Written by Alex Hughes, International Analyst, StocksInValue
The pharmaceutical industry has a lot going for it. Household names such as Johnson and Johnson (see valuation), Pfizer and Merck have been rock solid for decades, with enviable margins, high returns on equity and impressive growth in earnings driving returns for shareholders. As depicted below, pharma has dramatically outperformed the wider market over the last 6 years.
Figure 1. SPDR S&P Pharmaceuticals ETF rel S&P500
Part of this strength arises from the scalability of their businesses. To illustrate this, let’s use an analogy of an author and a hairdresser. The cost for an author to write a book is the same whether it is sold to one person or one million people. This dynamic allows successful writers to become very wealthy, as their sales potential is exponential relative to their cost. The complete opposite of this is a hairdresser, where a linear relationship exists between sales potential and cost. For example, the cost to cut 100 peoples hair is somewhere in the vicinity of 100 times the cost of cutting one person’s hair. As a result, wealthy individuals are most likely to be found where a non-linear relationship exists between sales potential and costs; think actors and musicians. Businesses can also be grouped into exponential and linear categories. Software companies (Google), movie production studios (Fox) and pharmaceutical companies all have the potential for sales to exceed development costs exponentially, as the cost to sell the second unit is drastically lower than the cost to sell the first.
However, a study from the Tufts Center for the Study of Drug Development has got us thinking about whether the future for the Pharma industry is likely to be as rosy as the past. The study found that the cost of developing one new prescription drug had skyrocketed over 145% to reach $2.6B based on 106 drugs tested between 1995 and 2007. More recent analysis suggests that this figure now exceeds $5B per new drug, illustrated in the table below on the right which displays the cumulative R&D spending over a decade versus the number of new products produced. Almost all of the major pharmaceutical companies we cover in StocksInValue appear in the table below. The higher cost is arguably evident in economic statistics with pharmaceutical spending increasing from 1.9% to 2.6% of GDP in the last 10 years.
|Figure 2: Cost of Drug Development
Source: Tufts Center
|Figure 3: Cost of Drug Development
As the industry has made a number of breakthroughs in the recent past it would be easy to surmise that the incremental breakthroughs are becoming that much more difficult and expensive. The large cost is not just in the finding of new drugs but also in the testing. A significant component of this is ensuring that the new drug does not induce side effects when consumed together with other drugs already in the marketplace. This factor is significant as the number of registered drugs has skyrocketed in recent decades, some estimates suggests the total number of drugs has increased over 33% in the last decade, and hence the number of potential combinations has increased exponentially, along with the testing cost.
Figure 4: Cumulative FDA approved new molecular entities (NME’s)
This is consequential as pharmaceutical companies operate under the looming threat of patent cliffs, a ‘known-known’ which encourages them to continue to invest to diversify their product mix and stagger their patent cliffs. When a company develops a new drug, they are typically afforded patent protection for a specified period, usually 20 years from date of filing, allowing significant profits to be generated while competition is held at bay. However, when patent protection runs off, the company immediately competes with low cost generics, (which tend to be reverse engineered to generate bioequivalents) which typically eliminates the outsized profits it was able to generate on the product in very quick succession.
It is this relatively short product lifecycle that essentially forces pharmaceutical companies to direct such large sums towards R&D. They must, otherwise their businesses would become obsolete along with their ageing products; a dynamic similar to the need for miner’s to continually expand their finite resource bases. As we can see below, the 13 pharmaceutical companies covered in StocksInValue collectively spent over $70B in R&D in 2014, up 6.1% p.a. since 2005. This level of R&D expenditure represents 17% of sales, a level which has been consistent over the last decade. With such large expenditure, it is clear that the return on this investment will be a key driver in future profitability. While this has not had an impact to profitability to date as illustrated by the grey line below, investing is all about looking through the windshield, not the rear view mirror.
Development expenditure is generally accounted for as both an expense and capitalised as an asset, and hence we would expect to see any impact of higher cost flow through in decreasing gross margins or rising operating expenses. As illustrated below, neither has occurred, as this group of businesses has actually become more profitable over the last decade, overwhelmingly due to a reduction in selling, general and admin expenses. However we cannot discount the possibility that the strong returns and improving margins influenced our decision to cover these companies (survivorship bias) and hence this sample is not representative of the average experience in the industry and what the future experience will be like. This next chart shows the average of various profit and loss components relative to sales for all of the pharmaceutical companies we cover, which includes Roche, Pfizer, Merck, Sanofi, Johnson & Johnson, Novartis, Eli Lily, Bayer, Novo Nordisk, Shire, Gilead Sciences, Celgene and Biogen.
Figure 5: Profits and Costs as % of Sales, Covered Pharmaceuticals
Source: Thomson Reuters
Figure 6. Covered Pharmaceuticals
Before you write off the sector completely, let’s consider some of the many positives the industry has going for it. A rising cost of development is not all bad news as it also works to increase the barriers against new entrants. The existing players have the balance sheets and scale to invest large amounts with uncertain payoffs, and this will become increasingly difficult for smaller players, which is supportive of industry consolidation and better returns for incumbents.
An interesting second order effect of the industrialisation of Asia is becoming evident in the consumption patterns of the emerging middle-class, and this is blowing a previously unforeseen breeze into Western pharma’s sails. As incomes rise, consumption levels of fat, sugar and alcohol are also increasing, which is causing the incidence of diabetes, heart and liver disease to converge towards western levels. For Western pharma, which has been selling treatments for such chronic diseases (that is, diseases that can be controlled but not cured) for decades, this is a big positive as their addressable markets and growth profiles expand accordingly.