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Earnings Drop 16% At AstraZeneca Plc

AstraZeneca (LSE: AZN) (NYSE: AZN.US) reported a 4% drop in revenue in the third quarter, but spending on replenishing the company’s drug pipeline meant operating profits dropped 29% and reported earnings per share were down 16%.

AstraZeneca is currently being buffeted by a series of branded drugs losing their patent protection – part of what is being called the pharmaceutical’s patent cliff which is expected to cost companies tens of billions of dollars annually for the next few years — and seeing lower-priced generics rush in to take their business.

The loss of sales to generics is one reason AstraZeneca’s earnings are expected to decline this year and next.

Not just sitting by

The patent cliff hasn’t really caught anyone by surprise, and AstraZeneca’s shares have trailed the market over the past three years as investors waited to see how the company would react.

AstraZeneca has reacted by investing in its drug pipeline and cutting costs. The current round of restructuring is expected to provide nearly £500 million in annual savings by 2016.

While trying to become more efficient the company hasn’t lost sight of its research needs, spending more than £2.5 billion annually on R&D each of the past three years and has spent another £2.1 billion so far this year. This research is making progress as two cancer treatments and an asthma treatment have moved into Phase III trials (the final stage before regulators give them the thumbs up or thumbs down) in the past two months.

In addition, it has been buying up other people’s research. The company’s biologics arm, MedImmune, has announced two acquisitions since August in an effort to build out its cancer-related treatment portfolio.

How long?

Of course, investors don’t generally like to see their companies wasting away and it takes patience to see a company through the long drug approval process. Admittedly, AstraZeneca’s pipeline management hasn’t been the best and it will take time to recover.

The company has attempted to tide investors over by returning their cash to them via dividends — the shares currently offer an impressive 5.5% dividend yield — and buying back shares — nearly £7 billion have been spent since 2010 to buy back 13% of the company’s shares.

Unfortunately, with falling profits AstraZeneca has less cash to spend on these returns and last year’s returns outstripped free cash flow by over £600 million. So far this year — with no share buybacks — the dividend payments have not been covered by free cash flow.

AstraZeneca’s balance sheet is relatively healthy with a modest debt load so this trend could be continued for some time, but eventually the company will need to see new products reverse the decline in sales. For investors the question is: When will this happen?

AstraZeneca’s dividend yield looks very attractive in today’s market, but income seekers need to determine how sustainable that dividend income is before making an investment. I don’t think AstraZeneca will have trouble maintaining its payments to shareholders in the near term, but if sales continue to slide it could become an issue.

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> Nate does not own shares of AstraZeneca.