Warren Buffett just bought Royalty Pharma, should you buy it as well?
Warren Buffett bought Royalty Pharma in the third quarter in 2021. When one of the greatest investors of all time opens a position in a company, it gets a lot of attention. I have investigated the company and here are my thoughts.
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 than others, as while Royalty Pharma was founded in 1996, it didn't IPO 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 %, which is what we require. Despite their new IPO, I still think it makes sense to value the company based on fundamental analysis, instead of doing a discounted cash flow. Hence, this analysis will use the frame as my usual analyses but without the historical numbers.
Royalty Pharma is different from the other pharmaceutical companies I have written about. Their business model is that instead of developing their own drugs, they buy royalties in drugs, it could be newly approved drugs that are early in their life cycles or late-stage development drugs. If you would like to understand more about how royalties work, I will recommend that you read page three in their annual report, as I don't want to go too much into details in this analysis. It means that they can benefit from many of the advantages in the pharmaceutical industry such as long product life cycles, significant barriers to entry and non-cyclical revenues, while having a 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, as other pharmaceutical companies. In their portfolio they have more than 45 commercial products and with their newly strategic funding partnership, they now also have nine development stage drugs in their portfolio. If you regularly read my posts here, you will know some of the drugs in their portfolio, as they receive royalties from the cystic fibrosis franchise of Vertex Pharmaceutical 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 Sqiubb. Their portfolio is very diversified, and they have exposure to several therapeutic areas such as 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 aboard all the way. Personally, I like when founders are in management positions, as they usually have a strong motivation in growing the business, and not only their bank account. He has grown Royal Pharma to be the largest buyer of pharmaceutical royalties. He has gained a vast experience in investing in pharmaceutical royalties with him being involved in the business for more than two decades. Prior to founding Royalty Pharma, he was an investment banker at Lazard Freres, while his is also a co-founder of Pharmakon Advisers. His educational background is a degree in industrial engineering from 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, which is a non-profit organization that is dedicated on enhancing the the quality of health care in Latin America. He has made some some fantastic deals for Royalty Pharma through the years, one of such examples is the the royalties of Humira he acquired for $700 million from AztraZeneca in 2006. 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 compound their cash receipts by 11 % since 2021. It is difficult to find much information about Pablo Legorreta, as he doesn't do many public appearances or many interviews. Nevertheless, I feel very comfortable with Pablo Legorreta being the right person to lead Royalty Pharma moving forward.
Here I would usually investigate the historical numbers but as I mentioned earlier, it isn't possible, as 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 so by dividing the total long-term debt by current cash flow. Doing the calculation on Royalty Pharma, I can see that Royalty Pharma has 5,97 years of debt. It is almost the double of what I would like, and while it doesn't exclude me from investing in a company, it is something that needs to be monitored.
Based on my findings so far, Royalty Pharma looks very intriguing. However, all investments come with a risk, and so does Royalty Pharma. One risk that always comes with pharma companies is drug pricing. Lately, we just had some news regarding the Reduced Costs and Continued Cures Act, which would allow price negotiation by Medicare. It is too early to say if it will get approved in Congress and how it will affect pharmaceutical companies moving forward. However, drug pricing is not a new discussion and so far, the strong pharmaceutical lobby has prevented it to be something that would affect the companies. Nevertheless, as with all companies, it is a risk for Royalty Pharma as well. Another risk for Royalty Pharma is that they use leverage in connection with their capital deployment. As they use borrowed funds to deploy capital, it may increase their risk of loss, if the asset doesn't generate enough income, especially because borrowed funds come with interest expenses. Finally, patent losses also hurt a company like Royalty Pharma. Once the patent expires, it significantly hurt the royalties of that drug due to generics coming to the market. Hence, these patents need to be substituted with new patents.
Luckily, Royalty Pharma elaborated on the risk of lower drug prices in their third quarter 2021 conference call. They said that based on the draft language, it potentially should only affect two drugs (Imbruvica and Xtandi), and if there will be lower drug prices in the United States, they would only "anticipate very little headwind without considering any increase in volume from potentially improved patient access". Regarding the use of leverage, you will need to trust the management on making the right decisions. Historically, the management has made a lot of good decisions as with the Humira example, and when using leverage, it does create an opportunity for an increased return as opposed to not using leverage. Finally, the patent loss/expiration is something all companies in the pharmaceutical sector deal with. Actually, Royalty Pharma experienced a patent expiration in their HIV franchise from Gilead in 2021, and yet the royalty receipts in the latest quarter grew 21 % compared to last year due to growth of other drugs in the portfolio.
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 3, which is a bit higher than the current one but lower than the one in 2020. I chose an Estimated future EPS growth rate of 11 (which I believe to be achievable), Estimated future PE 21,6 (which is the highest historically PE for Royalty Pharma) and we already have the minimum acceptable return rate on 15 %. Doing the calculations by using the formula I described in "MY STRATEGY" we come up with the sticker price (some call it fair value or intrinsic value) of $45,48, and we want to have a margin of safety on 50 % so we will divide it by 2, meaning that we want to buy Royalty Pharma at price of $22,74 (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 2.034,63. They have no Capital Expenditures or Tax Provisions! They have 429,51 outstanding shares. Since there are no capital expenditures or tax provisions, it is a very easy calculation that will be like this: 2.034,63 / 259,43 x 10 = $47,37 in TEN CAP price.
The last calculation is the PAYBACK TIME. I also described in "MY STRATEGY". With the Free Cash Flow Per Share at 3 and a growth rate of 11 %, if you want your purchase back in 8 years, the PAYBACK TIME price is $37,65.
I believe that Royalty Pharma is a very interesting company. It gives you the chance to get a diversified portfolio in different companies in several therapeutic areas. I personally like that it gives you a reduced exposure to industry risks. I do find the rather large debt and them using 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 quite a lot of insider selling lately, which is never a good sign. On the other hand, it probably comes after a lockup period after the IPO of June 2020. One positive thing I didn't mention in post is the huge margins that Royalty Pharma has, which makes me even more intrigued about the company. I wish I could have got in on the IPO price of $28 but I would definitely open a position at the PAYBACK TIME price at $37,65 as it would give me a 50 % discount on two out of three calculations. I might even open a smaller position before that, as it can still be bought below the TEN CAP price.
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I hope that you enjoyed my analysis. Unfortunately, I cannot do a post of all the companies I analyze. I am available to copy but if you do your own trades, you can follow me instead or check out my portfolio every now and then.
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.