Quick Pitch: Long on AstraZeneca (NYSE: AZN)

AstraZeneca (NYSE: AZN)
Current Price: $45.00
Target Price: $62.00
Source: Hedge Fund. Boston, MA.

Quick Thesis
2011 has seen an increased focus on cash generation and returns within the sector, in anticipation of the 2012 trough combined with the continued decline in global markets sentiment. Big ticket M&A - in anticipation of the upcoming 2012 patent cliff - has been a major use of cash since 2006.

The five large caps' (Sanofi (NYSE: SNY), Novartis (NYSE: NVS), AstraZenca, Roche,Bayer) aggregate spending has been $143bn on M&A (acquisitions >$2bn) plus a further $14bn in bolt-ons and licensing deals. Major deals include Sanofi's $20bn acquisition of Genzyme, Roche’s $47bn acquisition of Genentech, Novartis’ $41bn acquisition of Alcon and Astra’s $15m acquisition of MedImmune. Combined with $114bn paid out in dividends (35% of post-tax cash flow from ops), and $52bn on share buybacks (16% of post-tax cash flow from ops), between 2006 & 2011, the large caps are estimated to have had a negative $2bn cash movement.

Following FY’11 results reported last month we expect strong upside in AZN, as the impact of greater buybacks in 2011 and 2012 and a lower tax rate more than offset the cuts to core operating profit estimates. FY'11 results seemed to have reminded investors that operating free
cashflow will decline from the 2012 base for the foreseeable future. However, AZN cash generation remains sufficiently strong to (a) Support a growing dividend, (b) allow buybacks to boost EPS growth, and (c) still leave significant cash for business development (BD).

Therefore, AZN remains the stock with probably the best downside protection among Pharma large caps. In a worst case scenario, a £30 share price is well supported by a 6% dividend yield for many more years while AZN can shrink to a size where growth may be easier to achieve. Whilst scope for capital appreciation seems limited from operations alone, AZN’s re-rating potential remains substantial in the case that if AZN finds assets that reverse the slowly eroding CF trend.

We expect the FY dividend to increase by 9%, in line with 2011 Core EPS growth, as the pay-out ratio of only 40% still leaves sufficient scope for a pay-out ratio hike in 2012, to avoid a dividend cut next year. We expect AZN to announce a buy-back program of c. $3bn, though not exercising Option 2 of the Merck agreement may result in upside to this figure (The agreement dates back to 1998, a decision is expected in late April.

We have used the DCF valuation using conservative estimates to arrive at the fair value of AZN at $62 which represents a 40% premium to current trading price.

Conclusion
We believe the market doesn't full appreciate management's ability to rebuild the drug pipeline. AZN is well capitalized and is run by a capable management team. We believe the market is also assuming that generics will cut into profits quicker than might actually transpire. They also have low exposure to emerging markets which might provide a catalyst if they decide to enter this market.