On the Mend at AstraZeneca


By David Seemungal Following a negative showing last year, the ADS of major pharma outfit AstraZeneca (AZN

; recent price, $46) has been trending upward since the start of 2005. More recently, the shares climbed on the back of strong second-quarter results, released July 28. While management was quick to advise against extrapolating based on second-quarter results, it raised its earnings guidance for 2005. The company also announced a 29% increase in the dividend and boosted its share-buyback program to $3 billion, from $2 billion.

Over the next 12 months, we believe the strength of AstraZeneca's sales and earnings growth will provide further time and resources to enable the next generation of product development, either through in-house pipeline candidates or acquisitions from third parties. Together with further savings from the cost base, we believe that the company has the ability and flexibility to improve on its current guidance of $2.75 earnings per share for 2005.

FAT PIPELINE. Longer term, we believe that AstraZeneca's pipeline flow will support continued strong top-line growth seen with the key product drivers, including additional indications for existing launched products. While further work needs to be done to strengthen the pipeline, the outfit is making progress in this area, in our view. The stock carries Standard & Poor's highest investment recommendation of 5 STARS, or strong buy.

London-based AstraZeneca currently ranks among the world's leading drug companies. It has one of the highest levels of research and development spending in the industry. In total, it has more than 70 ongoing projects, including line extensions, in its R&D pipeline.

Key new drugs include Exanta, an oral anticoagulant used to prevent blood clots; Galida for diabetes; Faslodex, an anticancer drug; Cerovive for strokes; and various other compounds for arthritis, heart disease, cancer, depression, and other ailments.

BOOMING SALES. Total revenues in 2004 broke down as follows: gastrointestinal drugs, 28%; cardiovasculars, 22%; oncology agents, 16%; neuroscience drugs, 16%; respiratory items, 12%; other drugs, 3%; and other businesses, 3%. Geographically, 2004 revenues were divided as follows: U.S., 45%; Europe, 36%; Japan, 7%; and all other, 12%.

Our forecast of strong sales is driven by growth in key established lines. We estimate that sales of Seroquel, an antipsychotic, will advance about 40%, through gains in market share. We also see sales of Crestor, a cholesterol-lowering compound, increasing more than 50%, despite negative publicity relating to safety.

We expect growth for Symbicort, a respiratory therapy, and Nexium, a gastrointestinal agent, as well as for newer oncology therapies such as Casodex and Arimidex. Sales of most of AstraZeneca's older, off-patent drugs will likely decline, we believe.

Here's a look at the company's main compounds:

Seroquel. This drug is currently approved for the treatment of acute manic episodes associated with bipolar I disorder and the treatment of schizophrenia. We have relatively bullish expectations for Seroquel sales on the back of additional indications in the longer term and the possibility of off-label usage in the medium term.

On July 1, AstraZeneca released the results of a large-scale clinical study that examined the use of Seroquel as a treatment for depressive episodes in patients with bipolar I and II disorders. The study demonstrated a statistically significant decrease in depression scores at week one, and they continued to decrease throughout the eight-week study. It also showed that more than half of the patients receiving the drug responded and achieved remission.

This was the first published large-scale, controlled clinical trial to evaluate the drug as a stand-alone treatment for depression. If these latest trials were successful, Seroquel would be the first agent approved for the treatment of both depressive and manic episodes associated with bipolar disorder. Our 2005 sales estimate for the drug is $2.85 billion -- a 41% increase over 2004.

Crestor. The global statin market is about $27 billion, and growing at 9% per annum. However, following a series of high-profile attacks on the drug's safety profile, Crestor's share of the U.S. market has fallen to about 6% (from highs of about 8%).

We maintain our long-term view of Crestor sales reaching $3 billion by 2009, helped by this drug's ability to both lower LDL or "bad" cholesterol and raise HDL or "good" cholesterol. This translates to a 7% market share of the class. Crestor sales in the second quarter were $317 million (up 53%), marginally below our estimate of $323 million. We expect 2005 sales of $1.4 billion.

Nexium. The global proton pump inhibitor (PPI) market is $22 billion, and growing at 4% per annum. Second-quarter Nexium's sales were $1.2 billion, ahead of our $989 million estimate, and grew 35% from the year-earlier period. We estimate 2005 sales of $4.6 billion for the drug.

Nexium is relatively well-insulated from the pricing pressures facing the generic products in this therapeutic area, in our view, due to AstraZeneca's existing strong contract agreements with the large managed-care companies in the U.S.

PROMISING DEVELOPMENTS. AstraZeneca's focus in recent quarters has been to demonstrate that its pipeline has the potential to maintain the strong growth in sales and earnings into the medium and long term. We believe the weakness in AstraZeneca's business portfolio has been its pipeline (specifically following the disappointments of Exanta, Iressa and, to a lesser extent, Crestor).

The company, in a recent analyst meeting, discussed the pipeline-development program; we believe it's showing a more focused approach with the expected increase in attrition at early stages of development. Three key pipeline products are Cerovive for strokes; Galida for diabetes; and Zactima for lung cancer.

Here is a brief status report on each:

Cerovive. The recent positive data on Cerovive was the first positive pivotal study of a neuroprotectant for the treatment of acute ischemic stroke. Many attempts in this area have failed in the past, and that leads us to our cautious view of Cerovive's potential. The company's regulatory submission target date is the second half of 2006.

Galida. Like Cerovive, Galida is in Phase III development. Galida has completed FDA-required carcinogenicity studies. Additionally, the FDA required two-year clinical studies to be completed for the New Drug Application (NDA), and AstraZeneca agreed to extend the long-term follow-up clinical studies to two years, resulting in the filing date moving from 2006 into 2007.

Zactima. AstraZeneca recently reported results from two Phase II studies for the second-line treatment of nonsmall-cell lung cancer (NSCLC) using Zactima, a once-daily oral therapy. Both studies met their primary endpoints. The company has confirmed that Zactima was to enter Phase III clinical studies for NSCLC, with patient recruitment for Phase III trials expected to begin in late 2005.

The company also has a new chief executive in its executive pipeline. CEO Sir Tom McKillop will retire at the end of the year and will be succeeded by David Brennan, who currently heads U.S. operations. Brennan has an excellent track record, in our opinion, of delivering a strong sales and marketing performance in the key U.S. market, and we view this appointment favorably. We expect a renewed focus on managing the pipeline, following recent disappointments with late-stage pipeline developments.

REINING IN COSTS. AstraZeneca's second-quarter results were well above the high end of expectations. It appears to us from the conference call following the release that the results were relatively clean, with no significant non-recurring items. Revenues grew 12% in the first half of the year, which, coupled with productivity improvements, translated into 37% earnings growth and a 6.4% improvement in operating margins, to 26.7%.

R&D costs were down 6% from last year, in part due to bringing trials back in-house from commercial research organizations (about 80% of trials are now in-house, vs. the previous level of about 73%).

We expect 2005 sales growth of 12% -- slightly higher than management's guidance for sales growth approaching double digits. Based on guidance, we expect gross margins to expand, helped by the higher volume and manufacturing efficiencies. Profits should also benefit from tight control over selling, general, and administrative (SG&A) and R&D spending; higher operating income in other areas; and a sharp increase in financial income. We believe the tax rate will likely rise to 29%, from 24% in 2004.

TURNAROUND TIME? The shares have trended lower since May, which we believe is partially a result of investors' increased appetite for other companies in the sector -- primarily Roche. Following the strong second-quarter results and what we believe will be more positive news going forward, we expect the shares to regain favor and outperform peers.

More specifically, we expect positive news relating to its pipeline assets (Zactima, Cerovive, and Galida) and three launched products -- Seroquel, Symbicort, and the oncology portfolio (driven by Arimidex) -- to drive earnings and, even more so, the share price over the coming quarters.

We forecast 2005 sales growth of 12% to $24 billion, operating margins of 27%, and 2005 and 2006 EPS of $2.78 and $3.02, respectively, assuming stable currency exchange rates.

GROWTH PROJECTIONS. Our 12-month target price of $51 is derived by applying a price-to-earnings multiple of 18 times (modestly above the average multiple we see for peer European pharmaceutical stocks) to our $2.78 earnings per ADS estimate for 2005, and through our discounted cash flow (DCF) model. Our model assumes earnings growth of 27% in 2005, 9% in 2006, and low single-digit growth in 2007 through 2009.

Risks to our recommendation and target price, in our view, include another pipeline setback -- particularly in the high-risk Phase III candidates Galida and Cerovive. Similarly if the company's strategy with respect to promoting Crestor is less successful than we predict or if there is some data relating to adverse side effects of the drug, AstraZeneca's value may be significantly reduced.

Another risk, in our view, lies in a fundamental shift to the proton pump inhibitor market. Nexium is a key driver for AstraZeneca through 2008 (patent expiration: 2015), and any event that would create additional pricing pressure for Nexium could significantly hurt the stock's valuation. Regulatory and political changes may also potentially have a negative impact on the company's growth expectations and valuation. London-based Seemungal is an equity analyst following pharmaceutical stocks for Standard & Poor's Equity Research Services


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