Swiss giant Roche (NASDAQOTH:RHHBY) swims in treacherous waters. The pharmaceutical industry can be a challenging place to operate, as companies must spend $1 billion or more to develop a new drug and a majority of those that are put into development will fail to reach the market. Even if a company can beat the odds and get a drug to market, it will almost certainly face multiple competitors and a limited time of patent protection before generic manufacturers can sell knock-offs.
Even with that backdrop, Roche looks like a good bet to continue paying a healthy dividend. Roche has established itself as the leading player in biologic drugs and oncology, and a rich pipeline (backed by spending nearly 20% of sales dollars on R&D) bodes well for the future. Biosimilars are a threat to the company's established products and emerging areas like immuno-oncology have no shortage of would-be rivals, but Roche pursues a good balance of risk and reward with its pipeline and steady debt reduction efforts should free up even more capital in the coming years.
Rich cash flows from a leading franchise
Roche has grown its free cash flow at a compound annual rate of nearly 12% over the past decade, fueled in no small part by the success of leading drugs like Herceptin, Avastin, and Rituxan that have made Roche the leading company in oncology.
Over the past five years Roche has managed to convert nearly 27% of its revenue into free cash flow, despite spending close to 20% of its sales on R&D. Strong free cash flows have enabled Roche to not only pay $6 billion to $7 billion in dividends, but also reduce debt by nearly $8 billion while maintaining a cash balance of $12 billion or higher. Said slightly differently, Roche has paid out less than half of its free cash flow as dividends over the last two years (and just slightly more than half three years ago) and has had more than enough cash to reduce its debt.
A deep pipeline should offset generic risks
One of the biggest risks to Roche and its rich cash flow streams is generic competition. Generic versions of Roche's leading biologic drugs (called biosimilars) could start hitting the market in the EU and U.S. over the next five years, bringing with them the possibility of significant revenue, profit, and cash flow declines. Biosimilar development has proven more difficult than previously expected and the cost of production could limit some of the price competition, but it is nevertheless a threat to Roche's business model.
The optimal situation for a pharmaceutical company is to "self-obsolete" and develop strong follow-up drugs before losing sales and market share to generic rivals. Roche is certainly pursuing this path, with a deep pipeline focused largely on oncology, but with some quality assets in therapeutic areas like neurology and immunology.
Like Bristol-Myers (NYSE:BMY), Merck (NYSE:MRK), and AstraZeneca (NYSE:AZN), Roche has made a big push into immuno-oncology – a class of drugs that looks to modify natural immune responses to fight cancer. The first major category to go into advanced development is PD-1/PD-L1 antibodies, targeting indications like lung cancer, melanoma, renal cell carcinoma, and bladder cancer. Roche has reported very encouraging data in bladder cancer and may well have the best drug for lung cancer as well, while Bristol-Myers appears to have the lead in renal and Merck may be best in melanoma. AstraZeneca is a little late to the party and is focusing more effort on combo therapies.
Bristol-Myers, Merck, AstraZeneca, and Roche are all looking to their immuno-oncology pipelines to produce multiple billion-dollar-plus blockbusters and Roche has recently highlighted other drugs in its immuno-oncology pipeline that target CD40, CSF-1R, and OX40 among other targets. Relative to Merck and Bristol-Myers, Roche also has a deep pipeline of oncology targets outside of immuno-oncology and perhaps the richest opportunity set for various combination therapies.
Still willing to play offense
Investing in immuno-oncology drug development is not just about preserving Roche's lead in oncology and/or biologics. These developments may well grow Roche's business and extend its market share beyond traditional strongholds in breast cancer and hematological cancers.
What's more, Roche is still willing to invest for long-term growth. Programs like its mGlu modulators for depression, crenezumab for Alzheimers, and so on are not high-probability R&D efforts, but the rewards for success could be enormous. Likewise in life sciences – Roche has lost nearly all of its momentum in sequencing, but the acquisition of Genia (a development-stage semiconductor-based nanopore sequencing company) suggests that Roche is still willing to invest in rebuilding its position.
On the diagnostics front, Roche is arguably less aggressive, but still sees considerable potential in its immunoassay, clinical chemistry, tissue diagnostics, molecular diagnostics, and diabetes care franchises. All told, diagnostics generates close to one-quarter of the company's sale and Roche is focusing a great deal of attention on developing "companion diagnostics"-tests that can characterize the type of cancer a patient has and what drug(s) may be most effective. Tying together diagnostic and pharmaceutical revenue in this way is an option that really isn't available to rivals like Bristol-Myers, Merck, or AstraZeneca, who have had to seek out external partners for companion diagnostic development.
The bottom line
Roche is likely only a year or two from being in a net cash position with multiple phase 3 immuno-oncology programs. I do not expect tremendous revenue growth (4% to 5% a year), but Roche should be well-positioned to continue to generate FCF margins in the high 20%'s (or higher), supporting higher dividend payments while still leaving cash on hand to pursue internal R&D and external partnerships and acquisitions.
Top dividend stocks for the next decade
One of the reasons investors are excited about Roche is because the smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.
Stephen D. Simpson, CFA owns shares of Roche. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.