Friday, December 18, 2015

Pharmaceutical Flurry

What should pharmaceuticals do to satisfy investors:  acquire, merge, raise prices, or conduct painstaking research, as they used to do?
The pharmaceutical industry always seems to be in a state of flux. A flurry, more or less. Or a state of tumult.  Observe the headlines and investor discussions this past year.

It's an industry that seems to want to remodel and reinvent itself and that confronts a phalanx of issues related to economics, profit margins, board rooms, taxes, tax domiciles and shareholder value. Occasionally opportunities tied to potential miracle drugs and old-fashioned research and development forge to the top.

Observe the torrent of activity in the stocks of many pharmaceutical names this year (Bristol-Meyers, Pfizer, Merck, Lilly, Amgen, etc.). What captures the headlines and incites debate among industry leaders, analysts, and observers (including consumers)?

a) Big mergers 

b) Big companies acquiring small, unknown companies to achieve growth

c) Companies or hedge funds unrelated to the industry acquiring small drug companies

d) Companies setting or raising prices carelessly and without compassion for consumers

e) Companies engaged in mergers to avoid U.S. tax obligations

f) Companies accused of presenting misleading financial information.

Observe this fall's headlines of one company (Valeant) accused of presenting inaccurate financial information and maintaining shady ties with its distribution channels.  Notice this month's headline of securities fraud and accusations of investment trickery and price-gouging committed by hedge-fund types (Martin Shkreli, now labeled an industry scoundrel, and cohorts) who seem to have no ethical commitment to providing medical benefits to a broad public.

In some ways, it's ugly, it's messy and it's evolving, as pharmaceutical board rooms (and shareholder activists who roam around them pushing for results) rap their heads to figure out the best and fairest business model to achieve the highest returns on equity. 

The older, familiar business model involves a lengthy timeline.  Drug companies spend billions on research making a bet that a drug that will take most of a decade develop will be safe, will be approved by government regulators, and will be accepted by and helpful to a mass market. The model permits them to reap rewards by setting prices as high as much as the market can bear. In due course, they lose exclusivity in pricing the drug, at which time it becomes a "generic," attracts competition, and results in low profit margins.

At that point, they must repeat the cycle:  Engage in more research (continue to spend in R&D) to find the next new miracle.

Because the timeline is lengthy and long-term research has uncertain outcomes, pharmaceutical companies must look also to other strategies to appease investors. They pose the question: How do you achieve revenue growth and maximize ROE while still supporting the traditional model?

In the past year, the industry and its big names have focused on three strategy strands. Some companies resort to all three:

a) Acquire smaller companies--which requires financing and often regulatory approval, but shortens the timeline to discover and market new drugs. Revenues grow as soon as the acquisition is consummated.

b) Tweak pricing of existing drugs--which doesn't require financing or regulatory approval and can be done whether drugs are exclusive (protected by patents) or non-exclusive (especially if there are few competitors or pipelines to the marketplace). "Tweaking" prices is a euphemism for having the ability (and some say the economic power or right) to set the highest price possible for drugs to a public desperate for the drugs' life-saving capacities. 

c) Conduct old-fashioned research and development--which requires budgeted spending, market patience, long-term financing, meticulous testing, and regulatory approval, all of which is subject to a long, uncertain timetable. 

Because strategy (c) poses long-term risks, has uncertainty hurdles, and involves a painstaking regulatory process (not to mention an expensive marketing campaign), no wonder industry leaders look to achieve higher revenues and ROE's (and higher stock prices) by resorting to (a) and (b).

No matter the business model, the industry encounters other ongoing factors:  Who will pay for the drugs that are developed and marketed, and through what channels will they get to the consumer?Healthcare policy and the roles of insurance companies influence any business model the drug companies adopt. 

Take a peek at Merck. The global pharmaceutical firm remains profitable, despite recurrent restructurings and desperate efforts to find new drugs to offset older ones no longer with patent protection. After paring down, selling off business parts and acquiring small units, revenue growth is stagnant.  In recent years, revenues have slipped a bit.

Merck is a $42 billion-revenue company that still finds ways to squeeze out sufficient profits to pay dividends, manage a modest debt load, and generate lukewarm returns to shareholders. (ROE's are satisfactory (8-11%), not too low to incite shareholder activists, but not high enough to result in ovations from investors.)

It's a company knocking its head to find ways to get to the $50 billion-revenue mark, a threshold shareholders want to see soon enough, a level it can reach only if it pinpoints and adopts the right strategy to get there. (CEO Kenneth Frazier leads the charge.)

Which business model or corporate strategy should it settle on? Should it (a) acquire many smaller drug companies, as others have done, (b) double down on research and development expenses (and related investments), (c) diversify, expand into or invest in complementary, non-pharmaceutical ventures, or (d) merge with another big-pharmaceutical powerhouse?

If Pfizer hadn't adopted strategy (d) already via its recent blockbuster announcement to merge with Allergan, a combined Merck-Pfizer would have resulted in a $90 billion company (revenues). Yet the combination might have made little bottom-line sense and could have taken months to get regulatory approval and years to consolidate in the trenches.  (Pfizer is already enduring a publicity blow, as public officials argue Pfizer rationalizes the merger by boosting cash flow by avoiding U.S. taxes.)

While Pfizer went on a merger prowl, Merck, meanwhile, searches for growth with small add-on acquisitions and by retreating to the laboratory, promising that R&D won't fall annually below $7 billion and betting the old way that miracles will result from years of research toil.

Merck investors and credit ratings agencies haven't been too unhappy.  The stock has fluctuated significantly since market turbulence in August. Investors were pleased with corporate restructuring, but market values are down slightly in 2015.

Like all pharmaceuticals, investors get frustrated when they want growth, but don't see much evidence of it. Ratings agencies are kinder, since the company still generates cash flow (about $8-10 billion a year) to handle over $18 billion in debt.

For any company, R&D spending always has uncertain results. Certainty in this industry is that drug companies can't and don't stand still.  The flurry and the reshaping of business models will continue.

Tracy Williams

See also:

CFN:  What Does the Market See in Amazon? 2013
CFN:  Pepsico's CEO: Always on the Hot Seat, 2015
CFN:  Shake Shack's IPO, 2015
CFN:  Verizon Rescues AOL, 2015
CFN:  Tools for Financial Models, 2014
CFN:  Updating Financial Models, 2015

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