Put yourself in the shoes of an investor with a meaningful stake in AstraZeneca (LSE: AZN) (NYSE: AZN.US): the value of your holdings dropped 11% on Monday, while it’s virtually unchanged at about £42 on Tuesday.
AstraZeneca’s unaffected share price was £35.8 on 3 January. Your pre-tax paper gain is still a market-beating 17.3%.
There are several reasons why investors may be tempted to cash in now, although there remains a reasonable doubt that the deal might go through.
Profitability/Revenue
Between 2004 and 2010, Astra recorded a normalised growth rate of 18% for earnings before earnings before interest, taxes, depreciation and amortisation (EBITDA), but in the last four years cash flow has swiftly plummeted.
EBITDA — essentially operating cash flow adjusted by working capital, i.e. short-term cash items — has almost halved to less than £5 billion. According to market consensus estimates, revenue will decline by about 2% a year into 2016. Astra says its revenue will outpace market growth by 2023.
Growth
Assuming that Astra’s operating cash flow grows at a steady rate of 7% yearly, and assuming constant trading multiples, Pfizer (NYSE: PFE.US)’s latest proposal represents more than five years of growth for Astra.
A decent R&D pipeline and poor visibility into the next few years don’t justify a bullish stance on the stock – unless, that is, Pfizer is rejected and makes a comeback in six months.
Net Leverage/Free Cash Flow
Astra’s net leverage, as gauged by the net debt/EBITDA ratio, is low but rising. It stands at 0.6x, which isn’t unusual for big pharmaceutical companies. Its free-cash-flow yield is 5.5%. The payout has been flat at about $3.5bn in the last four years, for a current dividend yield of 3.5%.
The way it looks, Astra is an overpriced bond.
It needs a takeover premium to justify its current price.
M&A/Break-Up
Astra may be an obvious target for Pfizer, but other bidders are thin on the ground. One way to boost value, but also to heighten the investment risk profile of Astra, would be to become more acquisitive.
Astra is not an obvious break-up candidate, although one could argue for a separation of its R&D functions from sales and marketing in order to crystalise value all along the value chain. That’s easier said than done, however.
A large, debt-funded buyback would be accretive to earnings and would likely provide some support to Astra stock. That’s is an option management should consider along with a larger dividend.
Astra intends to preserve its credit rating and invest in the business to pursue long-term growth.
Valuation
This is the tricky bit. It’s unclear where trading multiples expansion will come from, particularly if growth sputters.
Astra’s trading multiples are still well above five-year highs. Astra will need shareholder-friendly activity to convince investors to stick with their bets. Management have a lot to do in the upcoming quarters to convince investors that they can beat estimates.
Managing expectations will be of paramount importance.
(For the record, everybody now has come to the conclusion that a bid in the region of £60 per share would be successful – just as we noted on May 6.)
