Pharm Exec's Ninth Annual Industry Audit
One explanation for the gap between strong revenues, high profits, and the low estimation of real value is the dead weight of uncertainty imposed by larger structural trends buffeting the industry. These include the patent cliff, lagging R&D productivity, more crowded therapeutic categories, phase-in of US health reform, and slower uptake of new products due to reimbursement pressures. Equally evident is that industry efforts to build a better value proposition—through consolidation and aggressive cost-cutting—is not a sustainable strategy for the long term. Hence the gnawing question: What will it take to put more "jig" in the jigsaw for puzzled investors?
This year's Audit is a study in continuity. Once again, one of our "stealth pharma" companies (see Pharm Exec's June 2009 issue, for a full profile of this group) takes the top honor, with Gilead repeating its win from last year with a tightly focused therapeutic franchise and formidable cost controls, reinforced by a strong Profit to Sales ratio. As it happens, the Audit's findings are reinforced by Pharm Exec's cover story in this issue on Gilead (in this isuue), its strategy, and line management.
A key lesson from this year's Audit is that staying lean makes you a mean competitor. Clearly, the smaller companies among the 24 carry an advantage in the rankings due to their ability to target and fill discrete market segments with niche products that carry a price premium, with fewer of the fixed overhead obligations (including a large sales force) required to prevail under the blockbuster model. While the Big Pharma giants, led by Pfizer and Merck, did score solid improvement in metrics that measure efficient management of costs and assets, our stealth pharma competitors as a whole did better—perhaps because smaller ships can steer faster through a turbulent business current and are quicker to recognize when ballast turns to bloat. But don't count the big players out. Size and a large cash hoard can provide cover for a raft of product failures, operational inefficiencies and strategic false starts while providing the resources to compete in a high-risk business where success requires global scale and reach. — William Looney, Editor-in-Chief
This year's Audit analyzes the calendar year 2009 performance of 24 publicly traded companies that file 10-K or 20-F reports on an annual basis with the US Securities and Exchange Commission. As in past years, the Audit includes a wider array of performance metrics than found in the standard financial and accounting statements. Drawing on this larger set of sources allows for a more meaningful picture of performance, analyzing such key metrics as Enterprise Value in Proportion to Sales—a critical portent of future prospects that focuses on profitability growth through product and process innovation.
In addition to the 10-K and 20-F reports, the Audit relies on proprietary and non-proprietary databases, as well as a broad array of secondary sources ranging from the business press to investor reports. Every effort is made to apply these sources uniformly to each company surveyed; this year, however, data on Novo Nordisk was derived exclusively from Dailyfinance.com and market capitalization rather than citing Enterprise Value due to the company not supplying its figures to Yahoo Finance as the Audit was being completed.
The key difference in this year's Audit is a reduction in the number of companies examined from 27 to 24, due to three significant M&A transactions: the acquisition of Wyeth by Pfizer, and Schering-Plough by Merck, as well as the transition to full ownership of Genentech by Roche. It should be acknowledged that consolidation has enhanced the weight of the 10 stealth pharma companies included in the Audit roster.
The Pharma Industry Audit is also uniquely positioned to demonstrate whether a company's business strategy is actually enhancing shareholder value. If there is one metric that's equivalent to food and water on a desert island, it's Enterprise Value. In the case of management, the measurement of success is simple: Do you create shareholder value or destroy it? For this reason, the Audit gives highest priority to just two metrics: Change in Enterprise Value and Enterprise Value to Sales. These numbers reflect a firm's market capitalization plus liabilities minus cash, or about what it would take to buy the firm on the open market. The Return on Assets metric is another worthy exemplar of a commitment to long-term profitability, and thus is given significant weight in the Audit.
The rating formula covering the eight metrics reflects the fact that some aspects of company performance are more important than others. Three of the metrics, covering value recognition and asset performance, are weighted at three; while the remaining five metrics are weighted at two. Two other metrics are not weighted; these are basic macro indicators covering scale and size that allows for viewing company performance in the context of overall industry trends.
Thus, determination of the final standing for each company relies entirely on the metrics—but not all metrics are equal. For example, if a company places 10th out of 24 on a metric weighted at three, it receives (10 x 3), or 30 points. Each company's points across all of the metrics are then totaled for a final score, with the company receiving the highest number of points overall designated as Company of the Year.
Macro Benchmarks: Sales and Sales Growth
Do I Hear Emerging Markets?
Overall, the group averaged sales growth of only 6.6 percent over 2008, better than last year but low from a historical point of view. The trend reflects the anemic economic prospects and harsher reimbursement climate in the mature markets of the US, Europe, and Japan. Still, the performance is generally in line with IMS data that pegged drug sales at 7 percent growth worldwide last year. With most of the forecast expansion in sales now slated to take place in emerging markets, those among the 24 that possess global reach should be in a position to benefit. IMS is also predicting an uptick in US market growth after 2013, as the patent cliff erodes and the expansion of insurance cover under health reform is phased in. Hence, we can safely conclude that the sales are for the taking, but the competition to attract skeptical customers with a fresh value proposition will be more intense.
With this as the background context, let's review the details driving results for the 24 surveyed companies.
Enterprise Value: The Indispensible Metric
The important caveat in presenting a true picture of performance is how that value is created—or destroyed. For example, Pfizer and Merck scored the biggest gains in Enterprise Value over 2008, moving up from fifth to second and from seventh to fourth, respectively. But most of this was linked to the one-time boost in sales associated with merger activity rather than the kind of permanent organic growth driven by new products, improved business processes, or other changes that demonstrate real added value to the customer.
Teva, BMS, Allergan, Watson, and Endo notched progress on this metric, though not at the pace of Pfizer and Merck. As these companies moved forward, GSK suffered the biggest downward shift, from second in 2008 to fifth place this year, followed by Sanofi-Aventis, which went from fourth to sixth. Both companies have hassled with regulators over key portfolio products that depressed share price to the point where, at least for now, neither is considered a "growth" stock. Significantly, the only two among the 24 to score an actual negative in Enterprise Value were in the stealth pharma segment: Cephalon and King, declining 4.2 percent and 10.1 percent, respectively, against their 2008 performance. Through much of the past year, the two companies faced generic threats due to pending patent expirations and enforcement disputes.
Pfizer, in contrast, scored a dramatic gain in the overall ranking, moving up the list from 19 in 2008 to ninth this year, but this is largely due to the temporary windfall impact of the merger with Wyeth. Merck evidenced a similar, but not as dramatic, jump.
Gross Margin: Free to Price is Key
But the real surprise is the still hefty 53 percent performance of the leading generic producer, Teva. Even though the number was slightly down against 2008, it serves as a counter to the notion that the generics segment is a low-margin business—a view clearly not shared by Teva management.
Sales to Assets: The Drive for Productivity
Finally, Profit to Assets is a stronger metric than either Profit to Sales or Sales to Assets on its own. GSK and Gilead performed best on this metric, although the trend line on Gilead is down. Both showed that strong management led to a maximization of profit margins—a key interest of shareholders.
As a result, most companies, with sales posting healthy growth, were able to improve their performance on this metric. Not surprisingly, specialty and biotech firms, with modest sales overhead and an ability to price to the market, outperformed the Big Pharma companies. Gilead again took top honors, far outpacing the pack, with a Sales per Employee number in excess of $1.8 million—twice as high as the runner-up, Endo. Conversely, Merck suffered the biggest drop in the ratio as it struggled to absorb staff from Schering-Plough. Genzyme's performance also lagged, as a consequence of disruptions in the manufacturing cycle for its major product; so did Pfizer, in its effort to digest Wyeth.
SG&A: The Tool You Can Control
A Final Look at the Winners
When all is said and done, the key differentiating factor in delivering superior performance to shareholders is good management. Gilead continues to shine on that score, with strong ratings on both of the Audit's top-weighted metrics: Sales to Assets and Profit to Sales. No other company in the annual survey has accomplished this feat. To its credit, Gilead has consistently demonstrated the internal capabilities to invest efficiently and grow wisely, in a way that enhances overall Enterprise Value. But as our cover feature shows, there are troubles ahead as the company confronts the administration burdens imposed by accelerated growth, higher investor expectations around its diversification model, and the arrival of new competitors in the HIV therapy area.
Runner-up Celgene has to be seen as the fresh "up and comer" in the industry and is actually the best performer on an across-the-board basis. Its cash cow, Revlimid, continues to sparkle with additional life in the franchise from possible new indications. Celgene also recorded the Audit's highest Enterprise Value to Sales ratio, of over nine-to-one. With stable management, it may be well-positioned to take top honors next year.
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