Pharmaceutical giant Shire’s (LSE: SHP) results slightly exceeded analyst expectations last week, but the biggest news was that the company wouldn’t undertake any new acquisitions until the end of 2017. After a $10bn shopping spree last year and the $32bn takeover of Baxalta this year, this will allow time to integrate new purchases and move forward with aggressive plans to shift its focus to rare disease treatments. The plan to become the world leader in rare disease drugs holds significant long-term potential as these drugs generally have little competition, very high margins, and governments regularly fast track regulatory approval. With roughly 7,000 rare diseases existing and treatments for fewer than 10%, Shire has a huge market to tap going forward.
The shares are trading at 11 times forecast 2016 earnings, reflecting substantial worry in the City over the cost of the Baxalta acquisition. While this deal will send net debt to an eye-watering $25bn, Shire has a long history of successfully and quickly paying down debt. With free cash flow of $2.2bn last year, this debt level shouldn’t scare off investors. Shire holds significant potential for long-term investors in my eyes, and at current valuations I believe the shares are a relative bargain.
Bad news today, better news tomorrow?
Thursday’s release of full year results at Rolls-Royce (LSE: RR) gave us a raft of bad news, including a dividend cut, a significant drop in profits and forecasts for further poor results this year. Despite this, the shares finished 18% higher by the end of the week. While part of this was surely a short squeeze, many traders were heartened that Rolls didn’t announce yet another profit warning, of which there have been five in the past two years. Furthermore, the stabilisation of revenue, which was only down 1%, lent credence to new CEO Warren East’s plan to quickly right the ship and return to growth in 2017. A significant portion of this plan is to shrink management headcount and simplify the bloated organisational structure, which activist investors have been calling for over a number of years.
There are other activist investor plans that could drastically improve Rolls’ long-term outlook. One of the first areas to look at would be the possible sale of the marine engines division, where gross margins are the lowest in the group. CEO East has so far resisted this call, but falling revenue and profits due to declining orders from oil & gas producers could change his mind eventually. Meanwhile, in the core civil aerospace division, margins are considerably lower than they are at chief competitor GE. GE tackled high costs by simplifying its supply chain and moving production in-house in many instances, two actions that could significantly improve margins.
If management were to implement these plans, I believe share prices could rise sharply. With a virtual duopoly in wide-body engines, capital expenditure falling as a new generation of engines goes into service, and concrete paths to improved profitability, I believe investors with a long time horizon would be well served by taking a closer look at Rolls Royce.
