MSc in Finance and International BusinessMaster Thesis 2012
Registration: August 1st 2011
Submission: January 3rd 2012
Author: Selma Palic
Academic advisor: Baran Siyahhan
Aarhus School of Business and Social Sciences
Aarhus University
Department of Economics & Business
Winter 2012
The table of contents
1.Introduction
1.1.Motivation
1.2.Problem statement
1.3.Delimitations (not done finish after you finish the project)
1.4.Methods (not done finish after the project is done)
1.5.Scope and structure
2.Presentation of H. Lundbeck A/S
2.1.Short history presentation
2.2.The vision, mission and values of the company
2.3.The breakdown of turnover
3.Pharmaceutical Industry and development
3.1.Market(s) definition
3.2.Global pharmaceutical industry characteristics
3.3.Market(s) size, share and growth
3.4.Key factors for success (KFS)
3.5.The future growth markets
4.Strategic analysis
4.1.PESTEL analysis
4.2.Industry analysis Porter’s five forces
4.3.Competitor profiling
4.4.Conclusion in a SWOT framework
5.Reorganizing financial statements
5.1.Accounting issues:
5.2.Capitalized expenses
6.Analyzing historical performance
6.1.NOPLAT
6.2.Invested capital
6.3.Free Cash Flow
6.4.Revenue growth analysis
6.5.Operating performance in the ROIC analysis framework
6.6.The historical stock market performance compared to the peer group
7.Forecasting
8.Estimating cost of capital
8.1.Lundbeck’s capital structure
8.2.Lundbeck’s cost of debt
8.3.Lundbeck’s cost of equity the CAPM
8.3.1.The risk free rate
8.3.2.The company’s beta
8.3.3.The market risk premium
8.3.4.The cost of equity
8.4.Conclusion the resulted WACC
9.Valuation of H. Lundbeck A/S
9.1.Valuation with real options theoretical aspect
9.1.1.Discussion of real option method
9.1.2.The framework for Real Option Valuation
9.1.3.The critic of the real option approach
9.2.Real option valuation
9.2.1.The static NPV analysis
9.2.2.The actual real option valuation
9.2.3.The sensitivity analysis
9.3.DCF valuation
9.3.1.Scenario analysis
9.3.2.The base case scenario
9.3.3.The best case scenario
9.3.4.The worst case scenario
9.3.5.Estimating the continuing value (note)
9.3.6.Calculating and interpreting results
9.3.7.Sensitivity analysis
9.3.8.Plausibility analysis
9.4.Valuation with multiples (comparables)
10.Conclusion
Literature list
Appendicies 1-11
1.Introduction
1.1.Motivation
It is estimated that by 2030 (assuming no increase in fertility), in most of the western countries there will be more people in their 70s than in their 20s.[1]In the light of the rapid increasing rates of population aging for the world’s wealthy nations and as the result the raise in health problems associated with this population segment, like Alzheimer’s disease,Depression and Parkinson’s disease to mention few. To quote Medical news today depression amongst older people arises due to their lifestyle, which fosters loneliness since “older people used to go to the corner shop, the post office, or pub, and this was a reason to dress nicely and make an effort, but because these local services are disappearing, taking the opportunities for new connections with them, this diminishes self-esteem and leads todepression and associated medical problems”[2]. As for Alzheimer’s disease, it is estimated that in the near future more than 35 million people worldwide will by 2015 suffer from Alzheimer’s disease. [3]Right now “Alzheimer's disease is the seventh leading cause of all deaths in the United States and the fifth leading cause of death in Americans older than the age of 65 years. More than 5 million Americans are estimated to have Alzheimer's disease… By 2050, the incidence of Alzheimer's disease is expected to approach nearly a million people per year, with a total estimated prevalence of 11 to 16 million persons”.[4]
All this makes it interesting to analyze a Danish pharmaceutical company H. Lundbeck A/S that specializes in treating all of the diseases mentioned amongst other disorders in central nervous system (CNS) as Huntington’s disease, Epilepsy and Psychotic disorders such as Schizophrenia. Pharmaceutical industry in which the company operates is less affected by the cyclical changes such as past financial crisis. This is because people are still sick whether there is a crisis or not and they need their medicine, therefore H. Lundbeck A/S as any other pharmaceutical company will not suffer that much during a economic recession. Because of new potential financial crisis in the aftermath of debt issues of some European countries with the prospect to follow in Greece footsteps are countries Italy and Spain, not to mention US debt problems as of august this year resulting on 4th of august the following headline on the Bloomberg homepageU.S. Stocks Plunge in Biggest Retreat Since 2009. [5]It is interesting for the new and old investors to look at stabile stocks such as Lundbeck’s to invest in, and to look closer at.
It should be mentioned that H. Lundbeck A/S faces important positive and negative changes that could also effect the fair share value of the company in the nearest future, such as aftermath of financial economic crisis in form of health care reforms in US and Europe. The US healthcare reform passed in March last yeareffects the prices on drugs for the poorest, and elderly people, and also putting new fees on the pharmaceutical industry, making it more costly for H. Lundbeck A/S to operate in the US market than before. In Europe (Greece, Spain and Germany) reimbursements and price reduction on prescription drugs will have noticeable impact on the company’s profitability. Another negative change is the future patent expiration of the depression drug Lexapro/Cipralex in 2012 in US market and 2014 in Europe market accounting for 56% of revenue in 2010[6]. There is a possibility that patent expiration will contribute to higher competition from possible market entrants (generic products) on these markets and give potential profit loss.
Couple of encouraging changes with likely positive impact on the profitability can be mentioned: In form ofresent and new product opportunities, 2010 release of a new untypical antipsychotic medication Sycrest in both Europe and US markets, and Lexapro drug has been recently approved in Japan. The seven new pipeline products are post proof of concept in clinical division ranging from treatment for psychosis, stroke, epilepsy, Lennox- Gastaut syndrome and new drug for alcohol dependence. Especially positive is launch of the new drug for depression in 2014 (LU AA21004) replacing the old depression drug Cipralex/Lexaprowith patent expiration already mentioned.
The analyst firm Jefferies & Co from NASDAQ on third of august this year classifies H. Lundbeck’s A/S shares to be a strong buy for the investors.[7]So the question will be, is this advisable recommendation, and is the company’s fair share value overvalued looking from the outside perspective?
So with all the above taken into consideration, especially the presented changes in the company and the market, with the financial crises, to answer this question the fair value of H. Lundbeck’s A/S ordinary shares will be estimated.
1.2.Problem statement
The main aim of the thesis is to estimate fair share value of Lundbeck’s ordinary shares, in order to asses if it’s advisable for the present and future private investors to continue buying the company’s shares.
In other words is the current fair share value of Lundbeck’s ordinary shares overvalued or undervalued compared with the market?
This problem will be addressed by answering following sub questions:
First of all from the Lundbeck’s strategic point of view these questions that follow are seen to be important for assessing the current and the future prospects of the company and thereby the fair share price.
- How is the political and legal environment effecting Lundbeck’s profitability, and what exogenous factors are having most significant impact on the company?
- Who are Lundbeck’s biggest competitors in the pharmaceutical industry? How is Lundbeck’s competitive position in this industry?
- What is the company’s strategy to maintain and improve the competitive position in relation to the main competitors found?
- What is Lundbeck’s growth strategy?
Secondly the financial aspect is also of paramount importance therefore the following questions will be considered.
- Based on the accounting figures during the period 2007-2010, how does Lundbeck’s present economical performance looks like, and what is characterizing these 4 years of economical development?
- Does Lundbeck’s growth consist of sustainable factors (organic growth) or contrary of temporary changes such as favorable fluctuations in exchange rates?
Finally the actual valuation of Lundbeck will be conducted with three valuation methods, where one is discounted cash flow based model: enterprise discounted cash flow model (EDCF). Additionally because it is a pharmaceutical company with considerable R&D investment it is seen as important to take account of this flexibility the real option valuation will be carried out, but only of new CNS drug. The final valuation method is seen as a useful supplement to the above valuation methods already mentioned. It is valuation with multiples (comparables). Thus the following questions are to be answered:
- What is the estimated cost of capital (WACC) of the company?
- What does real option analysis imply?
- What is the fair share price of the Lundbeck’s ordinary shares according to the EDCF – method and does it imply the same share price compared with the result given by multiples method?
- How sensitive isreal option model and EDCF method?
- How plausible is the resulting fair share price?
1.3.Delimitations
This thesis is primary of theoretical form, where existing strategic and theoretical models will be applied in practice. With this in mind, theory part will be briefly touched upon. The enterprise DCF valuation model and strategic models applied during the analysis are assumed to be known by the reader, and will not be discussed further in separate theoretical part. However as a way to inform readers about existing Real option valuation models a theoretical discussion will be made. This is done because an elaboration of the theory is seen as a description and also due to limited number of pages it will be a very minor part of the final paper. It is seen more important to apply the theory and models than to describe them. Furthermore due to limited number of pages the estimation and forecast of important exchange rates and overall risk assessment as initially planned to be included in the project will be omitted as well. Hereby I also delimit the contents of the project from the information available from December 2011, since it is most likely that the bigger part of the analysis will be finished by that time.
1.4.Methods
The main data used for the thesis will be annual statements from the Lundbeck’s homepage and other data found useful like peer group information, industry info, and such. Orbis database is found to be one of the sources, together with competitors’ homepages, and other available databases. Furthermore data necessary for estimating cost of capital and multiple analyses will be extracted and processed in Datastream due to no access to a Bloomberg terminal.
Finally Excel will be used for reformulation of annual statement, final calculation of WACC and forecasting. All the calculations will be burned on a disc and submitted together with the thesis.
1.5.Scope and structure
The scope and structure of the thesis will be as follows. After the introduction part with problem statement, delimitation and so on, will Lundbeck be presented, followed by a short description and analysis of the pharmaceutical industry and its development started with the market/markets definition, because it is important to know from the start what market and industry is strategically analyzed. There is no room for doubt when this is concerned. This part is included due to importance of future industry developments to the final forecast and valuation, the growth expectation of the markets concerning disorders in the central nervous system (CNS). Strategic analysis will follow and will be divided into: 1. environmental analysis and 2. industryanalysis and 3. competitor profiling. The strategic internal factor analysis will be omitted due to page limitations of the final rapport, although it is also an important part of the strategic analysis. Environmental analysis will be analyzed in form of PESTEL framework where this breakdown is chosen because legal part is found to be essential. Porter’s five forces will be an industry analysis, and is performed because it is the main tool for industry analysis for a certain company. After competitor profiling everything will be summarized in a SWOT framework.
Reorganizing financial statements will be performed next reformulating income statement and calculating NOPLAT[8], reformulating balance sheets and performing invested capital calculations, and finally calculating the free cash flow, that is going to be used for the final valuation. Reorganizing financial statements is important because the operating and financial items have to be separated to enlighten the performance of Lundbeck, and thereby improve the valuation. In this part only most important assumptions will be presented, and the final calculations and reformulations will be enclosed in the appendix as an overview.
As a natural way to continue when the reformulation is finished the analysis of historical performance will follow. It will consist of NOPLAT, Invested capital and FCF analysis, revenue growth analysis,operating performance analysis in the ROIC analysis framework, and finalized by the historical stock market performance analysis compared to the peer group. All this is done to put Lundbeck’s performance in perspective both in historical and competitive way, to better forecast the future performance.
The next part consists of forecasting, and cost of capital estimation. Forecasting will be a short one covering assumptions of the forecast period, due to page limitations the detailed forecasting assumptions will only be presented in the appendix as an overview. When estimation of cost of capital is concerned will first Lundbeck’s capital structure be covered, followed by estimation of cost of debt, CAPM and a conclusion of the resulting WACC.
Finally the valuation of Lundbeck will be conducted initiated with a Real option valuation and the theoretical aspect, followed by enterprise DCF valuation and multiple analyses. As a final part an overall conclusion is made.
2.Presentation of H. Lundbeck A/S[9]
The aim of the following part is twofold. First it is written to shortly introduce the company at hand to potential readers, and second it serves as prelude for later analysis both strategic and economic.
2.1.Short history presentation[10]
The story for company H. Lundbeck A/S begins nearly 100 years ago, 14th august in 1915 when Hans Lundbeck founds the company in Danish capital Copenhagen. The company back than was quite different from today’s, it operated as trading company and not as a pharmaceutical company as today. H. Lundbeck A/S as trading company was trading everything from cameras, machinery, biscuits and so much more. First in the 1930s when the worldwide economic crisis hit, when the medicine and cosmetics that company purchased ready packed was not possible due to Danish Government restrictions on foreign currency, the company begins its first production. The main event in 30s is that they launched they first medication for treatment of wounds Epuctan. In 40s the company goes from trading company to an organic chemistry manufacturing one, with its own research & development activities. By looking forward in time from 40s to 80s we reach the decade, when H. Lundbeck A/S begins the company’s strategic transformation to a company we know today due to lack of commercial success. They found that the key for success was to specialize, and they did exactly that by focusing on diseases of Central Nervous System (CNS) as they overall strategy. Furthermore from that time they begin having they own sales companies, apart from going trough agents. The major events before that was the launch of the Truxal medicine treating schizophrenia in the late 50s, and later in the 70s the launce of the extended drug Fluanxol for psychosis patients as a result of Citalopram invention. In the 1999 the company went through an IPO and was listed on Copenhagen Stock Exchange. During the 90s the focus lies on becoming world leader in treating mental disorders. In the years after 2000 the company engaged in R&D partnerships, in-licensing, and own drug development. As product partnership Merck & Co resulted in the launce of the Alzheimer’s disease drug Ebixa.After 2010 and forward Lundbeck enhances its presence in Asia for example by promoting Lexapro in China. The broad characteristic of this decade so far is increased international presence, and broader CNS portfolio. Currently it is a global company, where the global market they operate in is classified into three markets: Europe, USA and International markets[11].
As a rounding remark the following quotefits well for the company today:“Lundbeck is a global pharmaceutical company conducting research into, developing, manufacturing, marketing, selling and distributing pharmaceuticals for the treatment of disorders in the central nervous system (CNS), including Depression, Schizophrenia, Alzheimer’s disease, Parkinson’sdisease, Huntington's disease, Epilepsy and Insomnia.”[12]If the reader is interested a complete description of Lundbeck’s product portfolio and pipeline are disclosed in Appendix 1.
2.2.The vision, mission and values of the company
Any established company has a statement of a vision, mission and the values of the company, which has a purpose of distinguishing the company from competitors and as well position the company as a unique. The Lundbeck’svision is to become a world leader in treating psychiatric and neurologicdisorders and to improve the quality of life for those patients suffering is a company’s mission. The three values which describe best the company’s culture and what the company stands for are: 1. Imaginative - Dare to be different, 2.Passionate - Never give up and finally 3.Responsible - Do the right thing.[13]
2.3.The breakdown of turnover
This part of the report has a purpose to visualize and understand the Lundbeck’s breakdown of turnover presented in business segment turnover and geographical turnover in a figure framework, and several times during the paper this figure will be referred to.
Figure 2.1: 2010turnover breakdowns of Lundbeck’s business segments and geographical breakdown in percent of total revenue