Monday, February 25, 2008

Measuring Pipeline Self-Confidence

Earnings season is over for most of Big Pharma, and the simple good and bad news (’07 net up or down; ’08 guidance depressing or positive) pretty much out.

But even within the optimistic frames constructed by the industry's IR machines, the overall landscape remains depressing. So what's a drug company to do?

Companies have a choice. They can tell investors: “I’ll be gone awhile, slaving away in the R&D fields until I've created the bright stable home you'll be happy in.” Or they can send the golden chocolate box no investor can refuse. Cash.

To try to determine which lovers fall into which categories, and in preparation for a longer meditation due out in the March IN VIVO, we have been scuba diving the new cash-flow statements and combining what we’ve found with information from our Strategic Transactions Database. Our object: to classify companies as one or the other kind of lover.

None of this would be particular relevant were the drug industry’s cash flow to continue gushing at traditional rates, which would allow companies to do both – invest in their pipelines and generously dispense cash to shareholders.

The problem stems from what we suspect is the industry’s straitening cash flow.

Challenge number one: the industry faces the biggest generic chasm it has ever attempted to leap – drugs with $73 billion in US sales, according to Cowen & Co., will lose patent protection by 2012 (see this story for pharma's strategic reactions). And with in particular Teva more frequently attempting, either on its own or in uneasy partnership with other generic firms, aggressive at-risk launches, that chasm is widening as we watch.

Then there's challenge number two. At ever increasing rates: relatively new drugs are falling off the market (Avandia, Zelnorm)... or finding their growth stunted by new, confusing data (Vytorin)... or collapsing just before they get across the FDA’s finish line (Galvus). Indeed, just getting across the finish line will cost more than anyone, ten years ago, would have credited, given the requirements for safety and, we believe for next-in-class drugs, head-to-head outcomes data.

Put both those situations together, and it looks to us like pharma is soon going to have to make a big philosophical choice about what it wants to do with its cash: please investors in the short term or invest in the only thing that creates long-term pharmaceutical value: productive pipelines.

Hence, we’re trying out a new ratio for measuring pipeline confidence. In essence, we compare how much companies spend on their pipelines (via internal R&D spending and dealmaking) to how much they spend on shareholders (dividends and share repurchase programs). The higher the number, the more confidence they appear to have. The lower the number, the more the company feels it must pay to keep shareholders’ interest.

For the last three years, Eli Lilly has been relatively confident, with a three-year ratio of 2.29 (that is, they spend on internal R&D and dealmaking better than two times the amount they spend on more direct payments to shareholders). In contrast, Pfizer is at 0.7 ($41 billion on shareholders; $29 billion on deals and R&D spending).

The statistic, like all single-number measures, is hardly perfect. It masks changes over time, for one thing.

Take Novartis. Over the last three years, it seems to have demonstrated an extraordinary confidence in its ability to grow its business and thereby create shareholder value – spending on pipeline-filling activities more than twice what it’s spent on shareholders. But as Novartis’ business outlook has darkened, its wooing of shareholders has increased in ardor. When things looked rather more promising, in 2005 and most of 2006, it bought back a relatively minor amount of shares while continuing to increase its R&D spend and paying nearly $5.1 billion to buy out the rest of Chiron.

But in 2007, with big setbacks to Galvus and Zelnorm and shareholders fleeing the stock, Novartis upped its total dividend outlay by more than 50% (OK, that’s in dollar terms, where the increase is boosted considerably by currency changes) and bought back $4.7 billion worth of its own shares – 10 times the amount it had purchased over the previous two years. It also announced, during its January earnings meeting, that it would buy back another $10 billion.

We'll bring you some more analysis from our cash-flow investigations over the next few weeks. But in the meantime, we'd love to hear your thoughts on our new metric -- and indeed whether you, too, think the faucet on the industry's cash flow is tightening to such an extent that companies will soon have to choose between building pipelines and jollying along its short-term investors.
'chocolate money' photo by flickr user greefus groinks used under a creative commons license


Anonymous said...

What about R&D efficiency? A company doesn't have to spend more on R&D relative to its peers in order to have greater confidence in its pipeline. A superior business development strategy helps. Just look at Abbott: low R&D spend compared to peers, yet a strong pipeline buoyed by smart in-licensing and acquisitions.

Roger Longman said...

We agree: more efficient companies, by definition, should be able to do more with less. But actually our metric takes Anonymous' business development strategy into effect -- we include M&A and licensing in total pipeline spend. And while we haven't run the numbers yet on Abbott, our bet is that--given its acquisitions--its confidence ratio would be on the high end of the industry average.

Anonymous said...

Great post.

Two questions:
1. Since R&D investment amortizations are typically over 10yrs or so, shouldn't we look at an average number spanning 10 yrs rather than 3? The investments these guys did in 2001 are likely to generate cashflows in 2011?

2. How much of the payout to equityholders came from the large cash balances that that many of these guys carry? Arguably a lot of that cash could be used to reinvest or do deals but it is a safe bet that many in big pharma are just sitting on chunks of money that is earning 3-4% for years and so any payouts from these funds to equityholders may not be really monies that they would have invested in R&D or deals in reality.