MSc in Finance and International Business
Master Thesis 2012
Registration: August 1st 2011
Submission: January 3rd 2012
Author:
Selma Palic
Academic advisor:
Baran Siyahhan
Valuation of H. Lundbeck A/S including the real option
analysis of development of a new CNS drug
Aarhus School of Business and Social Sciences
Aarhus University
Department of Economics & Business
Winter 2012
The table of contents
1.
2.
3.
4.
5.
6.
Introduction .......................................................................................................................................................................................... 3
1.1.
Motivation ................................................................................................................................................................................... 3
1.2.
Problem statement ..................................................................................................................................................................... 5
1.3.
Delimitations (not done finish after you finish the project) ........................................................................................................ 6
1.4.
Methods (not done finish after the project is done) ................................................................................................................... 6
1.5.
Scope and structure .................................................................................................................................................................... 7
Presentation of H. Lundbeck A/S ......................................................................................................................................................... 8
2.1.
Short history presentation .......................................................................................................................................................... 8
2.2.
The vision, mission and values of the company .......................................................................................................................... 9
2.3.
The breakdown of turnover ...................................................................................................................................................... 10
Pharmaceutical Industry and development ...................................................................................................................................... 10
3.1.
Market(s) definition .................................................................................................................................................................. 10
3.2.
Global pharmaceutical industry characteristics ........................................................................................................................ 11
3.3.
Market(s) size, share and growth .............................................................................................................................................. 11
3.4.
Key factors for success (KFS) ..................................................................................................................................................... 14
3.5.
The future growth markets ....................................................................................................................................................... 14
Strategic analysis ................................................................................................................................................................................ 16
4.1.
PESTEL analysis .......................................................................................................................................................................... 16
4.2.
Industry analysis Porter’s five forces ......................................................................................................................................... 22
4.3.
Competitor profiling .................................................................................................................................................................. 27
4.4.
Conclusion in a SWOT framework ............................................................................................................................................. 34
Reorganizing financial statements ..................................................................................................................................................... 36
5.1.
Accounting issues: ..................................................................................................................................................................... 36
5.2.
Capitalized expenses ................................................................................................................................................................. 38
Analyzing historical performance ...................................................................................................................................................... 40
6.1.
NOPLAT ..................................................................................................................................................................................... 40
6.2.
Invested capital ......................................................................................................................................................................... 41
6.3.
Free Cash Flow .......................................................................................................................................................................... 42
6.4.
Revenue growth analysis ........................................................................................................................................................... 43
6.5.
Operating performance in the ROIC analysis framework .......................................................................................................... 45
6.6.
The historical stock market performance compared to the peer group ................................................................................... 49
7.
Forecasting ......................................................................................................................................................................................... 51
8.
Estimating cost of capital ................................................................................................................................................................... 51
8.1.
Lundbeck’s capital structure ..................................................................................................................................................... 53
Page 1
8.2.
Lundbeck’s cost of debt............................................................................................................................................................. 54
8.3.
Lundbeck’s cost of equity the CAPM ......................................................................................................................................... 55
8.3.1.
The risk free rate.............................................................................................................................................................. 55
8.3.2.
The company’s beta ......................................................................................................................................................... 56
8.3.3.
The market risk premium ................................................................................................................................................ 59
8.3.4.
The cost of equity ............................................................................................................................................................ 60
8.4.
9.
Conclusion the resulted WACC .................................................................................................................................................. 60
Valuation of H. Lundbeck A/S ............................................................................................................................................................ 61
9.1.
Valuation with real options theoretical aspect ......................................................................................................................... 61
9.1.1.
Discussion of real option method .................................................................................................................................... 62
9.1.2.
The framework for Real Option Valuation ....................................................................................................................... 63
9.1.3.
The critic of the real option approach ............................................................................................................................. 66
9.2.
Real option valuation ............................................................................................................................................................... 66
9.2.1.
The static NPV analysis .................................................................................................................................................... 70
9.2.2.
The actual real option valuation ...................................................................................................................................... 72
9.2.3.
The sensitivity analysis..................................................................................................................................................... 73
9.3.
DCF valuation ............................................................................................................................................................................ 74
9.3.1.
Scenario analysis .............................................................................................................................................................. 74
9.3.2.
The base case scenario .................................................................................................................................................... 75
9.3.3.
The best case scenario ..................................................................................................................................................... 76
9.3.4.
The worst case scenario................................................................................................................................................... 77
9.3.5.
Estimating the continuing value (note)............................................................................................................................ 77
9.3.6.
Calculating and interpreting results................................................................................................................................. 78
9.3.7.
Sensitivity analysis ........................................................................................................................................................... 82
9.3.8.
Plausibility analysis .......................................................................................................................................................... 83
9.4.
10.
Valuation with multiples (comparables) ................................................................................................................................... 83
Conclusion...................................................................................................................................................................................... 86
Literature list
Appendicies 1-11
Page 2
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 to depression 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. 3Right 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 homepage U.S. Stocks
1
http://www.lewrockwell.com/spl3/global-aging-crisis.html
http://www.medicalnewstoday.com/articles/218134.php
3 http://www.bloomberg.com/apps/news?pid=conewsstory&tkr=LUN:DC&sid=aFuDuK3g0D2c
4
http://www.ncbi.nlm.nih.gov/pubmed/18631956
2
Page 3
Plunge in Biggest Retreat Since 2009. 5It 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 year effects
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 20106. 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 of
resent 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/Lexapro with 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.
5
http://www.bloomberg.com/news/2011-08-04/yen-slumps-after-japan-intervenes-to-curb-rise-most-asian-stocks-advance.html
6
http://www.lundbeck.com/investor/Financials/Reports/Files/UK_versions/Annual_report_2010.pdf page 29.
7
http://www.nasdaq.com/earnings/analyst_recommendations.asp?symbol=HLUKY&selected=HLUKY
Page 4
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
Page 5
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 is real 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.
Page 6
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. industry analysis 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
NOPLAT8, 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
8
NOPLAT stands for Net Operating Profit Less Adjusted Taxes
Page 7
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/S9
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 presentation10
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
9
http://www.lundbeck.com/default.asp
http://www.lundbeck.com/aboutus/history/milestones/default.asp
10
Page 8
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 markets11.
As a rounding remark the following quote fits 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’s disease, 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’s vision is to become a world leader in treating psychiatric and neurologic disorders and to
improve the quality of life for those patients suffering is a company’s mission. The three values which
11
International markets consists of according to following presentation
http://www.lundbeck.com/investor/Presentations/Financial_presentations/Files/Roadshow_pres/Roadshow_Q1_2011.pdf are: Asia
(incl. Japan), Australia, Middle East, Africa, Latin America and Canada, where reported revenue from international markets
include three more countries Isreal, Turkey and Russia.
12
http://www.lundbeck.com/media/facts_and_background/fast_facts/uk/default.asp?media
Page 9
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: 2010 turnover breakdowns of Lundbeck’s business segments and geographical breakdown in percent of total revenue
Other
Sabril
pharmaceuti
(Epilepsy)
cals
1%
Xenazine
14%
(Huntington'
s disease)
4%
Azilect (AntiParkinson's)
7%
Other
revenue
2%
USA
25%
Europe
53%
Cipralex/Lexa
pro (Antidepressant)
56%
Ebixa (AntiAlzhermer's)
16%
Internation
al markets
20%
Other
revenue
2%
Source: Data used for the figure is from http://www.lundbeck.com/investor/Financials/Reports/Files/UK_versions/Annual_report_2010.pdf
see pages 24, 25 and 27. Besides the data the final figure is my own product .What international markets consists of see page 8 footnote 11 of this paper.
3.
Pharmaceutical Industry and development
The time has come for an industry framework the starting point is to define the market(s) Lundbeck operates
in. There next the global pharmaceutical industry characteristics will be outlined. Market size, share and
growth will be outlined next, followed by key factors for success in the industry (KFS), and finalized by
narrowing future growth markets. Under market size growth, and share Lundbeck’s submarkets such as
depression market, epilepsy and so on will all be analyzed simultaneously.
3.1.
Market(s) definition
Since Lundbeck’s products are marketed in three geographical markets Europe, USA and International
markets, the market is considered to be a global one. Moreover it is a specialized pharmaceutical company
focusing on producing and marketing in the area of CNS disorders, in consistence with Porter’s generic
13
http://www.lundbeck.com/aboutus/our_culture/vision_mission_values/default.asp
Page 10
strategies in the pharmaceutical industry Lundbeck is following a focus generic strategy. This is in order to
exploit the core competences in CNS market acquired during the years, in order to acquire the competitive
advantages. Furthermore Lundbeck has since the 2000 changed the strategy for acquiring market share to
include strategic alliances with some of the competitors, in R&D partnerships and in-licensing, such as
Merck and Co. and involved in mergers and acquisitions. So all in all in the global pharmaceutical industry
Lundbeck operates on the global CNS market, with several main sub-markets: depression market,
Alzheimer’s market, Parkinson’s market, Huntington’s market, epilepsy market and psychotic disorder
market.
3.2.
Global pharmaceutical industry characteristics14
The global pharmaceutical industry is more and more characterized by fast consolidation and concentration,
in form of mergers and acquisitions but also alliances or collaborations in R&D and marketing as a prevailing
strategic standpoint. The strategic synergies in marketing and drug development are the main outcomes of
consolidations and alliances. In turn it also means changing structure of competition and increased
competitiveness. The lack of introduction of new products and 2011 expiration of main blockbuster drugs
are characterizing the industry despite increased R&D investments. Furthermore the industry is characterized
by quick development of the world generic markets and for branded products generics are in turn
increasingly pressuring prices and market share due to regulatory compliances.
3.3.
Market(s) size, share and growth
The global pharmaceutical market was expected to have value of $ 693 billion in 2010, but ended up to be $
791 billion i.e. a 5% growth between year 2009 and 2010. According to Datamonitor’s expectations for 2010
the largest market share will have cardiovascular therapeutic area of 19.60% of total market value, but the
interest lies here in the CNS therapeutic area which was forecasted to have 18.60% of total value a second
largest forecasted therapeutic area in the global pharmaceutical market. However according to IMS world
review 2011, CNS accounted for the 16% of total global pharmaceutical market being the biggest market in
2010, sharply followed by cardiovascular (14%) and Alimentary (13%) therapeutic markets see table 3.1.
14
http://media.mmm-online.com/documents/19/outlookpt1_4530.pdf, Caruso, David “The market effectiveness: the key
competency for pharmaceutical growth, Kesic, Dragan “Strategic analysis of the world pharmaceutical industry” 2008.
Page 11
Table 3.1: Global Pharmaceutical market size, share and growth in 20101
Global Pharmaceutical market
Total value of $ 791 billion
Other therapeutic purposes
Cardiovascular
CNS
Alimentary
Respiratory
Total
2009-2010 growth
2010 (IMS world review 2011)
2010 (Datamonitor expected numbers)
3%
5%
5%
5%
5%
49.00%
14.00%
16.00%
13.00%
8.00%
100.00%
38.80%
19.60%
18.60%
14.40%
8.60%
100.00%
Source: My own design, but the data for the figure is based on Lundbeck’s 2011 3rd quarter road show p.86 and Datamonitor
In total the global CNS market size or value was at $ 125 billion, with a growth of 5%. The biggest
therapeutic area in the Global CNS market in 2010 was the market for anti-psychotics with a 20% market
share, followed by anti-depressive & and mood stab markets accounting for 16%. On the third and fourth
place anti-epileptic and anti-Alzheimer’s markets with 10% and 7% of market share are placed. The smallest
market share of 2% contributes the drugs used in alcohol dependence. What is important for the analysis is
how big the growth of the markets in the previous year was, because it shows what markets are mature with
lower growth and what markets have potential to be future growth markets. With 17% growth psycho
stimulants seems to be the most promising market, followed by anti-Alzheimer’s (12%) and anti-psychotics
(9%) market and also drugs used in alcohol dependence have a solid growth of 8%, see figure 3.1. The
smallest and negative growth of -3%, is seen in the anti-epileptic market. From above it seems that Lundbeck
strategy to invest in a R&D of a drug used in alcohol dependence is a wise choice and wise strategic move,
for future profitability when this market seems to have accelerating growth.
Page 12
Figure 3.1: Global CNS market size, share and growth in 20101
Antipsychotics
3% 2%
6%
4%
7%
17%
10%
8%
9%
Global CNS
market value of
$ 125 billion
and growth +5%
20%
4%
-3%
Antidepressive & mood
stab.
Anti-epileptics
Anti-alzheimers products
Psychostimulants
12%
Anti-Parkinson
16%
Drugs used in Alcohol
depedence
1
The inner circle is growth 2009-2010, and upper circle is share of global CNS market
Source: My own design, but the data for the figure is based on Lundbeck’s 2011 3rd quarter road show p. 86
According to “The global use of medicines: outlook through 2015”, the mature markets with negative
estimated growth in 2015 are anti-psychotics, anti-depressants markets. The market with most promising
growth is ADHD treatments with forecasted growth in a range of 4%-7%. The other two growth markets are
anti-epileptic and anti-Alzheimer’s markets. That anti-epileptic market is a growth market, is kind of in
contradiction with the historical numbers from 2010, which had a negative growth. The reason for the
difference could be that in the future bigger awareness and acceptance of the disease in some regions of the
world will give rise to higher spending in the future. It is a very positive outlook for Lundbeck that the
second largest revenue contributor in 2010 comes from anti-Alzheimer’s market, which according to above
have a promising growth opportunity. The negative is that anti-depressant market, the number one revenue
contributor for the company, seems to be a mature market and with a biggest stagnation in a range -5% to 8%, see table 3.2.
Page 13
Table 3.2: Estimated spending and growth of some of CNS’ therapy classes in 20151
Forecasted CNS therapy classes in 2015
Anti-psychotics
Anti-depressants
Anti-epileptics
ADHD
Alzheimer's
Estimated spending
$18-22 billion
$13-16 billion
$13-16 billion
$9-11 billion
$9-11 billion
Estimated growth
-3% to -6%
-5% to -8%
1% to 4%
4% to 7%
1% to 4%
Source: My own design, but the data for the table is based on: “The Global use of medicines: outlook through 2015 from IMS Institute
for healthcare informatics, May 2011, Appendix 4 p. 26
Currently in the global pharmaceutical market the Americas region with 51.8% of market share is a biggest
market, followed by Europe of 28.2% and Asia-Pacific of 20% market share. Besides looking at the overview
of geographical market share let us turn to the question what companies have highest market share in the
global pharmaceutical market? The top four companies in 2010 were Pfizer (10% market share), Merck & Co
(5.6%), Sanofi Avensis (5.0%) and Novartis (4.4%).
3.4.
Key factors for success (KFS)
The term key factors for success can be defined as in Lynch, Richard (“Corporate strategy” p. 809): “Those
resources, skills and attributes of the organizations in an industry that are essential to deliver success in the
market place, and it is not those factors that apply to an individual company. “ The KFS is useful for later
strategic analysis, as a way to assess what is important to analyze and narrow down factors of interest.
In the global pharmaceutical industry the standard KFS’s are investment in R&D together with marketing
and sales activities (Kesic Dragan 2009), but accordingly to Caruso, David “The market effectiveness: the
key competency for pharmaceutical growth”, there are additional and new key factors emerging for survival
in the industry the optimization of the information and collaboration in both R&D and marketing.
3.5.
The future growth markets15
An important question is what is the outlook for global pharmaceutical market in the medium term? It is
estimated that spending on the medicines will reach over $ 1,000 billion in 2015, but with slowing annual
growth between 3-6%. Furthermore the outlook for Lundbeck’s two biggest revenue market contributors
15
http://imshealth.com/imshealth/Global/Content/Document/IMS_Pharmerging_White_Paper.pdf; “The Global Use of
medicines: outlook through 2015”, IMS Institute for healthcare informatics, may 2011; Snyder, Glenn et. al. “The new
pharmaceutical market landscape”; Campbell, David et al “Pharmerging shakeup; new imperatives in a redefined world”, IMS
2010,and http://www.reuters.com/assets/print?aid=USN1921921520100420
Page 14
Europe and US is expected to have a declining trend of global spending from now to 2015. The spending on
drugs in top EU5 countries is forecasted to fall from 20% to 13%. The US share of global spending will in
2015 account for 31% compared to 41% in 2005. The current and future growth markets are seen to be 17
emergent markets a so called Pharmergent markets, with China in the leading position. In 2005 these
countries had only 12% of market share but it is estimated that in 2015 this number will grew dramatically to
28% of total spending. The other important prediction possibly affecting the Lundbeck’s future profitability
negatively is accelerating shift towards generics in 2015 forecasted to be 39% vs. 20% in 2005. What is also
discouraging is a prospect of rapid growth in the Pharmergent markets that is only lead by rise in generic
share of spending a 70 % outside developed markets. Furthermore it does not seem to be a good future
outlook, because the spending of branded products will be nearly the same in 2015 as in previous year. This
is due to lower volume growth of branded drugs, because of patent expirations reducing spending by $120
billion through 2015, but the slight increase will come from the population increase and drug use.
As mentioned already the future large and growing markets are the “Pharmergent markets”: China, India,
Brazil, Mexico, Russia, Turkey and South Korea (Snyder, Glenn). According to IMS latest report these were
the 7 emergent countries, which for three years ago gave the name “Pharmergent market”, because of the
major shift in growth seen at that time away from the mature developed economies; US, Japan, France,
Germany, Italy, Spain and Canada. Since then due to external market factors including economic crisis, now
the following four markets are seen as biggest growing markets; 1. China (20-23%), 2. Brazil (7-10%), 3.
Russia (14-17%) and 4. India (11-14%). The annual growth of these markets compared to 3-6% growth rates
of developed markets, which is also expected to grow through year 2014 are much higher see above
parentheses (Reuters 2010)16. So the characteristics of current and future market are the dramatic swing in
power to the Pharmerging markets, which will be the biggest contributor to global growth in the next five
years. Therefore it is seen as a very positive strategic factor that Lundbeck currently operates in the three out
of four biggest Pharmergent markets except of India. Seen in the light that China is the highest growing
market and is forecasted to be in the 3rd place in 2013 of the global pharmaceutical market, the launch in
2011 of Lexapro in China and Japan gives a positive outlook for the company, furthermore in October the
company engaged in an establishment of a research centre in China.
16
http://www.reuters.com/assets/print?aid=USN1921921520100420
Page 15
4.
Strategic analysis
To explore general environment, analysis with PESTEL framework is conducted, followed by the
competitive industry analysis in a Porter’s five forces framework. Before a conclusion of a strategic analysis,
a short competitor profiling will be conducted. Finally a conclusion of the strategic analysis is summarized in
a SWOT framework.
4.1.
PESTEL analysis
Political and Legal:
The most important current and future political issue effecting Lundbeck and entire healthcare environment
negatively is healthcare regulations, putting the ceilings on pharmaceutical prices and reimbursements.
Europe market and EU in particular is characterized by constant price pressure from healthcare reforms in the
individual countries, effecting negatively company’s revenue.17 Given that Europe market is Lundbeck’s
biggest revenue contributor in 2010 (53%), the healthcare regulations in this geographical area are of
considerable importance to the company’s profitability in the future. As pointed out by Moody’s in June
2011 it is most likely that intensified pressure on EU drug prices will see the light during 2011 and in future,
as a result of several European countries budget deficit problems, especially Greece and Spain. Following
quotation gives a good picture of the problem facing pharmaceutical companies: “National health programs
in these countries may seek to impose further drug price cuts to help repair public finances, adding to the
negative pressure on pharmaceutical companies' cash flows…where squeeze on healthcare spending likely to
spur generic products"18 Not only healthcare reforms in Europe are a problem but, also in other Lundbeck’s
markets, USA and China. In particular in US the 2009 Medicare reform is forcing all Americans to have
health care insurance putting new rebates and price discount rules on prescription drugs. For example there is
50% price discount on drugs provided through Medicare and 7% on generic products.19 What this will mean
to pharmaceutical companies as Lundbeck will first be seen in long term due to the fact that the Medicare
reform will fully be implemented in 2011. It could have two effects, due to more people are insured there will
be more drug sales though with lower prices, that could give rise in the companies’ revenues, or it could
mean that costs will be too high for pharmaceutical companies that they will lose revenue. The certain impact
17
18
19
Annual reports 2007-2010
The quote is from: http://www.reuters.com/article/2011/06/08/pharmaceuticals-europe-idUSLDE7571JE20110608
http://www.aarp.org/content/dam/aarp/health/healthcare_reform/2011_05/HCRLaw-Factsheet-at-a-Glance.pdf
Page 16
will be that generic products will benefit the most, because the focus is on “consumerisation” an increase
patient demand for more choices and cheap medicine. There is also a plan for Health Care Reforms in China.
Legally the company is protecting its patents and intangible assets and have pending litigations see page 26
note 31.
Economic: 20
In the light of today’s global economic climate wounded by the past financial crisis and seen together with
this year’s extensive economic turbulence throughout the globe this factor is probably one of the most
important subjects to address not only in general but also concerning the threat it possesses on the
companies’ profitability today and in the future. In general the profitability threat a company faces in the
aftermath of a financial crisis and economic turbulence is primarily coming from consumer and business
confidence deterioration induced by weakening of global capital markets, increasing unemployment rates,
inflation and downward pressure on the wages coupled by high number of company bankruptcies. For
consumers this means that they are more prices sensitive and risk averse implying increasing saving rates i.e.
saving for gloomy days, and searching for cheaper goods and commodities. Transferring this problem to
pharmaceutical industry it suggests an increase in sales of generic drugs since they are sold at considerable
lower prices than branded ones, possibly affecting the Lundbeck’s profitability negatively. Furthermore as
discussed in the political factor prior, governments are also squeezing the pharmaceutical companies’
revenue by health reforms that put pressure on the drug prices, provoked by the economic turmoil. According
to world economic outlook from September this year, the global economy outlook is not promising given the
fact that slowing growth and rising risks are the current dilemmas, in other words activity is weakened,
consumer and business confidence has dipped dramatically and downside risks are growing. The negative
economic outlook has its origin in multiple economic shocks that hit the global market in 2011. The shocks
are ranging from extreme financial turbulence in the Euro area with countries as Greece, Italy and Ireland in
the deep sovereign debt crisis to aftermaths of the Japanese earthquake and tsunami effecting negatively US
automotive market. Furthermore current and earlier unrest in the oil producing Middle East countries, and the
last and not least Standard & Poor’s U.S sovereign credit rating downgrade in the August this year from
AAA rating to AA+ caused by government’s high budget deficit and rising debt burden with the prospect of
20
http://www.elibrary.imf.org.www.baser.dk/view/IMF081/11731-9781616351199/11731
9781616351199/Other_formats/Source_PDF/11731-9781463940874.pdf
Page 17
another downgrade in next 12 to 18 months, gives rise to the market volatility in US but also around the
globe. 21
Since the 78% of Lundbeck’s revenue in 2010 comes from Europe (53%) and US (25%) market it is
significant to look closely at the economic outlook in those two regions.
In Europe current economic performances as well as future projections are mixed ones among European
countries according to Economic Outlook from September 2011. Therefore the European area is divided into
the Advanced Europe, Central Eastern Europe (CEE) and Euro Area. Overall the projected inflation for CEE
and Euro Area are most likely to drop from current percentage levels. In CEE the inflation is about to decline
from 5.25 % in 2011 to 4.50% in 2012, and in Euro Area the fall is from 2, 50% to 1, 50% in 2011 and 2012
respectively. The same inflation tendency is also the case in US a decline from 3% in 2011 to 1, 25 % in
2012, due to commodity price fall which peaked during this year. In all areas in general the real GDP growth
is expected to slow down, due to sluggish household consumption in Advanced Europe and fall in both
domestic and external demand in CEE countries. The annual Real GDP growth is going down from high 4,
25% in 2011 to 2,75% in 2012 projections for CEE countries. In Euro Area due to high commodity prices on
real disposable income, together with fiscal tightening and financial turbulence which gave drag on activity
and decline in consumer and business confidence and financing implied sharply growth decline in 2nd quarter
of 2011 from Annual Real GDP of 2% in 1st quarter to 0.25 % in 2nd one, and projected growth of slightly
above 1% in 2012. In U.S. current growth is a sluggish one a growth fall of 1,75 % point from 2,75 % in
2010 to 1% in 2011, and it is estimated that the economic growth will be modest for years to come with
1.75% growth in 2012. As it is evident that the economic performance varies between European countries a
few of them like Denmark, Germany and Switzerland have close to average pre-crisis growth rates, with
unemployment rates at or below pre-crisis levels, other countries like Greece, Ireland and Portugal have
recessions or fragile growth with very high unemployment, and rest of the region grew less than pre-crisis
averages. The current unemployment in U.S. of 9.1% is not likely to changes throughout year 2012, since
persistent economic slack and weak job growth is a reality. Furthermore the wages are held back, with very
high unemployment rate and weakened economic situation the workers have low negotiation power when
wages are negotiated.
21
http://www.reuters.com/article/2011/08/06/us-usa-debt-downgrade-idUSTRE7746VF20110806
Page 18
What it implies first and foremost that the financial turmoil in the Euro area could cause depreciation of euro
against any currency outside the euro area in particular USD. This could indirectly mean devaluation or a
weakening of DKK as well, since DKK is pegged to the Euro via the ERMII. In a case of a weakened DKK it
will imply higher revenues in local currency from US and other regions outside Euro zone. Lundbeck treats
the foreign currency fluctuations or risk such as these by use of financial instruments so called hedging
forward contracts, if interested see note 25 in 2010 annual statement.
It is positive that inflation rates in all regions are of declining trend in other words operating business of
Lundbeck will not be effected that much due to smaller incentives to increase sales prices, since growth of
costs of goods sold are about to be lower. Furthermore the economic weakening of the global capital markets
seems not to affect Lundbeck’s liquidity due to low debt ratio and good accessibility to capital markets.
Besides the already discussed effects of the crisis on Lundbeck’ s business it is worth mentioning that
pharmaceutical companies are not cyclical companies and are less exposed to systematic market risk the
same way people must eat they also need the necessary medicine. Therefore the medical products are bought.
Social:
In contrast to other factors in this analysis there is not much to say here besides already pointed out in the
introduction of increasing ageing of the population in the Western world and increasing global population
growth. For example according to World Bank in 2050 there is projected to be about 2 billion more people
than now, and we have reached 7 billion people in 2011.22 The reason that no other important measurable
social factors exist is that the company’s current product portfolio consists of treating hereditary diseases
from Huntington’s dieses to Schizophrenia, together with treating diseases mostly associated with elderly
people like Alzheimer’s and Parkinson’s disease, where social and cultural factors as a lifestyle have no
impact on. One can argue that depression is dependent on social factors like not being satisfied with the
current life, loneliness, stress or other lifestyle factors. However it is very hard to measure and therefore is
not included in the analysis.
22
http://www.worldbank.org/depweb/english/beyond/beyondco/beg_03.pdf
Page 19
Technological:
The relevance of this factor cannot be underestimated in the light of how immense it is in the pharmaceutical
industry to introduce new drugs and new patents, especially in the branded part of the market. In very few
words it represents competitive advantage and future business survival for Lundbeck as they as well on their
homepage point out: “..innovative research and development is the basis for our future”23. The rise in R&D
expenditures relative to revenue from past four years speaks for itself how innovation is important for the
company; from 19.60 % in 2007 to 25.80%, 23.20% and 20.60% in 2008, 2009 and 2010 respectively. More
to the point Lundbeck has currently 9 drugs in development in their pipeline. The investments in R&D is not
the only technological factor important for Lundbeck as a middle sized company, it is also important to work
in collaborations with other pharmaceutical companies in research & development of new drugs for faster
market introduction rates of the new drugs and more economical process, which stands for new research
initiatives and a new ways of business. This is evident in Lundbeck’s seven current R&D collaborations: 1.
Takeda Pharmaceutical Company Limited, 2. Genmab A/S, 3. Kyowa Hakko Kirin Co., Ltd., 4. Biotie
Therapies Corp. 5. Paion AG, 6. Zenobia Therapies, Inc. and 7. Vernalis plc. Besides presenting the
Lundbeck’s level of R&D expenditure it is insightful to compare it to company’s biggest competitors found
in competitor profiling. The Lundbeck’s average R&D expenditure from 2007-2010 of 22.30%, is only
surpassed by Forest Laboratories with 23.48%, sharply followed by Shire (20%) and Eli Lilly and Company
(19.63%). However the majority of the biggest players in the industry have below 17% average: Pfizer (15.70
%), GlaxoSmithKline (15 %), Novartis (16.60%), AstraZeneca (15.81%). This split in average of smaller
middle-sized pharmaceutical companies as Lundbeck that have high percentage of revenue invested in R&D
and market leaders as Pfizer that have much lower investments, indicates that bigger companies with bigger
pipelines and product portfolios are not that sensitive to patent expirations and tough industry competition
that they do not have to invest big percentage of their revenue. Another thing is that the investments of
leaders are in currency much higher than percentage than for the midsize companies due to higher revenues
of those companies. But all in all Lundbeck is technologically putting good effort and a promising one
compared to the peers. And as a rounding remark the slightly related industry of biosimilars and the possible
technological development in that industry could in future posses some threat in the pharmaceutical industry.
23
The quote is from: http://www.lundbeck.com/global/brain-disorders/research-and-development
Page 20
Environmental:
Even though environmental factors does not seem to have the same importance as the rest of the PESTEL
factors in this analysis, nevertheless it is seen as relevant to address because of the increasing environmental
awareness around the world, and also in the light of Lundbeck’s own corporate strategy to have corporate
responsibility regarding health and environment since 2004. The CO2 emission could possibly cause severe
climate changes around the world only through small changes in temperatures the so called greenhouse
warming is the primarily problem and a reason for increasing awareness. All though the effect of climate
change to some extant has in recent years been more visible with extreme weather changes in some regions
of the world the awareness of the severity of the problem is a not a new one for example UN convention on
climate change have been established since 1995, with conferences of the parties (COP) as an annual event,
to assess progress in dealing with this problem. Saving tomorrow today is the COP 17 slogan, held this year
in Durban Africa.
24
As mentioned before Lundbeck has since 2004 had long term effort in form of Health,
Safety and environment strategy, with transparent disclosure in the annual statements, under responsibility
and management. Furthermore this company’s awareness and focus on reducing the environmental footprint
has further been strengthen through signing the United Nations Global compact in 2008, and therefore
following the ten principles of anti corruption, human rights, labor and also environmental in following
principles 7-10:
“Principle 7: Businesses should support a precautionary approach to environmental challenges, Principle 8: undertake initiatives to
promote greater environmental responsibility; and Principle 9: encourage the development and diffusion of environmentally friendly
technologies.”25
In particular in 2010 the company has invested in new production technology, in order to reduce spillage and
energy consumption. The outcome of the company’s environmental strategy to the business as a whole is first
and foremost gained reputation of environment responsible company but also in saving money through lower
levels of energy consumed. All in all Lundbeck has a strong environment strategy which the company will
benefit from in the future.
24
25
http://www.cop17-cmp7durban.com/en/about-cop17-cmp7/greening-cop17-cmp7.html
The quote is from: http://www.unglobalcompact.org/AboutTheGC/TheTenPrinciples/index.html
Page 21
4.2.
Industry analysis Porter’s five forces
In order to get better insight what shapes Lundbeck’s strategy the industry analysis is a good tool for just
doing that. During the analysis the global pharmaceutical industry will be analyzed, and when seen necessary
specific CNS market conditions will be touched upon. In following the five competitive forces proposed by
Michael E. Porter will be of interest as an analysis tool, consisting of following forces see figure 4.1 below.
Figure 4.1: Porter’s five forces framework
Source: The figure is from Porter, M. E. (2008). “THE FIVE COMPETITIVE FORCES THAT SHAPE STRATEGY”.Harvard Business Review, 86(1), p. 80
One more thing left to clarify or define before the analysis. In the framework above who are the players
concerning each force in the global pharmaceutical industry? The rivalry among existing competitors is
analyzed only in reference to pharmaceutical companies, biopharmaceutical ones are not included. Regarding
extant of buyers bargaining power the hospitals, government agencies, drug retailers and other medium to
large sized buyers are seen as main buyers, but there is also the end users the drugs are intended for. In
general let’s call it health care providers and drug retailers. In similar fashion the key suppliers are defined as
providers of production devices and pharmaceutical ingredients. Threat of new entrants does not need further
clarification in contrast explanation of the threat of substitutes is necessary. For the branded drugs as
Lundbeck’s the first and foremost the generic manufacturers and their products are seen as substitutes,
furthermore the biosimilars could also be considered as such.
Threats of new entrants:
In light of the nature of the industry with stringent regulations concerning safety and efficiency of the
marketed drugs putting very high burden on the existing companies in the market in form of high costs, time
and extensive risk, is in itself substantial burden to be a considerable barrier to all future market entrants.
Page 22
Never the less the incumbents are protected by patents, making it possible for them to benefit and earn back
the development expenses and most likely earn extensive profit. This high degree of property knowledge is
also in itself a barrier to future entrants. The large multinational companies are also investing considerable
capital in R&D investments of developing new products which cannot be met under any circumstances by
the new or future entrants. Lundbeck itself is investing app. 21 % of its revenue in R&D investments. In
other words there are very high entry barriers in the industry in form of high fixed costs, knowhow; it is
capital intensive industry with high degree of knowledge needed to develop new blockbuster drugs. Due to
very low level of drug approvals and the time consuming effort to achieve this (takes more than 10 years
from a molecule is discovered to the marketed drug) that it is very unlikely in branded drug market that the
rise of new entrants occur. Furthermore it is getting less profitable in the whole industry due to global
reforming efforts to cut prices and costs of the drugs, as example can be mentioned US Medicare. The
existing companies competing in the market are trying to get new growth opportunities by marketing their
drugs in the “Pharmergent” markets such as China, India and Mexico with considerably less stringent
regulations to mention some. All in all it is evaluated that the likelihood of new entrants are of limited or
moderate degree in the industry.
The power of suppliers:
Large companies as Pfizer are producing some of their own chemicals to avoid the pressure of suppliers.
Lundbeck is applying the same strategy, as it is fully integrated pharmaceutical company, controlling
everything from research and development to manufacturing and marketing of a drug. In general the
pharmaceutical companies are met with high switching costs, when they change the supplier due to
contracting issues. All in all most companies in the industry are diversifying their raw material suppliers to
reduce their degree of power by not relying too much to one or two suppliers. The supplier power is strong in
the rare or specialized components like new raw materials for new drugs and sterile materials, where
suppliers can charge higher prices. In the case of Lundbeck this could be the only factor where the suppliers
could have high degree of power, because all other needed row materials are seen to be homogeneous. Even
though in the industry there is a moderate degree of supplier power for Lundbeck in particular is on a very
low level.
Page 23
The power of buyers:
There are many aspects to consider when analyzing the power of buyers; are they buying a patent protected
drug, the size and number of buyers, is a generic drug present on the market and is the drug a prescribed one?
If the drug is patent protected buyers have limited buyer power as long as the company has the patent,
according to Porter: “Pharmaceutical companies that offer patented drugs with distinctive medical benefits
have more power over hospitals, health maintenance organizations, and other drug buyers, for instance than
drug companies offering me-too or generic drugs.”26 However when patent expires with future competition
of generic drugs present the buyers power increases considerably. As it is going to be a problem when
Lundbeck’s depression drug Cipralex expires in US and Europe in the near future. There will be greater price
sensitivity on this drug, due to generic drug presence. In the light of large number of buyers from hospitals to
retailers the buyers in general have limited buyer power over pharmaceutical companies. Though the size of
the buyer’s matters also and if the buyers are big international companies they have greater purchasing power
and can negotiate lower prices. Furthermore the prescription drugs as Lundbeck’s, imply diminishing power
of drug retailer’s, because doctors at the end have all the power in saying what drugs the patient needs. This
in turn means that patients have not existent power in deciding what drug to buy, and negotiate prices.
Besides all the above US health care reform is also giving buyers considerable power in what drugs patient
should buy and to what price.27 Overall the power of buyers is of moderate degree.
The threats of substitutes:
The source of threats of substitutes in the global pharmaceutical industry is mainly coming from generics and
biosimilars, but also through alternative medicine and counterfeit medicine of both branded and generic
drugs. The patents are protecting branded drugs from substitutes as long as patent do not expire. But when
that is reality generics are offering lower prices for the same drug, because they are relying on benefits from
approvals granted to the innovator products they are copied from, acquiring no costs of themselves of clinical
trials and R&D investments. Alternative medicine and treatment as psychologists and such, are seen as no
threat for prescription medicine as Lundbeck’s, they posses bigger threats to OTC drugs. The treatment with
drugs in CNS area is seen as necessary that these alternative treatments are seen more as a supplement and
not a threat. The bigger threat for substitutes is counterfeit medicine: In 2007 in UK a drug of this kind
26
27
The quote is from: Porter, M. E. (2008). “THE FIVE COMPETITIVE FORCES THAT SHAPE STRATEGY” Harvard Business Review, 86(1), p. 8
If interested see PESTEL analysis for further information.
Page 24
intended for treatment of bipolar disorder and schizophrenia was found in the legal supply chain. 28 All
though there is very low threat of substitutes in general in this industry, it is seen as a strong threat for
Lundbeck due to patent expiration of blockbuster drugs in very near future; Cipralex (2012 (US), 2014
(Europe)), Ebixa (2014 (Europe)), Azilect (2015 in most European countries), and Sabril (2015 (US)).
Rivalry among existing competitors:
In the high competitive and highly regulated global pharmaceutical industry the market is characterized by
many companies but the majority of them are large multinational companies such as Pfizer, Merck & Co,
Sanofi Avensis, Novartis and others. In 2010 the four companies mentioned above accounted for one quarter
of the total market share.29 Due to the branding of the companies’ drugs and patent protection the market is a
heterogeneous one, and taken together with the competition described above it adds up to monopolistic
competition in the industry, with Pfizer as market leader with the 10% market share, sharply followed by the
other companies. Furthermore because there is difference in competitors in the industry from big to midsized companies, the market is a fragmented one. The fact that there are many companies competing along
with the reality that at the top players of the industry are approximately same size companies, the market
rivalry is intense or strong. All these large companies are competing approximately in the same markets,
pharmaceuticals branded drugs, vaccines, over the counter medicines (OTC) and generics i.e. they have a
broad product range. Lundbeck on the other hand is specialized company focusing solely on the CNS drugs
in the category of branded pharmaceuticals, giving the company an upper hand in production and knowhow
in this treatment area which gives the company the competitive advantage. On the other hand the major
players as Pfizer benefit from scale economies in both manufacturing and R&D. The nature of rivalry in this
industry is altered in consistence to Porter’s work by consolidations, either to diverse product portfolio or
geographical reach. The Lundbeck acquisition in 2009 of Ovation Pharmaceuticals and LifeHealth Lmtd. is
an example. With the acquisitions Lundbeck simultaneously diversified its product portfolio including
treatment of Huntington’s disease with Xenazine, and epilepsy with Sabril and thereby also entering new
geographical area the US market. During the past five years Lundbeck’s acquisition and rivalry alterations is
not the only one it is a way of business in the industry. As an example Pfizer acquired Wyeth in 2009,
AstraZeneca acquired MedImmune and Novartis acquired Chiron in 2006. By these means the rivalry is
28
29
Datamonitor’s: Industry profile ”Global Pharmaceuticals” (2010)
Ibid
Page 25
eased somewhat. Because innovation is very important to grant companies exclusivity to the market it is also
primary competition tool in the pharmaceutical industry. Another way of altering the means of the
competition is through collaborations with competitors in technological innovations and marketing, i.e. use
of in licensing. In-licensing is also a broadly used method in the industry and by Lundbeck as well. The
company’s top products today as well as future products are in-licensed ones; Ebixa, Azilect, Circadin and
Nalmefene are all in-licensed.30
Figure 4.2: Drivers of the degree of rivalry in the global pharmaceutical market in 2010
Competitior size
5
Zero sum game
Easy to expand
4
3
Undifferentiated…
Hard to exit
2
1
0
Storage costs
Lack of the diversity
Similarity of players
Number of players
Low cost switching
Low fixed costs
Source: The figure is from Datamonitor, Industry profile “Global pharmaceuticals” figure 10. Page 23, the degree 0-5, zero means no rivalry and 5 strong rivalry.
So the competition in technological innovation and marketing ability is also eased a notch by collaboration,
but the rivalry of the incumbents is still intensified due to high R&D investments, other investments and high
fixed costs. The rough industry rivalry intensifies for mature products such as Cipralex/Lexapro in
Lundbeck’s portfolio, where the rivalry is not only with incumbents’ products but also a direct competition
with generic ones. In the industry it is a constant battle to protect the existing patents and intangible rights.
Lundbeck is presently involved in pending court trials especially for depression compound (Esitalopram) in
Europe and International Markets.31 Undesirable result of such patent disagreement is loss of rights, implying
price competition with generic products which are lower priced as a rule and most possibly resulting in the
30
For further info see product overview Appendix 1
The exact companies are Austria, Belgium, Brazil, Canada, Denmark, Finland, France, Germany, Hong Kong, Hungary, Latvia, Lebanon, the
Netherlands, Norway, Portugal, Spain, Taiwan, Turkey, and the UK. See http://files.shareholder.com/downloads/AMDA31
GGC00/1424322190x0x516389/53e0fcdb-e581-402b-8c32-d913571f2fa2/Read_the_full_release_in_PDF.pdf
Page 26
price deduction and profit loss for the company. The generic competition is intensifying in the mature
pharmaceutical industry. For example from 2010 Escitalopram was introduced in Finland, Norway and Spain
effecting negatively the sales of Cipralex, and introduction of memantine in Canada, Lundbeck’s sales of
Ebixa halved.32 The overview of the industry drivers are summarized in the figure 4.2 above. So to conclude
companies operations are effected by multiple factors, new products introduced by the incumbents, industry
consolidation, technological improvements by one or more competitors, patents and drug approvals of the
rivals, and competitive combination products. All in all rivalry is strong in the global pharmaceutical industry
and is expected to further increase in degree in the future, due to maturing of the market.
The conclusion of the analysis is that in the global pharmaceutical industry on a moderate level are threats of
new entrants, the power of buyers and power of suppliers. Threats of substitutes are on a low level and
rivalry among the existent competitors is a strong one. For Lundbeck as a company there are slightly
differences from the industry as whole, threats of substitutes is seen as a strong one due to patent expiration
of blockbuster drugs, and power of suppliers are on a low level since the company is an strongly integrated
company.
4.3.
Competitor profiling
The purpose of the competitor profiling is twofold, partly it serves as an analysis and comparison of
Lundbeck’s main competitors to put Lundbeck as a company on the map. The questions to be answered are
how the company is doing in relation to its peers, concerning R&D investments, and other relevant matters
such as CNS revenue, product portfolios and patent expirations. Second reason for competitor profiling is to
narrow down the biggest Lundbeck’s competitors in the global CNS market for later multiple analysis,
because not all companies that are relevant as a Lundbeck’s main peer group in the global pharmaceutical
industry are the company’s biggest competitors in the global CNS market because some of the companies are
simply too different. All though Lundbeck is a global player it is still a specialized company, only focusing in
one therapeutic area CNS, making it very hard to find a proper peer group for the benchmark analysis. It is
essential to use right peer group, the benchmark companies should be similar in size of the business in terms
of revenue and products portfolios, and also geography are the most important criteria. 33 In accordance to
these criteria Lundbeck does not have any company in the global pharmaceutical industry that could fit all
32
33
Lundbeck’s 2010 Annual Statement
http://skillnet.com/services/market-intelligence/peer-group-analysis.html
Page 27
the criteria above i.e. a proper peer group for the company does not exist. Even though to find the next best
thing the criteria must be relaxed, and by doing so the following companies are seen as Lundbeck’s main
competitors in the local and global pharmaceutical industry; AstraZeneca PLC (5th), Bristol-Myers Squibb
Company (9th), Eli Lilly and Company (10th), Novartis AG (4th), Pfizer Inc (1st), Shire Pharmaceuticals
Group plc (43rd), GlaxoSmithKline Plc (2nd), Merck KGaA (24th), Neurocrine Biosciences Inc., NeuroSearch,
Novo Nordisk A/S (21st), Forest Laboratories Inc. (27th) and Dainippon Sumitomo Pharma Co., Ltd.34
NeuroSearch is a Danish company also specializing in CNS manufacturing as Lundbeck but does not operate
on the international plan therefore this company is not relevant for the analysis. Besides Dainippon
Sumitomo Pharma Ltd. and Neurocrine Biosciences the companies listed as Lundbeck’s biggest competitors
are among Worlds top 50 Pharma companies with majority in the top 10 league in year 2006, Lundbeck itself
is on the 40th place.35 So the two companies that are not a part of top 50 are not considered as proper peer
group candidates. There are two more companies listed above that are not considered as competitors in the
Global CNS market, and these are Novo Nordisk and Merk KGaA, the first one does not have CNS portfolio
and the other one has only one drug in the CNS portfolio treating Multiple Sclerosis a drug Lundbeck does
not have in the current CNS portfolio, and therefore is not seen as a direct competitor.
34
35
Lundbeck’s biggest competitors are from: Datamonitor’s H. Lundbeck A/S “Company Profile” from 30. August 2011
Gray, Nicole (2006) “Changing Landscapes A special report on the Word’s top 50 Pharma Companies”
Page 28
Table 4.1: H. Lundbeck A/S and The Peer Group overview of CNS share of revenue and R&D investments in year 2010
CNS
Company
share of
R&D
investment in
R&D
(all currency numbers
Total Revenue
Total
total
are in millions)
in local
Revenue
revenue
CNS revenue
% of total
investments in
currency
in DKK
in %
in DKK
revenue
DKK
14,765.00
98%
14,507.00
20.6%
3,045.00
H. Lundbeck A/S
DKK
14,765.00
Peer Group:
Pfizer
$ 67,809.00
366,951.25
11%
39,087.57
13.9%
51,006.22
GlaxoSmithKline
£ 23,382.00
203,212.73
7%
13,679.62
15.7%
31,904.40
Novartis
$ 30,558.00
165,365.90
7%
11,185.66
16.0%
26,458.54
AstraZeneca
$ 33,269.00
180,036.59
17%
31,008.14
16.0%
28,769.85
$19,484.00
105,438.48
13%
13,880.61
18.3%
19,295.24
$23,076.00
124,876.74
39%
49,041.02
21.2%
26,473.87
Forest Laboratories
$ 3,903.50
21,123.95
89%
18,700.67
27.0%
5,701.36
Shire
$ 3,128.20
16,928.39
43%
7,342.92
19.04%
3,223.16
Bristol-Myers
Squibb
Eli Lilly and
Company
Source: My own calculations based on the companies’ homepages
In the table above it can be seen that Lundbeck is a very small player in the global pharmaceutical industry
when total revenue in DKK from 2010 is considered, since it has smallest total revenue in the peer group. To
see the extant of this, Lundbeck’s total revenue in DKK is only 4% of Pfizer’s who is a market leader.
Compared with other peer group companies it is a similar picture Lundbeck’s total revenue is about 7% of
GSK’s, about 8%, 9%, 12% and 14% of AstraZeneca’s, Novartis’, Eli Lilly & company’s and Bristol Myers
Squibb’s total revenue respectively. So in total out of 8 companies in the peer group only two of them Forest
Laboratories and Shire have similar amount of total revenues as Lundbeck. As expected Lundbeck have the
largest CNS share of total revenue of 98%, and the two companies with similar amount of total revenue have
also closest CNS share of total revenue to Lundbeck’s. Forest Laboratories with 89% and Shire with 43%
followed by Eli Lilly & Co with 39 %. As before 5 out of 8 peer group companies have very low CNS share
of total revenue compared with Lundbeck’s precisely below 18%, and some of them have also below 10%
with 7% CNS share of total revenue. These companies are primarily the biggest players in the industry:
Page 29
Pfizer, GSK, Novartis, AstraZeneca and Bristol Myers and Squibb. Nevertheless the completely different
picture is painted when the CNS revenue is compared across the peer group. As Lundbeck has the biggest
CNS share of total revenue it is expected that the company no longer have smallest CNS revenue, and it is
completely true, this time Lundbeck’s CNS revenue of DKK 14,507.00 million precisely in the middle of the
9 companies considered. The smallest CNS revenue has Shire with DKK 7,342.92 million and the biggest
CNS revenue of DKK 49,041.02 million has Eli Lilly & Co. The difference in Lundbeck’s CNS revenue
compared with the peer group is not as big as when the total revenue is compared. In this context Lundbeck’s
CNS revenue is about 30 % out of Eli Lilly’s & CO CNS revenue. When CNS revenue is compared across
the peer group the closest revenue to Lundbeck’s have Forest Lab, Bristol Myers Squibb, GSK, and Novartis
respectively.
The other important issue is how much in percentage of revenue companies are investing in R&D, as it is one
of the KFS in the industry. It is evident that smaller companies as Lundbeck, Forest Laboratories and Shire
except for Eli Lily & Co are the ones investing the biggest percentage of the total revenue in R&D, close or
above 20% exactly. Nevertheless they still have smallest R&D investment in DKK compared to bigger
companies due to big difference in the total revenue across the peer group, as was the case with the
difference in total revenue. Pfizer invests smallest percentage amount of revenue in R&D (13.9%) but still
have the highest investment of DKK 51,006.22 million compared to the Forest Laboratories with the highest
R&D investment of 27% of total revenue but only an investment of DKK 5,701.36 million. When the R&D
investment in percentage is compared across the peer group Lundbeck have 3rd highest investment of 20.6%,
but the lowest amount in DKK of 3,045.00 million in the peer group, which is not that promising. The
positive thing is that Forest Laboratories and Shire who are the closest competitors do not have much higher
investment than Lundbeck. The above was a static picture of this issue if we on other hand look how the
R&D investment across the peer group in percentage is changing over a period from 2008 to 2010 we will
get a better sense of this see figure 4.1.
Page 30
Figure 4.1: The percentage change in R&D investments over a three year period (2008-2010)
-10.3%
-5.6%
-3.0%
-11.5%
-11.21%
2010
-29.2%
-35.2%
Eli Lilly and Company
9.0%
Bistrols- Myers Squibb
28.9%
AstraZeneca
Novartis
GlaxoSmithKline
Pfizer
Lundbeck
0.5%
2.7%
-6.0% 5.5%
3.4%
-1.2%
-40.00% -30.00% -20.00% -10.00% 0.00%
Shire
Forest Laboratories
18.9%
-5.1% 5.3%
11.4%
-18.0%
-5.2%
-5.3%
-4.8%
-10.08%
2009
2008
48.4%
7.1%
31.63%
10.00% 20.00% 30.00% 40.00% 50.00%
Source: My own calculations based on the companies’ homepages
In general the percentage change in R&D investment over the peer group is a negative one for the most
companies. As for Lundbeck in 2008 the R&D investment grew by 31.63% which was one of the biggest
changes that year, the biggest change had Forest Laboratories with a negative change of -35.2 % strongly
followed by Shire with -29.2 % R&D investment. From 2009 Lundbeck had a negative trend in R&D
investment and for Shire and Forest Laboratories it was mixed one positive and negative. All in all Lundbeck
is mostly doing as a peer group in R&D investment, but it is not that positive that the R&D investment trend
is the past two years being a negative one when it is obvious that they have a smallest investment in the peer
group and a potential expiration of the blockbuster drugs in near future.
Comparing product portfolios and pipeline across the peer group the following is to be induced. Looking at
the biggest revenue contributor for the company the depression and anxiety disorders therapeutic class, three
companies in the overall peer group Novartis, AstraZeneca and Shire are not the current competitors since
they have at present time no such product in their product portfolio. However they are seen as possible new
players since the most companies are faced with patents expirations relatively until year 2014 or have patents
that are already expired, (a part of Bristol –Myers Squibb that has already a brain new product on the market
Page 31
Abilify) and the two of them have one drug in phase III in their pipelines to be registered in US 2012 and
Europe 2015 respectively. In relation with the competitors Lundbeck is in the similar situation, the positive
thing to say is that they also have two new drugs in their pipeline and most importantly when the patent
expires on Cipralex/Lexapro they have a new drug in development phase III as the following competitors
have as well: Novartis, AstraZeneca, Eli Lilly & Co. and Forest Laboratories. Since they all operate in the
same markets the question is which drug and the corresponding company is to win the race of registration
approval and market dominance. As expected the big companies Pfizer and GSK have larger portfolios in
this treatment area consisting of three products in comparison with only one in other companies. What is
surprising is that the relatively small company as Forest Laboratories also has three drugs in their portfolio,
where one is shared with Lundbeck.
When looking at the Alzheimer’s disease market, the current competitors with only one drug in their
portfolios are Pfizer, Novartis, Forest Lab. and Shire. The information on expiration of patents is only
available for Lundbeck and Pfizer and it seems that the two companies are in similar situation, i.e. they are
both facing patent expirations Pfizer in 2013 and Lundbeck in 2014. The potential entrants are GSK,
AstraZeneca and Eli Lilly & CO. However Pfizer stands strong since they have three new potential drugs in
the pipeline which two are in phase III. Only one other company have a drug in a phase three Eli Lilly. All
other companies have drugs in the second clinical phase as Lundbeck or the first. From this point of view
Lundbeck does not have a promising future in this market since they have only one drug in the pipeline, and
the most companies have at least two or three.
Lundbeck has only two competitors in the Parkinson’s diesis market, GSK and Novartis. Out of the three
companies Novartis seems strongest with two products in the portfolio, vs. only one drug in the other two
companies. Besides this company also has a clinical phase III drug to be registered in 2012, and since no
products currently are threatened by patent expirations as for the other two, the GSK’s expiring in 2012 and
Azilect expiring in 2015 in most European countries Novartis is seen as leader. It should also be mentioned
that GSK is sharply following Novartis given that they also have one phase III drug in development. If there
is to be an entrant in the market the AstraZeneca is a possible candidate, having one drug in development
even though only in clinical phase I. Lundbeck is in comparison currently lacking development of a new drug
in the pipeline, and if they do not engage in future in a product development or introduce Azilect on the new
Pharmergent markets the future revenue contribution from this market is not promising one.
Page 32
GSK, Pfizer and Shire are the only three companies having a product treating epilepsy in the peer group and
are in competition with Sabril. The strongest position on the market seems to have Lundbeck since being the
only company having two new drugs in late development stages. One drug in phase III and Onfi is in the
registration process since 2010. Furthermore the patent on Sabril is to expire in 2015 and 2016 where GSK
already have expired patents in US and EU. Pfizer’s Lyrica has the longest patent duration until 2018,
however GSK also has a drug in registration process vs. Pfizer only having one in phase III and Shire having
none.
The three companies that are currently not in competition game in the psychotic dieses market are Novartis,
Shire and Forest Laboratories. Of the three company mentioned the Forest Laboratories is a very much a
potential new player, having two new drugs in clinical phases II and III. Lundbeck has two drugs on the
market Serdolect and Sycrest, the first one is no longer protected by the patent, and the second one is a new
marketed product in Europe. The two other companies with relatively new products on the market are Pfizer
with two and Bristol –Myers Squibb with one. All other companies have patents that are expired or are facing
patent expirations in the nearest future. Since Lundbeck already have one new product in the product
portfolio, two drugs in total (the maximum amount compared to other companies) and is the only other
company besides Forest laboratories having a drug developed in phase III, the future seems bright for the
company in this particular market.
In the other markets there is no peer group, since Lundbeck is the only company in the current peer group
having products marketed. In the future Nalmefene treating alcohol dependence is in a process to be
approved at the end of this year and Forest Laboratories is the only company already having Campral on the
market. The whole overview of the above described is in Appendix 3 if interested.
In what follows is a conclusion presented in a SWOT framework.
Page 33
4.4.
Conclusion in a SWOT framework
INTERNAL
Strengths
-
Weaknesses
The focus strategy plus long history in production and
knowhow
competitive
in
CNS
market
advantage,
giving
through
the
focus
-
company
in
Major drugs facing patent expirations in the near future
or are expired in certain
single
geographical
markets;
Cipralex/Lexapro, Ebixa, Azilect, Sabril, Serdolect.
therapeutic area enabling to build reputation in CNS
market.
-
A small and undiversified product portfolio compared to
the peers.
-
Strong current strategic alliances in R&D partnerships,
marketing and in-licensing.
-
Currently mostly dependent on mature markets i.e.
European market and U.S market, accounting of 78% of
-
Good accessibility to capital markets and low debt
the revenue in 2010.
providing financial flexibility.
-
High dependency on anti-depressant market of 56%
Acquisition of Ovation Pharmaceutical and LifeHealth
revenue contribution in 2010 is seen as a weakness since
limited.
this market is a mature one and with biggest stagnation
prospect in the future.
-
High R&D investments relative to revenue and one of the
highest compared to the peer group.
-
A very small player in the global pharmaceutical
industry.
-
Fully integrated pharmaceutical company from R&D to
manufacturing and marketing, implying very low level of
-
supplier power and increased gain in the know how.
-
investment in DKK.
Patented drugs with distinctive medical benefits implying
-
relatively bigger power over buyers.
-
Strong
awareness
and
focus
Compared to the peer group they have smallest R&D
A historical negative trend on R&D investments could
effect future profitability negatively.
on
reducing
the
-
One of the highest projected growth markets through
environmental footprint i.e. building good environmental
2015 in therapeutic area anti-Alzheimer’s, will not be
reputation.
well represented by Lundbeck since they are facing
patent expirations in 2014 and have only one early stage
-
Strong current presence in relation to peers and strong
new drug in the development compared to the peers.
future presence in anti-epileptic market, which is
estimated to be one of the highest growth markets in the
future. This is concluded since the company has two late
stage drugs in the development. Drug Onfi is to be
registered in US. (this is also an opportunity for revenue
growth)
Page 34
EXTERNAL
Opportunities
-
Lexapro marketing in China
Threats
-
Pipeline failures could effect the company’s performance
negatively.
-
A presence in the biggest Pharmergent markets (China,
Russia, Brazil) with highest projected market growth,
-
especially China the number one growing market.
Negative forecast of global spending in two biggest
revenue market contributors of the company Europe and
US.
-
Pursuing additional licensing and product acquisition
-
deals that could drive top-line growth.
Strong threat of generics due to quick development of the
world generic markets, and forecasted accelerating shift
towards generics through 2015 implying pressure on the
-
Lexapro’s entry into growing Japanese anti-depressant
market.
prices and market share.
-
Forecasted growth of Pharmergant markets which are
only lead by rise in generic share of spending.
-
Continued US expansion
-
Cephalon drugs in 2012
-
Alliance with Japanese Otsuka
-
Forecasted zero growth in spending on branded drugs
through 2015.
-
Health
care
regulations,
cut
in
prices
and
reimbursements: US: Medicare reform – 50% price
-
FDA approval of Onfi in US in 2011, with expected
discount
launch in January 2012, possibly implying solid revenue
medicare.
growth.
prescription
drugs
provided
through
Europe: future price cuts induced by current debt crises.
-
-
on
Negative global economic prospect, i.e. slowing growth
Since the CNS market is biggest market in the
and rising risks activity weakened, consumer and
pharmaceutical industry potential growth possibility and
business confidence fallen.
rise in the profitability.
-
Introduction of anti-alcohol dependence drug Nalmefene
Market volatility rising, downgrade of US debt and debt
crisis in EU.
in EU expected at the end of 2012 implying good
possible future profitability growth since this market is a
-
Growing number of legal disputes.
new one and it is expected to have accelerating growth in
-
Strong threat of substitutes due to patent expiration of
the future.
blockbuster drugs.
-
-
Population growth and growth in elderly people.
Market rivalry intense and strong in the Global
pharmaceutical industry.
-
Overall in most of submarkets there are potential rise in
couple of new entrants relative to peers, implying
intensifying market rivalry in these markets.
Page 35
5.
Reorganizing financial statements
As a starting point for a later historical performance analysis of the company at hand, the first step is to
reorganize Lundbeck’s financial statements. As mentioned in the previous chapter listing the scoop and
structure on page 6, reorganizing financial statements is important because the operating and financial items
have to be separated to enlighten the performance of a given company. In this part the reorganization of
financial statements from 2007-2010 will be conducted, based on Lundbecks’ financial statements from these
years. It should be mentioned that from the beginning the 5 year scoop for the companies’ historical
performance was planned i.e. including year 2006 in the reformulation. Due to certain changes in accounting
policies of Lundbeck in 2009, (see the part below about accounting standards) resulting in lack of
information it was difficult to restate the statements for the year 2006 to be comparable with other 4 years.
Therefore it is chosen to drop this year completely out of the analysis.
Below first will conclusion of relevant accounting issues be addressed, and shortly followed by capitalized
expenses. This chapter is theoretically speaking a ground work for the analysis of historical performance,
which is covered in the part 6.
5.1.
Accounting issues:
Below is a list of accounting issues applicable in general that are found important to address.
Accounting standards:
In accordance with the latest both domestic and international standards the annual statements for H.
Lundbeck A/S Group are prepared. As a Danish listed company on the Copenhagen Stock Exchange the
Danish Statutory Order on adaption of IFRS have to be meet which is the Danish disclosure requirements,
furthermore as a listed company Lundbeck also have to meet disclosures imposed by NASDAQ OMX
Copenhagen. On the international scale due to the fact that Denmark is a part of EU which adopted
International Financial Reporting Standards (IFRS), the (IFRS/IAS) are also followed by the company in
preparing the annual reports. Furthermore this means that the annual reports prepared are in accordance with
the International Accounting Standards Board (IASB) that publishes (IFRS/IAS).
Page 36
New and revised standards (IFRS/IAS) in the interval 2006-2010 implemented by Lundbeck:
It is found to be important to list changes in Lundbeck’s accounting procedures during the years, for better
transparency for the reader of accounting numbers in the final reformulated statements. As well as the
importance to argument varies reasons for dropping year 2006 of the historical analysis, see Appendix 5 if
interested only conclusion will be presented here. Hence the changes in accounting policies are severe in year
2009 that effects income statement, comprehensive income and balance sheet on many levels. This means
due to lack of insider information it is found to be impossible to restate year 2006 accordingly and any other
year for that matter previous to 2007, in order not to be misleading for historical analysis. For that reason
only already restated years 2007-2009 found in 2009 Annual report are of interest for the report due to the
comparability issue. Finally what can be concluded from the presentation of accounting policy changes
during the years 2006-2010? According to considerable changes in 2009 the financial statements for years
before and after 2006 are not comparable with 2007-2010 financial statements, resulting in final and only
valuable interval for historical analysis and reformulation the years 2007-2010.
Reporting currency: Due to the fact that the parent company is a Danish one all the figures are reported in
DKK.
Marginal tax rate: As reporting currency was Danish so is the marginal tax rate i.e. the Danish statutory tax
rate is used in the annual reports! In the time interval 2007-2010 the statutory tax rate was 25%.
Working cash: As expected, in Lundbeck’s annual report it is not disclosed how much the working cash is
vs. excess cash. According to Koller (2010) p.145 the good proxy for working cash in such a case is to take
2% of revenue and treat everything else as excess cash. This is applied in the reformulation.
Dividends:The company is historically paying dividends each year; however since 2009 the extra amount is
distributed to shareholders the excess liquidity the company does not need for business operations and R&D
investments. This amount has before been used to buy back shares. The company’s policy is to distribute
between 25-35% of the profit as a dividends to company’s shareholder’s. The proposed dividends for 2010
amounted of 30% as much as in 2009. In other words it means dividends of DKK 739 million or DKK 3.77
per share.
Page 37
5.2.
Capitalized expenses
R&D: In general because R&D investments in the development of the new drug is a very big part of the
company’s intangible assets as it is for any pharmaceutical company the R&D expenses are capitalized. This
is consistent with following quotation from Aswat Damodoran’s paper on R&D expenses:” We argue that
research and development expenses should be treated as tax-deductible capital expenditures, for purposes of
valuation, and this can have significant effects on operating income, capital and expected growth measures
for firms with substantial research expenses.36” In other words the failure to recognize the intangible assets
properly for a pharmaceutical company means overestimation of the company’s ROIC, contributed by the
underestimation of the Lundbeck’s invested capital. Koller recommends capitalization of the R&D expenses
for three reasons: 1. to represent historical investment more accurately, 2. to prevent manipulation of short
term earnings and 3. to improve performance assessments of long-term investments. Capitalizing R&D
includes amortization of R&D asset and based on Damodoran’s paper the proper method is to apply straight
line amortization assuming 10 years asset life. In order to reach the steady state it is recommended to use the
earliest year possible, for that reason the building and amortizing Lundbeck’s R&D asset is going back to
1987. See Appendix 6.9 for complete calculation overview. The ending R&D intangible calculated in turn is
used to adjust Invested Capital calculations, denoted capitalized R&D- intangible assets and adding it to
operating assets the adjusted invested capital without goodwill is calculated. Furthermore in order to total
funds invested balance the capitalized R&D is added to equity and equivalents. Adjusted NOPLAT partly
refers to NOPLAT incl. capitalizations, where the R&D costs from NOPLAT is replaced by calculated R&D
amortization. In order to balance, reconciliation with net profit is adjusted with net changes from R&D
capitalization. When R&D is properly capitalized it will not affect the FCF, regardless it is giving the same
result unadjusted or adjusted. The only difference is in FCF calculations, instead of NOPLAT the Adjusted
NOPLAT is used and additionally subtracting amortization of R&D to calculated the gross cash flow.
Moreover from gross cash flow investment in R&D (the R&D costs from NOPLAT) is also subtracted to get
to FCF.
Leases, pensions and other obligations:
37
In addition to capitalizing the R&D expenses the “off-balance-
sheet debt” the operating leases are recognized, in order not to bias the financial ratios and most importantly
36
The quote is from Damodorans, Aswat “Research and development expenses: Implication fro profitability measurement and
valuation” p. 2 see the abstract. The paper is from following homepage: http://pages.stern.nyu.edu/~adamodar/
37
Koller, Tim et al. “Valuation measuring and managing the value of companies”, chapter 27
Page 38
the driver of value creation ROIC upwards. In order to adjust for operating leases the value of leased assets
should be estimated, since it is not disclosed by Lundbeck or any other company. The following formula and
methodology is used to estimate the asset value: 𝐴𝑠𝑠𝑒𝑡 𝑉𝑎𝑙𝑢𝑒𝑡−1 =
𝑅𝑒𝑛𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑡 38
𝑘𝑑 +
1
𝐴𝑠𝑠𝑒𝑡 𝐿𝑖𝑓𝑒
. The rental expenses of
for example DKK 165 million in 2010 are found in Lundbeck’s annual statement see Note 26 Contractual
obligations under rental and lease obligations, and accordingly for other years. Estimating the appropriate
asset life is based on Koller’s median asset life of 10.9 years computed from 7000 firms over 20 years, which
in turn is based on Lim, Steve C et al. “Market Evaluation of Off-Balance-Sheet Financing: You can run but
you can’t hide”, EFMA 2004 Basel Meetings Paper (December 1, 2003). Hence this estimation method is
used since it seems reliable. In view of the fact that the operating leases is less risky than the Lundbeck’s
unsecured debt, since it is secured by the underlying assets, the cost of debt applied in the calculation is the
lower after tax cost of debt of 2.16% synthetically estimated rather than the cost of debt used in WACC
calculations of 2.86% after tax. When that is said the complete calculations are in Appendix 6.10. Similarly
as R&D capitalization the financial statements have to be adjusted to reflect operating leases appropriately.
Since rental expenses are recognized in income statement see note 26 the rental expense is added back to
Adjusted EBITA and corrected for lease depreciation. In reconciliation with net profit the after-tax lease
interest is added to Adjusted NOPLAT. Capitalized operating leases are added to invested capital excluding
intangibles in Invested capital calculations. Given that operating leases are classified as “off-balance-sheet
debt”, the same amount is capitalized under debt and equivalents. Finally the FCF is adjusted as follows;
decrease (increase) in capitalized operating leases is adjusted to get Gross investment. Consistently to flow to
(from) debt holders the after-tax lease interest is added together with decrease (increase) in capitalized
operating leases. Additionally the capital structure must be adjusted for leases, in order to lower the WACC,
to out weight the drop in return on capital. Therefore the value of operating leases is added to debt in capital
structure calculation, implying higher debt ratio than without the adjustment. Finally to determine equity
value later in the paper the current value of operating leases is subtracted from enterprise value.
To conclude the results of reorganizing the financial statements is presented below see the Appendices 6.16.12 for full overview, and in the next chapter the historical performance analysis is performed.
38
According to Koller there are three other methods available for asset value estimation, without further going into how it is
conducted they are seen as not valid since they either undervalue, or overvalue or simply give incorrect assessments.
Page 39
NOPLAT
Adjusted NOPLAT
Invested capital excluding intangibles
Invested capital including intangibles
Total funds invested
Cash flow available to investors
Adjusted Free cash flow after goodwill
Adjusted Free cash flow before goodwill
6.
2007
2008
2009
2010
(DKK mm)
(DKK mm)
(DKK mm)
(DKK mm)
2,432
3,438
6,165
19,284
22,720
2,389
3,523
5,725
20,120
23,910
2,016
3,113
2,461
2,816
4,555
5,773
27,088
29,024
2,798
2,833
2,833
3,342
4,731
5,824
29,271
31,668
2,128
3,205
2,440
Analyzing historical performance
In this part the analysis of the historical performance is conducted.
The analysis will start with NOPLAT, Invested Capital and Free cash flow followed by the revenue growth
analysis, operating performance in form of ROIC framework and finalized by historical stock market
performance compared to the peer group.
6.1.
NOPLAT
The net operating profit less adjusted taxes (NOPLAT) is defined as: “the profits generated from the
company’s core operations after subtracting the income taxes related to the core operations.” 39
Historically Lundbeck’s NOPLAT value is having a constant growing trend of both adjusted NOPLAT and
the one without R&D capitalization and operating leases during the years 2007-2010, see figure 6.1. The
difference in NOPLAT value between adjusted and not adjusted NOPLAT is about 40%, which is a
considerable amount, and proves the point made above why it is important to capitalize R&D expenses and
recognize “off-balance-sheet debt”.
39
The quote is from Koller, Tim et al.:“Valuation measuring and managing the value of companies” p. 40.
Page 40
Figure 6.1: H. Lundbeck’s A/S historical NOPLAT for years (2007-2010)
In millions
kr. 6,000
kr. 4,555
kr. 3,438
kr. 4,000
kr. 2,000
kr. 4,731
kr. 3,523
kr. 3,342
kr. 2,816
kr. 2,432
kr. 2,389
2007
2008
kr. -
NOPLAT
2009
2010
Adjusted NOPLAT
The source: My own calculations based on the reformulation of annual statements
Adjusted NOPLAT grew from 2007 to 2010 by 37.61%, being 3,438 million DKK in 2007 and 4,731 million
DKK in 2010. It is primarily driven by constant revenue growth, especially in 2009. Year to year NOPLAT
growth was 2.50% (2008), 29.28% (2009) and 23.85% (2010). The gigantic rise in Adjusted NOPLAT in
2009 is also affected by considerable drop in operating taxes from 14.53% to 12.81%. In addition the 26.75
% rise in Adjusted EBITA between 2008 and 2009 is also a reason for the high NOPLAT growth together
with the falling trend of administrative expense related to revenues from 13.52% in 2008 to 11.53% in 2009.
All this is probably caused by the 2009 acquisitions of Ovation and LifeHealt Lmt. For further information
about Lundbeck’s NOPLAT see the Appendices 6.3 and 6.11.
6.2.
Invested capital
“The cumulative amount the business has invested in its core operations…”40 represents invested capital.
Below in the figure 6.2 the historical overview of the Lundbeck’s invested capital is presented, since
intangibles are of great importance to the company’s value the invested capital with and without intangibles
are simultaneously presented. It is evident that the difference between invested capital excl. intangibles is 3-5
times smaller than the invested capital including intangibles. This difference is caused primarily by
capitalization of R&D expenses during the years. Except for invested capital excl. intangibles between years
2007-2008 the historical trend for all three invested capital values are of positive growth. The drop in
40
Ibid
Page 41
invested capital excl. intangibles between the two years is due to 6 % dive of net PP&E, and 21% dive in
capitalized operating leases. It is also clear that the extreme jump in the values amid the years 2008-2009,
only affects the invested capital including intangibles. This explosive growth of 34.63% between 2008 and
2009 of invested capital with intangible assets is explained by 330% growth in goodwill and 350% growth in
acquired intangibles, due to company’s acquisitions of the Ovation and LifeHealth Lmt.
Figure 6.2: H. Lundbeck’s A/S historical invested capital for years (2007-2010)
kr. 22,720kr. 23,910kr. 29,024 kr. 31,668
In millions
kr. 40,000
kr. 19,284
kr. 20,000
kr. 6,165
kr. -
2007
kr. 20,120
kr. 5,725
2008
Invested capital excluding intangibles
kr. 29,271
kr. 27,088
kr. 5,773
2009
kr. 5,824
2010
Invested capital including intangibles
Total funds invested
The source: My own calculations based on the reformulation of annual statements
All in all the growth of the total invested capital has grown by 39.4% between the beginning end the end of
the period. For further insight of the invested capital calculations see the Appendix 6.6.
6.3.
Free Cash Flow
“The cash flow generated by the core operations of the business after deducting investments in new capital”
stands for free cash flow.41
41
Ibid
Page 42
Figure 6.3: H. Lundbeck’s A/S historical FCF for years (2008-2010)
2010
kr. 2,440
kr. 3,205
kr. 2,128
kr. 2,833
kr. 2,833
kr. 2,798
2009
2008
kr. 2,016
kr. -
kr. 500
kr. 2,461
kr. 3,113
kr. 1,000 kr. 1,500 kr. 2,000 kr. 2,500 kr. 3,000
In millions
Free cash flow before goodwill
Free cash flow after goodwill
Cash flow available to investors
The source: My own calculations based on the reformulation of annual statements
What can be concluded from above figure is that free cash flow after goodwill historically is on a stable level
above the DKK 2,000 million.
6.4.
Revenue growth analysis
Revenue growth is a one of the value drivers of a company, therefore it is important to analyze. Though
revenue growth is tricky to sustain, especially for large companies and if a company have historically high
growth rates the tendency is that it decays very quickly. The decay happens primarily due to finite product
life cycles. The big companies have additional problem in sustaining the revenue growth in the long run
because of the limited possibilities to get bigger. The one way to grow by these companies is through
mergers and acquisitions, as is the case in pharmaceutical industry and Lundbeck as well see 2009
acquisition of Ovation and LifeHealth. The boring reality is that growing through acquisitions a company
will find itself in a situation with considerable revenue growth drop right after the acquisition. The other way
a big company can sustain the revenue growth is through growth of the markets the company operates in. In
the pharmaceutical industry the growth strategy that has the best potential is via the introduction of the new
branded drugs, because of the lack of competition in the new market. The lack of competition is primarily
Page 43
coming from patent protection lasting long time. The empirical evidence suggests that even the fastest
growing companies, in a 10 year period find themselves growing at a rate below 5%.
Table 6.1: H. Lundbeck’s A/S revenue growth analysis through 2008-2010
Organic revenue growth at constant
currency
Currency effects
Acquisitions
Sale of LifeCycle Pharma
Accounting changes
Revenue growth
2008
2009
2010
CAGR
2008-2010
6.00%
19.88%
4.00%
9.96%
-5.01%
2.60%
3.59%
-4.98%
0.41%
3.49%
18.80%
3.34%
0.06%
7.41%
-2.22%
0.14%
0.02%
2.03%
9.93%
The source: My own calculations based on the information from Annual Statements 2008-2010, some deviations
to the result is happened due to rounding of the decimals.
In the table 6.1 above Lundbeck’s revenue is depicted, and split up into parts. In the three years period from
2008 -2010 the reported revenue growth is very volatile, 3.59% (2008), 18.80% (2009) and 7.41% in year
2010. In 2008 the revenue growth is consistent with the empirical evidence above with a growth rate below
5%, precisely at 3.59%. Out of this revenue growth the biggest part of 6% is coming from the organic growth
the growth at the constant currency. At this year the negative currency effects for Lundbeck’s growth where
almost as big as the organic growth of -5.01%. Accounting changes from 2009 and according to these
changes restated revenue in 2008 gave rise to revenue growth of 2.60% in 2008 and 3.49% in 2009. In 2009 a
growth in Lundbeck’s existing markets, especially Parkinson’s disease market grew explosively during the
year. For example the sale of Azilect in international markets grew by 73% in local currency and in Europe it
was 40% relative to the year before, in total a 43% revenue growth. So in this year the organic growth is
extremely high of 19.88%, giving rise to the total revenue growth of 18.80%, which is not contributed by the
acquisitions made during the year constituting only of 0.41% revenue growth of the acquired product
Xenazine. The growth rate in 2009 could have been bigger if the negative currency changes did not draw the
revenue growth down by - 4.98%. In 2010 the impact of prior year patent expiration in international markets
of Cipralex effected negatively the revenue by competition of the generics, in 2009 the growth was 14% in
local currency and in 2010 it was only 7%. Since the company did not have further acquisitions during the
year and no new products so the light of the day the revenue growth started reverting towards long run
revenue growth i.e. the reported revenue growth of 7.41%. The organic growth dropped to 4% in this year the
favorable currency effect of 3.34% and sale of LifeCycle Pharma gave slightly rise in the revenue growth of
Page 44
0.06%. All in all the 2010 revenue growth could have also been under 5% if it was not for the favorable
currency effects.
If the Lundbeck’s revenue growth is compared to the median pharmaceutical industry revenue growth in the
1997-2007 interval, the company’s growth in 2008 and 2010 is below the median of 8%. However if the
CAGR is taken into account the revenue growth of the company is higher than the industry median of 9.93%,
and slightly better if the company’s organic growth is taking account of with 9.98%. It is a positive thing
that organic growth of the company is so high, but as it is also evident the company’s revenue growth is very
much effected by the currency changes and looking over the whole period the -2.22% CAGR gives an
indication that it is a negative one, which is dragging the high organic revenue growth down resulting in
much lower total revenue growth. According to Koller chapter 5 if the company has high ROIC, shareholders
return is effected more by an increase in revenues than an increase in ROIC, this is precisely the case with the
company analyzed with the ROIC of around and above 20%. This means that with high ROIC increasing the
rate of growth, Lundbeck can generate additional value to the company.
6.5.
Operating performance in the ROIC analysis framework
The historical analysis of the return on invested capital (ROIC) is important for variouse reasons, but the
main reason is that togheter with revenue growth it constitutes the two most important drivers of value
creation for a given company, i.e. they determine how cash flows arise from revenues. Therefore it is of great
relevance to analyse Lundbeck’s historical ROIC to assess where company’s value creation comes from. The
ROIC in turn is driven by competitive advantage of the company and the strategy implemented. A higher
ROIC relative to companies cost of capital, means value creation and the longer the high ROIC is sustained
the more value Lundbeck will create. For a pharmaceutical company the competitive advantage mostly
comes from R&D development of new drugs, and patent protection which is the most important contibuter to
sustainability of ROIC. But the life cycle of the drugs and the business is also of a importance, therefore
marketing of new drugs and finding a new markets is important.
In order to properly evaluate Lundbeck’s ROIC and its drivers the decomposition in a ROIC tree is made see
figure 6.4 below. The decomposition of ROIC into ROIC with goodwill and aquired intangibles and one
without is made with the intention of seperating the aggregate value creation for the Lundbeck’s shareholders
measured by the first and a measure of the company’s underlying operating performance indicated by the
Page 45
last. The ROIC excl. the goodwill is the measure used to compare performance with the peers, however
because of the extant of the data required to calculate ROIC of the peers the only comparison made is of the
pharmaceutical industry.
From the ROIC tree framework Lundbeck’s three years historical ROIC without goodwill is slightly
fluctating going up from 19.81% in 2008 to 23.98% in 2009, and falling down to 22.99% in 2010. The reason
for the percantage rise in 2009 could be because of the strategic acquisition of Ovation and LifeHealth
limmited during the year in quastion, which gave rise to the company’s compatitive advantage that in turn
effected positivly ROIC primarly through the boost of the revenue. The subsequent drop in ROIC without
goodwill in 2010 is to be seen in the light of a loss of the competitve advantage effected by patent expiration
in international markets of Cipralex in late 2009. This downword trend is likely to continue in the resent
future since the company’s major products face patent expiration for further information (see strategic
analysis). Therefor the introduction of new branded products is essential for the company to sustain the
current level of ROIC. Compared to the median ROIC of 23.5 % of the pharmaceutical industry during the
1965-2007, Lundbeck is performing satisfacturing in the last historical years i.e. ROIC without goodwill
being little above the median in 2009 and close to in 2010. It is another story when 2008 is conserend,
Lundbeck’s ROIC without goodwill is considerably lower than the industry median. This high level of ROIC
withouth goodwill in the pharmaceutical industry is in the persistently high level compared to other industries
like cyclical industries such as chemicals of about 11% median ROIC, restaurants of about 15% and
persistantly low level such aireline industry of 6% median ROIC.
Page 46
Figure 6.4: H. Lundbeck’s A/S ROIC tree for years (2008-2010)
Gross margin
Operating
margin
2008:
35.62 %
2009:
38.01 %
2010:
37.27 %
2008:
83.43 %
2009:
82.21 %
2010:
81.71 %
SG&A / revenues
Pretax ROIC
2008:
34.52 %
2008:
23.18 %
2009:
32.13 %
2009:
27.51 %
2010:
31.64 %
2010:
26.74 %
Depreciation
/revenues
ROIC without
goodwill
2008:
13.53 %
2008: 19.81 %
2009:
12.30 %
2009:
2010:
13.01 %
23.98 %
2010: 22.99 %
Operating lease
interest/revenues
Operating –cash
tax rate
ROIC with
goodwill
2008:
14.53 %
2008:
17.51 %
2009:
12.81 %
2009:
16.82 %
2010:
14.03 %
2010:
16.16 %
11.61 %
2008:
0.65
2009: 29.88 %
2009:
0.72
2010:
2010:
0.72
2008:
29.70 %
0.25 %
2009:
0.22 %
2010:
0.21 %
Operating working
capital /revenues
Revenues/invested
capital
Premium over book
capital
2008:
2008:
0.08
2009:
0.06
2010:
0.06
Fixed assets
/revenues
2008:
0.30
2009:
0.25
2010:
0.24
The source: ROIC numbers are based on my own calculations, and the ROIC tree composition is inspired from Koller, Tim p. 169. The ROIC with/without goodwill
in the figure stands for ROIC with and without goodwill and acquired intangibles.
Page 47
When looking closly at the ROIC tree the rise in the ROIC without goodwill in 2009 comes primarly from
pretax ROIC which is 4.33% point higher in 2009 than the previous year. Furthermore the fall in operating
cash tax rate between 2008 and 2009 from 14.53% - 12.81% contributed further to the rise of ROIC without
goodwill. For the 2010 year the opposite is true the drop in ROIC is due to the drop in Pretax ROIC and rise
of the operating cash tax rate from 12.81% to 14.03%. The high level of Pretax ROIC is explained by small
amount of operating working capital and fixed assets, and when the rise in the Pretax ROIC occurred the
drop in the ratios; operating working capital /revenue (0.08 to 0.06) and fixed assets/revenue (0.30 to 0.25)
happened. All this gave rise to capital efficiency measuring invested capital to revenues which rose from 0.65
in 2008 to 0.72 through out 2009-2010. In other words rise in capital efficiency of invested capital
contributed to the rise of Pretax ROIC between 2008-2009, but it does not contribute to drop in Pretax ROIC
in 2010 since the level is constant. Operating margin is also effecting Pretax ROIC. In 2009 it was at 38.01%
a 2,39% point higher than the year before which toghether with higher capital efficiency gave rise to Pretax
ROIC in 2009. Furthermore it dropped slightly to 37.27% in 2010 solily effecting negativly the Pretax ROIC
of that year. The operating margin is in turn effected by shifts in gross margin, SG&A/revenues,
Depreciation/revenues and operating lease interest/revenues. The gross margin of the company is histricaly
on the high level in all years above 80%. Nevertheless because the gross margin is a measure of how
profitable a company is, it is desirable for a company that the ratio is high, in order to have money left for
future investments and for Lundbeck investments in R&D. In this light the historical trend is discurigin since
gross margin is dropping in all the three years from 83.4% in 2008 to 81.71% in 2010, i.e. a negative trend.
The positive historical performance comes from the falling trend in SG&A/revenue ratio and Operating lease
interest ratio. The SG&A/Revenues is 34.52% in 2008, 32.13% and 31.64% in 2009 and 2010 respectivly.
The final ratio Depreciation/revenues have the same historical trend as Operating cash tax rate a shifting one,
first a drop in the ratio than a little rise. Hence the rise in Operating margin between 2008-2009 is primarly
due to positive effect of a drop in SG&A ratio and depreciation ratio, and for 2010 the opposite is true. The
aggregate ROIC the one with goodwill have a negative historical trend being 17.51% in 2008, 16.82% in
2009 and 16.16% in 2010. First of all it the difference between the ROIC without goodwill and the one with
goodwill is relativly large because the goodwill have a big part of invested capital in relative terms.
Furthermore since 2009 acquisitions it seems like the value is destroyed. Since there is higher ROIC without
goodwill in 2009 and 2010 than in the year 2008, but the ROIC with goodwill is at smaller level in the
Page 48
interval 2009-2010 than in 2008, hence the value is destroyed. According to Koller this is because the
investores are not properly compensated for the funds spent for the acquisitions.
Since cost of capital is 10.07% the company is creating value since ROIC is higher than cost of capital in all
years.
Finally the reasurch on the ROIC saggests that if a company is earning a high ROIC, there is a good chance
that the high ROIC will be sustainable in the future. In this context it seems very promissing for Lundbeck’s
future value creation, due to current high level of ROIC. The negative will be if the patent exparations in the
resent future lowers ROIC considerably it will mean that the lower ROIC is also likely to persist to.
6.6.
The historical stock market performance compared to the peer group
The perception of the overall historic stock performance of a certain company relative to the peer group is
traditionally measured by total returns to shareholders (TRS). This concept gives a company an idea of
investors’ expectation changes of company’s future performance over the time. In general it is a measure of
total return to investors, and besides being a measure of a performance of a giving company it is also a
measure of overall performance of the management. This concept has its limits; in particular the performance
of the management is over the short period, already altered or effected the share prices that the new changes
in share prices are not likely to occur, even though the future expectations for the company are promising,
For this reason the expectations are already a part of the TRS measure, therefore in the analysis below three
time spans are used to calculate TRS see the figure 6.5. Furthermore it is harder for already successful
company to increase TRS. All though the measure has its limits it is also easier to determine than calculating
the market value/invested capital which is an alternative measure, and requires more work because invested
capital is not disclosed in the financial statements and have to be calculated by in depth examination of the
annual statements. Ideally these two measures are also used as complementary measures, however in this
analysis it will take to many resources to conduct both of them for the entire peer group that only TRS is
carried out in the present framework.42
Consistent with the figure 6.5 the return to Lundbeck’s investors and shareholders was not that promising in
all three time periods. In the very short term (year 09-10) the return to investors was at next lowest return
2.40% on average compared to the six other companies in the peer group. Ely Lilly and company is the only
42
Koller, Tim et al. ”Valuation measuring and managing the value of companies”, chapter 3 p. 45-57 and p. 654-655
Page 49
company performing worst than Lundbeck in this time period of -2.35% as well as having a negative return
in all periods. The Lundbecks performance return in this period is much lower than Shire’s (24.14%), Forest
Laboratories’ (12.83%) and AstraZeneca’s (8.66%) but with the performance close in line with 1 st and 2nd
market leaders Pfizer (3.63%) and GlaxoSmithKline (3.58%).
Figure 6.5: Stock market performance measured by the total returns to shareholders (TRS)
TRS average 09-10
Shire
TRS average 07-10
24.14%
Forest Laboratories
Eli Lilly and company
AstraZeneca
12.83%
-2.35%
3.58%
Pfizer
3.63%
H. Lundbeck A/S
11.47%
2.40%
20.90%
-8.11%
-2.89%
-5.26%
-4.21%
8.66%
GlaxoSmithKline
TRS average 05-10
7.23%
13.38%
3.05%
-4.20%
5.03%
-2.14%
-5.72%
0.74%
Source: The figure is based on my own calculations: TRS is calculated using following formula: percentage ∆ in share price + dividend yield. The data for
calculations are from companies’ homepages and annual statements plus share price lookup, for historical share prices. Bristol – Myers Squibb and Novartis are
not a part of the peer group due to lack of information.
Since the TRS is not good measure over a short period the above analysis should be taken with care, and
compared with TRS of longer time periods. The company having best performance is Shire with average
shareholder return of above 10% in all the periods, followed by the AstraZeneca in (07-10) and (05-10). As
Lundbeck’s TRS (09-10) was next lowest so it is as well in (07-10) with a negative return of -5.72%. Over a
longer time period (05-10) the figures are similar to the previous time period (07-10). In this period
Lundbeck’s return seems better with very small positive return (0.74%), but compared to other companies the
performance is a mediocre one, however it is much closer to the negative performances of the Pfizer (2.14%), Eli Lilly and Company (-4.21%) and Forest Laboratories (-2.89) than the positive returns of Shire
(20.90%), AstraZeneca (13.38%) and GlaxoSmithKline (5.03%). All in all it seems like Lundbeck was
unable to satisfy the market expectations, and has historically mediocre or very low stock market
performance compared to the peers, which is not that promising. This could also be that the company simply
Page 50
is having hard time increasing the TRS and satisfying the expectations of investors and market because of its
past success.
7.
Forecasting
This chapter covers overall assumptions of the forecasting period the forecasting of the financial statements,
regarding revenue forecast is covered in detail in DCF analysis under scenario analysis.
The forecast period: In the light of the fact that all the calculations of continuing value depend on a
perpetuity formula, the explicit forecast must be long enough to reach steady state, where Lundbeck’s
revenue grows at constant rate and ROIC too. Koller p.188 recommends to use a forecasting period of 10 to
15 years, and to split forecasting into two periods a short term period and midterm forecast. In consistency
with this a short term period of 5 years is applied, a reason for choosing the 5 year period from 2011 to 2015
is due to the fact that the previous industry analysis is in that time period and the most of the Lundbeck’s
current blockbuster patents are expired in that time period. In addition it is difficult to forecast more years in
detail. The short term period is a detailed forecast of the complete income statement, balance sheet and free
cash flow. In contrast the midterm forecasting is a forecasting of few variables as revenue growth, EBITA
margins, ROIC and such, in a period of 10 years from 2015-2025. So as recommended the entire explicit
forecast period is 15 years. For complete short term period and midterm forecast period assumptions see the
Appendix 7. The terminal value is calculated after the explicit forecasting period of 15 years i.e. in year 2026
and beyond.
8.
Estimating cost of capital
In order to be able to value Lundbeck using DCF method, one component is yet missing to be estimated. The
hurdle rate or required return that is better known as the weighted average cost of capital (WACC). It is
needed for discounting the 15 years explicit forecasting made previously of the Lundbeck’s FCF from 20112025. This expected return is seen to have the similar risk to that of the overall company and thereby being
the appropriate discount rate of FCF if estimated correctly. The higher the WACC is the riskier the business
of a given company is, i.e. implying the lower company valuation at the end of the day. Broadly speaking
FCF and estimation of WACC must be consistent, for valuation to work as intended. In estimating process of
WACC following components have to be assessed and are essential for complete estimation; Lundbeck’s
Page 51
target capital structure calculated by market based weights rather than historical book values, the cost of
equity and the after tax cost of debt, and written as a formula it has following form:
𝑾𝑨𝑪𝑪 =
𝑫
𝑽
𝑬
𝒌𝒅 (𝟏 − 𝑻𝒎 ) + 𝒌𝒆 , with the variables
𝑽
𝑫
𝑽
= Lundbeck’s target level of debt to enterprise value (market values are used)
𝒌𝒅 = the company’s cost of debt
𝑻𝒎 = marginal income tax rate used by Lundbeck
𝑬
= Lundbeck’s target level of equity to enterprise value (market values are used)
𝑽
𝒌𝒆 = the company’s cost of equity
The WACC estimation is not straight forward, due to the fact that only marginal income tax rate is directly
observable and is 25% in this case, the rest of the variables have to be approximately acquired. For instance
the company’s cost of equity can be estimated with help of various models and the choice of the estimation
model effects the resulted cost of equity. The methodology available for the cost of equity estimation to
mention few are; The Fama-French three factor model, Arbitrage Pricing Theory (APT) and the simplest and
frequently used in this context is the capital asset pricing model (CAPM). Without going into detail what the
each model stands for, in theory the second model is best suited but it is not that easy to implement, while the
first is based on the empirical work measuring historical risk with no valid theory supporting the model it is
chosen in this context to go with the CAPM framework even with the possible lacks of the model. It is shown
according to Elton et al. “ that CAPM is descriptive of the data once we consider the model in a forward
looking sense that adjusts for changes in economic condition…despite the stringent assumptions and the
simplicity of the model and it does an amazingly good job of describing prices in the capital markets. “43
Whit that pointed out the estimation of WACC is conducted as follows: first will Lundbeck’s capital
structure be addressed in order to determine the target level of debt and equity to enterprise value of the
company. In the next subsection Lundbeck’s cost of debt is acquired followed by estimation of the
companies cost of equity with help of the CAPM methodology and concluded with the calculation of the
resulted WACC.
43
The quote is from: Elton, J. Edwin et al. “Modern portfolio theory and investment analysis”, International Student Version,
Eighth edition, John Wiley & Sons, Inc. (2011) p. 280 and 352 before the appendix.
Page 52
8.1.
Lundbeck’s capital structure
In order to estimate company’s target weights of debt and equity to enterprise value, the estimation of current
capital structure is needed. The methodology is only to estimate the company’s current market-value-based
capital structure. However when estimating target capital structure from an external perspective Koller
(p.266) recommends using combination of three approaches, review of the capital structure compared to
relevant peers, and review management’s approach to financing the business together with the above
described methodology. Second method however is impossible to implement since proper peers are not
existent as discussed in competitor profiling. The third method is omitted due to project limitations.
Lundbeck’s capital structure consist primarily of debt and equity, but also of complex capital structure
securities equity based claims such as warrants and share-based payments, but also debt based claims overall
denoted as hybrid securities or hybrid claims44. If hybrid securities are included in capital structure, it should
be the third term in the WACC as debt and equity. In that case Koller recommends to use other valuation
methods rather than DCF since using WACC is not reliable since it uses target capital structure and with
hybrid claims changes to capital structure is not avoidable. The recommended valuation is adjusted present
value (APV) that uses industry-based unlevered cost of equity to discount free cash flows that highlights
changing capital structure more easily. Therefore the hybrid claims are assumed not to be of relevant value to
include in the capital structure and WACC, i.e. the difference in valuation result is assumed to be
insignificant one, seen in the light of the fact that in 2010 for example warrants were not vested or they were
out-of-the money. Hence Lundbeck’s capital structure consists of equity and debt. The company’s market
value of equity can be determined calculating market capitalization however this is not needed from 2010
annual statement page 59 it can be read for all the necessary years. 45 Short-term debt, long-term debt,
nonoperating tax liabilities, value of operating leases and excess cash are debt items where the book value is
a proxy for market value. Non-operating provisions, retirement –related liabilities and other debt are also
debt items and there estimation of market value is already covered in DCF valuation. Enterprise value is
calculated as debt plus equity. For complete historical capital structure overview (2007-2010) see Appendix
8. As expected in 2009 debt over enterprise value is much larger than in previous years at 15.15% given the
fact that two companies that year were acquired Ovation and LifeHealth. Since Lundbeck in recent future
does not have any plans of further acquisitions it could safely be assumed that forward capital structure
44
For further explanation of the claims see the part of the paper going from enterprise value to share price.
The calculations in the annual statement are performed as follows: total number of shares, year-end, multiplied by the official
price quoted on NASDAQ OMX Copenhagen, year-end.
45
Page 53
would be somewhat stable and DCF is a reasonable valuation model. In relation to that it is obvious if we
look at after 2009 that the capital structure normalizes to 6.98% debt to enterprise value in 2010. Average
market-value-based capital structure across 2007-2010 is D/V = 8.07% and E/V = 91.93%. Hence the
estimated forward target weights of equity and debt to enterprise value are D/V= 8% and E/V = 92% when
the above average is rounded down and will be used in WACC calculations.
8.2.
Lundbeck’s cost of debt
In general the cost of debt for a company is estimated by using the yield to maturity of the company’s long
term, option free bonds as a proxy. A debt rated at BBB and higher is considered to be suitable for use of the
above method, but in a case of lower debt ratings WACC is not appropriate discount rate for valuation
(Koller p. 261). Estimating Lundbeck’s cost of debt is not that straight forward. However since Lundbeck
credit is not rated it is difficult to induce any outcome. On the other hand the company’s financial report from
2010 indicate that the company have a wish to carry on investment grade rating, and from Investopedia
investment grade rating refers to the quality of a company’s credit at or above “BBB credit rated by S&P and
Moody’s”.
46
“A number of financial institutions indicate that Lundbeck’s implied rating would be of an
investment grade nature”47. So indirectly deducing it is safe to use WACC since Lundbeck’s debt is of at
least BBB rating. In a case that the company is not rated according to Damodoran there exist two methods for
estimating the cost of debt; 1. estimating the cost of debt by synthetic rating or 2. recent borrowing history of
the company.48 So due to lack of one debt rating the cost of debt is first calculated by synthetic rating
estimator from Damodoran’s homepage.49 The resulting cost of debt is 2.88% and after tax cost of debt of
2.16%. Since Lundbeck had no bank debt in 2010 weighted average effective interest rate of short term debt
from 2009 is taken to consideration with interval of 3.80%-3.82%. The average rate is 3.81% implying the
1.43% additional risk seen in relation to the risk-free rate. If the synthetic cost of debt is compared to the one
estimated by the company’s historical borrowing rate; 2.88% < 3.81% the rating estimator is implying
24.41% lower cost of debt. This is seen as very high deviation where the 3.81% is seen to reflect Lundbeck’s
debt better than the synthetically made approximation. So 3.81% is the Lundbeck’s cost of debt.
46
http://www.investopedia.com/ask/answers/184.asp#axzz1gjti6vFx
The quote is from Lundbeck’s 2010 annual report, p. 92.
48
http://w4.stern.nyu.edu/~adamodar/New_Home_Page/valquestions/syntrating.htm
49
http://pages.stern.nyu.edu/~adamodar/ see fcffginzu.xls
47
Page 54
8.3.
Lundbeck’s cost of equity the CAPM
The cost of equity (𝑘𝑒 ) as mentioned before is built with the capital asset pricing model (CAPM):
𝐄(𝐑 𝐋𝐮𝐧𝐝𝐛𝐞𝐜𝐤 ) = 𝐤 𝐞 = 𝐫𝐟 + 𝛃𝐋𝐮𝐧𝐝𝐛𝐞𝐜𝐤 [𝐄(𝐑 𝐦 ) − 𝐫𝐟 ] where the variables are explained below;
𝑬(𝑹𝑳𝒖𝒏𝒅𝒃𝒆𝒄𝒌 ) = 𝒌𝒆 = expected return of Lundbeck’s security which is in turn equal to the company’s cost of equity
𝐫𝐟 = risk free rate (the common rate for all companies)
𝜷𝑳𝒖𝒏𝒅𝒃𝒆𝒄𝒌 = the company specific beta, i.e. the sensitivity to the market of the Lundbeck’s stock
𝐑𝐏𝐦 = [𝐄(𝐑 𝐦 ) − 𝐫𝐟 ] = the market risk premium defined as expected return of the market minus the risk free rate
In following subsections the risk free rate is first estimated, followed by estimation of Lundbeck’s beta and
the market risk premium.
8.3.1.
The risk free rate
The risk free rate according to Investopedia is defined as: “The theoretical rate of return of an investment
with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free
investment over a specified period of time.”50It is a theoretical rate because the return on a security with a no
covariance with the market a zero beta security or portfolio does not exist in the real world, given the fact
that every security has a little risk attached to it. A best proxy for such rate is the yield to maturity of a long
term government default –free bonds. As it is recommended (Koller Tim p. 241) to always use government
bond yields denominated in the same currency as the company’s free cash flow to incorporate the inflation
i.e. denominated in the DKK, the Danish 10 year government coupon bond is a proxy for estimation of the
risk free rate. Furthermore the maturity of the bond is 10 years even though Lundbeck’s projected free cash
flow is 15 years, because the longer dated bonds may not reflect the cash flows current value due to
illiquidity’s effect on the yield premiums of the bonds, and since the most common proxy in corporate
valuation have 10 year maturity, regardless of the number of years of the projected cash flow a 10 year
maturity is applied. Hence from 01.09.11 the 3% Dansk Stat Ink St. lån 2021 DK0009922676 with the yield
to maturity of 2.380% and duration 8.770 years is found to be best suited proxy for the risk free rate due to
the duration of the bond is closest to the chosen 10 year maturity, i.e. the 𝐫𝐟 is 2.380%. 51
50
51
The quote is from: http://www.investopedia.com/terms/r/risk-freerate.asp#ixzz1gWwz7psS
www.nasdaqomxnordic.com
Page 55
8.3.2.
The company’s beta
The beta coefficient is a Lundbeck’s stocks sensitivity to markets systematic risk or non diversifiable risk. As
outlined in Koller, Tim, first will the empirical raw beta be estimated by regression, than Bloomberg’s
smoothing technique will be used to improve the estimated beta together with an industry adjusted company
beta denoted as Lundbek’s relevered industry beta. Finally the all three betas will be assessed and the one
best suited to the industry, economic movements and systematic changes in Lundbeck’s stock risk during the
measurement period of choice outlined in a rolling beta graph will be picked as the resulting company beta.
The regression estimation of Lundbeck’s raw beta is conducted by the market model:
𝑅𝐿𝑢𝑛𝑑𝑏𝑒𝑐𝑘 = 𝛼 + 𝛽𝑅𝑚 + 𝜀 where the Lundbeck’s stock’s return is regressed against the market’s return.
The proxy for the market return is MSCI World Index, because a well diversified market portfolio is needed,
where in contrast the OMXC20 index is too small to be adequate for estimation it is a local market index
with only 20 companies measuring sensitivity to 20 biggest companies in Denmark. This means that the
currency used for both the index and Lundbeck’s stock return is in US dollars, due to the fact that it is not
available in DKK. What the best suited length and frequency of the raw regression should be depends on
what source is looked at. The Bloomberg uses two years weakly data. However there are several academic
papers addressing this topic, the two most cited ones with contradicting results are Daves et al. (2000) and
Bruner, R.F. et al. (1998). According to the first mentioned the best suited period is the three years or less of
daily return interval as estimation period. In this way the greatest precision of the beta estimate is found, due
to smallest std. deviation of the beta estimate. In the second one it is advised not to use shorter estimation
periods as weeks and days due to the possible undesirable systematic biases on the beta’s OLS estimator.
However the Koller (pp. 250-254) recommends at least five years of monthly returns, where more frequent
return periods are not advisable because of systematic biases if the stocks are thinly traded. This problem
according to J. Bartholdy et al. (2007) is caused by zero returns for non trading days and relatively large
positive or negative returns on days when stocks are traded. In turn the thinly traded stocks are stocks traded
on less than 40% of all trading days, where in contrast the thickly traded stocks are stocks traded more than
80% of all trading days. All in all due to empirical inconsistency in this area it is found that the best thing
will be to estimate the beta in accordance to both Koller and Daves i.e. a regression of 5 years monthly
returns (01.09.06-01.09.11) and 3 years daily returns (07.10.07-19.09.11) see figure 8.1. After calculating the
stock returns, the problem of thinly traded stocks are evaluated with a help of above restrictions. The result is
that in both estimation periods there are “zero” returns present, but is not considered to be a problem due to
Page 56
approximately 98% traded stocks in the monthly data and slightly above 80% traded stocks of daily data. In
other words the stocks are thickly traded and no adjustments are necessary, like summing lagged betas.
H. Lundbeck's daily stock returns
20.00%
15.00%
10.00%
5.00%
-10.00%
0.00%
-5.00%-5.00%0.00%
Regression beta = 0.8872
5.00%
10.00%
-10.00%
-15.00%
H. Lundbeck's monthly stock
returns
Figure 8.1: Resulting regressions of Lundbeck’s stock returns
30.00%
20.00%
10.00%
Regression beta = 0.6189
0.00%
-30.00% -20.00% -10.00% 0.00%
-10.00%
-20.00%
10.00%
20.00%
-20.00%
Morgan Stanley Capital International (MSCI) global
monthly returns
Morgan Stanley Capital International (MSCI)
global daily returns
Source: The figure is based on my own calculations, based on the data from Datastream
The betas of the regressions are as follows; for five years monthly returns β = 0.6189 and three years daily
returns β = 0.8872 represented as a slope coefficient of the fitted regression line see figure 8.1. The
coefficient or beta is in both regressions statistically significant giving the p-value of approximately zero.
However as Daves has predicted the 3 year daily returns have lower standard error of 0.000633 compared to
0.011 for 5 year daily returns, std. deviation is as well lower 0.024162 vs. 0.088618. The best fitted line
measured by 𝑅 2 is the daily return regression with approximately 25% of the variation of Lundbeck’s stock
returns are explained by the market i.e. the systematic risk vs. only 22% in the monthly returns regression.
Taking all the statistical results above, the best estimated beta would be the 3 years daily data. Hence the
investigation of systematic changes in a Lundbeck’s stock’s risk by rolling betas is only presented below for
this measurement period, if interested the rolling beta for 5 years monthly data is also attached in the
Appendix 9 together with rolling beta of more than two of Lundbeck’s competitors. In the figure 8.2 the
rolling betas of Lundbeck compared to Pfizer’s and Forest Lab. is graphed. Only two companies are chosen
for clarity purposes the market leader and a company that best fits to Lundbeck’s business structure
respectively.
Page 57
Figure 8.2: The rolling betas of Lundbeck and two competitors
1.20
1.00
0.80
β 0.60
0.40
0.20
0.00
7/10/2007
7/10/2008
7/10/2009
7/10/2010
7/10/2011
Years
H.Lundbeck A/S
PFIZER
FOREST LABORATORIES
Source: The figure is based on my own calculations, based on the data from Datastream
In a three years period the systematic changes affected all companies but mostly Lundbeck because it has the
most volatile betas in the period. The changes happened in 2008 when financial crisis hit increasing the
sensitivity of Lundbeck’s beta to approximately 1 from 0.80 level. The next change occurred in 2010 with
decrease of the beta to 0.60 level from little bit above 0.80. What exactly happened is hard to say, but it could
be better economic prospects compared to the financial crisis in 2008. And now due to new economic
turbulence see PESTEL analysis the beta has risen again to financial crisis level of 2008. Taking the not so
good prospects of the world economy in the future it is seen that the raw beta of 0.8872 will be to law,
therefore to improve the beta estimate, the smoothing process applied by Bloomberg that smooths raw beta
toward
1
is
conducted,
and
outcome
is
the
following
adjusted
beta;
𝑨𝒅𝒋𝒖𝒔𝒕𝒆𝒅 𝜷 = 𝟎. 𝟑𝟑 + 𝟎. 𝟔𝟕 ∗ 𝜷𝒓𝒂𝒘 = 𝟎. 𝟑𝟑 + 𝟎. 𝟔𝟕 ∗ 𝟎. 𝟖𝟖𝟕𝟐 = 𝟎. 𝟗𝟐𝟒𝟒.
Additionally the industry adjusted Lundbeck’s beta is estimated in order to improve the estimation. As
industry average unlevered beta 1.08 is used calculated from 301 companies in the drug industry.52 With
forward target market to debt to equity ratio estimated to be 8.70% the industry adjusted company beta, or
Lundbeck’s relevered industry beta equals 0.9936, i.e.
1.08⁄
(1 + 0.087) = 0.9936.
In the light of high world
economic uncertainty and the rolling beta in 2011 is approximately 1 or little above, it seems that the
relevered beta is best to explain current market situation but due to expected future changes the adjusted beta
52
From January 2011; http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/Betas.html, note not my own
calculations.
Page 58
is used for further analysis and because the resulted beta is slightly less than 1 as said before the company’s
stock returns vary less than the market returns, i.e. less sensitive to systematic risk than the market in general.
8.3.3.
The market risk premium
The estimation of market risk premium is not precise and none of the available methods are better to apply
according to Koller p. 242. Ideally it would be informative and enhancing the estimation of the market risk
premium if all the methods were applied and compared but due to lack of time and current project restrictions
only one estimation method will be used. Hence the one best suited and least time consuming method is
estimation of the future risk premium by measuring and extrapolating historical returns.53
The MSCI World Index as used for beta estimation and in order to be consistent is also a market proxy
applied here, However it is a relatively good market proxy, considering the size of the index and is often used
as benchmark for developed markets see following definition “a free float-adjusted market capitalization
weighted index that is designed to measure the equity market performance of developed markets”. 54Since it
is advisable to use the longest period possible in prediction of future market risk premium derived from
historical observations to reduce estimation error, the premium calculations have to be calculated relative to
historical risk free rate matching the historical market returns, the Danish long-term government bonds
cannot any longer be risk-free rate proxy since the historical observation are limited. Hence the proxy for
risk-free rate is US treasury bonds with constant maturity of 10 years denoted in US dollars, as well as the
MSCI World Index returns. The measurement period is from (1969-2011), and the returns are processed in
Datastream. The annual returns are calculated both with arithmetic average and geometric average (Appendix
10.1)55, resulting in the market risk premium of 4.02% and 2.48% respectively. Since statistical principles
dictate that the arithmetic average is the best unbiased estimator (Koller p. 244) 4.02 % market risk premium
is better estimate of the expected future rate of return. Furthermore the arithmetic average return calculated
has to be adjusted for survivorship bias, if the Brown, S. et al. (1995) academic paper is to be considered, due
53
The two methods not applied are: 1. Regression analysis linking the current market variables to project the expected RPm , 2.
The reverse calculation of market’s cost of capital derived from DCF valuation, estimation of ROIC and growth. (Koller p. 242)
54
The quote is from: http://www.msci.com/products/indices/tools/index.html#WORLD, and The MSCI World Index consists of
the following 24 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany,
Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden,
Switzerland, the United Kingdom, and the United States*.
55
Formulas applied: Arithmetic Average =
1
T
∑Tt=1
1+Rm (t)
1+rf (t)
− 1, and Geometric Average = (∏Tt=1
and later 8.
Page 59
1+Rm (t)
1+rf (t)
)
1⁄
T
− 1, where T = 41
to inclusion of only countries with strong historical returns in the sample. Hence when 0.8% survivorship
bias is subtracted from 4.02% annual arithmetic average rate we get the annual market risk premium of
3.22%.
The question now is, is this rate plausible to use as a future proxy? According to Jyske Bank’s equity strategy
paper from 06.12.12 over 10 years period the market risk premium is very volatile and currently being at
very high level i.e. 2.6 times higher than the historical average in the US market and 2.4 times higher in
Europe, see Appendix 10.2.56 In line with this it would imply current 10.08% market risk premium calculated
as 2.4*4.02%. Since the purpose of estimated WACC is to discount 15 years of projected FCF it is seen as
very high market risk premium to use for the WACC calculation, given that the world economy can change
in that period and thereby this high risk premium would undervalue Lundbeck’s performance today implying
law market share. In other words estimated historical market risk premium is to law if today’s economic
situation is considered and current market risk premium is too high to be used as future rate. Since the level
of risk aversion is highly volatile these days, it seems that shorter time period of extrapolating historical
returns is better fitting to the current situation. Thus calculating arithmetic average of for instance 8 years
period we get 7.29% market risk premium and 6.49% adjusted for survivorship bias. Nevertheless according
to the evidence the market risk premium is varying in the interval of 4.5%-5.5%, (Koller p. 242). All in all
the final market risk premium is somewhat in between all the estimations but due to the current turbulent
economic situation and taking the pessimistic view of the future it is estimated to be 9%.
8.3.4.
The cost of equity
As a conclusion the estimated cost of equity is calculated to be:
𝐤 𝐞 = 𝐫𝐟 + 𝛃𝐋𝐮𝐧𝐝𝐛𝐞𝐜𝐤 [𝐄(𝐑 𝐦 ) − 𝐫𝐟 ] = 𝟐. 𝟑𝟖𝟎% + 𝟎. 𝟗𝟐𝟒𝟒 ∗ 𝟗% = 𝟏𝟎. 𝟕𝟎%
8.4.
Conclusion the resulted WACC
The estimation process above results in the following estimated hurdle rate:
𝑾𝑨𝑪𝑪 =
56
𝑫
𝒌 (𝟏 −
𝑽 𝒅
𝑬
𝑻𝒎 ) + 𝑽 𝒌𝒆 = 𝟎. 𝟎𝟖 ∗ 𝟎. 𝟎𝟑𝟖𝟏 ∗ (𝟏 − 𝟎. 𝟐𝟓) + 𝟎. 𝟗𝟐 ∗ 𝟎. 𝟏𝟎𝟕𝟎 = 𝟎. 𝟏𝟎𝟎𝟕 ≈ 𝟏𝟎. 𝟎𝟕%
http://www.jyskebank.dk/_jb/commoninc/bin.asp?id=312331&src=aktieudsigterne2012.pdf
Page 60
9.
Valuation of H. Lundbeck A/S
The final part left of the project consists of the company valuation. The structure is as follows; first the real
option valuation of a development of a new CNS drug is presented initiated by a theoretical part and a
methodology choice for further real option analysis. There next the discount cash flow (DCF) valuation is
performed, and finalized by a multiple analysis for triangulating the results.
9.1.
Valuation with real options theoretical aspect
The enterprise DCF valuation method has its drawbacks, the most important one is that only single now and
never decisions are a part of the valuation. In other words investments in projects such as investments in
development of new drugs by pharmaceutical companies are overlooked in the valuation implying artificially
low company value. An R&D driven company like biotechnological and pharmaceutical companies this issue
is very important, especially because empirical evidence is conclusive that market values of such companies
are positively correlated with the current R&D commitments. Put another way current R&D investments are
characterized by considerable future uncertainties in the business environment, which are dealt with during
the projects life span and are not just one single number in the company’s FCF used for EDCF calculation.
This uncertainty implies that management in reality has a choice to revaluate the project if for instance
market risk changes and most importantly abandon the project all together if needed. As consequence this
flexibility is not accounted for in the previous valuation method. This is where option valuation plays a role
and to be correct real option valuation. In the Banerjee (2003 p.4) paper it is shown that real option valuation
best recognizes the underlying value of R&D investment(s) of new drug(s) and to apply real option valuation
to a pharmaceutical company like Lundbeck, corporate value is a function of present value of FCF from
(EDCF valuation) existing products plus value of R&D investments in drug development. In line with D.
Kellogg et al. (2000) the challenge is how to use real option valuation framework to assess the value of a
company when it is viewed as a portfolio of projects, as it is in a pharmaceutical company with a multiple
drug development projects in the existent pipeline. This is simply the sum of the values of the current
projects in the pipeline, each valued separately by the real option valuation.
Theoretically the definition of options is simply; that the owner of the option has a right and not the
obligation to either buy or sell the underlying asset at a strike price (predetermined), and if it is an American
option to either do the trade before or on the predetermined expire date. The financial instruments are
Page 61
underlying assets for options, where investment projects such as R&D investments, acquisitions, and
expansions are underlying assets for Real options.
The real options can be valued similar to financial options, and in particular a real option valuation of the
drug development, can be seen as a call option. The launch costs for the particular drug is a strike price,
expected sales or revenue is an underlying asset of the option. When the management of the pharmaceutical
company exercises the call option the investment and commercialization of the drug is made only and only if
the expected sales exceeds the cost of investment. On the other hand if the launch costs are larger than the
projected drug revenue of the company the R&D investment is abandoned.57
From now on only R&D investments in a drug development as underlying asset is of importance to the
analysis and company at hand, therefore the financial options will not be further discussed, i.e. it is found that
a discussion of general real option theory is less relevant than focusing the discussion on existent Real Option
theory in valuing pharmaceutical companies.
The purpose of this theoretical framework is to present it to the reader and to round down and argument for
the final and best suited choice of the real option valuation method for this paper. Therefore in the remaining
part first will shortly the most used methods be discussed together with the discussion of best method to use
in present context, followed by the in depth description of the chosen method. This way the framework for
the final real option valuation will be made. As a final remark the critic of the application of general real
option valuation will be given.
9.1.1.
Discussion of real option method
In order to frame the discussion let us begin with classification of the relevant Real option for the analysis in
terms of flexibility mentioned above. The R&D investment projects in a new drug development are
characterized by phased investments, i.e. the management at Lundbeck, have an option to continue the
project by investing additionally in the drug development or abandon it with the R&D cost already inquired
as sunk cost. Discontinuation of a compound Bifeprunox for treatment of Schizophrenia at the beginning of
clinical phase III in July 2009 by Lundbeck and its partner Solvay Pharmaceuticals, B.V. is an example.58
This option presents itself at each phase of the development process, preclinical, clinical phases: phase 1-3,
57
58
Bogdan, B. et al (2005)
http://investor.lundbeck.com/releasedetail.cfm?ReleaseID=608617
Page 62
registration application and launch. It is practically follow on options on options a so called compound option
or a growth option with staged investments. According to Bogdan et al (2005) p. 425, and Copeland et al
(2004) p. 1 the traditional Black-Scholes option-pricing model (BS) introduced by Black and Scholes, (1973)
and Merton, (1973) is not a useful or appropriate method for valuing compound options, since the model
cannot handle staged investments. On the other hand there exists a Geske model (1979) for valuation of
compound options which is an expanded version of BS model in continues time framework. But the method
that is simpler to work with and preferable by the academia are binomial or lattice models based on the work
by John Cox, Steve Ross, and Mark Rubinstein (1979) applicable in discrete time. Furthermore this model
which is built around decision trees according to Copeland’s et al (2004) paper is ideally suited to real-option
valuation, due to models ease of customizations to reflect changing volatility, early decision points and
compound option which means accounting for multiple decisions. In addition this model includes both the
market risk and technical risk facing the company according to Shockley (2006. p. 325).
So all in all the best method to apply is the Binomial model since it is a preferable method in academia, gives
a transparency and is relatively easier to apply than Geske model. Subsequently the framework of the
binomial method for valuing a pharmaceutical R&D project is described below.
9.1.2.
The framework for Real Option Valuation59
The first step in the Binomial model of R& D investment valuation of a new drug is to frame the problem,
answering each of the following questions:
1. What are the flexibilities?
2. Where they occur in time?
3. How much must be spent at each toll gate (during each (pre) clinical step through launch)?
4. What is the ultimate underlying asset and what is its current value?
5. What are the relevant uncertainties?
In order that one compound is successfully turned into a new drug, the discovery compound must
successfully go through five stages of R&D: Pre-Clinical trials, Phase I-III and Registration Application. As
59
This part is based on books: Koller, Tim et al (2010) , chapter 32, Shockley (2006) , chapter 8 and Tirgeorgis, Leons et al (2004), chapter 3.4.1 and Appendix 3.1
Binomial Option Valuation, and following papers: Cox, John et al (1973) , Copeland, Tom et al (2004), Bogdan, Boris et. al (2005), Banerjee, Ashok (2003) and
Kellogg, David et al (2000).
Page 63
a result careful description and estimation of each stage regarding the cost of completing the stage, time to
complete and probability of success, is needed.
As mentioned above the risk of R&D investment projects in a development of a new drug, comes from two
sources: 1. Market risk and 2. Technical Risk – which is the companies private risk, related to the uncertainty
about whether or not the development drug compound will do what the scientists have intended for it to do.
When these questions are answered the further process in valuing the flexibility, can be seen as a four or
three step process (regarding the source the analysis is based on here the three step will be presented)
incorporating the two risks gradually in the model. The starting point could be with the static NPV analysis
and use the PV of the expected FCF as starting value of the underlying asset. This is the same as estimating
NPV without flexibility. There next the problem is framed and analyzed assuming no technical risk. At the
end the valuation of the R&D investments in a new drug is conducted with technical risk.
The Static NPV is conducted first with calculating the expected PV based on the projected FCF from selling
the final developed drug. This is followed by calculating the PV of the expected investment costs. All this is
based on an assumption of 100 % success rate during the five stages and launch.
The expected PV is weighted by the cumulative probability of technical success through launch. The next
step is to discount this number with proper hurdle rate or WACC for the new drug (is assumed not to be the
same as a company WACC). Hence the formula for the Static NPV calculation for the new drug is:
𝑺𝒕𝒂𝒕𝒊𝒄 𝑵𝑷𝑽 = 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑷𝑽 ∗ 𝑻𝒆𝒄𝒉𝒏𝒊𝒄𝒂𝒍 𝒑𝒓𝒐𝒃𝒂𝒃𝒊𝒍𝒊𝒕𝒚 𝒐𝒇 𝒔𝒖𝒄𝒄𝒆𝒔𝒔 𝒅𝒖𝒓𝒊𝒏𝒈 𝒕𝒉𝒆 𝑹&𝐷 𝑝𝑟𝑜𝑐𝑒𝑠𝑠 − 𝑃𝑉 𝑜𝑓 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 𝑜𝑓 𝐷𝑒𝑣𝑒𝑙𝑜𝑝𝑚𝑒𝑛𝑡
Usually the Static NPV is expected to give the negative value implying that without accounting flexibility in
the valuation the R&D investment in a new drug will destroy value, hence will not be conducted.
But now we start with binomial model and use the calculated Expected PV as starting value for the binomial
tree of underlying values, which is denoted today. Before moving forward there is needed four more
parameters, volatility parameter which tells us deviation percent of our expected PV at launch date. “The
higher the volatility the lower the sales expectations can fall and the more valuable is the flexibility to
abandon the project.”60 Volatilities of 80% and higher means overvaluation, the 20% -40% are an acceptable
volatility for the pharmaceutical company. On the other hand Shockley’s estimation of the volatility is 50%,
however the volatility that will be used in the future analysis will be based on Bogdan’s acceptable
60
The quote is from Bogdan, Boris et al. (2005).
Page 64
volatilities for a pharmaceutical company, with the upper range of 𝜎 = 40%. The second parameter is length
of time denoted∆𝑡, third and fourth parameter needed is “up” and “down” steps which are calculated as
follows: 𝑈 = 𝑒 𝜎√∆𝑡 and 𝐷 = 1⁄𝑈. When the up and down steps are estimated the binomial tree of underlying
values can be calculated. The expected PV the starting value is multiplied first by up (U) number and than
with down (D) number. Therenext the two calculated up and down steps are multiplied each by the U and
than D, and so forth until the whole tree is build.
This Binomial Tree of Underlying values is used for both calculating the value of compound option on
marketed drug with and without assuming technincal risk. Furthermore for both valuations we need to
calculate the risk – neutral probabilities of the up and down steps using the risk free rate allready estimated
during calculation of the company WACC, which is 2,380 %. Risk-neutral probalbilities are calculated by
following formulas: An up step 𝑞 =
𝑒 𝑟×∆𝑡 − 𝐷
𝑈−𝐷
and a down step 1 − 𝑞.
In both valuations to get to the todays value of the compound options we need to work backwords, starting from the
last development stage which is Registration application at the time of the launch of the drug. The payoff of on the
continuation option if there is no technical risk (assuming 100% complition during all R&D stages) is calculated by
these formulas: 𝑚𝑎𝑥 = [𝑈𝑛𝑑𝑒𝑟𝑙𝑦𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒𝑢𝑝 − 𝐶 𝑁 , 0] and
𝑚𝑎𝑥 = [𝑈𝑛𝑑𝑒𝑟𝑙𝑦𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒𝑑𝑜𝑤𝑛 − 𝐶 𝑁 , 0] where C is the cost, and in the last stage it is a cost of going to launch. The
next step in the development stage the time ∆𝑡 before the last is calculated by
(𝑞 × 𝑝𝑟𝑒𝑣𝑒𝑢𝑠 𝑢𝑝 𝑣𝑎𝑙𝑢𝑒 + (1 − 𝑞) × 𝑝𝑟𝑒𝑣𝑒𝑢𝑠 𝑑𝑜𝑤𝑛 𝑣𝑎𝑙𝑢𝑒)/exp(𝑟 × ∆𝑡) and like this until the last step in
the clinical phase III. This is calculated by
max = {[ (𝑞 × 𝑝𝑟𝑒𝑣𝑒𝑢𝑠 𝑢𝑝 𝑣𝑎𝑙𝑢𝑒 + (1 − 𝑞) × 𝑝𝑟𝑒𝑣𝑒𝑢𝑠 𝑑𝑜𝑤𝑛 𝑣𝑎𝑙𝑢𝑒)/exp(𝑟 × ∆𝑡)] − 𝐶 𝑁 , 0},
and
this
process is continued until the value compound option at today is calcualted. The True NPV is 𝑁𝑃𝑉𝑡𝑟𝑢𝑒 =
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑 𝑜𝑝𝑡𝑖𝑜𝑛𝑡𝑜𝑑𝑎𝑦 − 𝐶𝑜𝑠𝑡𝑠𝑔𝑜 𝑡𝑜 𝑝𝑟𝑒𝑐𝑙𝑖𝑛𝑖𝑐𝑎𝑙 .The only difference in calculating the
compound option on marketed drug assuming technical risk is multiplying max calculations by probability of
technical success at that stage, for example
𝑃𝑡𝑒𝑐ℎ × 𝑚𝑎𝑥 = [𝑈𝑛𝑑𝑒𝑟𝑙𝑦𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒𝑢𝑝 − 𝐶𝑁 , 0] and so on. The final thing to do is to compare Static NPV
with the two Values of compound option with and without the assumption of technical risk. To value the
whole company the ideal situation is that each drug in the Lundbecks pipeline should be valued in the similar
fasion and values added toghether. But due to lack of time, space and availablity of information nedeed due
to insider information only one new drug development will be conducted in the final real option valuation.
Page 65
9.1.3.
The critic of the real option approach61
Due to the flexibility to abandon the project if not profitable real option approach is criticized to be yielding
too high values or simply overvalues the company’s growth opportunities compared to the simple DCF
method. Furthermore in order to conduct the real option analysis, one has to put more structure on the
problem than you would in the DCF framework, i.e. it is more complicated. The value of underlying assets is
not so clear cut in real options as it is for the financial options. For example in valuing pharmaceutical
company’s R&D investment projects of a new and untested drug the underlying value of the real option is
not straight forward to estimate. The one solution is to estimate the underlying values by looking at past
performance of the similar drug this means that the future estimates are relying on past performance which in
turn is a problem. As the real option approach relies on future forecasts of sales numbers which are very
difficult to forecast and are dependent of the assessment of the competition in the future, further application
of the drug and novel scientific techniques which are in itself difficult to predict, gives a room for
considerable valuation errors. In other words the real option technique relies on future forecasts of the market
risk and technical risk which may turn out to be under or over estimated by the manager. There is one more
critic of the use of real options valuation which is related to conducting financial options valuation methods
as the traditional Black-Scholes option-pricing model (BS) to value the real options. It is seen that simple
financial options are very different than the complex real options counterparts to be valued by the same
method, i.e. it is impossible to apply financial option models to real options decisions. In the light of the
binomial method choice for the real option analysis later in this paper, this critic is not seen as the problem
for the analysis, because it is not relevant. Moreover if the company’s projects are estimated to be highly
profitable or with little market uncertainty, the valuation with real options is not worth conducting, DCF is
more suitable valuation method, it is simpler and requires less effort.
9.2.
Real option valuation
The following real option valuation is based upon preceding theoretical presentation and dissociation. The
important aspect pointed out is that, since lack of time, space and availability of information the subsequent
real option valuation will be conducted for only one new CNS drug development in Lundbeck’s pipeline,
from preclinical trials to launch. The purpose of this is to show that with real option valuation the company is
worth more than presented in the previous, DCF valuation. Although ideally the sum of all R&D projects in
Lundbeck’s pipeline would be the best value approximation of the whole company, it is seen sufficient to
61
Bogdan, B. et al (2005), Copland et al (2004)
Page 66
illustrate this with development of only one new CNS drug. In general the valuation will be based on a
combination of actual facts, assumptions from papers and books, given that all information from costs in
each stage, industry wide rates of technical failures to projected revenues are not readily available.
The question now is what R&D project is the most suitable for real option valuation? One possible prospect
is in licensed compound from Kyowa Kirin in 18th of October 2011 the so called KW-6356 compound
already in a pre-clinical trial, intended for Parkinson’s disease treatment. 62 A second R&D project that could
be useful in this context is Cipralex for anxiety disorders in adolescents (CAP-E) currently in phase I of a
safety/efficiency study, recruiting participants, sponsored by University of Ottawa with Lundbeck’s
collaboration, i.e. identified by NCT01293838.63 A final candidate is the compounds working at the NPY-Y5
receptor treating cognitive disorders, the Lundbeck’s U.S patent application number 20110230497 from 22 nd
of September 2011.64 Since the third candidate is a recent one, is not in-licensed, is solely developed by
Lundbeck, can be assumed to be in the pre-clinical phase and is a compound for development of a completely
new product from scratch overall it is seen as the best to use in the valuation of the three candidates proposed
above. Let us call the R&D project NPY-Y5. Furthermore the analysis is from 31st of July 2011 seen as
today, from management point of view. In a given R&D project a pharmaceutical company to successfully
market a new drug, a certain compound must pass through several stages of development. The stages before
launch are a preclinical trials, clinical trials I-III, and registration application. In some papers there is also a
6th stage involving identification of active molecules a so called discovery stage for instance found in Kellog,
D et al. (2000). The development stage is seen as the first three years in Lundbeck’s figure depicting a
development of a new pharmaceutical product in the 2009 Annual statement page 24. Since NPY-Y5 is
already discovered this stage is omitted. Hence the assumptions for each stage are presented below.
62
http://www.accessmylibrary.com/article-1G1-241853554/kyowa-kirin-licenses-kw.html
http://www.clinicaltrials.gov/ct2/show/NCT01293838?spons=Lundbeck&phase=0&rcv_s=12%2F31%2F2008&rcv_e=12%2F22%
2F2011&rank=5
64
http://www.sciclips.com/sciclips/drug-discovery-news-archive.do and http://appft.uspto.gov/netacgi/nphParser?Sect1=PTO2&Sect2=HITOFF&p=1&u=%2Fnetahtml%2FPTO%2Fsearchbool.html&r=1&f=G&l=50&co1=AND&d=PG01&s1=20110230497.PGNR.&OS=DN/20110230497&RS=DN/20110230497
63
Page 67
Preclinical Trials: This stage in development is testing of non-human trials, i.e. testing of selected series of
active molecules through testing and experiments on rats or animals or simply performed in test tubes.
According to Lundbeck’s figure this stage has duration of about 2 years. In order to assess the expected cost
to complete and the industry wide rate of technical failures the table 1 from Kellogg, D et al. (2000) p. 79 is
used to get useful approximations. Hence the expected cost is $ 13.80 million converted to DKK it gives
DKK 111.55 million and industry wide rate of technical failures are seen as about 10%. The 25% technical
failures from Shockly are not applied; since it is not clear how it is induced in other words from what source
it is coming from.
Clinical trials Phase I: “Initial studies to determine the metabolism and pharmacologic actions of drugs in
humans, the side effects associated with increasing doses, and to gain early evidence of effectiveness; may
include healthy participants and/or patients.”65 In addition approximately 30-150 people are used in the
study (Annual statement 2009). Now when preclinical stage is successfully completed from management’s point
of view there must be assessed to abandon the project or to invest additional funds in the current phase. As in
preclinical trial the duration is based on the same source, and it takes about 1.5 years to complete. The
probability of success for a CNS drug is about 73%, and the expected costs are $ 11 million equivalently
DKK 88.91 million (DiMasi, J et al. (2004)).66
Clinical trials Phase II: This stage in development is characterized by further tests in patients, in a range of
100-500 test subjects, in order to explore therapeutic efficiency seen in relation to correct dosage, and a best
way to take the potential drug plus a duration of the therapy. It is estimated that approximate duration of the
completion is 1.5 years similarly as in the previous stage. 67 The completion of the development stage for a
CNS drug is estimated to cost approximately $ 23 million or DKK 185.91 million, with a very high failure
rate of 70.5 % (DiMasi, J et al. (2004)) compared to non-CNS drug developments being only 50% failure rate
according to Kellog, D et al. (2000) and 33% in Shockley, L. (2006). That high failure rate is chosen because
real option valuation it is for a CNS drug, and apparently is need in this context, otherwise the value
generated will be too high.
65
The quote is from:http://www.clinicaltrials.gov/ct2/info/glossary
DiMasi, J. et al. (2004) p. 215 figur 1+2
67
Lundbeck’s 2009 annual statement p. 24
66
Page 68
Clinical trials Phase III: Reaching successfully to phase III it means that the company if real option is not
abandoned engages in further testing on humans (500-5000 persons) the so called therapeutic confirmation,
that the product is safe and efficient lasting 3 years.68 The success likelihood of a CNS drug is of 51.10%
costing DKK 533.48 million converted from $ 66 million (DiMasi, J et al. (2004)). Completing whit success
phase III the registration application can be initiated see below.
Registration application: As long as the drug is marketable in the future, the additional investment of DKK
26.67 million is needed, or $ 3.3 million. Since all potential drugs applied for registration is not approved the
5% failure rate is to expect, the whole process lasts about 2 years. 69 The two years duration is consistent to
Kaitin, Ki et al. (2011 p. 186) estimation of CNS drug registration application of approximately 1.9 years or
rounded up to 2. In the case that the new drug is approved (NDA) the Lundbeck’s management has a task to
perform to decide if the launch of the new drug is profitable for the company. If the future revenue
generation of the product seem promising the launch and marketing of the drug is conducted. The necessary
assumptions are as follows:
Launch: Even if there goes a couple of months in preparation, from the time the drug registration is granted
to the final launch (09 Annual statements), one simplification assumption is made that the launch is
immediately implemented. The expected cost of the launch is about DKK 259.19 million (Kellog, D et al.
(2000).
All in all the whole 10 years CNS drug development will cost Lundbeck DKK 946.52 million without
including the cost of the launch.
In the case that the reader is interested in the real option decision diagram of the new CNS drug development,
described above see Appendix 11.1.
In consistency with the theoretical part the current real option valuation is gradually performed. It is strictly
speaking a three part analysis. The first analysis has a purpose to estimate the starting value of the underlying
assets necessary for later real option valuation. By static NPV analysis this is achieved, i.e. the valuation
without the flexibility. The next step is to incorporate flexibility into the analysis assuming no technical risk.
Subsequently the no technical risk assumption is relaxed and the final real option valuation is performed.
68
69
Ibid.
Ibid and Shockley (2006)
Page 69
Given that the real option analysis is a subject of a great uncertainty, regarding the assumptions made during
the analysis a short sensitivity analysis of most important factors is important. Hence the static NPV analysis,
real option valuation with/without technical risk and sensitivity analysis are found below in parts 10.2.1,
10.2.2 and 10.2.3 respectively.
9.2.1.
The static NPV analysis
The starting point for the analysis is to estimate expected future free cash flow generated primarily by the
expected future revenues of the new CNS drug currently in the development. For this to work the assumption
of the full technical success through all the development stages including the launch is imposed. The present
value of the FCF discounted by the appropriate hurdle rate for the marketed drug gives the required value of
underlying asset. The next step is to calculate present value of the expected costs of the development together
with the probability of the technical success throughout the R&D project. Hence the static NPV of the new
drug today is obtained by calculating probability weighted present value of the expected free cash inflow
subtracting the present value of expected costs of the development.
In view of the fact that information on the future expected revenues for a new drug is not readily available,
the methodology is to estimate future revenues from the estimated mean annual worldwide sales over the
product life cycle by the CNS therapeutic class, obtained partly by the historical revenues and partly is a
projection. This is not implemented with ease the one and only article found covering this is DiMasi, J. A. et
al. “R&D costs and returns by the therapeutic category” (2004). The drawbacks applying this method is that
the estimation is relying on only one source weakening the final analysis, and the figures are of relatively late
date concerning drugs approved in 1990-1994, which in turn could mean that the revenue projections could
be much different today, especially in the aftermath of the financial crisis and debt crisis covered in the
PESTEL analysis. Nevertheless the above method is applied because it is seen as the only available course of
projecting the revenues without effecting the reliability of the final analysis by guessing what the revenue
could be from today’s point of view.
And so the projected expected revenue in DKK converted from US$ in a six months period from AugustJanuary 2021 until February-July 2030 is presented in the figure 9.1. Furthermore other important
assumptions are also presented in the figure.
Page 70
Figure 9.1: Various assumptions
Revenue per half a year in
(DKK million)
August-January
2021-2022
296
February-July
2022
593
August-January
2022-2023
620
February-July
2023
1,239
August-January
2023-2024
1,415
February-July
2024
1,415
August-January
2024-2025
1,657
February-July
2025
1,657
August-January
2025-2026
2,021
February-July
2026
2,021
August-January
2026-2027
2,425
February-July
2027
2,425
August-January
2027-2028
3,031
February-July
2028
3,031
August-January
2028-2029
3,274
February-July
2029
3,274
August-January
2029-2030
3,435
February-July
2030
3,435
Percentage growth every six months after February-July 2030
-0.60%
Percentage growth every six months after February-July 2035
-23.83%
COGS/revenues
19.79%1
Marginal tax rate
25%
Annual WACC (The hurdle rate for marketed CNS drug)
14%
Six month WACC (The hurdle rate for marketed CNS drug)
6.77%
1
Based on the base case forecast calculations
Source: The figure is based on my own revenue calculations based on the DiMasi (2004) article
Time Period
Since the cost of capital is seen to be riskier for a particular R&D project development than the overall
company cost of capital calculated previously the 14% annual hurdle rate is based on Shockley’s estimation.
In general the patent registration is completed during the Pre-clinical phase and from that time the 20 years
patent protection for the launched product is calculated, meaning that during the 10 years of development the
half of the patent is already expired. This is consistent with the DiMasi’s figure 5, where maturity phase in
the product life cycle (PLC) for the CNS drug is reached after 9 years of product marketing. The slowdown
in sales growth is due to increased generic drug competition during the final year of the patent protection and
forward. For that reason the -0.60% growth is present from second half of the 2030, calculated as an average
of the growth rates between the second half of the 2030 until first half of the 2035. Accordingly the decline
phase is reached after 5 additional years i.e. the second half of the 2035, with average growth of -23.83%
calculated from 20035 to 2041. The direct expenses are based on COGS/revenue calculation from base case
forecast from 2011 giving 19.79% of projected revenue. During the analysis the marginal tax rate applied is
25%. The corresponding calculations of PV today are placed in the Appendix 11.2 Thus today the
31.07.2011 the present value of the expected FCF from selling the CNS drug is DKK 4,322.01 million.
Page 71
Similarly from present value of the expected costs of development calculation from Appendix 11.3 the
probability of success throughout the R&D process is 9.41% with PV of expected costs of development of
DKK 413.25 million. As a result the static NPV of the new CNS drug at July 31, 2011 is:
(𝟎. 𝟎𝟗𝟒𝟏 × 𝑫𝑲𝑲 𝟒, 𝟑𝟐𝟐. 𝟎𝟏 𝒎𝒊𝒍𝒍𝒊𝒐𝒏 )– 𝑫𝑲𝑲 𝟒𝟏𝟑. 𝟐𝟓 𝒎𝒊𝒍𝒍𝒊𝒐𝒏 = −𝑫𝑲𝑲 𝟔. 𝟔𝟏 𝒎𝒊𝒍𝒍𝒊𝒐𝒏.
Thus the negative static NPV means that the investment in the R&D project is value destroying, and is not
worth to invest in.
9.2.2.
The actual real option valuation
Given that procedure of the real option valuation is depicted in the theoretical part there will be no
explanations of the backwards calculations here. Furthermore since the calculation tables are large they are
enclosed in Appendix 11. The binomial tree of underlying values cannot be calculated without four
parameters. As mentioned in theoretic part the estimated volatility is 𝜎 = 40% and the adequacy discussion
is already made in part 3. Since the time length is six months the ∆𝑡 = 0.5. In addition the “up” and “down”
parameters are needed. The calculations are as follows; 𝑼 = 𝒆𝝈√∆𝒕 = 𝒆𝟎.𝟒𝟎√𝟎.𝟓 = 𝟏. 𝟑𝟐𝟔𝟗 and 𝑫 = 𝟏⁄𝑼 =
𝟏⁄
𝟏. 𝟑𝟐𝟔𝟗 = 𝟎. 𝟕𝟓𝟑𝟔 .
Now when the parameters are calculated the binomial tree of underlying values is ready to be calculated see
the final result in Appendix 11.5. From the underlying values the value of compound option on marketed
CNS drug with and without the technical risk is almost ready to be performed additional four parameters are
necessary. The discounting factor is one of the factors the risk free rate estimated in WACC estimation and is
2.380%. As well the risk free time value factor 𝒆𝒓×∆𝒕 = 𝒆𝟎.𝟎𝟐𝟑𝟖𝟎×𝟎.𝟓 = 𝟏. 𝟎𝟏𝟐𝟎. Finally the two last parameters
are the risk neutral probabilities the up step
𝟎. 𝟒𝟓𝟏 = 𝟎. 𝟓𝟒𝟗.
𝐪=
𝐞𝐫×∆𝐭 − 𝐃
𝐔−𝐃
=
𝟏.𝟎𝟏𝟐𝟎− 𝟎.𝟕𝟓𝟑𝟔
𝟏.𝟑𝟐𝟔𝟗−𝟎.𝟕𝟓𝟑𝟔
= 𝟎. 𝟒𝟓𝟏
and a down step 𝟏 − 𝐪 = 𝟏 −
Hence the value of the compound option on marketed CNS drug assuming no technical risk
i.e. with 100 % success rate during all the development stages is DKK 3,381.83 million at July 31, 2011. On
the other hand the compound option on marketed CNS drug assuming technical risk is at much smaller level
DKK 149.55 million. The true NPV that tells the management if the initial investment to go to preclinical
phase is worth a wile is calculated as follows
𝑁𝑃𝑉𝑡𝑟𝑢𝑒 = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑 𝑜𝑝𝑡𝑖𝑜𝑛𝑡𝑜𝑑𝑎𝑦 − 𝐶𝑜𝑠𝑡𝑠𝑔𝑜 𝑡𝑜 𝑝𝑟𝑒𝑐𝑙𝑖𝑛𝑖𝑐𝑎𝑙 .
The
𝒕𝒆𝒄𝒉𝒏𝒊𝒄𝒂𝒍 𝒓𝒊𝒔𝒌
𝒓𝒊𝒔𝒌
resulting true NPV’s are: 𝑵𝑷𝑽𝒏𝒐
= 𝑫𝑲𝑲 𝟑, 𝟐𝟕𝟎. 𝟐𝟖 𝒎𝒊𝒍𝒍𝒊𝒐𝒏 and 𝑵𝑷𝑽𝒕𝒆𝒄𝒉𝒏𝒊𝒄𝒂𝒍
= 𝑫𝑲𝑲 𝟑𝟖. 𝟎𝟎 𝒎𝒊𝒍𝒍𝒊𝒐𝒏.
𝒕𝒓𝒖𝒆
𝒕𝒓𝒖𝒆
In contrast to Static NPV indicating value destruction if company invests in the development of a new CNS
drug, the real option analysis suggests that it is worth investing in the initial investment to go to preclinical
Page 72
phase since the True NPV is positive in both cases with and without the technical risk. This is concluded
even though the two true NPV values are very different in a value and extremely high in no technical risk
scenario and very low when technical risk is included. In consistence with theoretical part value of the
company or enterprise value should be at least DKK 38.00 million higher than in DCF valuation. Since
Lundbeck has various other projects in the pipeline, this number could be much higher when all real options
for each project’s are added together. Therefore it seems that the value in DCF valuation below does not
include flexibility and therefore gives much lower value of the company suggesting that valuing flexibility
for a pharmaceutical company is important as theory implied.
9.2.3.
The sensitivity analysis
The sensitivity analysis is performed to see how sensitive real option model is to small percentage
The percentage change
In DKK million
The percentage change
-20%
-10%
+10%
+20%
-20%
-10%
+10%
+20%
3,260.17
3,260.61
3,303.78
3,356.50
-0.31%
-0.30%
1.02%
2.64%
0.75
18.57
58.22
78.19
-98.03%
-51.13%
53.21%
105.76%
Volatility
True NPV without technical risk
True NPV with technical risk
The percentage change
-2%
-1%
+1%
The percentage change
+2%
-2%
-1%
+1%
+2%
WACC
Static NPV
True NPV without technical risk
True NPV with technical risk
144.12
62.17
-64.49
-113.36
2280%
1041%
-876%
-1615%
4,886.75
3,998.64
2,663.32
2,153.14
49.43%
22.27%
-18.56%
-34.16%
162.29
92.07
-7.11
-42.78
327.08%
142.29%
-118.71%
-212.58%
Static NPV
-6.61
True NPV without technical risk
3,270.28
True NPV with technical risk
38.00
changes of the volatility and WACC. The true NPV with technical risk is highly sensitive to both changes in
volatility and hurdle rate, but where the true NPV with technical risk is more sensitive to positive changes in
volatility it is in comparison more sensitive to negative changes in the hurdle rate. For example 2% lower
hurdle rate means 327.08% higher True NPV with technical risk of DKK 169.29 million vs. DKK 38 million.
In contrast NPV without technical risk is almost not at all sensitive to volatility changes +20% increase in
volatility means only 2.64% higher value where the change is 105.76% higher if we look at true NPV with
technical risk with the same percentage change. The static NPV as well as True NPV without technical risk
are also highly sensitive to small WACC changes especially static NPV that also gives positive result if
WACC changes by -2% and -1% change, giving DKK 144.12 million of value a whole 2,280 % increase
Page 73
from -6.61. Another useful thing that can be concluded is that it is not advisable to invest in development of a
new CNS drug if the hurdle rate is higher by 1% i.e. 15% since the true NPV with technical risk is negative
destroying value as Static NPV suggests. Also in the same fashion all the valuation methods give the green
light for R&D investment if the WACC is 1% lower, with Static NPV being a positive one of DKK 62.07
million.
9.3.
DCF valuation
The following enterprise discount cash flow valuation starts with the scenario analysis, and with that
completed the estimating continuing value together with calculating and interpreting results are performed.
To finalize the valuation a short sensitivity and plausibility analysis are conducted.
9.3.1.
Scenario analysis
In the following the scenario analysis is conducted since the future regarding the business developments, the
overall macroeconomic factors and the development of the Pharmaceutical industry and the forecasting based
on the perception of that future is flowed and characterized by great uncertainty, the DCF valuation will be of
greater value if multiple scenarios of the future are implemented in the calculation of Lundbeck’s final share
price. In that light the three scenarios will be created for that purpose, a one where business as usual is
depicted followed by the best and worst case scenarios. The scenario analysis is based upon previous industry
analysis, strategic analysis and historical analysis. Since the strategic analysis and industry analysis is
summarized in a SWOT this will be a primary source of the estimation of the company’s future revenue in
the three scenarios. Given that almost all line items of the balance sheet and income statement are obtained
from the revenue forecasting the projected revenue will be the only change considering everything else equal
in the scenarios.
Before the actual analysis Koller p.301 recommends that critical review of assumption of certain variables
are of importance when analyzing the scenarios. The first question is how critical are the forecasts of broad
economic conditions to the final result? Since Lundbeck is operating in the pharmaceutical industry where
the shocks in the economy such as the late financial crisis and current debt crisis in the EU are not directly
effecting the company, see the company’s beta which indicates that Lundbeck’s stocks are less sensitive to
systematic risk than the overall market. However indirectly through the healthcare reforms and price cuts
induced by the crisis is effecting negatively the revenue growth of the company. All in all the effect is seen as
low one and will differ across scenarios. Second question is what does the competitive structure in the
Page 74
pharmaceutical industry means for the scenarios? While the competitive structure in the industry is
fragmented one and highly competitive it is seen unlikely that the mature drugs will increase revenue by
gaining market share, only launch of the new drugs will increase revenue trough significant increase in
market share and only since almost all the current drugs in both Lundbeck’s and competitor product
portfolios are facing patent expirations, that it is possible. Third question to be asked is, is Lundbeck capable
to achieve business results depicted in the scenarios? In other words since the revenue projections for the
short term forecast are of primary concern the revenue projections are based on current R&D projects in the
late clinical phases that have high success probability. Therefore it is assumed that Lundbeck in short term
forecast is capable of developing necessary drugs in time if not otherwise presented in the scenarios. The
assumptions of the financing capabilities of the company are implicitly made in the valuation, through the
forward estimated capital structure.
9.3.2.
The base case scenario
The base case scenario, a business as usual assumption is made. Therefore there will be no further
acquisitions, in-licensing and other forms of collaborations, and no important pipeline failures. The 2011
revenue forecast is based on the Lundbeck’s third quarter financial statement, where 10% revenue growth is
acquired during the 9 months of 2011, which is assumed to be constant during rest of the year and is the same
across scenarios. In the remaining four years the volume growth in Europe and US markets will slightly
decline since the negative projection of global spending in these two markets are outlined. Furthermore it is
assumed that only additional small price cuts in EU in 2012 will see the light of day induced by the current
credit crisis, effecting the revenue growth at a very small level that it is not important to mention further or
take into account in projections. Looking at the submarkets, the mature market drugs anti-psychotic and anti
depressants will drive revenue moderately and slightly down respectively from 2012 to 2015 since the
growth projected of this markets are negative ones and the blockbuster drugs have expiring patent rights. It is
a relatively moderate decline and not a large decline since the new products are to be introduced replacing
the old ones from 2014 and it takes time for the market to adjust from the patents expire until company faces
the full blown decline in revenues because of the generic drug competition. Furthermore the launch of
Lexapro in Japan and China in 2011 means a increasing depression revenue contributions even when the
patents in US and Europe expires all in all a very small initial decline in revenues. Initially it will not
overweight the decline from Europe and US since these are completely new markets in the introduction
phase of the product life cycle and have a small revenue growth. The Alzheimer drug until 2014 will have
Page 75
significant revenue growth but after 2014 when the patent is to expire the company will face slightly decline
in revenues, due to no potential drug replacing the old one in the 2015 and forward. The 2012 solid
13%growth is primarily driven by the two growing markets depicted in the industry analysis the Alzheimer’s
and Anti-epileptic market and are assumed to overweight revenue decline described above. Since the patent
expiration of Sabril a current drug treating epilepsy is to expire in 2015 and 2016 together a new drug for
treatment of LSG syndrome Onfi is FDA approved in US the launch of the drug in January 2012 is assumed
to contribute high level of revenue growth. The new product will not cannibalize the revenue of Sabril since
the two products are addressing two different segments adults and children. Furthermore the solid growth is
also due to rise in growth in Pharmergent markets and a launch of Cephalone product in 2012 in Latin
America. The projected revenue growth of 14% is based on same assumptions as for the previous year with
additional rise in revenue due to projected launch of Nalmefene a drug used for treating alcohol dependence
in EU. A revenue growth of 17% in 2014 is spiked by the later product launches which are assumed to be
growing at increasing speed due to reaching the product growth phase, with addition to assuming rising
revenues from Asia. In 2015 the decline of projected revenue growth of only 11% is due to the fact that
almost all of the current patents are expired for current blockbuster drugs and there are no new product
launches in this year that it means a slowdown in revenue growth. It should be mentioned that the growth
levels of and above 18% as in 2009 is not credible since the negative spending outlook in US and Europe is
to be expected and since these are currently two major markets they are putting the limit on the growth, and
in addition the projected growth is lower given that zero growth in spending on branded drugs and
accelerating shifts toward generics are also lowering the potential revenue growth. The projected growths are
also driven by population growth and growth in elderly people needing other drugs in the Lundbeck’s
product portfolio as Parkinson’s dieses. Given that the steady state is reached after these five years in 2016
the growth is fallen below five percent at long term average of 2% each year to 2025.
The corresponding DCF valuation results in DKK 180.88 per share.
9.3.3.
The best case scenario
The best case scenario leans mostly upon the previously described base case scenario, and below is the
difference elaborated. It is assumed that in 2012 Lundbeck initiates new acquisitions and collaborations in
licensing which are driving growth positively in that year. The launched products mentioned before are
having higher growth than in the base case. The world economic outlook is brighter especially in Europe
Page 76
where the current debt crisis is less severe than expected implying no future price cuts and health care
reforms. The projected decline in mature markets in Europe and US are of diminishing value, and generics
have lower growth of market share than expected, especially the forecasted zero growth in spending on
branded drugs through the 2015 are turned up to be positive due to higher population growth and product
awareness. The presence in Asian market and Pharmergent markets is better than anticipated with higher
market share growth. The revenue growth is as follows 15% (2012), 17% (2013), 19% (2014) and 15% in
2015 with long term average of 2.5% below the current Pharmaceutical industry growth of 5%.
The corresponding DCF valuation results in DKK 206.94 per share.
9.3.4.
The worst case scenario
The worst case scenario is also based upon the previously described base case scenario and differs as follows.
It is assumed that in 2012 and forward Lundbeck encounters a serious amount of pipeline failures. The
launched products mentioned before are having hard time gaining market share due to severe competition
and one or two of the drugs are seen as inferior to other drugs in the market. The world economic outlook is
worse than anticipated especially in Europe where the current debt crisis effecting negatively euro area and in
the worst case if Germany drops out of the euro collaboration are implying the collapse of Euro. The world
economy is in a recession where large future price cuts, health care reforms and regulations are the future
outlook. The projected decline in mature markets in Europe and US are of higher value, and generics have
higher growth of market share than expected. The presence in Asian market and Pharmergent markets is not
that big revenue contributor than anticipated with lower market share growth, due to severe generic
competition. Furthermore the blockbuster patent expirations in EU and US imply fast growth decline in this
markets. Thus the revenue growth remains stagnant and declines when prices erode and company loses
market share. The projections are as follows 8% (2012), 7% (2013), 5% (2014) and 2% in 2015 with long
term average of 3% below the market growth.
The corresponding DCF valuation results in DKK 138.50 per share.
The process of reaching the final share price is enlightened below.
9.3.5.
Estimating the continuing value (note)
In order to estimate continuing value the recommended formula for DCF valuation is the value driver
formula below: 𝐶𝑜𝑛𝑡𝑖𝑛𝑢𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒2025 =
𝑁𝑂𝑃𝐿𝐴𝑇2026 (1−
𝑔
)
𝑅𝑂𝑁𝐼𝐶
𝑊𝐴𝐶𝐶−𝑔
Page 77
with the variables,
𝑁𝑂𝑃𝐿𝐴𝑇2026
= NOPLAT in the first year after the explicit forecast period
𝑔 = expected growth rate in NOPLAT in perpetuity, 2.5% for best case scenario, 2% for base case scenario and 2% in the worst
case scenario, with all scenarios having lower growth rate than the market of 5% see the industry analysis.
𝑅𝑂𝑁𝐼𝐶 = expected rate of return of new invested capital is set to be equal to 𝑅𝑂𝐼𝐶2025 since Lundbeck have sustainable
competitive advantage in form of patents and branded drugs, otherwise it should be equal to WACC.
𝑊𝐴𝐶𝐶 = weighted average cost of capital estimated to be 10.07%
When taking all this in consideration the three continuing values are: 𝐶𝑉𝐵𝑎𝑠𝑒 𝑐𝑎𝑠𝑒 = DKK 110,600
million, 𝐶𝑉𝐵𝑒𝑠𝑡 𝑐𝑎𝑠𝑒 = DKK 128,945 million and 𝐶𝑉𝑊𝑜𝑟𝑠𝑡 𝑐𝑎𝑠𝑒 = DKK 80,697 million.
9.3.6.
Calculating and interpreting results
To complete valuation of core operations the estimation of enterprise value, equity value and value per share
are performed next. The process is as follows: Going from DCF value of operation to Enterprise value the so
called value of entire company the Nonoperating assets have to be added. To reach to the value of the
company that shareholders own the equity value the Debt and debt equivalents together with Hybrid claims
must be subtracted from the Enterprise value. The value per share (DKK) is than induced by dividing the
Equity value by current diluted share amount outstanding. First and foremost the estimation of DCF value of
operations are presented, followed by calculations of Enterprise value and moving from Enterprise value to
value per share.
9.3.6.1. DCF value of operation
The first step is to calculate present value of projected FCF’s in the explicit forecasting period by the cost of
capital of 10.07%. The next step is to discount the already calculated continuing value to the present time, by
the same discount rate. Added together they give operating value or total company value using the formula:
𝐿𝑢𝑛𝑑𝑏𝑒𝑐𝑘 𝑣𝑎𝑙𝑢𝑒 = 𝑃𝑉 𝑜𝑓 𝐹𝐶𝐹 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑒𝑥𝑝𝑙𝑖𝑐𝑖𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 + 𝑃𝑉 𝑜𝑓 𝐶𝑜𝑛𝑡𝑖𝑛𝑢𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒 (𝑡ℎ𝑒 𝑃𝑉 𝑜𝑓 𝐹𝐶𝐹 𝑎𝑓𝑡𝑒𝑟 𝑒𝑥𝑝𝑙𝑖𝑐𝑖𝑡 𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡 𝑝𝑒𝑟𝑖𝑜𝑑)
In order to include the fact that cash flows do not all come at the end of the year, it is assumed that cash flows
are realized on average in the middle of the year. Hence the midyear adjustment factor is calculated.
𝑀𝑖𝑑𝑦𝑒𝑎𝑟 𝑎𝑑𝑗𝑢𝑠𝑡𝑚𝑒𝑛𝑡 𝑓𝑎𝑐𝑡𝑜𝑟 = 1⁄(1
= 1⁄
= 1.05
+ 𝑊𝐴𝐶𝐶)−0.5
1 + 0.1007−0.5
. Multiplying the operating value with
midyear adjustment factor gives the Operating value discounted to current month. In the base case for
example all calculations performed are as follows:
Page 78
Present value of FCF2011-2025
Present value of CV
Total value
9,111.7
26,216.1
35,327.8
Continuing value
110,600
Operating value
Midyear adjustment factor
Operating value, discounted to current month
9.3.6.2.
0.2370
26,216
35,328
1.05
37,064
Calculation of Enterprise value
Since Nonoperating assets are a value to company shareholders they are added to DCF value operations. For
valuation purposes the each value of Nonoperating assets must be estimated in terms of market value, here it
is assumed that excess cash and securities are reported at their fair market value on the balance sheet. Hence
the 2010 book value are taken as proxies for market values. The most recent book values are also taken as a
proxy for the rest of the Nonoperating assets on the balance sheet; other financial assets, nonconsolidated
investment, other receivables and tax-loss carry forwards and there are no excess pension assets. The base
case enterprise calculations look as follows:
Book
value
DKK million
Market
value
DCF Value of operations
37,064
Nonoperating assets
Excess cash
1,999
1,999
Securities
54
54
Other financial assets
21
21
Nonconsolidated investments
Other receivables
Tax loss carry-forwards
Enterprise value
-
-
57
57
266
266
39,461
The rest of the scenario analysis’ are calculated in similar fashion.
9.3.6.3.
Moving from Enterprise value to value per share
The process of moving from enterprise value to value per share consists of subtracting nonequity claims.
These are the broadly speaking split into two parts the debt and debt equivalents, and hybrid claims. The
valuation of debt and debt equivalents that Lundbeck possesses are valued as follows;
Debt and debt equivalents: First and foremost these are; short term debt, long term debt, retirement-related
liabilities, nonoperating provisions, value of operating leases, nonoperating tax liabilities (assets) and
additionally unfunded pensions.
Short term debt in 2010 is 0 and therefore both book value and market value are 0.
Page 79
Long term debt’s market value is not sensitive to changes in interest rates, and since Lundbeck’s debt is not
publicly traded market quotes could not be of use. Therefore the book value is a good proxy for the market
value which is DKK 1918 million, and the assumption is that the long term debt approximates market value.
Retirement- related liabilities’ market value is the book value with statutory tax deduction of 25%, since
there are no actuarial losses on Lundbeck’s balance sheet in 2010. Hence the market value is DKK 168
million vs. DKK 224 million of book value.
Nonoperating provisions are 0 in 2010 and the market value is 0, but if it was not the case the market value
would be the book value adjusted for taxes applying 25% statutory tax rate.
The present value of non operating leases are also deducted since the adjustments are made in financial
statements, the market value is the same as the book value of DKK 1456 million.
Nonoperating tax liabilities (assets) are also deducted from the enterprise value, and the market value is
DKK 328 million.
Finally Lundbeck have in 2010 DKK 89 million unfunded pensions which also should be treated as debt and
debt equivalents, and the value above is the market value since companies report unfunded pensions at
market value. In total market value of debt and debt equivalents are DKK 3959 million.
Hybrid claims:70 Lundbeck has two types of Hybrid claims debt and equity based. The equity based claims
are Warrants and Share-schemes on the other hand the debt based claims are similar in conditions and award
criteria to equity based claims. These are Stock Appreciation Rights (SARs) a share price –based scheme
similar to warrants, and Restricted cash units (RCUs) a share price- based scheme similar to share –schemes.
Koller p. 286 recognizes three different methods for valuing such claims; 1. Using market value, 2. Black.Scholes value and 3. Conversion value. Since the above claims are valued in the Lundbeck’s 2010 annual
report by Black-Scholes valuation the same method is also applied here. Given that all the claims are seen as
a call option all are valued with one Black-Scholes valuation except for RCUs. The most assumptions and
variables needed for a Black-Scholes call option valuation with dividends are based on the annual report note
70
The values for option calculations are from http://files.shareholder.com/downloads/AMDAGGC00/1424322190x0x493921/f44db753-d0b7-4705-a12c-6e232d1e69c8/Lundbeck_Annual_report_2010.pdf, and
http://files.shareholder.com/downloads/AMDA-GGC00/1424322190x0x516389/53e0fcdb-e581-402b-8c32d913571f2fa2/Read_the_full_release_in_PDF.pdf
Page 80
3 except for current share price (S) of DKK 109. The rest of the assumptions are: Current stock price
adjusted for dividend yield (S*) equal DKK 107.39, Exercise price (K) equal to DKK 97, Risk-free interest
rate (rf) 2.06%, Time to maturity (T) is 5 years in average, Stock volatility (σ) is 31.40 and Dividend rate (Q)
of 1.5%. The resulting call option is DKK 34.64 per share. Furthermore the number of Warrants, shares,
SARs and RCUs are estimated to be: #Warrants= 771,666= Executive management (507,885) + Executives
(79,406) +other (203,659) – 2011 exercised warrants (19,284), #Shares = 102,689 = Executive management
(22,308) + Executives (22,781) +other (57,600), #SARs = 18,957= Executives (18,068) +other (889) and
#RCUs = 5,439 = Executives (5,184) +other (255). Below are the estimated values of hybrid claims.
Hybrid claims ( DKK million)
Equity based schemes:
Warrants
Share -schemes
-26.73
-3.56
Debt based schemes:
SAR
-0.66
RCU
-0.57
The resulting equity values are as follows, DKK 35,470 million in Base case, DKK 27.159 million in Worst
case and DKK 40,581 in the Best case scenario.
Currently number of diluted shares outstanding that Lundbeck has is 196.1 thousands based on the 3rd quarter
financial statement of 2011.
The final Lundbeck’s value per share when the scenarios and probabilities are weighted is
Worst
case
7%
32.39%
Base
case
13%
33.62%
Best
case
15%
33.98%
19.49%
22.06%
22.95%
Equity value (DKK million)
27,159
35,470
40,581
Equity value per share (DKK)
Probability (percent)
138.50
20%
180.88
75%
206.94
5%
Average revenue growth, 2011-2015 (percent)
Average Adjusted EBITA/revenues, 2011-2015 (percent)
Average Adjusted ROIC excluding goodwill, 2011-2015
(percent)
Expected value per share (DKK)
173.71
Page 81
DKK 173.71 per share. The probabilities assigned to each of the scenarios are based on the previous industry
analysis, strategic analysis and especially the world economic outlook. The most weighted scenario is the
base case of 75% probability, since the world economic outlook is not promising the there is higher chance
that it occurs than the best case. Hence the 20% probability is assigned to worst case and only 5% to the best
case scenario.
9.3.7.
Sensitivity analysis
Now when the final share price is estimated, the next step is to analyze how sensitive the model is to changes
of key variables; revenue growth, EBITA margin, growth in NOPLAT from year 2026, RONIC 2026,
WACC and certain WACC components. The analysis is performed by changing one variable like revenue
growth by for example +2% under ceteris paribus condition, which means that other variables including in
the model are constant. Below the resulting table is presented, with share changes and percentage changes in
relation to the final share price induced from the three scenarios.
The percentage change
-2%
-1%
+1%
+2%
Revenue growth ('11-25)
EBITA margin ('11-)
Growth in NOPLAT (2026-)
ROIC=RONIC (2026-)
135.13
165.84
171.01
172.00
153.17
169.77
172.37
172.90
197.06
177.64
175.04
174.43
223.16
181.57
176.38
175.09
Beta
Risk free rate
The market risk premium
179.50
266.79
257.51
176.57
213.13
209.73
170.91
143.90
145.89
168.17
120.87
124.00
WACC
278.08
217.15
141.66
117.40
Revenue growth ('11-25)
EBITA margin ('11-)
Growth in NOPLAT (2026-)
ROIC=RONIC (2026-)
-22.21%
-4.53%
-1.55%
-0.98%
-11.82%
-2.27%
-0.77%
-0.47%
13.44%
2.26%
0.77%
0.41%
28.47%
4.52%
1.54%
0.79%
Beta
Risk free rate
The market risk premium
WACC
3.33%
53.58%
48.24%
60.08%
1.65%
22.69%
20.74%
25.01%
-1.61%
-17.16%
-16.02%
-18.45%
-3.19%
-30.42%
-28.62%
-32.42%
The analysis is based on simultaneous change in all the scenarios, with the final share price in DKK
without any changes
173.71
The conclusion is that the model is highly sensitive to WACC changes one percentage change in WACC
means 25.01% higher share price if it is negative change, and lower share price when it is a positive change.
Not to mention a negative change of 2% gives whole 60.08% higher share price of 278.08 compared to
Page 82
173.71. It is a similar picture when the risk free rate and the market risk premium are changed, with very high
variations. The only WACC variable that model is not sensitive to is percentage changes in betas, for
example the 2% lower beta gives only 3.33% higher share price of 179.50. Additionally it seems that the
model is more sensitive to negative percentage change in WACC. This means that estimating WACC
correctly is very important for the company value, especially risk free rate and the market risk premium, and
it means less if you have higher WACC than very low one. As the whole model is dependent to revenue it is
expected that it is very sensitive to small percentage changes to revenue. All though the models sensitivity to
revenue is not as extreme as for WACC, it still has considerable sensitivity to revenue changes. One positive
percentage change in revenue growth means 13.44% increase in the share price and it more than doubles
when the 2% change is applied, giving whole 28.47% change in the share price 223.16 vs. 173.71.
Additionally it is less sensitive to negative changes than to the positive ones. The three last variables in the
table have very little impact on the model compared to other variables, i.e. the model is not that sensitive to
them.
9.3.8.
Plausibility analysis
Now the question is how plausible is this value per share at DKK 173.71? Based on the Lundbeck’s
homepage it is not that plausible at the current time, in view of the fact that the closest price level to the
estimated above was in 2007, but this year was not that promising as the highest share price level was around
the DKK 140 and at 31.12.2011 the share price was only at the DKK 108 per share level. Why are the
calculated values and the actual value per shares so different, is hard to say without saying that the market is
wrong the one plausible explanation could be that the two valuations are based on different assumptions. On
the other hand Lundbeck’s value per share at the estimated level above seems highly plausible according to
the Jyske Bank article on Danish winners at 19.12.2011, since Lundbeck’s shares are fundamentally
undervalued, where the market is undervaluing the company’s pipeline and growth potential in Asian
markets. Additionally they also have a best case scenario where the shares are above DKK 200 per share
similarly as forecasted in this paper where the best case scenario is of DKK 206.94 per share. 71
9.4.
Valuation with multiples (comparables)
A short valuation with multiples is performed below, in order to triangulate the DCF valuation and above
plausibility analysis. In company profiling the relevant peer group is depicted, even though it is not a right
71
http://www.jyskebank.dk/_jb/commoninc/bin.asp?id=235934&src=kbslg_131008.pdf
Page 83
peer group in consistency with the usual characteristics such peer group should posses which is impossible in
this case. In other words the peers should have similar outlooks for long term growth, ROIC, risk and capital
structure for the statistics as mean and median to be relevant. Therefore the multiple analyses should be taken
with consideration and not be treated as a Holy Grail, or a standalone valuation as DCF. The analysis is
performed anyway for information purposes. In the analysis the forward looking multiples are applied, since
the evidence suggests that they are more accurate than historical ones in value prediction. Since the valuation
is a short one and already has its limits, only next year forward looking estimates are seen as enough since
projections 5 years or above will not improve the valuation or its short comings. The widely used equity
multiple price to earnings (P/E) is only presented in the valuation table but will not be used for further
valuation, since it gives relatively wrong valuation, change in capital structure and non-operating gains and
losses are distorting it. Additionally the best forward looking multiple would be EV/EBITA and not
EV/EBIT or EV/EBITDA, in order to avoid the miss valuation of company’s relative operating performance.
However building EV/EBITA multiple could not be performed given that the Datastream software the source
of the 1-year forward looking estimates unfortunately lack forward looking EBITA estimates. Hence it is
assumed in the analysis that current depreciation Lundbeck has is not an accurate predictor of future capital
expenditure in order to conclude that EV/EBITDA is better multiple to use than EV/EBITA. In addition
EV/next year’s revenue and EV/EBIT multiples are performed. The resulting multiple analyses are depicted
in table 9. What can be concluded from the table below is that the deviation is very high between the
multiples across the peer group since the deviations in the three multiples are around plus 30%. When that
said, as concluded in the share performance analysis previously it seems that the market believes less in
Lundbeck’s strategic position to create more value than the peers since the multiples Lundbeck has, are all
negative compared to the calculated peer mean. Hence the revenue multiple is 40.5% lower than the peer
mean, 21.5% lower EV/EBITDA and -3.8% lower EV/EBIT. This is very much consistent with the share
performance analysis implying that Lundbeck was unable to satisfy the market expectations and historically
have mediocre or very low stock market performance to the peers. In relation to the company profiling and
the strategic analysis the explanation could be that the company is a small one compared to the peers and
depends strongly on mature markets Europe and US and number one revenue contributor comes from
stagnating depression & anxiety market. Furthermore the company is in the similar position as the peers
relative to potential patent expirations compared over the submarkets, but the difference is that Lundbeck
Page 84
have smaller diversified portfolio of drugs that it is more dependent on the current drugs and their patent
protection than peers, and therefore are more vulnerable to their expirations.
Table 9.1: Multiple analysis, November 2011
Equity value multiples
1-year forward multiples
Times
P/E
EV/Revenue
EV/EBITDA
EV/EBIT
H. Lundbeck A/S
9.3
1.4
5.5
7.2
Pfizer
GlaxoSmithKline
8.1
2.2
4.6
5.7
10.7
2.6
7.1
Novartis
8.3
9.8
2.3
6.8
8.6
AstraZeneca
6.8
1.9
4.5
5.2
Bristol-Myers Squibb
14.0
2.5
8.1
4.2
Eli Lilly & company
9.6
1.7
5.9
7.2
Forest Laboratories
13.2
1.6
8.2
9.4
Shire
16.0
3.7
10.6
11.6
Peer Mean
11.0
2.3
7.0
7.5
Peer Median
10.2
2.2
6.9
7.7
30.5%
30.7%
29.1%
31.7%
-40.5%
-21.5%
-3.8%
Enterprise value using Peer Mean
34,066
25,805
21,058
Equity value with Peer Mean
30,076
21,814
17,068
Lundbeck's #Diluted shares outstanding
196.1
196.1
196.1
153.37
111.24
87.04
Peer group:
Peer Deviation (percent)
H. Lundbeck A/S vs. Peer Mean
Share Price (DKK)
Source: The table is based on my own calculations except for P/E ratios and data used is from Datastream, both for current Enterprise values and for forward
estimates, of revenue, EBITDA and EBIT.
The resulting share prices induced by each multiple are as follows: EV/revenue implies a DKK 153.37 per
share, EV/EBITDA implies lower value per share in DKK of 111.24 and EV/EBIT gives the smallest fair
value per share of DKK 87.04. While current share price of the company is DKK 108 per share, it seems that
the market is undervaluing the company’s shares, in relation to the two first multiples. Nonetheless the last
multiple in contrast suggest a strong overvaluation. However the most reliant multiple is the second one
suggesting a little undervaluation compared to the markets share price. This is in the strong contrast to the
DCF valuation, and forecasts of professional company profilers in the Jyske Bank that also suggested a
strong undervaluation.
Page 85
10.
Conclusion
In the light of that 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 answering the question Is the current fair share value of Lundbeck’s ordinary shares overvalued or
undervalued compared with the market? Following is induced.
The most important political and legal factors that effects Lundbeck’s profitability negatively through price
cuts on branded drugs are current and future healthcare reforms and are those factors together with economic
that have the most significant impact on the company.
The biggest competitors found of the company are top players in the global pharmaceutical industry and are
Pfizer, GlaxoSmithKline, Novartis, AstraZeneca, Bristol Myers Squibb, Eli Lilly & company, Forest
Laboratories and Shire. However Forest Laboratories is seen as closest competitor since that company has
highest percentage of revenue contributed to CNS of 89% across peers. Competitive position in the industry
is mixed in relation to submarkets, good in anti-epileptic market but bad in anti-alzheimer’s. From Strategic
analysis can be concluded that in the global pharmaceutical industry on a moderate level are threats of new
entrants, the power of buyers and power of suppliers. Threats of substitutes are on a low level and rivalry
among the existent competitors is a strong one. For Lundbeck as a company there are slightly differences
from the industry as whole, threats of substitutes is seen as a strong one due to patent expiration of
blockbuster drugs, and power of suppliers are on a low level since the company is an strongly integrated
company.
The company’s growth strategy is investing high level of revenue in R&D compared to competitors
involving in partnerships, in licensing, mergers and acquisitions finding new markets as marketing Lexapro
in China a Pharmergent market with highest growth potential. All this is also a main strategy of the company
to improve the competitive position in relation to competitors, and are very much in line with KFS in the
industry. Furthermore the company is more and more diversifying the product portfolio with new products
such as anti-alcohol drug Nalmefene.
Historically present economical performance indicates very volatile revenue growth. Compared to median
pharmaceutical industry in 2008 and 2010 the growth is below the median growth of 8%, but overall organic
growth is above average industry levels with CAGR of 9.98%. Furthermore historically the value is created
Page 86
in the company since cost of capital (WACC) is lower than ROIC in all historical years. Lundbeck is also
performing well compared to median ROIC of 23.5% of the industry in 2009 and 2010 being above or close
to this level, only in 2008 being slightly under 20%. Finally the reasurch on the ROIC saggests that if a
company is earning a high ROIC, there is a good chance that the high ROIC will be sustainable in the future.
In this context it seems very promissing for Lundbeck’s future value creation, due to current high level of
ROIC. The negative will be if the patent exparations in the resent future lowers ROIC considerably it will
mean that the lower ROIC is also likely to persist to.
From revenue growth analysis it can be concluded that Lundbeck’s growth is a sustainable one seen
historically since the major part of the growth consists of organic growth. However as it should be expected
for a global company the revenue growth is very sensitive to fluctuations in exchange rates overall effecting
Lundbeck’s growth negatively with CAGR of -2.22%.
After a thorough discussion, review and estimation of Lundbeck’s cost of capital (WACC) the final outcome
is a WACC of 10.07%. One of the cost of capital building blocks is cost of equity where capital asset pricing
model (CAPM) is applied to estimate it, resulting in k e = 10.70%. Furthermore since the company in the
question is not credit rated the company’s cost of debt is estimated by recent borrowing history of the
company resulting in k d = 3.81%. Since after tax cost of debt is needed a statutory tax rate of 25% is applied
in calculations. Additional building blocks are the target weights of debt and equity to enterprise value being
8% and 92% respectively.
Empirical evidence suggests that market values of R&D driven companies as Lundbeck are positively
correlated with the current R&D commitments, overlooking the flexibility issue when investing in new drug
development will give artificially low company value, as is the case in DCF valuation. By real option
approach assessing the investment in a new CNS drug from pre-clinical trials to launch, using a real life
project of development of a new CNS drug treating cognitive disorders by investing further in development
of new compounds working at the NPY-Y5 receptor (NPY-Y5 project) the above validity of the theoretical
part conclusions are assessed. In short the outcome of the real option valuation is supporting the theory. The
outcome is based on the fact that a development project that according to Static NPV (a valuation without
flexibility) will destroy value giving negative DKK 6.61 million, is worth investing in when flexibility is
accounted for. Hence a True NPV with technical risk, being +DKK 38 million that represents additional
Page 87
value foregone by DCF valuation. However the sensitivity analysis implies that the real option model applied
is very sensitive to small percentage changes in WACC and volatility. In particular the True NPV with
technical risk and Static NPV are highly sensitive to these changes. A useful thing that can be concluded is
that it is not advisable to invest in development of a new CNS drug if the hurdle rate is higher by 1% i.e. 15%
since the true NPV with technical risk is negative and destroying value. In other words there are conditions
where valuing the flexibility will destroy value in strong contrast to the theory. However all in all it seems
that the value in DCF valuation does not include flexibility and therefore gives artificially lower value of
Lundbeck as theory implied as long as the hurdle rate is sufficiently low, suggesting that valuing flexibility
for a pharmaceutical company is important.
Applying enterprise discount cash flow (EDCF) method in valuing the company, resulted in the final fair
share price of the Lundbeck’s ordinary shares of DKK 173.71 per share. The final fair share price is based on
scenario analysis including base case, worst case and best case scenarios. The scenarios are subsequently
weighted with the probability of occurrence in the future based at previous strategic, industry and historical
performance analysis. The base case scenario is weighted with 75% probability, due to a pessimistic view on
the future global economic situation the worst case scenario is assigned 20% probability of occurrence and
remaining 5% to best case scenario. The sensitivity analysis is also performed indicating highly sensitive
DCF model to small percent changes in WACC and also as expected to small percentage changes in revenue.
Additionally it seems that the model is more sensitive to negative percentage changes in WACC and
similarly to positive changes in revenue. This means that estimating WACC correctly is very important for
the company value and it means less if you have higher WACC than very low one.
Performing plausibility analysis of resulting fair share price of DKK 173.71 per share, gave mixed
conclusions. Hence according to the current market prices the value is way above the current share price of
DKK 108 and therefore is not that plausible. In contrast looking at professional profilers taking Jyske Banks
as proxy indicated that Lundbeck’s shares are fundamentally undervalued, where the market is undervaluing
the company’s pipeline and growth potential in Asian markets, additionally they also have a best case
scenario where the shares are above DKK 200 per share similarly as forecasted in this paper where the best
case scenario is of DKK 206.94 per share. All in all it is left to the reader to assess which outcome is the best
to explain the reality.
Page 88
In addition the multiple analysis of 1 year forward looking multiplies also indicates mixed outcome, and
EV/EBITA as the best multiple given DKK 111,24 per share giving very different outcome than DCF
valuation and furthermore implying a small undervaluation in the market.
In general as concluded in the share performance analysis previously it seems that the market believes less in
Lundbeck’s strategic position to create more value than the peers. This is very much consistent with the share
performance analysis implying that Lundbeck was unable to satisfy the market expectations and historically
have mediocre or very low stock market performance to the peers. In relation to the company profiling and
the strategic analysis the explanation could be that the company is a small one compared to the peers and
depends strongly on mature markets Europe and US and number one revenue contributor comes from
stagnating depression & anxiety market. Furthermore the company is in the similar position as the peers
relative to potential patent expirations compared over the submarkets, but the difference is that Lundbeck
have smaller diversified portfolio of drugs that it is more dependent on the current drugs and their patent
protection than peers, and therefore are more vulnerable to their expirations.
So to answer the question: Is the current fair share value of Lundbeck’s ordinary shares overvalued or
undervalued compared with the market? The answer will be that the strong undervaluation is present in the
market if the current valuation is considered, and Lundbeck’s stocks will be a strong by for investors.
Page 89
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