A Big Pharma Titan Prepares For the Next Generation

Bristol-Myers Squibb (NYSE: BMY  ) and Merck (NYSE: MRK  ) have made one thing pretty clear – they want to be more like Roche (NASDAQOTH: RHHBY  ) . Roche is the #1 company in oncology and has developed three of the top 10 best-selling drugs in the world. Now the company is looking to a deep pipeline of antibodies, antibody drug conjugates, and small molecules to maintain that leadership into the next decade. Valuation is not undemanding here, though, and that puts a premium on clinical success and operational execution.

Building the next round of oncology blockbusters
Rituxan, Avastin, and Herceptin have been incredibly successful drugs for Roche, due in no small part to demonstrated efficacy in a variety of cancer types. In particular, Roche has established a veritable fortress in breast and blood cancer indications. Nothing lasts forever, though, and patent expirations and new competing therapies are forcing Roche to build for the next round.

Roche's anti-PDL-1 antibody (MPDL3280A, or MPDL) is a little behind Bristol-Myers' nivolumab and Merck's lambrolizumab, but it is shaping up as a highly effective entry in this next round of blockbuster immuno-oncology antibodies. Best of all for Roche, it looks like it may be most effective in non-small cell lung cancer (or NSCLC) – the largest of identified PD-1/PDL-1 targets (melanoma, renal, NSCLC).

What's interesting to me is that it looks like each of these drugs will have their place. It is scientifically and statistically dubious to compare across different early stage trials like this, but lambrolizumab has shown better results than nivolumab in melanoma, nivolumab has looked better than MPDL in renal, and MPDL has looked better than nivo in NSCLSC, while also presenting a lower rate of pneumonitis than either nivo or lambrolizumab.

Roche's oncology pipeline is not just MPDL. Perjeta is off to a good start in breast cancer, while Gazyva has delivered strong results in CLL (where it will absolutely see fierce competition from Johnson & Johnson/Pharmacyclics drug Imbruvica). On the immuno-oncology side, the company has a deep pipeline of checkpoint blockers, immune stimulators, vaccines (DNA and peptide), bi-specific TCRs, and various small molecules. I would not say that Roche's pipeline is richer than Bristol-Myers, but it is probably the second-strongest (though AstraZeneca's is better than commonly credited).

While Roche's immuno-oncology pipeline is a multiyear development project, Roche has some more near-term checkpoints to monitor. Phase III data on MetMab in NSCLC will also provide some valuable insight as to whether biomarkers and companion diagnostics really make a difference, and the MARIANNE study of Kadcyla and Perjeta in 1st-line breast cancer will test Roche's "Replace and Expand" strategy. This combo could carry a monthly price tag of over $16,000, but it must show a significant efficacy advantage over Kadcyla monotherapy.

Outside of oncology, Roche needs to improve
Roche has had some success outside of oncology, most notably in macular disease and inflammatory/autoimmune, but success outside of oncology has gotten more scarce lately. Roche had high-profile failures with drugs for cardiovascular disease, diabetes, and most recently schizophrenia.

All large pharmaceutical companies have trial failures, but Roche's issues go deeper. Roche had once made a large commitment to RNA interference research, only to shut it down completely. Now that Isis and Alnylam have multiple potential rare disease blockbusters in their pipelines (and Roche and Alnylam were partners), that decision is looking questionable.

Little is likely to change right away. Management has made it clear that they believe biotech valuations are too high for value-creating acquisitions, and the company is not looking for a megadeal either. Biotech has long been a cyclical space and valuations will likely contract again in the future, giving Roche the chance to buy into non-oncology therapeutic areas, but Roche's dependence on the oncology space is a mixed blessing. For now, generous reimbursement has made oncology a hot sector, but that may not be the case in another five or 10 years.

Quality, but not as much value
I've enjoyed owning Roche, but I cannot pretend that the shares carry low expectations now. I do believe that Roche's strong oncology pipeline will support one of the highest revenue growth rates in the space (between 4% and 5%), but the company's margin potential is more limited than other Pharma companies, and I'm looking for FCF growth around 6%. With that, I believe fair value for Roche is around $74. Were Roche to see surprising success outside of oncology (say in Alzheimer's), there would certainly be upside to the target. Likewise, if the company's oncology pipeline stumbles, that would represent real downside risk.

The bottom line
With a healthy dividend, I believe Roche is priced to match or modestly beat the overall stock market. That argues for Roche being a worthwhile holding, but it's tougher to argue that new investors should make a major commitment here. Still, the valuation is more appealing than for Merck or Bristol-Myers and the company's sizable diagnostics and emerging markets business enhance the value to some extent.

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