Pharmaceuticals INDEPENDENT RESEARCH. Pharmaceuticals. Our valuation methodology for big pharmas deserves new adjustments

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1 INDEPENDENT RESEARCH 8th April 2013 Pharmaceuticals Our valuation methodology for big pharmas deserves new adjustments Pharmaceuticals ASTRAZENECA BUY 3600p vs Last Price p Market Cap. GBP41,021m BAYER BUY EUR75 Last Price EUR79.07 Market Cap. EUR65,387m GLAXOSMITHKLINE NEUTRAL 1760p vs Last Price p Market Cap. GBP74,601m IPSEN BUY EUR29 Last Price EUR Market Cap. EUR2,302m MERCK KGaA NEUTRAL EUR100 Last Price EUR115.9 Market Cap. EUR25,198m NOVARTIS BUY CHF72.3 vs. 70 Last Price CHF65.5 Market Cap. CHF177,255m NOVO NORDISK NEUTRAL DKK920 Last Price DKK935 Market Cap. DKK423,100m ROCHE HOLDING NEUTRAL CHF236 vs. 208 Last Price CHF220 Market Cap. CHF154,564m SANOFI BUY EUR84.5 vs 80 Last Price EUR77.56 Market Cap. EUR102,871m SHIRE PLC BUY 2250p Last Price 1926p Market Cap. GBP10,720m UCB Under review U.R. Last Price EUR47.75 Market Cap. EUR8,758m After decades during which pharmaceutical companies were seen as growth stocks by the financial markets, the sudden slow-down in market trends, lack of innovation and threat of patent expiries has changed perception a lot and, although attempts to make value calls failed, the pharmaceutical sector was no longer seen as a growth one. But for a couple of years now it has been reviving and there is no doubt that a rerating is under way. And we believe this should last. Behind this performance we see companies getting out of their respective patent cliffs more strongly, wealthier, more diversified and again able to deliver innovation through a mix of internal R&D and external partnerships. This winning combination is offering fairly bright perspectives for the years ahead prompting managements to form reassuring medium-term guidance. But for us, it means that we have to carry on thinking about how to adapt our valuation methodologies, not to be late movers in our assessments. We have decided to add new assets to the future revenue flows but also to remove our specific risk premiums thus translating into significant FV upgrades for the 5 Big pharma names under coverage. We are therefore still strongly advocating a call in favour of pharma stocks whose re-rating is not over yet in our view Hypothesis for valuation methodologies: summary of changes previous specific risk premium (as % of ERP) previous WACC new WACC influence on FV AZN 5.0% 8.14% 7.85% +140p (+4.0%) GSK 5.0% 7.82% 7.57% +90p (+5.5%) NOV 2.5% 7.90% 7.76% +2 CHF (+2.9%) ROC 7.5% 8.18% 7.75% +16 CHF (+7.4%) SAN 5.0% 7.89% 7.61% +4 EUR (+5.0%) Analyst: Sector Analyst Team: Eric Le Berrigaud Mathieu Chabert 33(0) Martial Descoutures eleberrigaud@bryangarnier.com r r

2 From successful growth status to unconvincing value status and now back to growth? The market used to pay a premium for pharma stocks, do you remember that? It was a long time ago. At the time, the underlying market was growing at a double-digit rate, driven by the lucrative US market, DTC campaigns and upgrades in sales forces supported easily by more or less innovative drugs and in the end the pharma industry was making easy money with no pain. Starting in 2001 with generic Prozac, things turned progressively negative and less easy. Healthcare costs surged, public deficits exploded, scandals about drug safety monitoring multiplied and while big products were getting older and approaching patent expiry dates, regulators and payers were becoming more stringent. Progressively only true innovation was still paying off and the pharma industry had to adapt, to restructure, to think and operate differently and it took time before it started delivering. All the more so that the first benefits were either reinvested (in future growth platforms) and/or used to offset patent losses but did not resume bottom-line growth thus keeping the turnaround for a later date. From that perspective, 2013 is likely to be the turnaround year. Early this year, we saw GSK doing first-time guidance since Witty became CEO, vartis doing first ever mid-term guidance or AstraZeneca claiming that consensus for 2018 was far too low. If 2013 is a transition year with still significant downward profit trends for a quarter (GSK) to a half-year (Sanofi, vartis) or even the full-year (AZN), 2014 and 2015 should be characterised by restored top and bottom-line growth. Although it may seem premature to call for a return to growth, we also see maturing pipelines that are offering long-term opportunities and visibility. What do you then have today when you buy a pharma stock? Well perhaps not always the same cocktail depending on which one you pick up but there are ingredients in common in the recipe. And to start with this topic, we would like to take the credit markets as reference because the way that they are appreciating the risk associated with the sector is interesting in our view. After a period when not only were cash-flows under pressure with patent expiries but most of the companies engaged in aggressive M&A strategies thus translating into credit ratings on the downside, things turned positive. It is worth mentioning that even to finance the biggest transactions over the last few years like Alcon or Genzyme, the companies benefited from very favourable conditions and it is increasingly the case. Credit ratings have moved upwards again and stand at high levels (Fitch upgraded Roche to AA in January 2013, Moody s upgraded Sanofi to A1 in March 2013). And yesterday Sanofi announced that it had successfully priced a new 5-year bond of USD1.5bn for an annual interest rate of 1.25%. Beyond these considerations, we have already discussed several times the improvement in R&D productivity characterised by pipelines increasing density and maturity for a reduced or stable overall cost together with statistics of approvals on the rise (see FDA approval figures for 2011 and 2012). Moreover, despite differences in product cycles with all companies not aligned, 2013 is usually the bottom for most of them: Sanofi and vartis clearly stated that the year would be made of two different parts with the second half starting to improve gradually, GSK said it would grow sequentially over the year and even AstraZeneca suggested that 2013 had a chance to be the bottom of the cycle. So to make it short, when you buy a pharma stock today you have strong cash flow generation (still), high dividend yields (still), renewed R&D capability, improved visibility over top and bottom-line growth, reasonable valuation based on multiples. So we believe that sector re-rating will persist. 2

3 R&D revival requires action. For almost a decade, the pharma industry has spent a lot and every year even more in R&D for little payback. Considering this background, it is understandable that the market approached the topic very cautiously and gave little to no value to pipelines for years until recent times, at least to assets anywhere else than well advanced in phase III trials. We did similarly and not even factored in all phase III assets in the FV calculation until we issued a note in April 2012 entitled R&D trend changes: It is worth revisiting our models. At the time we stressed that improving success in R&D output was forcing a re-appreciation of how to better capture the value deriving from pipelines in our fair values. And we decided to add several projects as a consequence. Since then it has just become clearer that the management of R&D has made significant progress and that pipelines have matured a lot, making old models useless. vartis held an R&D day in Boston in vember where it stressed that many compounds were undervalued by the market. Roche included a slide in the full-year presentation that was putting light on upcoming decision points in 2013 for 13 projects. Sanofi offered a tribune to Elias Zerhouni during its annual results meeting like never before. GSK repeatedly says how proud it is about its pipeline. And AstraZeneca said during its Investor Day in March 2013 that strategy was about Innovation and growth. But all is not just about words: there are converging trends forming evidence towards R&D improvements. As an example we are more often positively than negatively surprised by new products. So with few exceptions of binary outcomes for potentially big products (that in case of failure would put us at risk of significant downward FV revisions) for which the zero risk will continue to prevail (i.e. darapladib, bitopertin), most if not all phase III assets will be valued and in some cases (notably fast followers when first-in-class is in phase III), some phase IIb assets will be too. We are making the following changes and will introduce new assets more regularly as the body of evidence grows and probability of success increases. Fig. 1: Phase III assets new entries AZN GSK NOV ROC SAN Phase III new - mepolizumab (30p) herpes zoster vaccine (25p) AFQ056 (0.6 CHF) Mircera US (1 CHF) RG7421 (2 CHF) - Phase III still not factored in fostamatinib (unconvincing sirukumab (lack of data) phase II data) vercirnon (lack of data) IPX066 (lack of confidence) MAGE-A3 (binary) darapladib (binary) LCZ696 (lack of confidence) aleglitazar (class) bitopertin (lack of data) gantenerumab (binary) C. Diff. Vaccine (not seen phase II yet) iniparib (lack of confidence) LixiLan (timings to be reassessed) Source : BG estimates Our WACC calculation is too conservative. Each analyst has to think twice before making a change to the hypothesis used for the methodology of valuation because it is usually seen as very artificial or as a weak explanation for FV upgrades. But the underlying structural trends the sector is experiencing forces us to ask the question and not doing so would be wrong. In doing so, we are targeting three criteria: a) beta: it is the weakest argument but we are using a beta of 0.8 across the sector when we are noting that calculated beta (Thomson Reuters/BG, 5y vs STXX) are ranging from 0.67 to 0.88 for the 5 Big Pharma stocks with a median of 0.72 (moreover 3y vs 5y suggests a further decline from 0.72 to 0.68, stressing the perceived improvement). We are therefore very pessimistic with our covered stocks; b) long-term growth: across the same list of 5 companies, we are using very low LT growth rates (a period that usually starts in 2021) in a range between 1% (AstraZeneca) and 1.88% (Roche) mostly depending on product-mix with a median of 1.63%. This is conservative both in relation to worldwide GDP 3

4 rates which are usually used as benchmark for consumer stocks but also when comparing to what analysts covering other sectors are using (2.25% for cosmetics, 2.5% for luxury goods, 2.5% for hotels, 2.5% for software, 3% for cement producers). Here also, we are rather conservative; c) equity risk premium: we have opted for a global approach to the topic for the whole BG research department with only bi-annual reassessment favouring a long-term perspective in line with DCF and EVA models. Currently we use a 3.3% risk-free rate and a 6.1% equity risk premium. But in the middle of the previous decade we introduced a specificrisk premium because we considered that forward risks in the sector were not properly captured by historical methodologies. With most of the patent cliff behind us, with less binary events (and no value in the flows for such compounds when they are still in development), with more balanced portfolios, there is less to no reason to persist with this incremental pain whose impact on WACC ranges from 14bp to 44bp. We could have argued and acted on the three criteria but we will keep, for the time being, both 0.8 beta and existing growth rates to infinity. In contrast, we are removing the specific risk premiums because we are already discounting for risks at various stages. Fig. 2: Hypothesis for valuation methodologies: summary of changes previous specific risk previous WACC new WACC influence on FV premium (as % of ERP) AZN 5.0% 8.14% 7.85% +140p (+4.0%) GSK 5.0% 7.82% 7.57% +90p (+5.5%) NOV 2.5% 7.90% 7.76% +2 CHF (+2.9%) ROC 7.5% 8.18% 7.75% +16 CHF (+7.4%) SAN 5.0% 7.89% 7.61% +4 EUR (+5.0%) Source : BG Estimates VALUATION Additions of assets in phase III clinical development and removal of specific risk premium together with some minor adjustments here and there lead to FV upgrades for all our covered stocks. All included, new FV are as follows: AstraZeneca (3,600p vs 3,520p; +2% because most of the changes were made recently after the Investor Day), GSK (1,760p vs 1,580p ; +11%), vartis (72.3 CHF vs 70 ; +3%), Roche (236 CHF vs 208 ; +13%) and Sanofi (84.5 EUR vs 80 ; +6%). We will revisit our Top pick list by the end of the week. As of today and for the first-quarter AstraZeneca and Sanofi are included, on top of Fresenius Medical Care (FMC) for other segments in the healthcare space. NEXT CATALYSTS 11 April 2013 : First-quarter sales Roche 17 April 2013 : Advisory Committee Breo (GSK) 24 April 2013 : First-quarter results GSK & vartis April 2013 : EASL congress 25 April 2013 : First-quarter results AstraZeneca 2 May 2013 : First-quarter results Sanofi 4

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