According to CEO Pablo Legorreta, Royalty Pharma has a very attractive risk/reward profile compared to most other companies in the life sciences industry. I tend to agree with him, as Royalty Pharma has no capital expenditures, while still offering exposure to some of the largest therapies in the world. In this analysis, I will investigate whether now is the right time to buy Royalty Pharma.
This is not a financial advice. I am not a financial advisor and I only do these post in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.
Since I have attended the workshop with Phil Town, I have decided to change the layout of my analyses a bit. I will do some more calculations and also briefly go through why the company has meaning to me. If you want to read more about how I evaluate a company, please go to "MY STRATEGY" on my website.
For full disclosure, I should start by mentioning that at the time of writing this analysis, I do not own any shares of Royalty Pharma. If you would like to view the stocks in my portfolio or copy my portfolio, you can do so on eToro. Instructions on how to do so can be found here. However, I do own stocks in traditional pharmaceutical companies such as AbbVie, Novo Nordisk, and Genmab. Nonetheless, I have no personal stake in Royalty Pharma. If you want to purchase shares or fractional shares of Royalty Pharma, you can do so through eToro. eToro is a highly user-friendly platform that allows you to get started on investing with as little as $100.
The Business
Royalty Pharma was founded in 1996 in New York, United States, and went public with its IPO in 2020. Royalty Pharma operates as a purchaser of biopharmaceutical royalties. It is also involved in the identification, evaluation, and acquisition of royalties on various biopharmaceutical therapies. Its portfolio consists of royalties on approximately 35 commercial products and 14 development-stage product candidates that address various therapeutic areas, such as rare diseases, cancer, neuroscience, immunology, respiratory issues, infectious diseases, hematology, and diabetes. Royalty Pharma does not develop its own therapies but buys royalties in therapies developed by other companies. It means that they can benefit from many advantages in the pharmaceutical industry, such as long product life cycles, significant barriers to entry, and non-cyclical revenues. At the same time, they have reduced exposure to industry challenges, such as early-stage development risks and high research and development costs. At the same time, they have a similarly strong moat, like other pharmaceutical companies. Some of the therapies in their portfolio include the cystic fibrosis franchise of Vertex Pharmaceuticals and Imbruvica from AbbVie. In addition to these two companies, they also receive royalties from other companies such as Biogen, Pfizer, Merck, Eli Lilly, Johnson & Johnson, and Bristol Myers Squibb. Royalty Pharma is the largest royalty buyer company in the United States, holding a 53% market share, while its largest competitor only has a 13% market share.
Management
The CEO is Pablo Legorreta. Besides being the CEO, he is also the founder of Royalty Pharma, which means he has been involved since the beginning. Personally, I prefer it when founders hold management positions because they typically have a strong motivation to grow the business, rather than just focusing on their bank account. He has grown Royal Pharma to become the largest purchaser of pharmaceutical royalties. He has gained extensive experience in investing in pharmaceutical royalties, having been involved in the business for over two decades. Prior to founding Royalty Pharma, he was an investment banker at Lazard Frères. He is also a co-founder of Pharmakon Advisers. His educational background includes a degree in Industrial Engineering from the Universidad Iberoamericana in Mexico City. He also serves on the Board of Directors of Epizyme and on the Board of Governors of the New York Academy of Sciences. He also founded Alianza Medica para la Salud, a non-profit organization dedicated to enhancing the quality of healthcare in Latin America. He has made some fantastic deals for Royalty Pharma over the years. One such example is the acquisition of the royalties of Humira from AstraZeneca in 2006 for $700 million. In 2018 alone, Royalty Pharma collected $499 million in royalties from Humira. According to an article in Forbes, Pablo Legerreta has led Royal Pharma to increase its cash receipts by 11% since 2021. It is difficult to find much information about Pablo Legorreta, as he does not make many public appearances or give many interviews. Despite that, I feel very comfortable with Pablo Legorreta as the right person to lead Royalty Pharma moving forward.
The Numbers
The first metric I investigate is the return on invested capital, also known as ROIC. We would like to see a 10-year history where all the figures have been above 10% each year. Royalty Pharma made its IPO in 2020. Thus, we only have the numbers from 2020 and onwards. The numbers are underwhelming in most years as Royalty Pharma has only managed to deliver a Return on Invested Capital (ROIC) above 10% in one year out of the four years since they went public. However, the only year with a growth rate above 10% was in 2023, which is encouraging. Hopefully, this will set a trend for the future. Nonetheless, I would like to see Royalty Pharma deliver a consistent Return on Invested Capital (ROIC) above 10% in the future.
The following numbers represent the book value + dividend. In my previous format, this was referred to as the equity growth rate. It was the most important of the four growth rates I used in my analyses, which is why I will continue to use it in the future. As you are accustomed to seeing numbers in percentage form, I have decided to provide both the actual numbers and the year-over-year percentage growth. We only have data from 2020 and beyond. Royalty Pharma has experienced two years with a decrease and one year with a slight decrease in equity. Year-over-year movements are not that important, and I find it positive that Royalty Pharma's equity has increased by nearly 32% from its IPO in 2020 to 2023, which is encouraging.
Finally, we will analyze the free cash flow. Free cash flow, in short, refers to the cash that a company generates after covering its operating expenses and capital expenditures. I use levered free cash flow margin because I believe that margins offer a better understanding of the numbers. Free cash flow yield refers to the amount of free cash flow per share that a company is expected to generate in relation to its market value per share. Royalty Pharma has managed to deliver a positive free cash flow in all four years since it went public. Free cash flow decreased slightly in 2021 but has increased in both 2022 and 2023, meaning that Royalty Pharma achieved its highest free cash flow since its IPO in 2023. Levered free cash flow margin is very high due to the business model that Royalty Pharma operates, which involves no capital expenditures. Thus, it is expected that the levered free cash flow margin will continue to be high moving forward. Free cash flow yield is also very high, indicating that Royalty Pharma shares are trading at a discount. However, we will revisit this later in the analysis.
Debt
Another important aspect to consider is the level of debt. It is crucial to determine whether a business has manageable debt that can be repaid within a period of 3 years. We do this by dividing the total long-term debt by earnings. Upon calculating Royalty Pharma's financials, I have determined that Royalty Pharma has 4,02 years of earnings in debt. It is above the three-year threshold. Thus, while debt may not be alarming, it is still something that needs to be monitored when investing in Royalty Pharma.
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Risks
Based on my findings so far, Royalty Pharma looks very intriguing. However, all investments come with risks, and the same applies to Royalty Pharma. One risk is that Royalty Pharma uses leverage when deploying their capital. Royalty Pharma uses borrowed funds to finance a significant portion of its deployed capital. The use of leverage creates an opportunity for increased returns but also increases the risk of loss if assets do not generate sufficient cash flows. The interest expense and other costs incurred in connection with such borrowings may not be covered by Royalty Pharma's cash flow. Furthermore, leverage may constrain Royalty Pharma's operational flexibility and diminish the cash flow earmarked for dividends or share repurchases. Furthermore, the level of indebtedness could limit Royalty Pharma's ability to respond to changing business conditions. The various agreements relating to their borrowings may impose operating and financial restrictions on Royalty Pharma, which could affect the number and size of the royalties they would like to pursue, thus hurting future growth.
Another risk involves patent losses. Royalty Pharma's entitlement to receive royalties typically relies on the presence of valid and enforceable claims of registered or issued patents in the United States and other parts of the world. Patents covering pharmaceutical company products typically provide market exclusivity, which is essential for the profitability of many pharmaceutical products. As patents for certain products expire, these products could face competition from lower-priced generic or biosimilar products. The expiration or loss of patent protection for a product is usually followed promptly by substitutes that may significantly reduce sales. This, in turn, will decrease the royalties that Royalty Pharma receives, as these are typically calculated as a percentage of sales.
Reliance on a limited number of products. While Royalty Pharma's current asset portfolio includes royalties related to over 35 marketed products, the top five product franchises accounted for 66% of their royalty receipts in 2023. The largest contributor to royalties in 2023 is the Cystic Fibrosis franchise by Vertex Pharmaceuticals, accounting for approximately 31% of the total revenues. Vertex Pharmaceuticals is currently developing a new therapy for cystic fibrosis. If this therapy proves to be more effective than Trikafta, it could become the preferred treatment option in the future. This could potentially have a significant impact on Royalty Pharma's business. Royalty Pharma receives a 9% royalty on Trikafta, the therapy that the new treatment will cannibalize. However, Royalty Pharma has no involvement or stake in the development of this new therapy.
Reasons to invest
There are also numerous reasons to invest in Royalty Pharma. One advantage of investing in Royalty Pharma is the opportunity to invest in the pharmaceutical sector with reduced risks. The pharmaceutical industry benefits from several highly attractive characteristics, such as long product life cycles, significant barriers to entry, and non-cyclical revenues. Royalty Pharma focuses on acquiring royalties from approved products or development-stage product candidates that have generated strong proof-of-concept data. Investing in Royalty Pharma allows you to avoid the risks associated with early-stage therapies that may or may not be successful, unlike other pharmaceutical companies. Royalty Pharma is conducting their due diligence to find these products. In 2023, they conducted 400 reviews, resulting in 47 proposals and only seven transactions, accounting for just 2% of their initial reviews. Other factors contributing to the reduced risks include Royalty Pharma's highly diversified portfolio with 15 blockbuster therapies, exceeding the industry average of 9. Additionally, Royalty Pharma does not incur research and development (R&D) or manufacturing expenses.
Synthetic royalties. Synthetic royalties refer to the contractual right to a percentage of top-line sales by the developer or marketer of a therapy in exchange for funding. A synthetic royalty may also include contingent milestone payments. Royalty Pharma funds ongoing research and development for biopharmaceutical companies in exchange for future synthetic royalties and milestones if the product is approved. Thus, these differ from third-party royalties, which are the contractual rights to a percentage of top-line sales from a licensee's use of a product, technology, or intellectual property. Synthetic royalties have accounted for only 3% of the total funding over the past five years. Royalty Pharma believes that there will be a fast-growing business opportunity in the coming years. Royalty Pharma has a good track record of delivering higher returns on synthetic royalties than on third-party royalties.
High insider ownership. Management aims to align with shareholder interests, which is why executive officers hold a 16% ownership stake in Royalty Pharma, in contrast to less than 1% insider ownership in large-cap pharmaceutical companies. If you include the board and employee ownership of Royalty Pharma, the percentage reaches 32%. High insider ownership typically signals confidence in a company's prospects and commitment to its shares. This, in turn, provides the company's management with an incentive to ensure profitability and maximize shareholder value. Management has mentioned that investors should see them as fellow shareholders since they own a significant portion of the business. They aim to propel growth and create value for all investors, including themselves.
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Valuation
Now it is time to calculate the share price. I perform three different calculations that I learned at a Phil Town seminar. If you want to make the calculations yourself for this or other stocks, you can do so through the tools page on my website, where you have access to all three calculators for free.
The first is called the Margin of Safety price, which is calculated based on earnings per share (EPS), estimated future EPS growth, and estimated future price-to-earnings ratio (P/E). The minimum acceptable rate of return is 15%. I chose to use an EPS of 2,53, which is from the year 2023. I have selected a projected future EPS growth rate of 10%. Finbox expects EPS to grow by 14% in the next five years, but management expects to grow the topline by a 10% compounded growth over the next decade. Additionally, I have selected a projected future P/E ratio of 20, which is double the growth rate. This decision is based on Royalty Pharma's historically higher price-to-earnings (P/E) ratio. Finally, our minimum acceptable rate of return has already been established at 15%. After performing the calculations, we determined the sticker price (also known as fair value or intrinsic value) to be $32,44. We want to have a margin of safety of 50%, so we will divide it by 2. This means that we want to buy Royalty Pharma at a price of $16,22 (or lower, obviously) if we use the Margin of Safety price.
The second calculation is known as the Ten Cap price. The rate of return that a company owner (or stockholder) receives on the purchase price of the company essentially represents its return on investment. The minimum annual return should be at least 10%, which I calculate as follows: The operating cash flow last year was 2.988, and capital expenditures were 0. The tax provision was 0. We have 446,692 outstanding shares. Hence, the calculation will be as follows: 2.988 / 446,692 x 10 = $66,89 in Ten Cap price.
The final calculation is referred to as the Payback Time price. It is a calculation based on the free cash flow per share. With Royalty Pharma's free cash flow per share at $6,45 and a growth rate of 10%, if you want to recoup your investment in 8 years, the Payback Time price is $81,16.
Conclusion
I find Royalty Pharma to be a very intriguing company, and I also appreciate its management. ROIC has been underwhelming since its IPO, but it is encouraging to see that ROIC was above 10% in 2023. Royalty Pharma is facing some risks. One reason is that they use leverage to deploy capital. Thus, it could increase losses if the assets that Royalty Pharma chooses to acquire royalties in do not generate sufficient cash flows for them. Patent loss is a risk for all companies operating in the pharmaceutical industry, including Royalty Pharma. It is something that investors in the industry will need to accept. Reliance on a limited number of products poses a risk for Royalty Pharma, especially their dependence on Vertex Pharmaceuticals' Cystic Fibrosis franchise. Royalty Pharma is currently in a dispute with Vertex Pharmaceuticals. Royalty Pharma believes that they are entitled to receive 8% in royalties from the new product that Vertex is developing. This claim is based on the similarity of the deuterated ivacaftor component to that of Trikafta. However, it remains unresolved. In the worst-case scenario, Royalty Pharma expects to be entitled to 4% of the royalties from the new products, which is significantly lower than the 9% from Trikafta. There are plenty of reasons to invest in Royalty Pharma. Various factors reduce the risk when investing in Royalty Pharma instead of directly in a pharmaceutical company. Furthermore, Royalty Pharma expects that synthetic royalties will grow in the future, which has historically delivered higher returns to the company. Finally, the significant insider ownership indicates that management has every reason to prioritize long-term growth for the company. I already have significant exposure to the industry, so I will not be buying shares in Royalty Pharma. However, if I want to increase my investment in the industry and have a long-term viewpoint, I would buy shares in Royalty Pharma below $30. This would provide me with a significant discount to the intrinsic value.
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I hope that you enjoyed my analysis. Unfortunately, I cannot do a post of all the companies I analyze. I am available to copy but if you do your own trades, you can follow me on Twitter instead, as I tweet when I buy or sell anything.
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