Royalty Pharma: An alternative way to invest in pharma.
Opdateret: 7. aug.
According to CEO Pablo Legorreta, Royalty Pharma has a very attractive risk/reward profile compared to most other companies in the life sciences industry. I tend to agree with him, as Royalty Pharma has no capital expenditures, while still providing exposure to some of the largest therapies in the world. In this analysis, I will investigate whether now is the right time to buy Royalty Pharma.
This is not a financial advice. I am not a financial advisor and I only do these post in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.
Since I have attended the workshop with Phil Town, I have decided to change the layout of my analyses a bit. I will do some more calculations and also briefly go through why the company has meaning to me. If you want to read more about how I evaluate a company, please go to "MY STRATEGY" on my website.
This analysis will be a bit different from others because although Royalty Pharma was founded in 1996, it did not go public until 2020. It means that I will not go through the historical numbers, but I can tell you that the ROIC in 2020 was 10%, 7,4% in 2021, and 4,7 % in 2022. Despite their new IPO, I still think it makes sense to value the company based on fundamental analysis instead of using discounted cash flow. Hence, this analysis will use the same framework as my usual analyses, but without the historical data. I should also mention that I own shares in Royalty Pharma. You can find information on how to view or copy my portfolio here. If you want to buy Royalty Pharma stocks, you can do so on eToro.
Royalty Pharma differs from the other pharmaceutical companies I have written about. Their business model is to buy royalties in therapies instead of developing their own. These therapies could include newly approved therapies in early stages of their life cycles or late-stage development therapies. Royalty Pharma is a market leader, with a 60% market share of all royalty transactions in the industry. If you would like to gain a better understanding of how royalties work, I recommend reading page three of their annual report. I don't want to delve too deeply into the details in this analysis. It means that they can benefit from many advantages in the pharmaceutical industry, such as long product life cycles, significant barriers to entry, and non-cyclical revenues. At the same time, they have reduced exposure to industry challenges, such as early-stage development risk and high research and development costs. At the same time, they have the same strong secret moat, like other pharmaceutical companies. In their portfolio, they have more than 35 marketed therapies. If you regularly read my posts here, you will know some of the therapies in their portfolio, as they receive royalties from the cystic fibrosis franchise of Vertex Pharmaceuticals and Imbruvica from AbbVie. Besides these two companies, they also receive royalties from companies such as Biogen, Pfizer, Merck, Eli Lilly, Johnson & Johnson, and Bristol Myers Squibb. Their portfolio is highly diversified, encompassing various therapeutic areas including rare diseases, cancer, neurology, infectious diseases, diabetes, hematology, and cardiology.
Their CEO is Pablo Legorreta. Besides being the CEO, he is also the founder of Royalty Pharma, meaning he has been on board all the way. Personally, I prefer it when founders hold management positions because they typically have a strong motivation to grow the business, rather than just focusing on their bank account. He has grown Royal Pharma to becomethe largest purchaser of pharmaceutical royalties. He has gained extensive experience in investing in pharmaceutical royalties, having been involved in the business for over two decades. Prior to founding Royalty Pharma, he was an investment banker at Lazard Frères. He is also a co-founder of Pharmakon Advisers. His educational background includesa degree in Industrial Engineering from the Universidad Iberoamericana in Mexico City. He also serves on the Board of Directors of Epizyme and on the Board of Governors of the New York Academy of Sciences. He also founded Alianza Medica para la Salud, a non-profit organization dedicated to enhancing the quality of healthcare in Latin America. He has made some fantastic deals for Royalty Pharma through the years. One such example is the acquisition of the royalties of Humira from AztraZeneca in 2006, for $700 million. In 2018 alone, Royalty Pharma collected $499 million in royalties from Humira. According to an article in Forbes, Pablo Legerreta has led Royal Pharma to increase their cash receipts by 11% since 2021. It is difficult to find much information about Pablo Legorreta, as he does not make many public appearances or give many interviews. Nevertheless, I feel very comfortable with Pablo Legorreta as the right person to lead Royalty Pharma moving forward.
Here, I would usually investigate the historical numbers. However, as I mentioned earlier, it isn't possible because Royalty Pharma has only been listed on the stock exchange since 2020. However, I can investigate their debt. I would like to see a business having a reasonable debt that can be paid off within 3 years. I do this by dividing the total long-term debt by current earnings. Doing the calculation on Royalty Pharma, I can see that Royalty Pharma has 11,45 years of earnings in debt. It is much more than I would like, and while it didn't exclude me from investing in Royalty Pharma, it is something that needs to be monitored.
Based on my findings so far, Royalty Pharma looks very intriguing. However, all investments come with risks, and the same applies to Royalty Pharma. One risk that always comes with pharmaceutical companies is drug pricing. Lately, we received news about the Reduced Costs and Continued Cures Act, which proposes allowing Medicare to negotiate prices.It is too early to say if it will be approved in Congress and how it will impact pharmaceutical companies in the future.However, drug pricing is not a new topic of discussion, and thus far, the powerful pharmaceutical lobby has prevented any significant impact on the companies. Nevertheless, like for all companies in the sector, it is also a risk for Royalty Pharma. Another risk for Royalty Pharma is that they utilize leverage when deploying their capital. As they use borrowed funds to deploy capital. Royalty Pharma has a high debt for this reason. Using leverage may increase the risk of loss if the asset does not generate sufficient income, particularly due to the additional interest expenses associated with borrowed funds.Using leverage may also impact Royalty Pharma's ability to pay dividends or engage in share buybacks, as it could have an effect on free cash flow. Patent losses are a risk for any pharmaceutical company, including Royalty Pharma. Once the patent expires, the royalties for the therapy will drop significantly. It will drop for two reasons: generic therapies will enter the market and capture a portion of the revenue, while the price of the original therapy will also be reduced. Hence, Royalty Pharma will continuously need to find substitutes for therapies that are nearing patent expiration. Finally, a concentration on Cystic Fibrosis. Royalty Pharma receives approximately 25% of its revenues from Vertex Pharmaceuticals' Cystic Fibrosis franchise (Kalydeco, Orkambi, Symdeko, and Trikafta). Vertex Pharmaceuticals is currently developing a new therapy for Cystic Fibrosis. If this therapy proves to be more effective than Trikafta, it could become the preferred treatment option in the future. This could potentially have a significant impact on Royalty Pharma's business, as they do not have any involvement or stake in the development of this new therapy.
There are also plenty of reasons to invest in Royalty Pharma, though. One advantage of investing in Royalty Pharma is the opportunity to invest in the pharmaceutical sector with reduced risks. The pharmaceutical industry benefits from a number of highly attractive characteristics, including long product life cycles, significant barriers to entry, and non-cyclical revenues. Royalty Pharma focuses on acquiring royalties in approved products or development-stage product candidates that have generated strong proof-of-concept data. It means that by investing in Royalty Pharma, you can avoidthe risks associated with early-stage therapies that may or may not be successful, which other pharmaceutical companies face. Furthermore, Royalty Pharma has no research and development (R&D) or manufacturing expenses. Diversification. While Royalty Pharma generates a significant portion of its revenue from the Cystic Fibrosis franchise, itstill maintains a highly diversified portfolio. They have 35 marketed therapies, including 15 blockbuster therapies, which is higher than the industry average of 9. A blockbuster therapy is a drug that generates $1 billion or more in sales. Another proof of diversification is that through Royalty Pharma, you gain exposure to a wide range of therapeutic areas, spanning across numerous of the largest pharmaceutical companies in the world. High insider ownership. Management wants to align with shareholder interests, which is why executive officers have a 16% ownership stake in Royalty Pharma, compared to less than 1% insider ownership in large-cap pharmaceutical companies. If you include the board and employee ownership of Royalty Pharma, the percentage reaches 32%. High insider ownership typically signals confidence in a company's prospects and ownership of its shares. This, in turn, provides the company's management with an incentive to ensure the company is profitable and maximize shareholder value. Furthermore, CEO Pablo Legorreta has recently announced his intention to acquire up to an additional $50 million worth of stocks, citing the compelling value he believes the shares represent.
All right, we have gone through the business, potential and risk regarding Royalty Pharma, and now it is time for us to calculate a price for Royalty Pharma. In order to calculate price, we will need the numbers that I have explained in the "MY STRATEGY" section of the website, as I do not want to go through the whole calculation here. I chose to use an EPS of 4, which is a bit conservative, as the EPS was $1,60 in Q1 2023. I chose an estimated future EPS growth rate of 10% (management expects to grow the topline by a 10% compound annual growth rate in the next decade), an estimated future PE of 20 (which is double the growth rate, as the historical PE for Royalty Pharma has been higher),and we already have the minimum acceptable return rate of 15%. Doing the calculations, we come up with the sticker price (some call it fair value or intrinsic value) of $51,29. We want to have a margin of safety of 50%, so we will divide it by 2. This means that we want to buy Royalty Pharma at a price of $25,65 (or lower, obviously) if we use the Margin of Safety price.
Our second way to calculate a buy price is the Ten Cap price, which is also explained at "MY STRATEGY". To do so, we need some numbers from their financial statements, keep in mind that all numbers are in millions. The operating cash flow last year was 2.144. They have no capital expenditures or tax provisions. They have 443.166 outstanding shares. Since there are no capital expenditures or tax provisions, the calculation is quite simple. It will be as follows: 2.144 / 443,166 x 10 = $48,38 in Ten Cap price.
The last calculation is the Payback Time. I also described in "MY STRATEGY". With Royalty Pharma's Free Cash Flow Per Share at 4,86 and a growth rate of 10%, if you want to recoup your investment in 8 years, the Payback Time price is $61,14.
I believe that Royalty Pharma is a very interesting company. It gives you the opportunity to have a diversified portfolio across various companies in multiple therapeutic areas. I personally like that it reduces your exposure to industry risks. I do find the rather large debt and their use of leverage in capital deployment to be something that needs to be monitored. On the other hand, we have seen that the management has executed very well in the past. Another concern that I didn't mention in the post is that there has been a significant amount of share dilution since the IPO, which is not something I appreciate. I'm also slightly concerned about Vertex Pharmaceuticals developing a new therapy for Cystic Fibrosis, as it could potentially harm the business of Royalty Pharma if it proves to be more effective. However, there are also many great things about Royalty Pharma. You can gain diversified exposure to an attractive sector with lower risks. It is also encouraging to hear that the CEO will buy shares, even though we already see a high level of inside ownership. I already own shares of Royalty Pharma, and I am considering increasing my position if the stock drops below $30. I find that valuation to be attractive.
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Some of the greatest investors in the world believe in karma, and to receive, you will have to give (Warren Buffett and Mohnish Pabrai are great examples). If you appreciated my analysis and want to get some good karma, I would kindly ask you to donate a bit to the Grevy's Zebras. These are rare zebras that are known for their larger size and round Mickey Mouse ears. There are only 3.000 of these beautiful animals left! If you have enjoyed the analysis and want some good karma, I hope that you will donate a little to the Grevy's Zebra here. Even a little will make a huge difference to save these wonderful animals. Thank you.