Some weeks having passed since Pfizer finally gave up on its bid for fellow pharmaceutical giant AstraZeneca, The Value Perspective feels able to attempt something truly shocking and we hope you will forgive us. Rather than considering the deal’s implications for, say, employment or UK plc or the aspirations of certain politicians, we want to analyse what it would have meant for shareholder value.
Controversial, we know, but bear with us and let’s see where this leads. What we are going to do is imagine we are shareholders in Astra – actually, no imagination is necessary since we have been invested in it for some time – and then think what we would be assuming about the future were the business trading on a range of stand-alone share pieces.
As it happens, the management team at Astra have actually come up with a very explicit profits forecast for the next decade, which leaves The Value Perspective a little unsure about what to think. On the one hand, in a business with such a long lead time – it takes ages to invest and test new drugs – a 10-year planning cycle seems eminently sensible and so you have to give them credit for effort.
On the other hand, however … well, regular visitors to this site will be well aware of our belief long-term forecasts are not worth the cartridge paper on which they are laser-printed. Nor was our scepticism in any way reduced by the discovery Astra’s management has now been making these 10-year forecasts for quite some time.
After all, if you have the huge advantage of actually being on the inside of a pharmaceutical business and therefore knowing which drugs you have in your pipeline, you presumably should be able to flag up in any half-decent 10-year forecast whenever your sales look like collapsing as the result of, say, an upcoming patent cliff. And if Astra ever did that, The Value Perspective never received the memo.
All of which suggests we ought to be quite cautious when dealing with a pharma-oriented future but, hey, let’s throw caution to the wind and assume Astra’s current 10-year forecast is spot-on. Yes, the psychology of the bid situation suggests it may be a tad optimistic – as a rule, bid targets tend to put everything but the kitchen sink in the shop window – but let’s say they nail it. What can we assume?
Well, we can assume – because that is what Astra tells us – that sales in 2023 will be $45bn (£27bn). We also know that, historically, drug companies enjoy around 30% profit margins. Some – Pfizer, for example – manage more and Astra might argue it will too but investing in your future drug pipeline for the next decade is an expensive business so let’s keep to that figure of 30%.
Let’s also assume that, over this period, AstraZeneca pays out about half its cashflows to shareholders as dividends and that, come 2023, it is sold at 12x operating profits. Maybe that is a little cautious –12x is, historically, an average sort of a multiple for what we would consider a better-than-average business – but, then again, we have thrown caution to the wind everywhere else in our assumptions.
At this point, we are almost in a position to calculate an ‘IRR’ – an internal rate of return – where we can work out what return we would make every year between now and 2023 should Astra deliver on everything it has promised and its 10-year forecast comes perfectly true. All we need now is a share price – or, for the purposes of this article, four share prices.
Pfizer’s original bid valued Astra at £46.60 a share. If Astra were to hit all its forecast targets between now and 2023, then that price equates to its shareholders enjoying a return of about 11.5% a year over the next decade. Historically, equities have made around 8% a year over the longer term so there is a decent margin of safety built in should we happen to have been wrong with some of our assumptions.
Pfizer’s next bid upped the valuation to £50 a share so how does that affect our maths? Well, it brings the annual return down to about 10%, which is obviously still ahead of that 8% equity return but, just as obviously, gives us a lot less margin for error. We would need to be very sure of our assumptions – and we have already suggested a few reasons why we might not want to bet our mortgage on them.
Before it gave up on Astra – at least for the time being – Pfizer’s final bid valued the business at £55 a share, which equates to an annual return of just over 8.5% for the perfect execution of a 10-year plan. At the £58.50 a share Astra said it wanted, meanwhile, you are assuming a sub-market return for a hiccup-free decade. All these numbers got rather lost in the heated debate that engulfed the deal.
We are back here to the tension between the ‘inside’ and ‘outside’ views discussed in articles such as Picture imperfect and Pep talk. on the inside, astra’s management clearly feel they have reason to be optimistic about the business’s pipeline and prospects. on the outside, however, bitter experience has taught investors that the road to drug discovery is paved with disappointment.
as such, we would be inclined to argue £55 a share represented an attractive price for astrazeneca and one that deserved greater consideration than it apparently received. certainly we are disappointed astra’s management were unwilling to explore the offer in more detail with pfizer so they might better understand what assumptions had been used to reach that figure and thus begin a more rational debate on its suitability. in the end, shareholder value always comes down to numbers and, in this instance; the numbers suggest to us that astra’s management may have missed a trick.