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Shire - Growing pains

Equity research team | 1 November 2016 | A A A
Shire - Growing pains

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Growing pains

Shire announced a reported operating loss for the third quarter of $406m, compared to income of $456m a year earlier. The group blamed the fall on the impact of 'aquisition accounting', with underlying operating income up 73% to $1.3bn, primarily due to the inclusion of Baxalta.

The shares fell 5% following the announcement.

Our View

Sales of key products, such as $470m Vyvanse - up 20% in the quarter, may be rising rapidly; but come the early 2020s a number will lose patent protection. Bolt on deals can only go so far to plug these lost revenue streams and management obviously felt that something more radical was needed to secure the company's long term future. The Baxalta deal - by far the biggest in Shire's history - is the chosen medium.

The acquisition significantly strengthens and diversifies Shire's drug pipeline. The combined company has 40 programs targeting areas of "significant unmet medical need" with the most recent drug to emerge from the labs, XIIDRA, expected by some analysts to see peak annual sales in excess of $2bn. That should take some of the pressure off when the patents begin to fall.

The deal also bumps up Shire's exposure to rare diseases, and reduces its dependence on individual treatments. The combined group has market leading presence in haemophilia and positions in immunology and cancer; as well as substantially increased global scale, with operations in 100 markets.

Baxalta is far from a magic pill though.

There are competitive threats in haematology, which accounts for over 25% of group revenues, while US officials have suggested that Haemophilia treatments might not be covered by insurance. Meanwhile, question marks remain over whether the anticipated cost synergies can be delivered. Shire's balance sheet is perhaps the greatest source of concern. It has been stretched by the deal, with net debt jumping from $1.5bn in December 2015 to $23.3bn today, which further increases the risk to investors.

These concerns probably explain why the shares still trade at a c.35% discount to their long term average P/E rating, at just 11.3 times next year's earnings.

If all goes to plan, Shire could do well. Earnings would benefit from $700m in synergies, and new product launches offer the prospect of double digit revenue growth as far out as 2020. But big deals always bring risks.

Third quarter results:

Q3 sales rose 111% at constant exchange rates, hitting $3.3bn. That was primarily driven by the inclusion of $1.5bn Baxalta sales, but Shire legacy products also delivered growth of 15%. However, pro-forma Baxalta legacy sales fell 1%, impacted by the timing of large orders.

Dry eye treatment XIIDRA saw 64,732 prescriptions written to October 21st, following the products launch in August. The drug now has a market share of c. 16%. The launch contributed to a 98% increase in selling, general & administrative (SG&A) costs.

Integration of Baxalta is reportedly on track, with operating expense savings ahead of schedule. The acquisition leaves the group with net debt of $23.3bn.

Free cash flow fell 27% on an underlying basis, to $395m, as net cash from operating activities fell 6%. The fall was primarily driven integration costs and higher tax and interest payments.

The issue of new shares to fund the Baxlta deal reduced overall earnings per American Depositary Share (ADS) by 2%, with statutory numbers showing a loss of $1.29 per ADS.

Unless otherwise stated, all estimated figures, including prospective dividend yields, are taken from a consensus of analyst forecasts compiled by Thomson Reuters. These estimates should not be taken as a reliable indicator of future performance.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research for more information.

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