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4th July 2014

Stephen Bailey shares his thoughts on why he and his colleagues believe AstraZeneca is undervalued.

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Stephen Bailey, co-manager of Liontrust Macro UK Growth and Liontrust Macro Equity Income

The rejection of Pfizer’s proposed offer for AstraZeneca has seen shares in the latter fall back to a level at which we believe its substantial drug pipeline potential is undervalued. We took the precaution of reducing our holding in AstraZeneca in April, at a share price of between £47 and £48, in order to protect against the transactional risk. We have, however, been able to build this position up again in the £41 to £43 range, following the board’s rejection of the proposals. AstraZeneca’s management mounted a creditable defence to Pfizer’s proposed offer, but they now face the challenge of justifying the rationale behind their rejection.

We shouldn’t lose sight of the fact that slightly over half of the proposed £55 per share on offer from Pfizer was payable in its shares, the value of which would vary. However, £55 will nevertheless represent a fairly firm watermark, which AstraZeneca’s management will come under pressure to achieve. We believe shares in the company are certainly capable of justifying a price tag of £55 or more, but we are fairly agnostic as to whether this is achieved via a takeover bid or under the company’s own steam.

If – as was reported recently – AstraZeneca’s search for strategies to release shareholder value has gone so far as to consider the effective sale of some of its patents, this raises a red flag for us and we think the same would be true for some of the company’s largest investors. Such a deal would be seen as a takeover defence against the likes of Pfizer, who would be reluctant to buy a company that had sold the (rights to the) ‘crown jewels’.

Revival of Pfizer's offer

Given that Pfizer has to wait up to six months if it wishes to revive its offer, investors in AstraZeneca may be willing to give its management team time to articulate its strategy for growth and justify its assertion that Pfizer’s offer “undervalues the company and its attractive prospects”. However, we think there would be resistance to a plan that makes the company less attractive to suitors.

A 2011 amendment to the UK Takeover Code allowed negotiations to be revived again before the six-month cooling-off period had ended, if they are instigated by the target company, but “such consent will not normally be given within three months”. A scenario where investor pressure persuades AstraZeneca’s board to reconsider Pfizer’s overtures within this three-to-six month timeframe should therefore not be discounted, and its likelihood increases if off-the-wall defence strategies come under consideration.

The potential for a Pfizer/Astra combination is motivated by more than just balance sheet efficiencies, as we view AstraZeneca’s pipeline potential as providing Pfizer with a credible growth strategy and, importantly, it would satisfy Pfizer’s ambitions in the field of immuno-oncology.

Sector re-rating

We think there is the potential for a substantial rerating of the pharmaceuticals sector, as pipeline potential translates into profit growth potential. Following something of a ‘lost decade’, the sector is finding growing political patronage, which is encouraging companies to shed consumer-facing businesses and return to being the innovative growth businesses they once were. More efficient research processes and various regulatory changes certainly provide further encouragement to “Big Pharma”. Many companies have now negotiated the so-called ‘patent cliff’ and we hope that pipeline success will provide the necessary earnings stimulus required to justify investors’ faith and belief in the sector. The global healthcare theme accounts for 18.0% and 17.5% of the Macro Equity Income Fund and Macro UK Growth Fund respectively, with positions in AstraZeneca of 4.0% and 3.5% (as at 27 June).

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Stephen's views are his own and do not constitute financial advice.