Wide-Moat Roche Is Undervalued

We think

In Roche’s pharmaceutical division, blockbuster cancer biologics acquired with Genentech--including Avastin, Rituxan, and Herceptin--continue to grow as they gain market share in approved indications and garner widened approval in new indications and emerging markets.

Strong information sharing continues 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.

Roche’s biologics focus and innovative pipeline are key to the firm’s ability to maintain its wide economic 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. With the launch of Perjeta in 2012 and Kadcyla in 2013, Roche is in a strong position to expand its breast cancer franchise beyond Herceptin, regardless of biosimilars (which we expect as early as 2017 in Europe and 2019 in the United States). Gazyva, now approved in chronic lymphocytic leukemia and non-Hodgkin’s lymphoma, could also extend the longevity of the Rituxan franchise (biosimilars expected in Europe in late 2017). Avastin’s lung cancer sales are vulnerable to competition from new therapies Opdivo and Keytruda, but Roche’s own immuno-oncology drug Tecentriq launched in 2016.

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 SIEGY, Abbott Laboratories ABT, and Ortho Clinical Diagnostics. Pricing pressure has been intense in the diabetes-care market, but new instruments and immunoassays have buoyed the core professional diagnostics segment.

Drug Portfolio, Diagnostics Dig Wide Moat 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). 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 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. Genentech's commercial structure in the U.S. 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.

Roche’s Herceptin was one of the original personalized therapies, and breast and gastric cancer patients who are HER2+ continue to see strong survival benefits from this antibody therapy. Since then, Roche has established a record of developing and launching personalized medicine therapies and companion diagnostics in oncology, including Tarceva in EGFR-mutant patients, Kadcyla and Perjeta for HER2+ patients, and melanoma drug Zelboraf for BRAF mutation patients. Zelboraf was the first product developed using a companion diagnostic from the start of clinical trials; pairing drugs with diagnostics early in development shortens development timelines, reduces up-front investment, and boosts the likelihood of a meaningful benefit to patients. We think this will allow Roche to justify high price tags globally for future personalized therapies despite global pricing pressure and budget constraints.

Three fourths of Roche’s pharmaceutical sales are from biologics; biosimilars are only beginning to penetrate the European market, and the first biosimilar (Novartis’ NVS biosimilar version of Amgen’s AMGN Neupogen) was recently 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 blockbuster oncology therapies 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 delays and discontinuations with 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, biosimilars are expected to reach this market in 2017.

Biosimilar Competition Could Ding Sales 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 REGN Eylea, and Lucentis will not 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.

Roche’s financial health remains robust. At the end of 2016, Roche owed CHF 23 billion in debt and held cash and marketable securities of CHF 9 billion, or net debt leverage of less than 1.0 times 2016 adjusted EBITDA. Debt maturities are spread over the next several years, and we expect the firm will meet these obligations easily, given our estimates for free cash flows north of CHF 14 billion annually, on average, over the next five years. We expect Roche to maintain a dividend payout ratio north of 50%, implying mid-single-digit annually increases in dividends per share.