Is AstraZeneca worth more dead than alive?

Drugs giant AstraZeneca (LSE: AZN) looks dirt cheap. But there are some very good reasons for that, as its results demonstrated. So is it a classic value trap or is it worth hanging on to for now?

At first glance, Astra's 2011 performance looks respectable not great, but hardly disastrous. Sales rose 1% to $33.6bn, while underlying operating profit fell 3% to $13.2bn.

After buying back 127 million shares over the year (at a cost of $5.6bn), and paying a lower tax rate on its profits, earnings per share grew by 9% to $7.28. The full year dividend was hiked by 10% to $2.80 or 175.5p.

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However, the overall tone of the statement was downbeat. Getting profits growing again is going to be incredibly tough. Yes, demographics are supportive for healthcare companies people just keep getting older, and so demand for healthcare will grow.

The real problem is: who's going to pay for it? Western governments the biggest buyers of Astra's drugs are running out of cash. This means they are going back to the drug companies and asking them to cut their prices, and at the same time buying more generic (unbranded) drugs, which are much cheaper.

These twin effects cost AstraZeneca $3bn in lost sales during 2011. It is hard to see this pressure easing soon.

Where is the next wonder drug?

How do you replace that lost revenue? One way is to come up with new best-selling drugs. But Astra has a particularly poor track record on this score. And today's news wasn't encouraging: Astra spent $5.5bn on research and development in 2011, yet the company has cut its expectations of how much it can make from recently launched and 'pipeline' products (those still being researched).

To complicate matters even more, the economics of pharmaceutical research are becoming more challenging. At the same time as customers want to pay less for drugs, the cost of R&D is going up. Not a promising mix.

So what can it do? It might try to buy its way out of trouble. The main worry then is that it will overpay for promising companies. And that's a real possibility, given that it is not alone in its struggle to find replacement drugs. The $15.2bn it shelled out for MedImmune in 2007, for example, was an expensive purchase - and investors are right to be wary of the same scenario being played out again.

The good news is that on the current low valuation, investors certainly aren't pricing the stock as if they expect a lot of good news on the research front. Indeed, Astra might be worth more dead than alive. One option for the stock a defeatist strategy, but a potentially more valuable one to shareholders would be scale back investment, and pay the cash flows from its existing drug portfolio out to investors.

Good yield but a gloomy outlook

That's unlikely to happen in the near future it would effectively be throwing in the towel on the business. But 2012 looks to be another tough year.

With more patents running out (so that generic rivals can launch cheaper versions of existing drugs), Astra expects earnings per share to fall to between $6 and $6.30, despite another $4.5bn of buybacks being planned.

However, based on its policy of paying out 50% of earnings in dividends, shareholders should still see their payout grow to around $3 per share giving a not-too-shoddy 6.4% yield (based on a share price of 2,984p and an exchange rate of £1=$1.58).

Looking further out, annual revenues between now and 2014 are set to come in at the lower end of its previous guidance of $28-$34bn, which suggests profits may have further to fall. Buybacks are buying the company time but it needs to do something about profits growth soon.

We last tipped AstraZeneca as a 'buy' in November. We believed that a lot of the bad news about its future prospects was priced in, and that the shares were probably cheap. This may still be true, but the news is not getting any better.

In short, we feel more nervous about its future, and are beginning to wonder if AstraZeneca has the hallmarks of a classic 'value trap'. The shares pay a good dividend, which is worth hanging on to, but we wouldn't be keen to buy any more.