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Morningstar | Chugai's 2018 Earnings Strong as Expected; Raising FVE to JPY 6,000 on Change in WACC

Chugai Pharmaceutical announced 2018 earnings that were in line with our expectations. We are transferring coverage to a new analyst and raising our fair value estimate to JPY 6,000 per share from 4,820. This is primarily due to an update to Morningstar’s cost of equity assumption for Japanese stocks. We maintain our narrow moat and stable moat trend ratings.

The earnings metrics were broadly in line with our expectations. Revenue growth was 8.5% versus our estimate of 7.6%, primarily due to higher royalties and other income in the fourth quarter. Operating margins for the full year were 21.4% versus our estimate of 19.8%, due to the aforementioned royalties (which improves gross margins), lower sales and distribution expenses, and lower research and development spending. Management’s forecasts for 2019 indicate top-line growth of only 2.2%, which we think is quite conservative, and a JPY 12.6 billion increase in royalties and other income (mostly from Hemlibra royalties), which could improve gross margins by 200-300 basis points.

The primary reason for the fair value estimate increase is our lower assumption for weighted average cost of capital; we reduced our WACC to 6% from 7% to reflect Morningstar’s most recent update to our cost of equity for Japanese stocks. This is partially offset by a modest reduction in revenue forecasts, lowering our estimate for the next 10 years from a 5.5% compound annual growth rate to 4.7%.

Regarding specific developments in the portfolio, immunology drug Actemra and lung cancer drug Alecensa continued to show strong growth in the overseas market, with annual sales to Roche growing 33.9% and 36.1%, respectively. In-house hemophilia drug Hemlibra and Roche’s PD-L1 inhibitor Tecentriq both enjoyed approval progress this past quarter. Hemlibra was approved by the U.S. Food and Drug Administration in October 2018 for the noninhibitor hemophilia A population, an important milestone since this group is much larger than patients with inhibitors. While uptake is expected to be slow due to the conservative patient base, overseas sales via Roche will likely be a key revenue driver within a few years. In December 2018, Tecentriq was approved in Japan as a first-line combination therapy (with Alecensa) for non-small-cell lung cancer and filed for approval as a first-line treatment for SCLC (a much smaller lung cancer population compared with NSCLC) and a first-line treatment for triple-negative breast cancer. Additionally, it is expected to file for a number of other line extensions in 2020. Finally, SA237 (satralizumab) completed a phase 3 trial for treatment of neuromyelitis optica spectrum disorder, an ultra-rare autoimmune disease, and received breakthrough therapy designation from the FDA. While SA237 is not expected to be a blockbuster, this is the seventh breakthrough therapy designation that Chugai has received for an in-house drug, which speaks to the strength of its research platform.

We reaffirm our narrow moat and stable moat trend ratings. We continue to believe that Chugai’s internal research platform and access to Roche’s innovative portfolio will allow it to maintain its leadership in Japan’s oncology and therapeutic antibody markets. The main limitation of its moat is the company’s concentration in Japan. Approximately 80% of its revenue is derived from domestic sales, and it is likely that Japan’s single-payer system will continue to implement cost-cutting measures to combat slow economic growth and aging demographics. These include encouragement of generic and biosimilar substitution, more stringent review of efficacy, biennial price cuts, and additional ad hoc price cuts.