20th May 2014
Neil Woodford, head of investment at Woodford Investment Management, has provided some detailed analysis of the prospects for AstraZeneca. We include his note in full below.
Pfizer’s recent bid approach for AstraZeneca has presented investors with a classic dilemma. Would shareholders choose the allure of a substantial short term profit and, for those who elected not to sell immediately, a new equity risk (a Pfizer / AstraZeneca combination) or, as AstraZeneca’s management has argued, the brighter, more valuable long term future of an independent AstraZeneca.
As with any large bid for a UK company there are many issues beyond the narrow shareholder value considerations. Clearly Pfizer’s reputation as a serial acquirer of large pharma companies and subsequent radical cost rationalisations raised concerns about the loss of high value jobs in the UK’s life science research establishment. Politicians and commentators quite rightly highlighted the importance of this industry to the UK’s economic future. The long hoped for rebalancing of the economy away from consumption, housing and financial services, towards a sustainable future based on investment, manufacturing and exports can only ever come to pass if technology-based industries such as life sciences thrive and prosper.
If Pfizer were successful in acquiring AstraZeneca there would have been very legitimate concerns that the UK’s critical infrastructure in this industry would be harmed.
Having invested in early stage science in the UK for over 10 years, I know first-hand how important centres of excellence are in the long process of drug discovery and development. Scientific collaboration with expertise in the same location can often be the difference between success and failure. This is evident in the ascendancy in the US of the Boston cluster and its life science industry.
However, these legitimate concerns are for politicians and commentators to ruminate over. I share many of them and redundancies in this industry may well adversely affect other investments I have in this sector. But, my duty as a fund manager requires me to stick to the narrower issue of shareholder value in this bid situation, as it does in any other situation. My responsibility is to make a judgement on which outcome I believe will deliver the best long term result for my investors. Of course, in coming to that judgement I must consider all the key issues that will impinge on value. The most important of these is the subject of AstraZeneca’s pipeline.
The company’s current portfolio of approved drugs will generate cash flows now and in the future. The value attached to this portfolio may well be disputed, but the variability between the bulls and bears is not the key differentiating factor in the adjudication of value.
The key difference between those that might advocate cashing in now and those holding for an independent AstraZeneca future, will be the value that is attached to the pipeline of yet to be approved drugs. Here, the process of analysis and judgement gets necessarily hazy.
All valuation judgements have a foundation in science and art. Forecasting cash flows 10 years into the future is based on assumptions around capital structure, sales and margins. Discounted cash flow (DCF) valuations rely on assumptions being made about an appropriate discount rate and terminal value. All this sounds terribly scientific but in reality it isn’t. There is a very wide divergence between the values analysts could attach to the AstraZeneca pipeline simply because valuing it requires judgement. Art plays a greater role than science and different assumptions deliver very different outcomes.
Many investment analysts solve this conundrum by starting with the answer and working back to it, flexing their assumptions to do so. Hence the cluster of sell-side analysts, many of whom were sellers of AstraZeneca at £30 per share, but who now suggest AstraZeneca may be worth 50% more.
My judgement about AstraZeneca is just that, a judgement. It is built on some science but relies on a considerably larger helping of art. In arriving at an investment decision I must, amongst other things, make assumptions about issues which are difficult to model but which will have a huge bearing on value outcomes.
These include, for example, leadership and management. Two years ago AstraZeneca’s Research & Development (R&D) division was languishing, riven with risk aversion following a string of late stage pipeline disappointments. Risk committees and bureaucracy were suffocating the process of drug discovery. Less than two years on, under the leadership of Pascal Soriot, the division has been liberated and the late stage portfolio has been transformed from one of the poorest in the industry to arguably the best. It now boasts 19 products that are either in or entering late stage trials by the end of 2015. Each of them has the potential to deliver significantly improved patient outcomes and billions of dollars in sales. In summary: same science, many of the same people, different leadership, different results.
This point only serves to underline how one’s perception of future value flexes with issues that analysts find incredibly hard to fathom and measure.
It would appear that Pfizer’s pursuit of AstraZeneca has now failed. Yesterday’s fall in AstraZeneca’s share price reflects selling by those shareholders who were hoping for a deal and “risk arb” funds which are now exiting their positions. I am, however, relieved that AstraZeneca appears to have retained its independence. I applaud the board’s resolute resistance of the Pfizer approach, based on their long term value judgement that I fully support. I remain convinced that an independent AstraZeneca will achieve far better returns for its shareholders than the combination of cash and Pfizer paper would have delivered. The long term future for AstraZeneca looks very bright indeed.
A combination of astute leadership and great science has enormous potential for the business, its shareholders and, importantly, for patients.
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