Pharmaceutical companies are under siege from generic providers of drugs. They're also under the thumb of drug regulators and under pressure to develop best-selling wonder drugs.
It hasn't always been difficult. Pharmaceutical company Pfizer also succeeded in developing a blockbuster a number of years ago – a drug called Viagra that has sold in its millions since it was first launched. But the pharmaceutical giant responsible for a sexual revolution in male health is suffering some ill health of its own. One consoling factor for Pfizer's highly paid executives is that other pharmaceutical companies are suffering the same fate.
Famous though it may be, Viagra's sales of $1.76bn (£888m) in 2007 did not get Pfizer's shareholders excited. The company's total sales in 2007 were close to $48.5bn. Yet its share price has declined 31.4 per cent in the past 12 months as investors worry that there is no replacement for its $13bn-a-year cholesterol reducing statin, Lipitor.
Pfizer, and its peers – GlaxoSmithKline, Roche, Merck, Abbott Laboratories, AstraZeneca and Wyeth – have grown fat. The market capitalisation of each of these companies is greater than $60bn. The traditional definition of a blockbuster drug being one that sells $1bn or more in any given year is no longer valid. Annual sales of any one drug need to be more like $5bn in order to make a material difference to the profitability of these companies.
But the probability that big pharma will land a blockbuster drug of this significance is diminishing. This is because regulators are getting tougher. Last year the US Food and Drug Administration approved just 19 new medicines, the lowest number since 1983. And yet, over the same period, expenditure on research and development has trebled.
Most recently GlaxoSmithKline's anti-depressant treatment Seroxat has come under close scrutiny following complaints that it triggers suicidal feelings in some patients. The company is under fire from the Medicines and Healthcare products Regulatory Agency (MHRA) for failing to raise the public's awareness of these side-effects, of which it had evidence.
Back at Pfizer, the patent on its statin drug, Lipitor, runs out in four years. Despite the fact that it will contribute at least $33bn to Pfizer's pre-tax profits in its remaining life, Pfizer's share price could well head further south.
Evolution Securities analyst Peter Cartwright sums up the prevailing view of the markets, which tend to look favourably on companies with earnings momentum, at the expense of the magnitude of their profits: "Blockbusters are seen as a double-edged sword. They are great when they're entering the marketing space and sales are going up. But when they lose [sales] momentum, or worse, when they come to the end of their patent life or successful patent challenge by a generic company, investors just don’t want to know."
Pfizer's shares now trade on a one-year forward price-earnings (PE) ratio of nine times, compared with an equivalent multiple of 25 times just two years ago. But Pfizer is not alone. The market has de-rated most of the big pharmaceutical companies in degrees of this magnitude. AstraZeneca and GlaxoSmithKline both trade on one-year forward PE ratios of close to 12 times, a long way from their multiples of 25-30 times just three years ago.
What this means is that investors are no longer valuing the famous research and development pipelines of the big pharmaceutical players, which in the past have produced blockbusters. The harsh reality for pharmaceutical companies has dawned on investors, according to Dr Cartwright: "If one drug represents 20 per cent or more of sales, that company is left with a terrible job replacing it."
This isn't to say that investors are ignoring these pipelines, but the model the big pharmaceutical companies are adopting is changing fast and it is throwing up all sorts of possibilities for investors. The company with the biggest pipeline isn't necessarily better in the new world and, as with markets at any stage in the cycle, price is everything.
Big pharma's strategy is now becoming more like that of the speciality pharmaceutical companies. The model used by successful companies such as attention deficit and hyperactivity disorder (ADHD) specialist Shire and diabetes specialist Novo Nordisk are being emulated to some degree.
The benefits of biologics
Citigroup's analyst Amit Roy says that big pharmaceutical companies are targeting specific areas that have a limited number of patients, but are very profitable. Their aim is to produce the best therapy, which can command a premium price – the very same strategy used by the likes of Shire and Novo Nordisk.
"These companies are looking for first-in-class drugs that treat new conditions with little competition. This means that successful drugs are harder to come by and that's why they are targeting cancer and neurological diseases," says Dr Roy.
This strategy involves developing (and buying) drugs that are harder to replicate, rather than the 'small molecule' drugs that big pharmaceutical companies have relied on for years. The drugs that are hardest to replicate are typically 'biologics', or drugs that are based on advances in recombinant DNA and molecular biology. These drugs are made from cell lines that are cultured, harvested and purified, rather than the simple chemical synthesis used to develop small-molecule drugs such as Aspirin.
Companies such as Amgen have grown rapidly by developing biologics. Amgen raised $43m in 1983 and now has a market capitalisation of over $54.4bn. It developed Epogen, which has annual sales of close to $3bn. Epogen is a recombinant version of a human protein that stimulates the production of red blood cells and is used in the treatment of anaemia.
Mr Roy says that companies are targeting cancer and neurological drugs because of the lack of success with existing treatments, which means that the amount charged is much higher.
"They are low-volume sales, but if they can produce first-in-class for treating new conditions and have payers that are willing to pay, sales in dollar value will be high, with nice margins," he says.
Evolution's Peter Cartwright agrees and says that the ease of manufacturing cheaper imitations of drugs is forcing big pharmaceutical companies into areas where the medical science involved in discovering and producing the drug is more complicated.
"To produce a serious blockbuster drug is tough. Competition is moving much faster. Generic companies can see what they're doing from Phase 1 and can copy or attempt to copy very quickly," he says.
Roche's Herceptin drug for breast cancer is a good example of targeted therapy. It only works on patients that have high levels of growth hormone HER2 present. Herceptin's sales last year were close to $4bn. Drugs that are very specialised, such as Herceptin, command premium prices because they are not replicable by generic substitutes.
A big benefit from a business perspective is that, because these types of conditions are very specialised, there is no need for a big sales presence. Volume is not as important when a drug might cost $60,000 a year for an average patient. A big advantage for companies with US approval from the Food and Drug Administration is that costs are reimbursed by its government.
Consequently, big pharmaceutical companies such as GlaxoSmithKline and AstraZeneca are shedding salesforces as fast as they can, with a ruthless regard for increasing profits. But no matter how much they cut down on their sales personnel, they will never be as small and nimble as most of the speciality pharmaceutical companies. Shire's £5.5bn market capitalisation, and even Denmark-based diabetes specialist Novo Nordisk, whose market value is £18.7bn, are dwarfed by GlaxoSmithKline's £61bn. Their smaller size means that a drug that sells close to £200m has a big impact on their bottom line. Put another way, Shire's turnover of £2.3bn means it only needs a couple of drugs of this magnitude to make a big difference to its profitability. By contrast, GlaxoSmithKline's £22bn annual turnover means it needs nothing short of a blockbuster drug selling £3bn a year to make a material difference to its profits.
What smaller companies also have is corporate appeal. There is no doubt that big pharmaceutical companies trading on low multiples, such as Pfizer, look to be an attractive proposition. But, with the current squeeze in the availability of credit, large takeovers look unlikely. The giant pharmaceutical companies like Pfizer, GlaxoSmithKline and AstraZeneca are victims of their huge size.
But the big companies aren't taking this lying down. In early May, GlaxoSmithKline raised $9bn in new debt as part of its undertaking, shared by most of its peers, to return substantial cash to shareholders through large share buy-back programmes and increased dividends. Also in early May, US-based Merck said it planned to cut its domestic marketing staff by 15 per cent. Job cuts are now common throughout the industry, as companies remain determined to raise profitability. Watched eagerly by its UK peers AstraZeneca and GlaxoSmithKline, in May Shire moved its tax domicile to Ireland after facing the prospect of paying UK taxes on foreign profits. UK-based companies are also angry about the British government’s efforts to reduce drug prices.
But pipelines matter, too. One of the reasons we prefer GlaxoSmithKline to AstraZeneca is that it has a much bigger pipeline. Both companies trade on similar PE ratios, but GSK has 34 potential products at the Phase III/registration stage, compared with AstraZeneca's 10 products and Sanofi-Aventis's 28 products. It is the composition of the pipeline that counts. The market is only going to value those compounds that are likely to be launched within the next year.
The other factor is price. There has been a general de-rating in the sector and value investors such as Warren Buffett are taking advantage of the intrinsic value in companies producing billions of dollars of cash on low multiples. His fund has stakes in GlaxoSmithKline, Johnson & Johnson and Sanofi-Aventis.
