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Morningstar | Takeda’s 4Q IFRS Earnings Lower than Expected, but Core Earnings Strong and Guidance in Line

Takeda reported full-year earnings with lower-than-expected IFRS numbers, but better-than-expected core earnings after removing the one-off cash charges from acquisition-related costs, and non-cash costs from purchase accounting. Additionally, management gave updated guidance on synergies and cost-cutting initiatives that is in line with our positive view of the company’s long-term margin expansion ability. We are reviewing our model but we do not expect a major change in fair value.

Takeda reported net income of JPY 109 billion, which is a 42% drop compared with the previous year. However, after excluding acquisition-related costs of JPY 185 billion and non-cash impact from purchase accounting (due to inventory step-up and higher amortization of Shire’s intangible assets), Legacy Takeda’s full-year core earnings grew 21.9% and Legacy Shire’s grew 42.4%.

Core earnings margin improved 540 basis points for Legacy Takeda, of which 400 basis points was from its OPEX cost savings program. The company also revised its cost savings guidance upwards to USD 2 billion (6.6% of pro forma 2018 revenue) of annual savings starting in fiscal year 2021, from its initial guidance of USD 1.4 billion (4.6% of pro forma 2018 revenue) provided last May. As a result, management believes they can improve core earnings margin from 22% reported this year to mid-20s, which is in line with our view of Takeda’s margin improvement opportunities.

The market has reacted negatively, and the stock trades at a 22% discount to our fair value. We believe this is because of the low IFRS headline numbers, which will continue to be dragged down by higher (but non-recurring) acquisition-related costs for the next couple of years, and non-cash amortization expenses from purchase accounting. However, in our view, the company’s margin improvement opportunities outweigh these effects, and we see value at current market levels.

While the company’s cost savings guidance improved, this was partially offset by an increase in estimated implementation costs, which rose modestly to USD 3 billion cumulative to fiscal year 2021 (9.9% of pro forma 2018 revenue), from USD 2.4 billion provided last May (7.9% of pro forma 2018 revenue). Management indicated 90% of these costs would be incurred by the end of fiscal year 2020. We believe these near-term costs will be more than offset by long-term margin improvement from synergies.

IFRS expenses will remain significantly elevated due to non-cash expenses from purchase accounting. The estimated impact for fiscal year 2019 is JPY 692 billion, or 21% of fiscal year 2018 pro forma revenue. Inventory step-up will unwind over two years and is estimated to be JPY 250 billion for fiscal year 2019 (7.6% of fiscal year 2018 pro forma revenue), and Shire’s intangibles will amortize over 10 years and is estimated at JPY 439 billion for fiscal year 2019 (13.3% of fiscal year 2018 pro forma revenue).

We are still reviewing our model and will have an update shortly. We do not expect a major change in valuation, as our forecast changes are likely to only affect the next few years.