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Is the AstraZeneca share price undervalued?

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The excitement of last summer — when AstraZeneca (LSE: AZN) announced positive vaccine trial results — seems a long time ago now. The market is less enthusiastic about the pharma giant now. The AstraZeneca share price has now fallen by 25% from the 10,120p high seen last July.

I reckon Astra’s share price reflects wider concerns about the company. But I’m starting to think that the stock may have dropped far enough. For the first time in a while, I’m thinking about buying AstraZeneca shares for my portfolio.

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What I like

Anyone following the news headlines could be forgiven for thinking that the Covid-19 vaccine is key to AstraZeneca’s future profits. It isn’t. The company’s most important products are specialist medicines in areas such as cancer, heart disease, and respiratory illness. Vaccines are not big business for the Anglo-Swedish company. In any case, CEO Pascal Soriot has promised not to profit from the Covid-19 vaccine during the pandemic.

Since Soriot took charge in 2012, AstraZeneca has invested heavily in new product development and acquisitions. Astra was playing catch-up, but Soriot’s strategy finally seems to be paying off.

In 2020, AstraZeneca’s sales rose by 10% to $26,617m. Pre-tax profit rose by 150%, from $1,548m to $3,916m.

City analysts’ consensus forecasts suggest that Astra’s sales will rise by a further 15% in 2021, and by 13% in 2022. This should be paired with a sharp rise in profits and cash generation.

I’ve avoided AstraZeneca shares for a number of years because of the group’s rising debt and falling profits. But I do believe the business has returned to growth and offers a much-improved outlook.

What I don’t like

I still have some concerns about this business. AstraZeneca’s share price has risen steadily in recent years, even though Soriot’s plan has been half-finished at best. That’s left the stock looking expensive to me.

Although last year’s results were much improved, there were still some serious weaknesses, in my view. One concern for me is that less than half the firm’s adjusted profits were converted into surplus cash, known as free cash flow. I often use this as a test of earnings quality — companies with good quality accounting earnings should convert most of them into cash.

As a result, my analysis suggests that AstraZeneca’s dividend has not been covered by free cash flow since 2014. That indicates the company may have used borrowed cash to support the payout. That’s not ideal, in my view, as it leaves shareholders at greater risk of a cut.

AstraZeneca share price: on the up?

I reckon that AstraZeneca shares overheated last summer and were due a correction. The stock is now down by 25% from its all-time highs, so is it now cheap?

Looking at recent performance and forecasts for the next couple of years, I think that AstraZeneca’s share price is now fair. I don’t yet think the stock is undervalued, but I reckon any further falls could leave the stock looking quite cheap.

The $39bn acquisition of US firm Alexion is expected to complete later this year. Management expects this rare diseases specialist to deliver “double-digit revenue growth through 2025”, resulting in strong cash flow.

AstraZeneca is on my watch list for further research. I’m not rushing to buy, but I wouldn’t be too uncomfortable adding the stock to my long-term holdings at current levels.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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