AstraZeneca Stock Upgraded: What You Need to Know

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Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

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Shares of U.K. drugmaker AstraZeneca (NYSE: AZN) are in a rut. In contrast to much larger big pharma peers like Pfizer (NYSE: PFE) and Merck (NYSE: MRK), both of whose shares have been gaining, AstraZeneca stock is down more than 4% over the past year.

This means that, in a market that has risen nearly 15% over the same period, AstraZeneca stock was lagging the market by a good 20 percentage points as recently as early this morning. But then, a miracle happened -- investment banker Bernstein laid out a case for buying AstraZeneca stock, and the shares shot up 3% in response. According to the banker, AstraZeneca at $32 and change is priced to outperform the market, and shares are actually worth closer to $39.

But is Bernstein right to recommend AstraZeneca? Is the stock's newfound price strength warranted? Here are three things you need to know.

1. What Bernstein said

StreetInsider.com (requires subscription) laid out Bernstein's argument for AstraZeneca stock in a note this morning. As the site reports, Bernstein sees the bull case on this stock ranging from good to...even better. Although the company has suffered one high-profile drug setback (Mystic), Bernstein believes AstraZeneca still has a good base of business in its existing product lines. With drugs covering the treatment of cancer, cardiovascular, and respiratory problems, AstraZeneca should be able to keep growing "even [if] no new pipeline drugs [were developed from now] to 2025."

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What's more, Bernstein says AstraZeneca boasts "one of the fullest phase 3 pipelines" in the pharmaceutical industry today, a fact which the analyst believes will make AstraZeneca "a take-out candidate."

2. Where have we heard this before?

As a matter of fact, AstraZeneca was a "take-out candidate" as recently as 2014, when Pfizer tried to buy it. This historical fact tends to support Bernstein's view that one of the larger pharmaceutical giants could make a follow-on attempt to buy this somewhat smaller giant. AstraZeneca, at $81 billion, is less than half the size of Merck (at $178 billion) or Pfizer (at $213 billion), for example.

And yet, Bernstein notes with interest, AstraZeneca at 22 times earnings sells for a significantly cheaper multiple to earnings than its peers do. There's "little premium" built into AstraZeneca's "current share price" to account for the potential of a buyout.

Why might that be?

3. Trouble in paradise

Seeing AstraZeneca stock valued at barely 22 times earnings, while shares of Pfizer go for more than 26 times earnings and Merck costs more than 35 times earnings suggests there's something more to this story than Wall Street simply failing to anticipate that a large company might buy a smaller one. After all, at $87 billion in market capitalization, Eli Lilly (NYSE: LLY) is a morsel nearly as easy to digest as AstraZeneca. But Lilly stock sells for nearly 36 times earnings -- a significant premium incorporating the potential that someone might try to buy it.

All of which gets an investor to wondering: What's wrong with AstraZeneca? What might it be that's keeping the stock's valuation depressed? In fact, I think I see several things wrong with AstraZeneca, which undermine Bernstein's argument that the stock is underpriced.

Let's start with the debt. With $6.2 billion in cash on its balance sheet, but debt of $19.7 billion, AstraZeneca bears a net debt load of $13.5 billion, making the stock about 17% more expensive than its market cap alone makes it appear. That's about twice the debt load that Eli Lilly carries (and on a smaller market cap). While not excessive, this added debt in and of itself might make AstraZeneca a less attractive "take-out candidate" than Lilly.

A second reason is the debt loads that would-be acquirers themselves are carrying. At $29.5 billion, Pfizer's debt is the heaviest of the companies mentioned so far. Merck's a bit less debt-laden at $13 billion -- but even so, the more debt a would-be acquirer is carrying, the lesser the likelihood it will be able to swing a buyout of somebody else (like AstraZeneca).

Speaking of debt, cash -- the thing that companies generate to pay down debt, or to avoid getting into debt in the first place -- is a bit of a sore point at AstraZeneca. Although AstraZeneca reported earnings of $3.9 billion over the past year under generally accepted accounting principles (GAAP), data from S&P Global Market Intelligence confirm the company's true free cash flow was just $1.7 billion -- a mere $0.44 in cash earnings per dollar of reported profits. Contrast that with Lilly's financials, which show Lilly generating $4.6 billion in free cash flow over the past year, versus net income of only $2.4 billion -- $1.89 in free cash flow for every $1 of reported profit.

The upshot for investors

Bernstein thinks AstraZeneca stock is a good target for a buyout by a larger pharmaceutical player -- and maybe it's right. With a steady business and a strong pipeline of new drugs in the works, AstraZeneca might well be something a larger big pharma company might want to buy -- but in spite of the stock's valuation, not because of it.

At just 22 times earnings, AstraZeneca stock looks cheaper than the competition, but between the company's significant debt load and its weak free cash flow, I fear those looks could be deceiving.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.