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Morningstar | Takeda’s 3Q Earnings Strong, Upgrading to Narrow Moat on Change of Coverage. See Updated Analyst Note from 06 Feb 2019

Takeda’s earnings were strong this quarter, driven by strong margin expansion and continued growth of its key drugs. Its R&D progress was mixed but fairly inconsequential. At the same time, we are transferring coverage to a new analyst, and have decided to upgrade its moat rating to narrow in consideration of Shire’s assets and global footprint. Finally, we are maintaining our fair value estimate of JPY 5,100 per share. While we raised our WACC due to the more global nature of Takeda’s business, this was offset by better margin assumptions.

The company reported significant margin improvement, with underlying core margins expanding by 530 basis points from last quarter, and 370 basis points of it (70%) attributed to cost savings from its Global OPEX initiative. Operating margins are now 20.6% year-to-date, which is a massive improvement over last year’s 13.7%. Additionally, the two most important drugs in Takeda’s portfolio both exhibited healthy growth, with Entyvio growing 38% year over year and Ninlaro growing 33%. This was somewhat tempered by a 22% drop in consumer healthcare, which raises the question of whether management will be able to find a buyer for this noncore business.

There were a few incremental updates on its R&D pipeline this quarter. Most notably, Takeda withdrew Ninlaro’s (multiple myeloma) application for usage in a maintenance setting after stem cell transplant. The FDA wanted more data on overall survival, or OS, which Takeda currently does not have, and management did not have a timeline on when they would be able to resubmit. This delay is unfortunate, because while economic opportunity exists in the maintenance treatment market, it could disappear when generic copies of Revlimid (the market leader) enter the market (potentially 2022). This is especially true if clinical results from MM4 (Ninlaro in a nontransplant maintenance setting) do not prove to be superior.

On a positive note, management reported that TAK-003 (Dengue vaccine) met the primary endpoints of its Phase 3 trial. While we do not expect this drug to be a material driver of the firm’s value, it is a small positive and reflects well on Takeda’s research productivity.

In terms of strategy, management has indicated they will be focused on integrating Shire, such as realizing synergies and retaining key talent, and are unlikely to consider more acquisitions for the time being. Growth will continue to be driven by new drugs such as Ninlaro, Entyvio, Trintellix. Upcoming data points include Shire’s earnings (mid-February) and pro forma guidance from management (May).

After reconsidering Takeda’s portfolio and market position after the Shire acquisition, we upgrade our moat rating to narrow from no-moat due to intangible assets. Shire provides Takeda with strong assets in ultra-rare diseases and plasma-derived therapies, which we consider to be well protected from competitive threats, as well as a truly global footprint that allows it to diversify away from the cost-cutting policies of Japan’s single-payer market. We are optimistic that management can realize its targeted synergies, and in the long-term believe that the new portfolio and broader geographic presence afford Takeda a better competitive position.

Finally, our fair value estimate is unchanged at JPY 5,100 per share. We raised our WACC assumption from 7.4% to 7.8% in order to account for the more global makeup of Takeda and Shire’s combined businesses. However, this is offset by an increase in operating margin assumptions from 28% to 30% at the end of our 10-year forecast, which we believe is supported by management’s progress in cost-cutting over the past two years, as well as the reasonable synergies they have identified.