong. With a 20% share of the global in vitro diagnostics market, Roche holds the number-one rank in this industry over competitors Siemens, Abbott, and Johnson & Johnson. Pricing pressure has been intense in the diabetes-care market, but new instruments and immunoassays have buoyed the core professional diagnostics segment.

Wide Moat Comes From Oncology Market Share Roche's wide moat arises from its status as the leader in oncology therapeutics (30% market share) as well as in vitro diagnostics (20% share), and the firm has a promising strategy of combining its expertise in both areas to generate a growing personalized medicine pipeline, making use of companion diagnostics. Much of Roche's moat in pharmaceuticals is derived from its long relationship with Genentech. Roche first acquired a controlling interest in Genentech in 1990 and owned almost 56% of the firm before Genentech's board accepted its $95 per share offer to acquire a full interest in 2009. Genentech's portfolio of blockbuster cancer biologics--which includes Avastin, Rituxan, and Herceptin--continues to grow quickly. Genentech's commercial structure in the United States complemented Roche's international operations, and Roche also secured rights to Genentech's pipeline in the process, as its option to in-license drug candidates from Genentech was set to expire in 2015. Three fourths of Roche's pharmaceutical sales are from biologics; biosimilars are only beginning to penetrate the European market and have yet to be approved in the U.S. Biologics can be difficult to characterize, and structural instability under certain conditions and the potential for immunogenicity (immune system reactions to the drugs) are concerns. Therefore, biologics are associated with significantly higher costs of manufacturing, clinical trials, and marketing than traditional small-molecule therapies. Monoclonal antibodies like Roche's blockbusters Rituxan, Avastin, and Herceptin could be more difficult to replicate without causing higher immunogenicity. In addition, biologics for chronic indications such as rheumatoid arthritis could require more safety data to secure regulatory approval or physician acceptance. For example, we have seen significant delays in at least two advanced Rituxan biosimilar programs, and we believe hurdles for this product could be higher, owing to maintenance use in non-Hodgkin's lymphoma as well as chronic use in rheumatoid arthritis. Despite the fact that patents in Europe expired in 2013, Roche does not expect to see biosimilars reach the market until 2017.

Roche Will Continue to Focus on Innovation, Acquisitions Roche will continue to rely on innovation and key acquisitions to maintain growth. While patent portfolios for Roche's top drugs generally extend for the next several years, and potential biosimilar competitors have seen setbacks, the firm will be experiencing pressure on several significant drugs in the interim. Blockbuster eye disease drug Lucentis is witnessing intense competition from Regeneron's Eylea, and while we expect the drug to hold its own, we doubt Lucentis will continue to serve as the growth driver it has been for the past several years. Boniva and NeoRecormon have succumbed to competition following patent expirations, Pegasys is declining as all-oral hepatitis therapies come to market, and other drugs are in the process of going generic, including Valcyte and Xeloda. Roche has had several high-profile pipeline failures in recent years--including diabetes candidates taspoglutide and aleglitazar, cholesterol drug dalcetrapib, and schizophrenia drug bitopertin--and it may continue to struggle to diversify outside its strong foundation in cancer biologics. If monoclonal antibody biosimilars are quickly approved and accepted by insurers, physicians, and patients, Roche could experience top-line pressure as key products Rituxan, Avastin, and Herceptin go generic. Slightly more than 50% of Roche's U.S. sales are government paid, as its oncology antibodies are most often paid for through Medicare Part B. We have seen recent proposals for lowering reimbursement further for Part B drugs, and we think some of Roche's high-priced cancer therapies could be vulnerable to pricing pressure in the U.S. in the long run through private payers as well, as competition increases.