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Pharma battens down the hatches

The traditional defensiveness of the pharmaceutical business model has come under severe pressure in recent years due to the steadily expiring patents of blockbuster drugs, combined with the aggressive approach of generic medicines manufacturers based in emerging markets. So, investors will be even more aware that 2011 brings the industry's looming patent cliff in 2012 a step closer, but there are still grounds for optimism.

At the large-cap end of the sector, this year is likely to bring more evidence of a change in business model for all the UK's large pharmaceutical companies that emphasises the diversification of products, the substitution of revenues hit by patent expiries, cost savings to guarantee dividends, a push into more specialised treatment areas (a Shire Pharmaceuticals speciality) and expansion into emerging markets. Small-cap biotech could also be worth following in 2011 after a series of consolidating takeovers and a renewed round of fundraising gave smaller companies some new year's cheer.

In some ways, looking at the pharma industry in its UK context is too restrictive when the vast majority of revenues are generated across the globe. If the likes of GlaxoSmithKline and AstraZeneca are to succeed in overcoming their patent issues then both sets of management may need to look closely this year at their corporate strategy. GSK has arguably made the quickest start in diversifying a creaking business model, but the overall picture is still of an industry still groping its way towards an uncertain future.

Product diversification has been a significant theme for GSK and this is set to continue into 2011. In a move to bolster its consumer healthcare division, the company recently bought Europe's largest manufacturer of exercise supplements for body builders and gym fanatics, Maxinutrition, for £162m; this came hot on the heels of a buy-out of Chinese medicine maker Nanjing MeiRui for $70m (£44m). Also the type of deals the company is doing suggests it is trying to limit losses on drug development to the cost of a licensing deal. For instance, GSK's agreement with Impax Pharmaceuticals to develop a Phase III Parkinson's drug for $186m is an obvious attempt at boosting the productivity of its R&D pipeline; if the drug fails then GSK has a quantifiable loss it can book, rather than the annual cost of employing expensive R&D researchers.

These bolt-on acquisitions set the template for chief executive Andrew Witty's diversification strategy and it is doubtful that mega-mergers will emerge in the UK pharmaceutical industry this year, but that is equally true of the international market. The departure of Pfizer's chief executive Jeffrey Kindler, the architect of deals such as the $68bn takeover of vaccines-maker Wyeth could be a sign that investors have finally woken up to how value destroying such deals can be; Pfizer has underperformed the rest of the S&P 500 by almost 10 per cent in the last year.

The activity at the small-cap end of the biotech market in the UK could also start to pick up next year. Several companies, among them Reneuron and Oxford Biomedica, have succeeded in raising significant sums of money from the market, while BTG has started to establish itself as a major mid-cap pharma company after ending the year with a takeover of Biocompatibles.

BTG aims to enter the US market, where it is funding the late-stage development of its varicose veins treatment Varisolve, and Biocompatibles has a number of products in the US that could be sold through BTG's US marketing channels. This year will be a make or break for an entry into the US market. Overall, the drastic consolidation of the small-cap biotech sector has left a number of companies sharing common characteristics: marketed products, regular income and cash on the balance sheet. With many of the also-rans already gone, the small-cap sector looks its healthiest in years.

COMPANYPRICE (p)MARKET CAP (£m)PE RATIOYIELD (%)1 YEAR PRICE CHANGE (%)LAST IC VIEW
BTG22758512.80.030.6
GENUS85251123.21.424.4
ASTRAZENECA2,99542,1466.85.21.1
GLAXOSMITHKLINE1,22663,68010.15.2-3.9
HIKMA PHARMACEUTICALS8751,69333.60.968.1
SHIRE1,6409,22027.50.532.8

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