Royalty Pharma

Moat: 3/5

Understandability: 4/5

Balance Sheet Health: 4/5

Royalty Pharma is a biopharmaceutical royalty company, financing innovation in the healthcare industry by acquiring royalties on drugs developed by other companies.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Royalty Pharma (RPRX) operates as a consolidator in the royalty space, acquiring royalty rights on pharmaceutical products, both approved and in development. This business model allows them to generate revenues from top-selling and high potential drugs without incurring the risks or costs of product development and manufacturing.

Business Overview

Royalty Pharma’s business model is a hybrid that sits at the intersection of finance and the pharmaceutical industry, involving the acquisition of royalties on approved and late-stage drugs. Rather than investing directly in R&D, they provide non-dilutive capital to biopharmaceutical companies, research institutions, and universities in exchange for a future share of revenues derived from the sales of the drug. The company then receives royalty revenue whenever drugs on which they hold royalty interests are sold.

Revenue Distribution: Royalty Pharma’s revenue streams are largely based on the therapeutic areas and products they have acquired rights to. The majority of their revenue comes from their top-selling products, notably: Tremfya, Tysabri, Imbruvica, Nurtec and Tavneos, and also from newly acquired royalties from Cytokinetics. It is important to note the variability in revenue and profitability depending on clinical trial results and subsequent FDA approvals. Given that they invest in a diversified portfolio, a few failures are usually offset by successes, so a failure on a single molecule may not hurt as much.

Trends in the Industry: The biopharmaceutical industry is constantly evolving with continuous pressure to bring innovative medicines to the market. New drug launches and growth often rely on successful clinical trials, FDA approvals, and effective marketing. The increasing cost of R&D is also a key factor, with more and more companies turning to royalty financing as a non-dilutive source of capital for their research. The pharmaceutical industry has become very concentrated, with just a few companies generating more than 50% of the revenue within most therapeutic segments. The most successful companies also have a large amount of operating expenses, because creating and promoting a new drug is a very expensive endeavor.

Margins: Profitability is largely based on the acquisition costs of royalties and the potential of those drug sales. Margins can be high when a company makes a smart purchase of a royalty stream, but these margins could shrink when sales of a drug disappoint. They also depend on the number of products which are covered by the agreement and the structure of the agreement. Generally, these royalties have a very high margin because they have very small expenses, besides acquisitions and their employees. The company typically has high gross margins (around 90%) because it essentially receives a share of future revenue, without having expenses like production, marketing, or distribution. Operating income and net income show more variability due to factors such as interest expense, nonoperating gains and losses (and their tax impact), and changes in fair value of financial assets. Because of the way the income statement is designed, any company-specific insights into their profitability (outside of top-level metrics) are hard to uncover from it.

Competitive Landscape: The biopharma royalty market has very few dominant players and is largely fragmented. Most of the time, transactions are tailored to specific needs of those selling and buying royalties. Royalty Pharma is by far the largest dedicated acquirer of biopharma royalties, but faces competition from other specialized firms, private equity, and sovereign wealth funds.

What Makes the Company Different:

Focus on Royalty Monetization: Royalty Pharma solely focuses on acquiring royalties and does not engage in drug discovery, development, or manufacturing.
Scaled Royalty Portfolio: They have built a very diverse portfolio of different drugs and therapeutic areas.
Non-dilutive Capital: They do not take equity from the companies, instead they fund through debt.
Expertise: This allows them to focus only on identifying royalty streams that can generate a high cash flow.
Experienced Management Team: Their management has experience with financial transactions, drug development, and the biopharma industry overall.

Financials In-Depth

Revenues: Royalty Pharma’s revenues primarily consist of royalties from their portfolio of pharmaceutical products. These revenues are highly predictable because they are tied to the sales of blockbuster drugs.
Operating Expenses: Operating expenses, in contrast to sales, are relatively low because the business does not directly incur costs for manufacturing, marketing, and R&D of pharmaceuticals. As a result, profitability depends on smart royalty acquisitions instead of minimizing expenses, as is typical for other types of businesses.
Net Income: The net income, as previously discussed, will vary based on nonrecurring items, financing decisions, and currency fluctuations.
Cash flow: Even with net losses, this company has consistently been cash flow positive for most years. The free cash flow is usually used for repaying debt and making acquisitions. The ability to generate a positive cash flow on a constant basis is a strong point for RPRX.
Debt: Since they don’t use equity capital, debt is a major factor in this company’s capitalization. Interest expenses are high, but management has been able to keep it at sustainable levels. These debts are used to acquire more royalty interests, which creates a virtuous cycle for this company.
Equity: As a pure royalty business, equity levels are very low, and almost all the equity is generated through the issuance of Class A common shares. This is very common in companies that rely on acquisitions for growth and is a key difference between RPRX and a typical pharmaceutical company.
Valuation and Valuation Metrics: Traditional valuation metrics like P/E or Price to Earnings are not helpful in valuing this business, as earnings are very volatile, depending on acquisitions and other financial variables. Instead, one should look at cash flow metrics (such as FCF and yield on FCF) and projections of free cash flow in the future. Enterprise value is very sensitive to the assumptions surrounding growth and WACC (discount rate), as these valuations use DCF approach. A simple key driver analysis of their value shows that the three main driving forces are growth of royalty assets, ROIC, and WACC.

Recent Concerns: The biggest recent concerns about this company come from a decline in core royalty revenues and debt-driven acquisitions. The market fears a decrease in the overall profitability of their royalty interests (as a result of competition from generics or new products) and that they are acquiring too many royalty interests that are not profitable. Furthermore, the company faces concerns over currency rates as many of their royalty streams are in currencies other than U.S. dollars. In the recent earnings calls, management reiterated its commitment to being a diversified long-term investor, and also said that a decline in certain royalty revenue is being offset by new royalty income. Management was also bullish about their pipeline and stated that they will continue to look for ways to return cash to shareholders.

Moat Rating: 3 / 5

While Royalty Pharma possesses some characteristics of a strong business, it does not have a wide moat like a brand company, nor does it have a very narrow moat like a pipeline company. The main components of RPRX’s economic moat that justify this rating of 3 are:

Niche Market: RPRX operates in a somewhat specialized niche that is very hard to penetrate by anyone who does not have the specific expertise that they have in this industry and also a large capital base. Scale: RPRX has a scale and size advantage over its competition. Because of its size, they get better access to deals with pharmaceutical companies and are able to acquire larger and more profitable royalty streams. They can also have a better access to deals and due diligence, which enables them to find better opportunities. Strong Relationships: They have built relationships over the years with pharmaceutical companies, universities, and other royalty-holders, allowing it to maintain a steady deal flow. Intangibles: They have built a reputation and brand within the bio pharmaceutical royalties space that is widely recognized, which gives them an advantage over newcomers.

Their moat, however, is not very durable:

Technological Disruption: As it is with all pharmaceutical businesses, there’s always a possibility that the technologies that they are making royalty money from could become obsolete because of a better drug or another technological improvement. This will cause revenue streams to end much earlier than expected, destroying an important part of the company’s value. Pricing Power: RPRX is not really able to command a large premium over their peers because they do not sell directly to consumers and they have no control over the sale prices of pharmaceutical companies. Therefore, they are very dependent on pricing policies and actions of others. Competition: The financial community is ever-evolving, and more investors could try to enter into the royalty business, putting more pressure on prices, and diminishing margins. Management: There are few studies that show a meaningful relation between past performance and management, and a significant drop in management quality will not affect their business for at least some time, especially given their current structure and business model.

Business Resilience

RPRX’s resilience is quite average. The business has a somewhat diversified portfolio of royalties, which gives a layer of insulation if any one product fails to reach expectations. Management has also shown to be good at reallocating capital when a product stream is not generating the expected cash flow.

However, the risks to RPRX include:

The reliance on the success of others (the pharmaceutical companies which they are buying royalty streams from). Their free cash flows are dependent on the effectiveness of R&D and marketing activities of other players. This is a factor that is completely outside RPRX’s control.
The large amount of leverage (debt) that the company has, which creates systemic risk if any one thing goes bad. - Volatility of the pharmaceutical industry is very significant, and it is susceptible to both regulatory changes and new technologies which could completely disrupt the value of the company’s products. - Their current structure of being only a royalty business means that they do not have experience in other core activities like R&D and marketing which could protect them if there are structural or systemic changes in the pharmaceutical industry.

Understandability: 4 / 5

While at first sight, the business may appear complicated, it is, in essence, a fairly simple one to understand. They operate as a middleman for biopharmaceutical companies, providing capital and taking royalty payments in return. The simplicity comes from the fact that they do not directly operate as a pharmaceutical company and thus do not need specialized knowledge from the science side. The complexity of financial assets comes from the nuances surrounding their valuation and how you calculate the present value of future cash flows. There are other complicated parameters ( such as calculating WACC) that may be hard to understand for non finance professionals. These nuances justify a rating of 4 and not lower.

Balance Sheet Health: 4 / 5

Although the debt is high, it is reasonably sustainable and structured:

Long-term debt is in good position.
There are no impending debt repayments that could materially hurt the business in the short term. - They have high levels of excess cash.
They have positive free cash flows. - RPRX has shown a history of generating positive profits and revenue for their business, and thus the financial position is overall stable and reliable.

Their balance sheet, though, is not bulletproof. The debt is high and a sudden collapse in some of their businesses, or problems with debt markets, can severely affect their financials. This is why I rate them as a four, instead of a five.

Final Thoughts

Royalty Pharma is a unique player in the healthcare industry, leveraging a stable financial model to make a profit, without the risk of drug development. However, their reliance on external factors and their leveraged financial position create some risks for them. The investor must analyze this industry with caution, paying special attention to the different parameters that can determine the company’s long-term profitability and value.