Roche (RHHBY) Stock Needs Some Wins

Swiss drug giant Roche (OTCQX:RHHBY) has long enjoyed a strong reputation, but reputations can sometimes outrun or outlast the underlying facts, and I’m getting more concerned that that may be the case here. While Roche has a huge presence in oncology and has done well for itself in newer markets like multiple sclerosis and hemophilia, the reality is that the company’s long-term stock performance has lagged its peer group and the company hasn’t been able to consistently generate strong economic returns from its large R&D budget.

Roche could really use some meaningful clinical wins now. This was a year of significant clinical read-outs, and thus far Roche doesn’t really have any big wins. Not only does that hurt the revenue outlook, but it also saps confidence and sentiment. Valuation isn’t really compelling in either direction right now; while I expect many will continue to defend Roche as a long-term buy-and-hold core holding, I think the incoming new CEO may want to think about some internal restructuring with an eye toward generating better long-term returns.

Waiting For A Big Win

Roche went into 2022 with several important clinical read-outs that tied into billions of future high-margin revenue. So far, these read-outs have not gone in favor of the company or its shareholders.

The potential blockbuster anti-TIGIT drug tiragolumab failed to hit the mark in the initial reads of the SKYSCRAPER-01 and SKYSCRAPER-02 studies in non-small-cell lung cancer and extensive-stage small-cell lung cancer. Management isn’t giving up yet, but it’s hard to have much confidence here given the shortfall in progression-free survival (usually a less demanding hurdle than overall survival). This one stings a little more as not only would sales of tiragolumab be additive, the combination with Tecentriq would help boost sales of a drug that still is basically an also-ran in the large U.S. lung cancer market (and the PD-L1 market overall).

Roche also reported a disappointing failure with giredestrant in a type of advanced breast cancer. Here too, management isn’t giving up entirely, but even if sub-group analysis leads to an approval drug, it won’t be what it was once hoped to be in terms of a revenue driver.

That leaves two more drivers that I addressed in my last article left to go. The read-outs from adjuvant Tecentriq studies have been pushed out into 2023, and while I’m still fairly bullish here, these aren’t going to be as thesis-changing as the others. Still, approval of a subcutaneous form of Tecentriq won’t hurt the case.

I’m also going to make a brief mention here of Vabysmo, Roche’s new ophthalmology drug for macular degeneration and macular edema. The drug showed non-inferiority to Bayer (OTCPK:BAYRY)/Regeneron‘s (REGN) Eylea (the BALATON and COMINO studies) in macula edema from branch and central vein occlusion, and a better dosing schedule does support a strong case for this drug (in a growing market), but this is more of a replacement/successor to Lucentis in terms of financial contributions than a new driver.

The last big readout is for gantenerumab – Roche’s IgG1 antibody drug for Alzheimer’s. Biogen (BIIB) saw an unexpected win with its IgG1 antibody lecanemab earlier this year, but there are still significant uncertainties about Roche’s drug. If Roche could show a similar 25%-30% reduction in cognitive decline (lecanemab came in at 27%) with gantenerumab, this could be a big winner, particularly given the more convenient/comfortable subcutaneous formulation. Still, betting on an Alzheimer’s drug has never been a particularly good bet to make, so I still regard this as a longshot for Roche.

Is Roche Taking The Right Approach?

As management highlighted in its fall Pharma Day, nobody spends more than they do on R&D as a percentage of sales. But, while 27% of sales going back into R&D is impressive (compared to 26% at AstraZeneca (AZN) and 25% at Lilly (LLY) and Bristol-Myers Squibb (BMY)), it hasn’t translated into superior results relative to those peers or others like Johnson & Johnson (JNJ) that have also been investing considerable resources into their pharmaceutical operations.

Obviously, there are many nuances and relevant details when trying to make these comparisons. Roche has, for instance, had to overcome the meaningful generic erosion of its former blockbusters Avastin, Herceptin, and Rituxan. Likewise, there very well may be a hidden gem in Phase I or Phase II studies right now (Ocrevus wasn’t pegged as a big winner from Day One).

Still, Roche makes some curious decisions. Roche took a different design approach with its PD-L1 entry, and it hasn’t paid off in the market against Merck‘s (MRK) Keytruda or BMY’s Opdivo. Roche likewise took a nonconventional design approach with its anti-TIGIT antibody tiragolumab, and initial pivotal trial results have been disappointing (though it remains to be seen if alternative approaches will fare any better).

The company has likewise made some curious decisions with M&A, recently acquiring its way into modified IL-2 therapies (controversial in the wake of Nektar‘s (NKTR) failure), and being late to join in areas like CAR-T and antisense/RNA interference. In fact, addressing the latter, Roche was an early partner of Alnylam (ALNY), only to bail out early in the development of the therapeutic approach and recently licensing compounds with Ionis (IONS) to get back into the technology.

To be fair, it is very easy to criticize R&D and M&A decisions with the benefit of hindsight. There’s a reason that multiple clinical trials are required for a drug to get to market, and even the best drug developers fail more often than they succeed. My issue or question is really more this – is Roche doing all they can to maximize their odds of success? I believe Johnson & Johnson has done great things with a core science-driven approach, and while Roche does a good job of churning out new drug candidates every year, maybe it would serve the company well to reexamine their approach with an eye toward improving their R&D productivity.

The Outlook

By no means am I predicting doom and gloom for Roche. Recent results from the pharmaceutical business have been lackluster, but I think some of that is down to timing and geographic mix. At the same time, the diagnostics business is performing rather well, and I’m more bullish on the company’s ability to leverage some of its gains from the pandemic into a sustainably better competitive position.

There are programs and pipeline candidates worth following – the company’s KRAS compound could be best-in-class if desirable in vitro traits prove out in human testing, and there are likewise interesting compounds in the pipeline for oncology (including a PDL1xLAG3 bispecific antibody) and neuroscience (fenebrutinib for MS and RG6356 for DMD).

I do still believe that Roche can generate long-term revenue growth in the neighborhood of 3%, with FCF margins in the mid-to-high 20%’s supporting modestly higher FCF growth and mid-to-high single-digit EPS growth. Still, relative to my prior model, I see weaker performance over the next five years due to missing out on some of those positive drivers and some challenges for contributors like Tecentriq and Hemlibra.

My point here is more to caution investors that reputations require ongoing care and maintenance, and while Roche has been a strong company for quite a long time, recent results have been less compelling. That makes the valuation a little more demanding at this point.

The Bottom Line

Between discounted cash flow and EPS growth-driven P/E, I believe Roche is around fair value now, with an expected long-term annualized total return of around 8%. A win with gantenerumab would certainly drive a meaningful improvement not only in expected revenue and profits but sentiment as well. Should that opportunity fizzle (which is my base-case assumption), it could take a little time for the next collection of drivers to emerge, and this is a stock where I’d be a little more careful about my entry price given sluggish near-term momentum in the core business and a lack of thesis-changing drivers.