The AstraZeneca (LSE: AZN) share price jumped 5.5% after releasing its Q3 trading update last week. The FTSE 100 pharma giant said: “The third quarter again saw all three therapy areas and every sales region produce encouraging performances.” Management upgraded its full-year sales guidance to an increase by “a low to mid-teens percentage” from its prior guidance of “a low double-digit percentage.”
Bulls have been buoyed by the update but, for me, it highlights what I think is an elephant in the room. This particular pachyderm has been hiding in plain sight in the AZN atrium for several years, growing bigger all the time. Let me show you how it’s developed, and how I think it impacts the valuation of the company.
Smoke and mirrors
Earlier this month, AZN announced it’s agreed to sell the commercial rights for Losec for $243m. Now, you might think the one-off gain from the sale of this non-core asset would be excluded from its core operating performance as an exceptional item. Not a bit of it. AZN includes such “gains on disposal of intangible assets” in its core numbers. The table below shows their contribution to total core operating profit over the last five years.
|
 |
2014 |
2015 |
2016 |
2017 |
2018 |
|
Total core operating profit ($bn) |
6.9 |
6.9 |
6.7 |
6.8 |
5.7 |
|
Core operating profit before gains on disposals ($bn) |
6.9 |
5.9 |
5.4 |
5.3 |
3.8 |
|
Gains on disposals ($bn) |
0.0 |
1.0 |
1.3 |
1.5 |
1.9 |
|
Gains on disposals as percentage of total core operating profit |
0 |
14 |
19 |
22 |
33 |
As you can see, gains on disposals of drugs AZN has deemed no longer core to the business have made an increasing contribution to core operating profit. Such disposals have gone from £0 in 2014 to £1.9bn in 2018, the latter representing a whopping 33% of total core operating profit. At the same time, what I view as the true core operating profit (before gains on non-core disposals) has fallen each and every year from £6.9bn in 2014 to £3.8bn in 2018.
A cynic might say AZN has used non-core disposals to try to maintain core operating profit, and keep investors onside, while it waits for real operating profit to come through from new drugs. In other words, it’s employed smoke-and-mirrors accounting.
Crystal ball
Happily for the company, it looks nailed-on that 2019’s core profit (before gains on non-core disposals) will increase for the first time in five years — i.e. be higher than 2018’s $3.8bn — and gains on non-core disposals will be lower than 2018’s $1.9bn.
Last week’s Q3 update told us total core operating profit for the year to date is up 41% at $4.9bn, while core ‘other operating income’, the lion’s share of which will be gains on non-core disposals, is down 7% at $1.1bn.
Looking into my crystal ball, I can see AZN posting investor-friendly strong and steady core earnings growth in the coming years, built on rising real core profits from new drugs and a managed decline in the contribution of non-core disposals, deflating the elephant in the room. However, if AZN runs out of non-core assets to sell — or willing buyers — before real core earnings have increased sufficiently, investors could be in for a nasty shock.
At a share price of 7,383p, the company is trading at a whopping 41 times my calculation of real 2018 core earnings of around 180p a share. As such, I’m inclined to avoid the stock until I’ve seen the extent to which real earnings have risen and non-core disposals have deflated in 2019.