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Royalty Pharma: The Time Has Come

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Pharmaceutical industry and drug manufacturing
Pharmaceutical industry and drug manufacturing

Within the realm of pharma investments, Royalty Pharma plc (NASDAQ:RPRX) has emerged as an intriguing choice. This company offers a unique business model centered around a diverse portfolio of royalties obtained from biopharmaceutical therapies. As the world’s largest purchaser of pharma royalties, Royalty Pharma has collaborated with global pharmaceutical companies, academic institutions, small/mid-cap biotech players, and non-profit organizations. It went public in June 2020 with an initial stock price of $28.00 per share.

Despite solid execution, unchanged business fundamentals, and strategic capital deployment for diversification, Royalty Pharma’s stock price has dipped by 32.67% this year. Before delving into the upside potential, we must address the negative aspects of the company and our forward-thinking estimates:

  1. Royalty Pharma’s revenue growth rate is declining. Based on our analysis, the company’s adjusted cash receipts saw growth rates of 18%, 10%, and 9% for 2021, 2022, and 2023, respectively. However, during this year alone, Royalty Pharma has announced transactions worth over $1.7 billion.
  2. Inflation expectations and higher interest rates are eroding the net present value of Royalty Pharma’s royalties and negatively impacting the business.
  3. The impact of individual retirement account (IRA) regulations might cause general investors to reallocate funds away from pharmaceutical corporations. However, Royalty Pharma expects only a slight reduction in adjusted cash receipts due to this effect.
  4. A significant contributor to Royalty Pharma’s receipts has been the Vertex franchise, which focuses on cystic fibrosis therapies. This franchise accounted for 33% of Royalty Pharma’s adjusted cash receipts in Q2 2023. While the cystic fibrosis drug’s patent is set to expire in 2037, Vertex has a new application in Phase 3, which, if approved, may limit Royalty Pharma’s earnings. Despite this, Royalty Pharma’s founder and CEO remains confident in the company’s patent position. Our analysis suggests that a complete transfer of the cystic fibrosis franchise to Vertex would result in a $300 million reduction in adjusted cash receipts and a negative net present value of 20%.
  5. In the past, there was some investor concern about Royalty Pharma’s dividend yield. However, the current yield of around 3% aligns with the average in the Big Pharma sector, making this concern less significant.

Reasons to Consider Royalty Pharma as an Investment

  1. Building on the points mentioned above, Royalty Pharma has recently acquired two new royalties. These agreements, valued at $150 million and $300 million respectively, highlight the company’s strong momentum for sales growth. The deals involve Ascendis and Ferring’s Adstiladrin, which show Royalty Pharma’s leadership position in the industry. The former agreement is expected to generate an internal rate of return (IRR) of 12-15%, with estimated sales between 2025 and 2031 reaching $248 million. Details of the latter agreement are more complex, with an upfront payment of $300 million and an additional $200 million milestone payment upon achieving manufacturing goals in late 2025. Adstiladrin, a drug approved in December 2022 for the treatment of bladder cancer, has significant blockbuster potential. Royalty Pharma will receive royalties ranging from 5.1% to 8.0%, depending on the investment tranche.
  2. In support of our investment thesis, Royalty Pharma has been actively deploying capital in high-quality assets while increasing the duration of its royalties portfolio. These strategic moves aim to boost future adjusted cash receipts and diversify risks.
  3. In terms of valuation, Royalty Pharma’s shares have already factored in the worst-case scenario. Despite the risks associated with the Vertex franchise and expiring patents, the company’s stock price reflects these concerns. Additionally, Royalty Pharma has ample opportunities to fund biopharmaceutical innovation due to its lower cost of capital and substantial cash reserves (around $2.2 billion as of June 2023).
  4. Royalty Pharma has not only demonstrated its commitment to shareholders through a dividend yield in line with the industry average but also through a $1 billion share buyback program announced in March. This buyback initiative has already seen the repurchase of 6 million shares, equivalent to approximately $186 million in value. With a current buyback yield of 5%, Royalty Pharma presents an investment opportunity with a potential return of around 8%.

Conclusion and Valuation

While Royalty Pharma’s shares may lack a short-term catalyst, the valuation is becoming increasingly attractive. With projected growth between 6% and 10%, resulting in cash receipts of $2.9 to $2.975 billion, Royalty Pharma offers a compelling investment opportunity. Even considering the potential positive outcome of Vertex’s readout, it’s important to address the patent expiration in 2037. A resolution must be found to ensure long-term visibility on contracts. Nonetheless, Royalty Pharma appears well-protected by its intellectual property rights. Despite the stock’s ongoing struggle, we initiate coverage of Royalty Pharma with a buy rating and a price target of $42 per share.

Evaluating Royalty Pharma’s valuation in comparison to pharma peers, we note that a 2024 EV/EBITDA multiple of 12x is common in the industry. Royalty Pharma, with a multiple of 9.02x, affords investors a margin of safety. Notably, Royalty Pharma boasts a higher margin, higher free cash flow yield, lower operational risk, and reduced risk associated with individual retirement accounts (IRAs). To further inform our analysis, we also consider other royalty companies. Typically, these entities trade at a premium compared to their respective sectors. For instance, in the oil and gas and mining sectors, royalty companies trade at higher price-to-earnings multiples compared to major corporations. We believe Royalty Pharma’s current P/E of 7x, while the industry is valued in double digits, is unjustified. Thus, we reaffirm our buy rating.

Figures and images sourced from Royalty Pharma Investor Presentation and Annual Report.

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