Thesis and background

I first covered Amgen (NASDAQ: AMGN) back in October 2021 in an article titled “Amgen Stock: Shoot Fish In A Bucket Like Buffett”. The thesis to this was that it was an excellent investment combining security, current dividends and potential for appreciation. It was on course for a double-digit total annual return given its strong pipeline, reasonable valuation and secular yield. Indeed, it has generated a price appreciation of 14.5% and a total return of 16.5% since then, while the overall market has lost over 12%.

This article provides an updated analysis of AMGN, and the conclusion is that our bullish thesis holds even after the considerable price appreciation since then. We remain optimistic for much the same reasons. We’re impressed with his updates on the pipeline during his latest earnings report. The pipeline includes several promising late-stage candidates, including TEZSPIRE for severe asthma and its collaborative efforts with Eli Lilly (LLY) to develop antibody compounds to fight COVID-19. As summarized by CEO Robert A. Bradway (and accents added by me),

“We achieved strong volume-driven growth in the quarter while launching two very promising first-in-class drugs. We are also advancing a strong pipeline with data for several mid-to-late-stage candidates expected over the course of the year.“

Additionally, we also appreciate the strong balance sheet and solid cash flow, especially in turbulent times like this. The stronghold’s financial situation will not only allow AMGN to continue to focus on R&D and innovation in a sustainable manner, but also provide security for our investments, as detailed below.

Stable and solid capital structure

The following table summarizes AMGN’s financial positions and capital structure over the past decade. As can be seen, even though it has gradually taken on debt and its long-term debt has increased from $21 in 2011 to approximately $36.9 billion as of March 31, 2022, its financial situation has actually strengthened and its capital structure has become less leveraged. Its equity/EV ratio has steadily improved from 71% in 2012 to around 80% in recent years. And the Debt/EV ratio has continued to decline, from 29% in 2011 to the current level of just 20%. The company currently maintains plenty of cash, with cash and investments totaling $6.5 billion on its balance sheet as of March 31, 2022.

Going forward, I expect its financial position to improve further given its healthy cash flow and excellent capital allocation flexibility. Shareholders should expect AMGN to generate a generous cash return while continuing to focus on new drug development, as highlighted by the following financial data in its Q1 2022 Earnings Report:

• The Company generated $2.0 billion of free cash flow in the first quarter of 2022 compared to $1.9 billion in the first quarter of 2021.
• The Company’s first quarter 2022 dividend of $1.94 per share was declared on December 3, 2021, representing a 10% increase over 2021.
• On February 24, 2022, the Company entered into Accelerated Share Repurchase Agreements (ASRs) to repurchase an aggregate of up to $6 billion of Company common stock with an initial number of 23.3 million shares received and withdrawn.

Low cost of capital and high profitability

This section assesses its profitability by comparing its cost of capital to its return on capital. This analysis uses the weighted average cost of capital (“WACC”) to assess its cost of capital. The calculation of the WACC is carried out in the following way as detailed in our previous article here:

WACC = share of equity * cost of equity + share of debt * cost of debt * (1- tax rate)

We already have all the above inputs for calculating the WACC from the capital structure assessment. Thus, the following graph directly shows the results of the WACC. Note that the cost of equity is calculated using the Capital Asset Pricing Model (“CAPM”), taking into account the stock’s volatility (the beta) and the risk-free return (the return on 10-year Treasury bonds).

As can be seen, the cost of equity for AMGN has been fairly stable in the range of 8.3% to 8.6% over the past decade, averaging 8.4%. And also note that due to its strong financial strength and investment grade status, it was able to benefit from relatively low borrowing rates in the range of 2.9% to 4.8% with an average of 3 .8% on its long-term debt. And finally, its WACC was also stable and fluctuated only within a narrow range of 6.8% to 7.2%, with an average of only 6.8%.

The following graph now compares the WACC to its return on capital employed (“ROCE”) to illustrate its superb and consistent profitability. As can be seen, its average ROCE has averaged 45% and has consistently outperformed WACC by a considerable margin of over 38%. Working capital, net property, plant and equipment and R&D expenses are capitalized in the ROCE calculation.

Valuation and expected return

With the WACC, I will then use the Discounted Dividend Model (“DDM”) to analyze its fair value given AMGN’s stable dividends. AMGN’s fair value is considered to be the sum of all its future dividend payments discounted to their present value with the WACC as the discount rate.

DDM calculations for AMGN are shown below. These calculations took into account different combinations of WACC ranging from 6% to 8%. I would like to consider a wider range than the historical range of 6.8% to 7.2% established above to explore a wider range of scenarios. These calculations also took into account a terminal dividend growth rate (“DGR”) range, ranging from 2.5 to 5.5%.

For me, the scenarios highlighted in red in the middle of the table are the most probable. To summarize, the expected return and safety margin over the next five years are:

• As a base case, I expect the fair value to be around $285. The base case assumes an average WACC and an average growth rate. In this case, the current price represents a margin of safety of around 16% and an annual return of around 3% in the next 5 years.
• The bullish scenario takes into account a faster growth rate as well as a lower WACC. In this situation, the fair market value will be around $340. In this case, an investment at the current price has a margin of safety of 38% and the five-year annual return is expected to be 6.7%.
• Finally, the bearish picture is an unfortunate mix of higher WACC and slower growth. Even then, the investment would hardly lose any money.

Final thoughts and risks

I continue to be bullish on AMGN despite price appreciation of around 15% since our first coverage. I don’t see any change in the fundamentals. It is still a great investment offering an excellent combination of strong pipeline, fortress financial strength, conservative capital structure and potential for price appreciation. In its current conditions, I see a very skewed risk-reward profile. The decline is very limited (almost zero) but the increase is very significant (up to 38%) in the coming years.

Finally, a few words about the risks. Drug development is inherently uncertain and a generic risk for all pharmaceutical companies, including AMGN. Of its many clinical trials currently underway, many may fail and not pass regulatory approval. A risk more specific to AMGN involves its collaborative efforts with Eli Lilly to develop COVID-19 antibody compounds. COVID-19 remains an extremely fluid situation. The AMGN-Eli Lilly collaboration may experience delays and the COVID pandemic may develop in such a way as to negatively impact the AMGN.