Chief Investment Strategist
In order to understand why AstraZeneca has risen to become the fourth most valuable company in Europe and one of the highest quality companies in the world, we must go into the history books.
AstraZeneca was formed in 1999 through the merger of two companies, Astra AB of Sweden and Zeneca Group PLC of the UK. The early 2000s were focused on expansion through acquisition such as MedImmune in 2007 and research in oncology which would later show was the early seeds of the company’s current success. In the 2010s, the company made a strategic shift after a negative period from 2010-2012 where the sentiment among investors was cautious because AstraZeneca faced expiration of several key drugs like Nexium and Seroquel. The company launched a substantial restructuring plan to address the financial pressures and created financial space for increasing R&D in rebuilding the drug pipeline.
In 2013, a new CEO Pascal Soriot (still CEO today) was appointed and he focused the business on three therapy areas: oncology, cardiovascular & metabolic diseases, and respiratory. In the years that followed from 2014-2016, AstraZeneca launched several new drugs like Tagrisso for lung cancer and Lynparza for ovarian cancer. The stock price was steadily improving and AstraZeneca secretly becoming a high quality stock with growth characteristics. The global fame came during the COVID-19 pandemic when AstraZeneca in collaboration with the University of Oxford developed an early COVID-19 vaccine. Oncology has continued to become the most important business segment for AstraZeneca representing 37% of revenue in FY23 and the drug pipeline in oncology is what the market is excited about in 2024.
AstraZeneca’s focus on R&D regardless of a patent cliff or falling revenue is well illustrated in this chart showing that R&D in percentage of revenue rose steadily from FY09 to FY18 despite revenue falling 31% highlighting that the restructurings of the company were made to make room for maintaining R&D at absolute levels as long as possible. This strategy proved to be correct.
When the CEO Pascal Soriot shifted the strategic focus to oncology in 2013 the division only delivered 11.8% of revenue corresponding to $3bn in revenue in FY14. The FY11 stand as pivotal year in AstraZeneca’s history as that was the fiscal year when revenue peaked at $33.6bn driven by its successful drug Crestor (treatment for high cholesterol) which alone was 20% of revenue at $6.6bn in revenue. From FY11 to FY18 revenue declines in all years except for FY14 with Crestor going from $6.6bn in revenue to $1.1bn in FY23. So despite a decline of $11bn in revenue the R&D spending actually rose to build the future which was a very brave move by the management team.
The return on invested capital (ROIC) was running around 35% in the years 2008-2011, before collapsing to more modest 5-10% range during the years of falling revenue. 2020 with the successful COVID-19 vaccine revenue and profits rise significantly and ROIC jumps to 15% which is the level when the quality stamp comes back. It then drops to the lowest point in 15 years in 2021 when it acquires Alexion, to get access to its rare disease portfolio, for $39bn doubling the invested capital to around $73bn. Because Alexion is an emerging growth company the invested capital goes up much more than the operating income and as a result ROIC plunges to just 2%. It has since recovered to 12% in FY23 and with the current trajectory we expect the ROIC to continue to improve over the coming years.
It was FY18 that was the turnaround year for AstraZeneca as that was when the bleeding stopped and growth in oncology took over. Oncology goes from $3bn in Fy14 to $6bn in FY18 to $17bn in FY23 with the four largest drugs being Tagrisso (lung cancer), Imfinzi (lung and bladder cancer), Lynparza (ovarian cancer), and Calquence.
The cardiovascular division where Crestor was previously the big drug has since turned things around and returned to growth in FY19 with especially the Farxiga (for diabetes and heart failure) drug growing rapidly.
When you look at AstraZeneca’s share price since December 2003 it is impressive. The total return has been 11.9% annualised compared to 7.9% annualised for the MSCI World Index. That is 4%-point alpha over two decades. This is despite a 30% decline in revenue along the way and facing a patent cliff. This extraordinary turn of events for a stock that nobody wanted to own in 2010-2012 tells you that there is something unique about AstraZeneca.
Looking back it is clear that the CEO Soriot and his steady leadership over 10 years is one of the ingredients in the secret sauce. It requires a stellar management team to navigate such a difficult transition and doing it while planning for the future and keep the market excited about the future. The decision to double down on research and oncology was a bold move, but also ultimately what has paved the way to what AstraZeneca has become and will become in the years ahead.
The oncology pipeline is strong and AstraZeneca has an ambition to redefine cancer care and vision to eliminate cancer as a cause of death. This is the company’s north star and what guides its investments and R&D. The company recently announced that it intends to double revenue to $80bn by 2030 driven by its oncology division and what is called combo drugs. The lessons for investors about AstraZeneca are smart and steady management team, laser focus on the business, and intense focus on R&D regardless of short-term declines in the business. Basically think long-term and stay the course.
The biggest risks for any pharmaceutical company are the following:
Quality companies can be defined in many different ways just like value. MSCI, which is world’s largest equity index provider, has defined it using three fundamental variables return on equity, debt to equity, and earnings variability. This definition makes sense because it can be applied to all companies regardless of which sector they are part of. The definition puts emphasis on profitability relative to the deployed equity, leverage ratio (less debt leverage relative to equity is good), and finally the predictability of the business with less variance in earnings being a good thing. In our past equity research we have also found that the lower earnings variability a company has the higher its valuation becomes, so this is a quality marker.
In our equity research note Top quality companies and how to decode their traits we focused on return on invested capital (ROIC) relative to the cost of capital (WACC) as the key measure to identify quality. Next we explained, that around half of those companies with the highest ROIC see their ROIC falling from the top to outside the top over three years due to competition or changing technologies. This is the quality trap that investors need to avoid. It is about finding enduring quality. The “7 Powers” framework is a good approach to analyse whether a company has enduring characteristics or not. Finally, a company can have a stable spread in ROIC minus WACC with a ROIC not in the absolute top and still be a phenomenal stock for shareholders. All it requires is that the business can invest a lot into the business. Historically, Walmart was exactly such a case.
The interesting thing about researching quality companies is that you cannot put it all into a formula. You must apply discretionary thinking about the business, its products, the company’s strategy, the industry drivers, technologies strengthening or weakening the business, because in the end the big returns about changes in expectations for the company.
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