Shareholder value now depends on finding pockets of "good" growth, in segments with fewer players, and where expenses can be tightly controlled.
Success for today's biopharma enterprise requires continuous education around a lesson plan guided by a simple choice: Grow your core, or die in place. Putting it more bluntly: sink or swim. The standard business model of frequent product introductions propelled by huge investments in promotion to plump up prescription volume is no longer delivering the rich returns expected by management and shareholders. Quite simply, the industry must adjust to a new era of lower margins. That makes strong organic growth—fueled by internal drivers like superior administration and a focused strategy to be recognized as a full partner in healthcare—more important than ever in maintaining a place at the top of the league charts. It's the signal message in our 11th annual Industry Audit of the highs and lows of performance among 24 of the largest publicly traded companies prepared by Professor Bill Trombetta of the St. Joseph University Haub School of Business.
The objective of the Industry Audit is to furnish a snapshot of how well companies are doing in advancing shareholder value. This measure is open to interpretation, particularly because there is no other standard accepted reference point we can cite that looks at performance from this perspective. Our approach is idiosyncratic, but it does reveal the importance of metrics that often escape the attention of the major investor rating institutions. One example is the return on assets against profits, which allow for the valuation of intangibles like patent holdings. Shareholder value is also a good indicator of long-term success because of its association with stability: when the investment community is happy, there is less pressure for changes in the c suite and management has some leverage to place riskier bets on investments that may play out only over time.
Audit Data Sources & Key
A historical attribute of the industry—revenue growth rates high enough to paper over a multitude of sins, such as tolerance for bloated sales and administrative expenses—has faded in the face of the patent cliff. Since 2007, the last year of the good times cycle for Big Pharma, growth across the industry has slowed. Although the R&D productivity lag and genericization of major brands are a factor, structural changes in the way companies must do business are arguably more important as drivers of lower growth. Chief among these changes is a radical transformation in the customer base, led by a vastly more heterogenous community of stakeholders and the dominance of payers over clinicians in determining treatment options for patients. The reality is that accelerating growth today requires a different mindset, with strategies geared to smaller, more differentiated revenue targets often requiring up-front commitments that impose high short term costs that eat into margins.
Many high performing companies are pursuing that model, which is reflected in our survey group. Even in the midst of poor economic conditions, the 24 were still able to outperform the drugs sector as a whole on sales growth, posting an average 7.3 percent compared to a global expansion of 3 to 4 percent. Yet pressures on pricing are evident too, with a group-wide drop of 1.4 percent on gross margins as the "proof of value" trend spreads to oncologics and other specialty segments.
Given the trend, what this year's survey shows is the importance of efficient cost management. Reducing overhead through the productive deployment of assets, capital, and resources is crucial to ensuring that lower growth does not corrode competitive advantage—where the winner is the company able to squeeze more and sweeter lemonade, from fewer lemons.
The survey relies on 2011 data to compare performance against 2010. As in years past, we use eight metrics to assess performance: sales growth; enterprise value growth; enterprise value to sales; gross margins; earnings before interest, taxes, depreciation, and amortization [EBITDA] to sales (an indicator of profit margin); sales to assets (or asset turnover); EBITDA to assets (a measure of the profitability of individual assets); and sales to employees (a ratio to assess productivity). Each metric is weighted, with the highest score of three given to enterprise value growth; enterprise value to sales; and EBITDA (profit) to assets. All the others are scored at two. The higher a firm places on the list, the higher its score relative to the 23 other companies. A company with the highest ranking on any metric would be ranked at 24, while a company performing at the lowest level would come in at one. Weights attach accordingly, so if a company came in at 21 on a metric with a rate of two, then its total points on that metric would be 42, for a standing of fifth best out of the 24 companies—this is in contrast to the scoring for golf, where a low score reflects high performance. If a company comes in next to last on a metric with a weight of two, then its place in the rankings would be second, with total points of two times two equaling four points, on that metric.
From a macro perspective, the best way to evaluate the results is in comparison to trends in the economy overall. Generally speaking, a company should perform at least as well as the real growth rate in GDP and in range of the performance of other healthcare sectors. US GDP expanded by 1.7 percent in 2011, while the CPI rate averaged about 2 percent. Economic growth outside the United States clocked in at slightly more than 3 percent. Other relevant macro metrics are the Dow Jones Industrial Average, which grew 5.5 percent in 2011; NASDAQ, which contracted by minus 1.8 percent; and the Standard & Poor healthcare index, which shows comparisons against other health providers and ran up 10.2 percent. Together, these parameters are the minimum hurdle for companies to be perceived as successful enterprises. In that regard, 14 of the 24 outperformed the S&P benchmark, a ratio roughly the same as last year, where 11 of the 23 companies profiled did better. On average, the group posted a gain of roughly 12 percent, or nearly six times US GDP growth.
Surprisingly, turmoil in the biopharmaceutical market has not forced a change in the revenue ranking of the 24 companies (Annual Sales table). In fact, we see a remarkable level of stability, with the specialty firm Shire and Abbott's injectable generics spinoff, Hospira, joining the group this year to replace Genzyme and Cephalon, which were acquired by Sanofi and Teva, respectively. Leadership in the top 10 of sales changed not at all, except for the inclusion for the first time of Roche in the survey, which pushed Bristol Myers Squibb down a notch, to number 11. Top-ranked Pfizer maintained its perch, with $67.4 billion in sales, or more than 25 times the $2.7 billion sales of the smallest of the 24, Endo Pharmaceuticals. Ironically, Pfizer was alone in recording a slight drop in sales against the previous year, while Endo, in spite of its small size, earned the top spot in revenue growth, gaining 58 percent over 2010. In fact, the biggest growth spurt took place towards the bottom of the chart, with Endo's blistering pace nearly matched by the niche players Celgene, Watson, and Shire. The contrast proves the adage that the bigger you are, the harder it gets to move the revenue needle forward.
It should be noted, however, that sales growth is not the most relevant element of performance. The numbers can be "gamed" depending on when and where you start to measure. In addition, its importance can be overstated if the numbers are driven by merger and acquisition activity, which creates inefficiencies, bloat, and strategic drift that leads to stagnation over time. The better growth is organic, achieved internally through a company's own process improvements and in-house labs and R&D. The paradox is that when sales reach way into the billions, bureaucracy takes over and organic growth becomes harder to attain.
Enterprise value (EV) is a critical metric because it is a straightforward signal of shareholder value. You either create shareholder value—or you destroy it. The impact on the investor can be dramatic. To put it in perspective, what if in 2000 you chose to invest $1,000 each in two companies, Hewlett-Packard (HP) and Amgen. Five years later, the $1,000 spent on HP stock was worth only $500, while the $1,000 that went to Amgen could be cashed out at more than $30,000.
Enterprise Value to Sales
Technically, enterprise value (EV) is comprised of market capitalization (total number of shares of common stock outstanding times the price of the stock on a given day) plus cash and cash equivalents minus debt. It is a mark of what the value of a company is if you considered buying it, plus or minus a competitive premium. It is close to market capitalization: valuing a company by its total common stock outstanding at a price on a given day. But when you buy a company you use cash/cash equivalents on the balance sheet to purchase and you also acquire the acquired firm's debt. These latter can be deceptive, so EV is the better measure.
EV itself is similar to sales volume. One would expect larger sales revenues to correlate with larger EV ratios. As noted in the Enterprise Value table, Pfizer had the highest EV for 2011—a reflection of the recovery of its stock price due to CEO Ian Read's "back to the core" strategy—followed by J&J and Roche, all quintessential Big Pharma firms. Notwithstanding J&J's seemingly endless cycle of product recalls, it managed to plump up shareholder value by over 5 percent. Again, smaller players—Biogen-Idec, Endo and Shire—as well as Bristol-Myers Squibb, created the most shareholder wealth. But there are exceptions. Hospira posted the largest decline in EV from some unwelcome safety side effects of growth and the cost sensitivity of its hospital injectables business.
Another key metric related to EV growth is the ratio of enterprise value to sales. We call this ratio the "equalizer" because it serves to normalize differences in size and scale. The absolute size of a firm's enterprise value tracks it sales volume and hence creating or adding to shareholder returns becomes a key indicator of overall value. EV/sales is similar to a ratio called the PEG ratio, or the relationship between the price to earnings multiple and estimated earnings growth. The higher the ratio, the inference is that things can only get better for a firm, i.e., "you ain't seen nothing yet." The lower the ratio relative to its peers suggests a firm's best days are behind it and growth and profit will be increasingly harder to come by.
Although EV/sales decreased overall for the group compared to last year, where a firm places on the list (Enterprise Value to Sales table) is still a strong indicator of its future potential. Here, the biotechs rule: Celgene and Biogen-Idec, along with Novo Nordisk, continue to impress, while Endo rises in the ranks dramatically, from 20th in 2010 to 11th this year. Teva, in contrast, encountered a steep fall in the ranks compared to last year, mainly because of some costly acquisitions and investments. Interestingly, Forest Labs comes in last on the list, even though it boosted shareholder value by 20 percent. Investor maverick and Forest board member Carl Icahn should get some thanks for the spike in enterprise value despite the low EV/Sales ratio, which nevertheless suggests the company is going to face some big difficulties in the post Lexapro era.
Net Income to Sales
Gross margin (GM) represents sales revenue minus the cost of goods (COG) sold on the P&L statement. This metric is heavily influenced by the pricing conditions faced by each of our companies. The higher the GM and a track record of strong GM performance over time suggests a healthy degree of market power in obtaining good prices from the customer base. What is less well known—but increasingly important in this new era of biologics—is that GM also reflects the ability to get good prices on API and other materials required to manufacture a drug: the cost of goods sold.
Here again, past is prologue, with companies having a strong specialty franchise and a selective customer base doing the best (Gross Margin table), where placement ranking goes from high (24) to low (1). Biogen-Idec, Celgene, Allergan, Amgen, and Shire take the top five spots because of their ability to wrest nosebleed prices. Significantly, we do see a slight drop in margins over 2010 for all of these companies, save Allergan. This suggests a slow market trend toward more crowded competition in the specialty space and thus greater price resistance from payers.
The EBITDA (earnings before interest, taxes, depreciation, and amortization) to sales metric (Net Income to Sales table) is a simple way of demonstrating a company's basic profitability. It is the net income from operating the firm as a business before accounting and finance issues create more smoke and mirrors. Gilead comes in first with a ratio of earnings to sales ratio of over 49 percent—which is actually down from last year—followed by Biogen-Idec and then Pfizer, which benefited handsomely from aggressive cuts in operating expenses. Forest Labs had the steepest decline in profit performance of the group as it confronted the expiry earlier this year of the US patent on its biggest blockbuster drug, Lexapro.
To put both the gross margin and EBITDA/sales rankings in perspective, compare our audit's high flyers to Apple, arguably the most innovative firm in the world. Interestingly, Apple spends only 2.2 percent of its sales on R&D, far less than the norm for Big Pharma. Apple's gross margin for 2011 was 40.5 percent with a profit margin of 35.6 percent; this is small change compared to Biogen-Idec's gross margin of 86.8 percent and an EBITDA to sales ratio of 42 percent. The data shows overall that biopharmaceuticals remains one of the most profitable business sectors, with consistent high returns close to the 20 percent range. However, it is an open question whether in the long term these big margins in pharma can be sustained, even for products with small eligible populations for which there is a real medical need.
Building on the profit margin, which is facilitated by how well a company maximizes revenues while maintaining tight control of operating expenses, sales to assets (Sales to Assets table) is an indicator of the ways a company deploys its assets. It is vital to recall that a firm is in business to use assets, not just to own them. The more a firm can keep assets off of its balance sheet, the higher the turnover on sales to assets. On this measure, Novo Nordisk comes in at the top, at 1.09, i.e., for every dollar Novo Nordisk invests in assets, it generates $1.09 in revenue. Roche, Lilly and Hospira follow, respectively. Amgen brings up the rear, with 32 cents spent on assets to generate every dollar in revenue.
Sales to Assets
The EBITDA (or net profit before taxes) to assets ratio is a critical measure. It reflects how good a firm is at the two basic ways to make money: margin management and asset management. Novo Nordisk, AstraZeneca, Roche, Biogen-Idec, and Gilead shine in the Income to Assets table. All have a reputation for high levels of efficiency in using their in-house resources while working the customer base to maximize pricing opportunities. The surprise here is Teva, which scored lowest on this measure and appears to be having trouble absorbing the spate of recent acquisitions designed to diversify its offerings beyond generics.
The ratio of sales to the number of employees is a basic measure of productivity: it links the revenue to the size of the company's employee base. The key is not necessarily to have the fewest workers but to maximize the revenue that each of these workers generates in the course of a year. The Sales to Employee table shows that Gilead generates about $1.9 million in revenue for every employee, followed by Celgene, Biogen-Idec, and Amgen. The differential between high and low is startling. The Gilead employee produces about eight times the revenue that a worker at Hospira or Mylan does—both are mired in commoditized business lines with low margins. It is another indicator of the importance today of smaller, highly trained, and focused sales teams able to target segmented therapeutic areas where there is the opportunity to charge premium prices because of the high unmet medical need.
GSA has to do with the expenses a firm incurs day-to-day in operating. GSA includes marketing and sales spend but does not normally include R&D spend. We do not include it in the survey as a metric to be weighted because in any given year a company may be launching a new drug or retraining its sales force and these expenses will be outsized at pre-launch and early launch. But over time, GSA should not exceed sales growth or profit growth. The norm shows that significant progress remains to be made. While sales for the 24 companies increased by 12 percent, GSA expenses rose by an average 28.6 percent. Allergan spent the most on GSA, but this is expected given its reliance on aesthetic products based on cash out of pocket payments. Only five firms showed a decrease in GSA for the year: Pfizer, Roche, Watson, Hospira, and Celgene. Looking over the years, Gilead, Mylan, Watson, and Hospira do more with less than the other companies in the survey.
Income to Assets
Biogen-Idec, which came a close second to Novo Nordisk last year, emerges at the top of the list for 2012, followed by Shire and Novo Nordisk. Rounding out the top five are BMS and Celgene, separated by a cat whisker. Behind Biogen's success is its consistently high performance on our top graded metrics designed to tease out a company's underlying value to the shareholder: enterprise value growth, enterprise value to sales, and EBITDA to assets. Sales growth for Biogen, at a little more than 7 percent over 2010, was actually on the low side compared to the group as a whole. Yet its enterprise value growth rating, at 62 percent, was by far the highest of the 24, and way ahead of runners up Shire and Endo, at 41 percent and 48 percent, respectively. Likewise, on enterprise value to sales, it came in at second, after Celgene. All told, the readings indicate that the market feels Biogen-Idec has a lot of upside potential: the company's future is going to be even better than the present.
The numbers make a larger point about strategy. Those who do best in our audit—Celgene, Novo Nordisk, Gilead, Shire and, increasingly, BMS—share several aspects of a superior business model. These include a strong focus on narrow market segments that are relatively price insensitive and tend to have active, engaged customers. Such customers do not require extensive and costly outreach through traditional marketing channels. Big sales forces are not required as a cost of doing business and there are rich opportunities to deploy new, low risk technologies through social media. With Shire as the exception, our top performers kept GSA expenses lower than average for the 24 while securing high levels of revenue growth.
Conversely, the Big Pharma companies are saddled with the unwelcome burdens of size, such as a dependence on diversification and the blockbuster model, both of which impose enormous overhead charges. These behemoths must place equally enormous bets on new products just to generate the minimal growth rates that Wall Street expects.
The bright spot is that the industry still remains highly profitable, with much additional room to manage expenses. Four of our 24 surveyed companies—Watson (16), Allergan (27), Celgene (31), and Biogen–Idec (35) made the Bloomberg BusinessWeek 50 top performers in profit potential for 2011. Biogen also placed fourth in the Fortune 500 return to shareholders metric, with a 64 percent rating, surpassed only by El Paso, an energy company, WellCare, a publicly traded managed care Medicaid company, and Mastercard; BMS returned 39.4 percent to shareholders for 2011, a tad better than one could get on a standard certificate of deposit. Other than Shire, our top performers kept costs lower than average in terms of GSA expenses with strong growth.
2007 was the last year when the stock market was relatively strong and valuations for most biopharmaceutical companies were robust. Hence we thought it would be useful to review progress from that relative height to the more straightened circumstances of today, and pose the question of which company did the best in creating shareholder value over the last five years. In the Mining Shareholder Value table, we ask who has "risen from the ashes" with good news for shareholders, as measured in growth in enterprise value.
Sales to Employee
We performed the calculation for our 24 companies on these two metrics, enterprise value growth and enterprise value to sales, focusing on the five years starting from 2007 as the baseline. Our smallest member in terms of sales revenue, Endo, delivered the most in shareholder wealth, with an increase of 142.3 percent in share value over this period. Celgene was second.
Bill Trombetta’s Hall of Fame
Is there a reason to explain why Endo leads in the track records of shareholder value? With its strategic focus on the continuum of care, where its products seek to integrate within larger trends in the way health care is delivered and financed, Endo is scratching the surface of a powerful strategy that has been pursued in other sectors since the late 1950s: category captain management (CCM). CCM is a strategy based on the rationale that most products are similar in terms of their physical features and characteristics. Hence there is a need to differentiate your product on more than just these directly observed attributes. It is all about continuously adding value beyond the product. As Franz Houten, CEO of Philips puts it in a recent Wall Street Journal interview: Selling means waiting for an order vs. transitioning to how can my company help you with your problems?
Mining Shareholder Value 2007 â 2011CCM is a strategy that offers a sustainable competitive advantage. CCM is competitive in that it enables strategic differentiation, and it is sustainable in that CCM is difficult to copy by a competitor if your firm establishes it first. When your customer is approached as a strategic partner, the end result is a relationship that endures because there are now formidable costs to switching. CCM positions the firm as a source of competitive advantage compared to just a source of supply, where, as former Lilly CEO Sidney Taurel put it, the drug industry is seen as nothing more than a "pill pusher."
And the winner isâ¦
A good example of CCM in action comes from outside pharma. Kraft Foods also has a blockbuster product: string cheese! And how can you possibly differentiate string cheese from other commodities in the business? By approaching its operations from the customer's business perspective. Kraft has secured effective control of space in two thirds of all supermarket dairy aisles in the country by following one principle: to make money for the retailer first. The retailer could care less what brand of cheese is in the dairy aisle, just as a hospital P&T committee or a doctor could care less what drug is on the formulary. Instead, Kraft stoically assumed its dairy products are not all that different physically from its competitors and then pursued a plan to improve asset turnover, boost profitability on sales per square feet, and offer services that make life easier by treating the customer first as a partner in the management of his own supermarket. In biopharmaceuticals, the message from this is simple: Take the relationship beyond the pill. For more on how CCM can be applied to healthcare, see: "Category Captain Management: An Idea Whose Time Has Come in the Pharmaceutical Industry," International Journal of Pharmaceutical & Healthcare Marketing, 4 (2) 2010, www.emeraldinsight.com/1750-6123.htm.
Bill Trombetta, PhD, is Professor of Pharmaceutical & Healthcare Marketing at St. Joseph University, Haub School of Business.