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The Hidden Nasty In AstraZeneca plc’s Latest Results

AstraZeneca (LSE: AZN) (NYSE: AZN.US) is a firm that I rate highly, but I recently discovered a ‘hidden nasty’ in the firm’s operations, which I feel potential shareholders should be aware of.

In this case, the problem isn’t financial — indeed, Astra’s balance sheet, which has minimal debt and plenty of cash, looks much more attractive than GlaxoSmithKline‘s debt mountain.

However, Astra’s earnings keep falling, as key products lose patent protection without being replaced by new products. My hidden nasty suggests that Astra is going to have to do some serious spending if it is to overcome this challenge in the next couple of years.

Phase lag

When a pharmaceutical company develops a new medicine, it goes through three sets of trials — phase 1, phase 2 and phase 3.

The majority of phase 1 and 2 trials don’t result in products that make it through to production, so as investors, it makes sense to concentrate our attention on phase 3 trials, around three-quarters of which do result in commercial products.

I’ve taken a look at the latest published pipeline documents for both AstraZeneca and Glaxo, and I’ve noticed what I believe to be a significant difference.

Approximately 30% of Glaxo’s current clinical trials are in phase 3, compared to just 15% of Astra’s.

When you consider that even after a successful phase 3 trial, medicines require regulatory approval, and can take several more years to reach the market, you can see what a mountain AstraZeneca has to climb in order to replace core products such as Nexium and Seroquel IR.

The fact that such a small proportion of Astra’s trials are in late stages is worrying for future revenues, and to me, this suggests that Astra’s pipeline is lagging significantly behind that of Glaxo.

Worth the wait?

AstraZeneca currently trades on a forecast P/E of 11.7 and offers a prospective yield of 4.8%. I think that’s an appealing valuation, despite the fact that Astra’s earnings per share are expected to fall by a further 9% this year, placing it on a 2014 forecast P/E of 12.8.

As a long-standing Glaxo shareholder, I’m going to sit tight, but if I were starting afresh today, I would almost certainly choose to invest in AstraZeneca, thanks to its strong balance sheet and cheap valuation. Over the medium term, history suggests that these attributes will provide above-average returns.

A dividend for life?

Astra's 4.8% prospective yield is one of the main attractions for potential buyers, but the firm's payout has not risen significantly since 2011, and is also expected to remain largely flat this year.

As a result, high-yielding Astra could fail one of the five 'golden rule' dividends tests detailed in a new Motley Fool special report, "How To Create Dividends For Life". To see whether the UK's second-largest pharmaceutical firm passes the other four tests, click here to download your free copy of this valuable report immediately.

> Roland owns shares in GlaxoSmithKline but does not own shares in AstraZeneca. The Motley Fool has recommended shares in GlaxoSmithKline.