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Diverse Development

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Karen Andersen, CFA
[email protected]

We think Roche Holding’s (RHHBY) drug portfolio and industry-leading diagnostics conspire to create sustainable competitive advantages. As the market leader in both biotech and diagnostics, this Swiss health-care giant is in a unique position to guide global health care into a safer, more personalized, and more cost-effective endeavor.

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 [treatment] 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 [products manufactured in or extracted from biological sources], 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 2016. 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 [products with active drug substances made by a living organism or derived from a living organism], which we expect as early as 2016 in Europe and 2019 in the U.S. Gazyva, now approved in the U.S. in chronic lymphocytic leukemia (CLL) and in testing in non-Hodgkin’s lymphoma (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.

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.

Roche’s Herceptin was one of the original personalized therapies, and breast and gastric cancer patients who are human epidermal growth factor receptor two positive (HER2+) continue to see strong survival benefits from this antibody therapy. Since then, Roche has also demonstrated the benefit of Tarceva in EGFR-mutant patients, introduced Kadcyla and Perjeta for HER2+ patients, and created new diagnostic tests to determine the course of Pegasys therapy in hepatitis C.

The firm’s melanoma drug Zelboraf, specifically targeted to patients with BRAF mutations, was the first product developed using a companion diagnostic from the start. Pairing drugs with diagnostics early in development shortens development timelines, reduces upfront 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 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 2016.

Steve Scala, R.Ph., CFA
Cowen and Company
[email protected]

Roche offers at least average, but highly visible, EPS growth potential through 2020, supported by a handful of still robust franchises, including Avastin, Rituxan and the HER2 franchise. While these products are unlikely to deliver upside to expectations, we believe they are equally unlikely to disappoint.

The pipeline has a few high-potential products, recent approvals have had strong launches, and the InterMune acquisition bolsters longer-term prospects. Biogenerics are a manageable risk, given Roche’s efforts to advance the standard of care. A powerful Diagnostics Division is well positioned for the emergence of personalized medicine.

Second half of 2014 EPS of Swiss francs (CHF) 6.72 (flat) were CHF 0.61 below our estimate. Newly issued 2015 guidance calls for group sales growth of low- to mid-single digits (at a constant exchange rate, or CER) and core EPS growth ahead of sales growth (at CER).

Using exchange rates as of mid-January, the company indicated the estimated foreign-exchange impact for 2015 to be a 6% hit to sales and a 9% hit to profits. This implies reported 2015 sales growth to be roughly up 1% to down 4%, and reported core EPS to be flat to down 4%. Our last published 2015 sales estimate is CHF 44 billion (-7%) and EPS estimate of CHF 12.55 (-12%), which includes foreign exchange; we will revisit these estimates.

2H’14 group sales of CHF 24,488 million (+4%) were CHF 509 million above our forecast. Key products beating estimates included Herceptin, Avastin, Cellcept, Xeloda, Tarceva and Zelboraf, which combined were CHF 132 million ahead of our forecast with Herceptin CHF 66 million and Avastin CHF 38 million higher. Products below estimates were Rituxan, Actemra, Kadcyla and Pegasys, which were a combined CHF 93million shy of forecast; Rituxan was CHF 59million below our target.

Strong 2H sales [were] offset by increased spending and higher tax-rate gross profit margin of 77.7% was 1.7 percentage points below our 79.4% estimate; research & development of CHF 4,709 million was CHF 28 million ahead of our estimate, and selling, general & administrative expenses of CHF 6,094 million were CHF 762 million above our forecast (includes a one-time, U.S.-branded drug fee charge of CHF 202 million).

A non-operating expense of CHF 458 million was CHF 217 million below our estimate; the tax rate of 24.2% was 1.2 percentage points above our estimate (clipped EPS by CHF 0.10).


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