This FTSE 100 company has trebled earnings and dividends since 2001 yet trades on a P/E of 8.
Today I'm looking at a company whose shares trade at a PE ratio of just over 8, yield about 5% and has almost trebled its earnings per share and dividends since 2001. It's AstraZeneca (LSE: AZN), the multinational pharmaceutical company. To quote Del Boy, lovely jubbly!
Hang on, I hear you say. Isn't British manufacturing in terminal decline? Well, much of the doom and gloom about the manufacturing sector comes from some politicians who, when not fiddling their expenses and cheating on their taxes, whine nostalgically about the so-called golden days of British manufacturing. Those were the days when many firms gleefully fobbed off sub-standard products onto a captive public.
British manufacturing today increasingly relies on brainpower, not horsepower, and AstraZeneca is a prime example of a high technology high value-added manufacturer.
AstraZeneca's main competitors are other pharmaceutical multinationals such as GlaxoSmithKline (LSE: GSK), America's Pfizer, Switzerland's Novartis and Germany's Bayer. Competition also comes from many smaller generic drug manufacturers all over the world.
The pharmaceutical industry has historically been well-protected from economic downturns because people will generally maintain their spending on drugs, preferring to cut their other spending. Furthermore the aging of the developed countries' populations combined with the increasing affluence of many developing nations will continue to increase the demand for drugs even as public health budgets are being pressurised.
A look at the accounts
AstraZeneca's publishes its accounts and declares dividends in US dollars. In 2008 the dividend increased by 9.6% from $1.87 to $2.05, but thanks to the strengthening of the dollar in 2008 the increase in sterling terms is an eye-catching 42.6% (93p to 132.6p). Earnings per share were $5.10, up 8%. When looking at AstraZeneca, it's best to think in terms of dollars, not pounds.
A 9.6% dividend increase is extremely good in times of economic uncertainty and shows management's confidence in the business outlook. Compare this to the many companies who have either slashed or eliminated their dividends, especially firms which disguise the cut using weasel words such as "…rebased the dividend".
So where's the catch? Surely investors prefer companies which show strong growth in earnings and dividends? It's not the pension scheme, the deficit is relatively low in comparison to the company's market value and nothing particularly leaps out from the accounts. This needs further investigation…
See you in court
A quick summary: AstraZeneca's low P/E ratio and high-yield is mostly due to the combination of soon-to-expire patents, litigation risk and the uncertainties of ongoing research and development (R&D).
AstraZeneca is the subject of several government investigations and is the target of and the instigator of several large patent infringement lawsuits. That's the nature of the pharmaceutical business; you constantly have to be on the lookout for competitors selling products that are suspiciously similar to your patented products. Sometimes a company spends a fortune to develop a product only for the regulator to stop you from selling it and occasionally a successful product turns out to have harmful side-effects several years after it has been on sale resulting in lawsuits and bad publicity.
Okay, so when I said that "nothing particularly leaps out from the accounts", I meant to say that "for a pharmaceutical company, nothing particularly leaps out from the accounts". Every pharmaceutical major experiences similar problems -- you'll see patent lawsuits and regulatory issues mentioned in the accounts of any member of "Big Pharma."
The Fire of Genius
As Abraham Lincoln famously put it in his 'Fire of Genius' speech, patents "…added the fuel of interest to the fire of genius, in the discovery and production of new and useful things."
At the heart of a pharmaceutical company is patent law ("patent" is mentioned at least two hundred times in AstraZeneca's 2008 accounts; I stopped counting part way through!). Pharmaceutical companies depend on their lawyers as strongly as on their scientists; litigation protects their patents and thus their profits. It's all part of the cost of doing business.
A patent grants a legally protected monopoly for about twenty years so that the company can sell the drug at prices which cover its huge R&D costs. It is often said that the first pill costs a billion to make but the second pill only costs a few pence. The massive R&D costs don't seem to stop those politicians and celebrities who sometimes berate pharmaceutical companies for refusing to sell their products at the manufacturing cost. Whenever you hear someone bashing a pharmaceutical company's patents there's a simple equation to remember. No patents = no R&D = no new drugs = bad for people's health.
As patents are applied for at an early stage of the development process, well before the regulators approve the product, the company may find that once it starts selling a new drug it has less than a decade to recover its costs before the patent expires. As soon as your patent expires, generic manufacturers will pounce like a pack of wolves, selling their own version thus causing your profits to evaporate.
The stock market pays a lot of attention to patent expiration. An oft-quoted figure is that anything up to 39% of AstraZeneca's sales are for a variety of drugs that lose their patent protection by the end of 2012, which explains some investors' concerns. Thankfully AstraZeneca has a reasonably good pipeline of new drugs awaiting regulatory approval.
Firms can to some extent protect themselves from patent expiration in several ways. One way is to launch a successor drug which performs similarly and which is protected by new patents. Another is to reach for the lawyers, suing anyone who looks remotely like they're breaching your patents and trademarks, or perhaps producing your own generic version of a drug that has just gone 'off-patent' so as to ward off the generic manufacturers. AstraZeneca, and all other major pharmaceutical companies, employs some of these methods and a few more besides.
To sum up AstraZeneca is a share for both income and growth, for those of us who are prepared to accept the uncertainties inherent in the pharmaceutical industry.
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> Tony owns shares in both AstraZeneca and GlaxoSmithKline.
