Prescriptions: Closing the gap?

As big pharma companies drew inexorably closer to the patent cliff — and grew increasingly aware that their existing pipelines were insufficient to fill the ensuing revenue gaps — it became imperative to find additional ways to boost shareholder value to meet investors’ expectations.

In particular, these firms needed to find new sources of growth beyond their current drug portfolios.


In recent years, big pharma companies have undertaken numerous measures to drive shareholder value. In addition to fervent cost-cutting, they have downsized operations, spun off assets, restructured R&D, repurchased stock and increased dividends. These efforts will continue, but they are not, by themselves, a sustainable long-run solution. At some point, companies run out of fat to trim — and risk cutting into muscle and bone instead. Stock repurchases and raising dividends work in the short run — the 16 largest big pharma companies delivered total shareholder returns of more than 17% in 2012 — but ultimately require increasing operating cash flow. In the long run, therefore, big pharma inevitably needs revenue growth to create shareholder value in a sustainable way.


Growth, of course, hasn’t been easy to come by. With anemic sales growth in developed markets, companies have looked to emerging markets as a key part of the solution. However, this strategy presents its own challenges. Emerging markets have slowed in recent quarters, exacerbating the growth gap. Stagnation in the Eurozone has hurt even more.


Just how big is pharma’s growth gap? Prior to 2010, big pharma (defi ned as the 16 largest US, European and Japanese companies — see Appendix for details) generally kept pace with the global drug market. That changed in 2011, when the overall drug market grew faster than big pharma — a difference of about US$20 billion — and 2012, when we expect the gap to widen further to US$50 billion primarily due to the patent cliff. We expect big pharma to fall even further behind in the years ahead. The gap between IMS Health’s global drug market forecast (4% CAGR) and analysts’ estimates of big pharma sales widens steadily over the next several years. As shown in the chart on page 3, this gap is projected to reach US$100 billion by 2015.


This inevitably leads to two questions:

• Where will growth come from?

• What else can pharma companies do to boost shareholder returns?


Let’s examine these questions and explore the challenges companies face in developing sustainable answers.




No easy answers: the fi repower gap


Answering these questions requires an appreciation of the current context in which pharma operates. Specifically, pharma’s attempts to fill the growth gap will be made more difficult by a second gap that the industry faces: the fi repower gap. We define “fi repower” as a company’s capacity for conducting M&A deals.


With sources of organic growth under pressure, as discussed earlier, a potential solution is to seek inorganic growth through transactions. However, the capacity of big pharma to conduct deals has diminished in recent years — particularly relative to other industry players. Deals inevitably have to be funded through some combination of cash, stock and debt, and each of these potential currencies is now under increased pressure.


Cash: Big pharma has less cash for deals because the patent cliff and pricing pressures have diminished operating cash fl ows and because of its spending on prior transactions, stock repurchases and dividends.



2. Debt: In recent years, big pharma companies have taken on much more debt, in part to fund some of the megamergers of recent years as well as to finance dividend increases and stock buyback programs. The industry’s debt-to-equity ratio has risen from 9% to 18% over the past five years. From a capital structure perspective, this is a positive development, since these firms have historically been under-leveraged as compared to similar sized companies in other industries. However, since they have already assumed large amounts of debt, they have les flexibility for financing future deals.


Stock: Relative to cash and debt, equity is a somewhat more volatile measure — a company’s stock price fluctuates on a daily basis — meaning that short-term stock market performance is less relevant than longer-term shifts. For instance, while the stock prices of big pharma companies recovered somewhat in 2012 along with the broader stock market, a longer-term perspective reveals that the stock prices of these firms have fallen significantly since 2006 — despite attempts to support share prices with measures such as stock repurchases and dividends. Short-term blips not with standing, big pharma’s capacity to use stock as a currency is signifycantly diminished compared to a few years ago.



To quantify the impact of these shifts, we have developed the Ernst & Young Firepower Index — a measure of companies’ capacity for conducting M&A deals. A company’s fi repower is diminished as its market value and cash and equivalents fall or as its debt level rises. (For more details on the methodology and assumptions behind the Index, refer to the Appendix.)



As might be expected, big pharma’s fi repower has fallen markedly in recent years — we estimate that, for the 16 largest US, European and Japanese pharma companies by revenue, fi repower declined by 23% between 2006 and 2012. Even as big pharma’s fi repower has shrunk, however, the next tier of companies — specialty pharma and big biotech firms with 2012 revenues between US$1 billion and US$20 billion — has seen its fi repower increase. In 2012, the fi repower of big biotech increased by a whopping 61% relative to 2006, on the strength of premium pricing power and no generic exposure. Specialty pharma’s fi repower increased by a relatively modest 20%, reflecting rising strength of generics offset to some extent by patent expirations of a few major brands. The net result of these shifts is that big pharma’s share of the combined fi repower of these three segments has fallen steadily in recent years, from 85% in 2006 down to 75% in 2012. This shift in fi repower — from big pharma to big biotech and specialty pharma — has powerful implications.


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