Lundbeck Languishing Without Clear Drivers (OTCMKTS:HLUYY)

Danish drug company H. Lundbeck A/S (OTCPK:HLUYY) (“Lundbeck”) hasn’t underperformed in terms of core operating earnings since my last update, but the company has seen unsatisfying results for its main growth drivers and the pipeline remains skewed to high-risk late-stage programs and unproven (and high-risk) early-stage compounds. On top of all that, the company is proposing “a heads we win, tails we still win” split share structure that favors its primary shareholder.

I’ll discuss the share split later, as it really irritates me. Operationally, I don’t see the story as having changed so much from my last update, and a lot is still riding on a normalization of marketing behaviors where the company can get its reps in front of doctors. While I can make the argument that these shares are undervalued, potentially significantly so, a lot is riding on the upcoming read-out of Rexulti in Alzheimer’s-associated agitation, as there is little to drive the stock higher in the short term beyond that.

Go/No-Go On Rexulti In Agitation

Some time toward the end of the second quarter (likely June), Lundbeck will release top-line results from its Phase III study of Rexulti in agitation associated with Alzheimer’s disease. This is a fairly common side-effect of the disease, occurring in around 30% to 50% of patients according to some studies, and it has a disproportionately negative impact on quality of life, as it is frequently the leading reason that a person with Alzheimer’s is moved from in-home care to an outpatient facility.

Lundbeck announced back in April of 2021 that an interim analysis did not meet the requirements to end the study for overwhelming efficacy or futility. Commentary from management since then has led me to believe that the bar for an early end on efficacy was higher than I appreciated, while passing the futility threshold should remove risk of an outright failure.

This could be a major follow-on indication with revenue potential in excess of $1B, as there are currently no good treatments for the condition. It all rests on how good the data are, though, and that’s almost impossible to handicap other than to say it doesn’t have incredible efficacy (the study wasn’t halted early). I expect somewhat equivocal results, setting up a situation of ongoing uncertainty as to whether the FDA will approve the indication and whether the drug will see significant in-market use even if approved.

A Mixed Pipeline Behind Rexulti

The outcome of this study in Alzheimer’s agitation is all the more important because there aren’t a lot of other thesis-changing pipeline events right now.

Vyepti is currently driving about 30% of the R&D budget, as the drug is in multiple, expensive late-stage studies, but the outcomes of these studies (ALLEVIATE in cluster headache and multiple studies in Asia) are already generally assumed to be positive based on earlier clinical results. The main question with Vyepti isn’t on the clinical side, but on the commercial side and I’ll get to that in a moment.

Beyond Vyepti studies, there are upcoming discussions between the company and the FDA about future study design for a Phase III study of Rexulti in post-traumatic stress disorder, but this is a very high-risk indication with a low likelihood of success (though very significant economic potential if it were to succeed). There is also a pending filing for a two-month formulation of Abilify Maintena, but again this is something I think the Street has been treating like a given for a while now.

Management has two Phase II compounds to watch, Lu AG09222 in migraine (the HOPE study, which should read out in 2023) and Lu AG82422 in multiple system atrophy (a rare, awful, disease somewhat similar to Parkinson’s but with worse survivability), and the Phase I study of Lu AF28996 in Parkinson’s should read out this year. Lundbeck also has early-stage MAGL and CD40 compounds worth watching, the latter recently acquired from Korea’s AprilBio and suggesting some preclinical promise in conditions like multiple sclerosis, ALS, and Alzheimer’s.

Drugs like Lu AG82422 could meaningfully improve the long-term outlook for Lundbeck if and when there is solid proof-of-concept data, but it will take time to obtain those data. Moreover, it’s worth mentioning that CNS is an area with below-average success rates, so I believe it appropriate to heavily discount these programs in terms of their contributions to future results.

Time For Blocking And Tackling

The pandemic has impacted all companies, but specific to Lundbeck there has been a significant impact on the company’s marketing efforts. Drugs like Brintellix/Trintellix, Rexulti, and Vyepti require above-average marketing efforts to differentiate themselves in the market, and those efforts have been hampered by the restrictions put in place due to the pandemic. I believe those marketing challenges are part of the reason that Rexulti and Vyepti missed expectations in the first quarter (renewed restrictions due to the Omicron variant).

Now that conditions are starting to normalize again, it will be incumbent on management to show acceleration in these businesses. With Vyepti, though, that may be a longer process. Clinical data have been encouraging (including the recent-ish DELIVER study) relative to compounds from Amgen (AMGN), Lilly (LLY), and Teva (TEVA), but the drug is still seeing significant competition from oral CGRP drugs and Vyepti’s ultimate market potential is likely centered in patients that need more immediate relief and/or have failed multiple other treatments.

A Questionable Share Split Proposal

Lundbeck has proposed a new share structure that will see a split into Class A and Class B shares. There will be identical economic rights between the two classes, but Class A shares will have preferential voting rights (10 votes).

The motivation behind this move is pretty simple – to give Lundbeck the option to use equity in M&A without diluting the control of the Lundbeck Foundation, which currently stands at around 70%.

I personally find these arrangements objectionable. I can appreciate that Lundbeck Foundation has long been the controlling shareholder in the company, but I don’t like the special treatment. If they cannot (or choose not) to maintain their proportionate equity ownership through future deals, they should either accept a potential loss in control or use their existing control to exclude future equity deals that would dilute their stake.

I’d also note that Lundbeck’s M&A history of late hasn’t been all that good. It’s too soon to say that the Alder deal (which brought in Vyepti) was bad, but Vyepti is clearly not the lead drug in the class and other deals (Prexton and Abide) were abject failures. I don’t want this to sound like an overly harsh critique of management – as I said above, success rates in this field are below average (and the “average” isn’t very good!) – but a sweetheart deal for a legacy shareholder to facilitate more M&A does not sit particularly well with me.

The Outlook

Management believes they can get to 25% adjusted EBIT margins by the end of 2024 with the business as it is today (including, I believe, a successful outcome in the Rexulti agitation study). Given the amount of money spent on late-stage clinical studies, that’s plausible, but it will take good execution on marketing, particularly with Vyepti, and that is still very much a “show me” story.

I continue to value Lundbeck on the assumption of minimal long-term revenue growth, as opportunities like increased Vyepti revenue and revenue from an Alzheimer’s agitation indication are offset by eventual patent cliffs in other drugs. Given the low odds of success, the pipeline today contributes little to the long-term growth outlook apart from Rexulti in agitation. If and when some of these early-stage programs show significant proof of concept data, that could add some meaningful potential revenue and profits to the longer-term forecast.

I am looking for around 6% annualized FCF growth relative to pre-pandemic norms, but that’s driven largely by operating efficiency.

The Bottom Line

Lundbeck shares look undervalued by more than 30% on the basis of both discounted free cash flow and EPS (with the forward P/E driven by a model based off of what the market has historically paid for given levels of EPS growth from pharma companies).

A lot is riding on a meaningful upswing in Vyepti revenue as well as success in the Rexulti agitation study and both are far from assured. On top of that, I would argue that the split share class proposal, while understandable and potentially facilitating value-adding M&A, is not exactly “shareholder-friendly”. All in all, then, this stock is looking more and more like its pipeline – a high-risk, high-reward set-up that won’t appeal to all investors but could deliver better upside if management can execute on its opportunities and create new ones.