The COVID-19 pandemic has created many challenges across the healthcare sector, but it has been even a little more challenging for H. Lundbeck (OTCPK:HLUYY) as the CNS drugs that make up Lundbeck’s focus are more sensitive to in-patient visits. Still, the company has executed reasonably well, with better than expected progress on cost-cutting.

As has been the case for some time, the pipeline is the main sticking point. Another clinical failure of a once-promising asset means no novel compounds in Phase II or Phase III testing, and the jury is still very much out on the value of the company’s forays into M&A. Without M&A and/or successful follow-on indications, Lundbeck has all the assets its going to have for at least the next five years, and the real question is whether management can prudently deploy the free cash flow the company will generate. I do think the shares are somewhat undervalued now, but the pipeline/new drug development issues are significant.

A Decent Result On Better New Drug Performance

Lundbeck reported a 3% improvement in revenue for the second quarter, beating expectations by about 2%. The company’s portfolio of newer drugs contributed about half of the relative upside, as these drugs grew 16% in total.

Abilify Maintena (up 15%) continues to gain share, and beat expectations, and so too for Rexulti (up 23%) and Northera (up 16%). Trintellix sales rose 9%, but missed expectations and new patient starts have been hurt by COVID-19, as doctors generally want face-to-face consultations before starting patients on drugs like this. Vyepti sales missed expectations by $3M (18%), but it is still very early in the launch.

Adjusted gross margin improved 150bp from the year-ago period, while significantly lower SG&A spending helped drive a 12% “core” operating earnings beat (down 15%, with margin down 530bp).

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Management maintained its revenue guidance for the year, but did boost its earnings guidance for the year. Even so, it sounds as though all of the cost-cutting that will be done in response to COVID-19 has been done. Management did announce an R&D restructuring in early June that will lead to firing about 130-160 people, so there’s some potential leverage there.

Looking ahead, management seemed to spook the market by acknowledging that they will likely increase spending to support the Vyepti launch next year. Now I realize that a lot of sell-analysts and investors didn’t like the acquisition of Vyepti and many want Lundbeck to maximize margins today by cutting spending, but I don’t see what choice management really has – there is no novel compound in the pipeline beyond Phase I, and for better or worse, Vyepti is really the only asset that can help offset future patent expirations for Northera, Brintelleix/Trintellix, and Abilify Maintena.

More Pipeline Woes

About a week before earnings, Lundbeck announced that it was discontinuing the Phase II proof-of-concept study for Lu AF1167 in the negative symptoms of schizophrenia due to a futility analysis. Although this was a very promising opportunity (multibillion-dollar potential) given the frequency of these symptoms and the lack of alternatives (dealing with these issues is one of the primary causes of “self-medication” among patients), the drug was a high-risk program and the efficacy failure is not altogether surprising. Even so, it continues a bad run of clinical failures and it removes the only novel compound in the pipeline beyond Phase I.

Lundbeck does have numerous novel compounds in Phase I, and just added another monoacylglycerol lipase inhibitor, or MAGLi, (Lu AG06479) to the pipeline, with the intention of starting at least four Phase I studies over the next year or so. While a prior MAGLi was studied in Tourette’s, there are a number of neurological/neuromotor conditions where the compound could be studied.

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Lundbeck now has seven novel compounds in Phase I studies, including some first-in-class compounds, with a range of target indications including neurodegenerative, neuromotor, and psychological targets.

The company is also pursuing multiple follow-on indications/studies. Rexulti is being studied in Alzheimer’s-associated agitation, PTSD, and borderline personality disorder. While the agitation indication remains very interesting, this is going to be a difficult study to conduct under COVID-19 given the impact of the virus on long-term memory care facilities. Given the treatment/care burden created by agitation, though, this could be a major opportunity – Alzheimer’s agitation is a major factor in moving patients out of their homes and into care facilities, as it significantly increases the difficulties and burdens of care.

Vyepti is also a key expansion opportunity. Management has made cluster headache its first priority for follow-on approval, and has also started a study (DELIVER) in patients refractory to prior preventative treatments. Management will also pursue two-month, and perhaps three-month formulations; these will not only be significantly more convenient for patients, but they will also limit generic erosion threat.

The Outlook

There’s definitely a “trust issue” now between investors, analysts, and Lundbeck – and it’s not exactly unfair. It’s been a while since this company has had any noteworthy clinical success, and the recent returns from M&A have not been good – including clinical failures (foliglurax, Lu AG06466) and a compound (Vyepti) with a very uncertain commercial future. While I like and support the new approach management has taken towards clinical trial management (snuffing out less promising candidates earlier in the process), the weak pipeline remains the prime negative talking point.

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I’m looing for Lundbeck to generate revenue growth of around 3% to 4% over the next five years, driven largely by Abilify Maintena, Brintellix/Trintellix, Rexulti, and Vyepti. My longer-term revenue growth is closer to zero because of the impact of generic competition, and that highlights the need to develop (or buy) some promising pipeline candidates. Given the need to leverage an existing sales force, I wouldn’t be surprised if M&A over the next few years is directed more towards de-risked late-stage programs where the owner doesn’t have the resources to commercialize on its own.

I do believe that Lundbeck can remain relatively profitable during this time, and I’m looking for EPS growth of around 6% to 7% over the next five years and FCF margins in the 20%’s.

The Bottom Line

Lundbeck looks priced for double-digit returns now, and that’s typically my cut-off for “buy” recommendations. I do think Lundbeck has some valuation-based appeal, but the pipeline risk is real and I think there is a risk that these shares “drift” in the absence of positive clinical updates (updates on Rexulti in agitation and/or PTSD in 2021 are possible) or signs of a stronger launch for Vyepti.

Disclosure: I am/we are long LUN.CO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.