Multinational Pharmaceutical Companies
Steven R. Gerst*
Wayne Huizenga School of Business and Entrepreneurship, Nova Southeastern University, 1010 Seminole Drive #811, Fort Lauderdale, FL 33304
Wayne Huizenga School of Business and Entrepreneurship, Nova Southeastern University, 3301 College Avenue, Fort Lauderdale, FL 33314
Although drug companies have enjoyed higher profits than most in the Fortune 500 list, the pharmaceutical industry is a high-risk business because large scale changes are quickly occurring and its companies can be vulnerable both domestically and internationally.
Dozens of blockbuster drugs have started to come off patent protection, but few new drugs are coming along to replace the profits of those facing patent expiration. In addition, the cost of developing, testing, achieving approval for a drug and bringing it to market has risen dramatically.
Excess “me-too” drugs are closely tied to excessive marketing expenditures to influence prescribing physicians’ behavior. In the face of this shortage of new medications, drug companies are trying to merge with or acquire other companies. These mergers can also be dangerous to international profitability since each merger creates a higher revenue base and a larger debt service.
The large pharmaceuticals have also attempted to use the legal system to protect their patented drugs from generic cannibalization of profits. Pricing pressure from insurers and Canada is another source of risk.
The cost of these companies can vary significantly with changes in foreign exchange rates, tax law changes, and the instability of certain governments/economies. All these risks require hedging and careful use of derivative instruments.
Harris and Ravenscraft (1991) state that “the industrial organizational view of multinational activity has identified research and development intensive operations and differentiated products [as] logical candidates for [foreign direct investment] FDI.” For foreign investors, patented research and development (R&D) creates both a barrier to entry and monopoly power which overcomes the inefficient market transfer of technological information. The ability to spread R&D fixed costs over a number of national markets may yield an important cost advantage that localized manufacturers do not have, especially in countries with markets of limited size or product lines. Therefore, multinational production capability may be essential since the sale or licensing of specialized knowledge may disclose important competitive information, or create difficulties for local competitor to copy complex transfer technologies.
Harris and Ravenscraft (1991) illustrate the need for FDI in multinational pharmaceutical companies. The costs associated with the U.S. regulatory environment combined with the capital intensive nature of (1) pharmaceutical research, (2) large scale manufacturing and production facilities, (3) enormous sales and distribution costs in multiple currencies and at varying exchange rates all support Harris and Ravenscraft’s notion that costs need to be distributed over an international market to maximize revenue and profitability. Indeed the costs of setting-up revenue collections/expenses in a variety of international currencies may require swaps, and other sophisticated hedging techniques to smooth earnings and control multi-currency exposures that may reduce the firm’s cost of capital.
As a result, multinational pharmaceutical companies are involved in nearly all aspects of FDI. FDI activities include the decision to acquire or joint venture (JV), the use of foreign currency swaps, and the use of forwards and hedging to smooth earnings. Moreover, differences in regulatory environments, such as the requirement for government approvals of research protocols, manufacturing and product distribution are multinational issues. These topics are discussed in this paper.
Of the world’s top 14 pharmaceutical companies, eight are U.S. based (Table 1). U.S. based companies account for more than half (379,381 million £) of the total international market capitalization (750,270 million £). This is more than twice that of the nearest country, Switzerland with (141,753 million £). Great Britain is third with 130,190 million £. Translating to U.S. currency, at 1.90 US$/£ (September 2006’s spot rate), the total international pharmaceutical market capitalization is $1.426 trillion, with U.S. companies again owning the majority market capitalization ($721 billion).
Data in this report is from sources and studies covering from 2002 to 2005. An industry this large and profitable would suggest a relatively static relationship between company rankings. Yet, 42 of the 52 blockbuster drugs on the market in 2001 are expected to go off patent in 2007. Those 42 drugs account for $82 billion in sale. As this occurs, generics and “Me-Too” look-a-like drugs will flood the market. Significant profits may be lost unless the patent-protected manufacturers arrange other solutions (e.g. they may pay the generics to not produce or seek patent extension).
Table 1: Market Capitalization of the Top 14 Pharmaceutical Companies (2005)
|Name of Company||Country of Origin||Market Capitalization (£M)|
|Johnson & Johnson||USA||103,950|
|Takeda Pharmaceutical Company||Japan||27,949|
Source: 2005 GlaxoSmithKline Annual Report
Moving to 2009, 12 of the top 35 drugs today will lose their patent protection. Twenty eight percent (28%) of the global drug industry’s $307 billion in sales will be exposed to generic challenge in America alone, due to drugs going off-patent in the next five years.
As a result, drug manufacturer profitability and rankings may change dramatically. The combined effect of (1) significantly tighter regulations, as is the case with FDA approvals of both new and popular Me-Too drugs, (2) large pipeline protecting international M&As, (3) devastating verdicts from lawsuits and product recalls, and (4) recent CEO and CFO resignations (e.g., Bristol Myers Squibb) has already changed market leadership in the past few years (e.g. Pfizer’s vs. Merck’s rankings by revenues 2001-2005). Further, new biotech genomic product competition is working to rapidly change the industry landscape. These topics will be explored in more detail later.
Higgins and Rodriguez (2006) studied pharmaceutical company acquisitions for an eight-year period (1994 to 2001). They found support for acquiring companies realizing significant positive returns (3.91%). 71% of acquirers either maintained or improved their product pipelines and drug sales portfolios after acquisition. They noted that in most acquisitions, the stock prices of acquiring firms generally decline (while the target stock price usually rises). However, in the pharmaceutical industry, acquirers were able to perform sound due diligence to avoid selecting a bad target, and avoid the overbidding for the target firm, and hence stock prices performed much better.
Higgins and Rodriguez (2006) developed a unique Desperation Index to determine the current status of a firm’s internal productivity. They found that pharmaceutical firms experiencing declines in internal productivity (i.e., desperate for a research pipeline to maintain sales levels and improved profitability) were more likely to acquire another company to refresh pipelines than firms with good research and pipelines of new drugs.
Good pre-acquisition information through alliances with either the target firm or the firms conducting research similar to that of the potential target firm is important to pharmaceutical firms if the firm is desirous of improving its research pipeline or product mix. Higgins and Rodriguez (2006) focused on the biopharmaceutical industry because it has extensive publicly available data for both the acquiring and target firms. That data included disclosure of new drug research, thereby lowering information asymmetries, and provided measures of acquirer firm performance subsequent to an acquisition. Performance data related to R&D productivity, specifically, product pipeline improvements ratified the reasons for acquisition and presumably the price paid for the target. Alliances with target firms or similar research oriented firms result in a more accurate valuation of intangible assets after acquisition. An acquirer’s past internal research experience, if in similar areas to a target, significantly correlated with acquirer success.
II. The Pharmaceutical Industry: An Overview
II.A. Profitability and Revenues
In 2002, all top 10 Fortune-500 pharmaceutical companies had the U.S. as their major profit center. The U.S. market generated $217 billion in revenues and $36 billion in profits. Profits of these 10 drug companies were more than half of the $69.6 billion in profits earned by the entire Fortune 500 group of companies. Table 2 shows that the U.S. pharmaceutical companies had an average return on assets (ROA) of 14.1%, and a return on equity (ROE) of 27.6%.
Table 2. Revenues and Profits of Top 10 Fortune-500 Pharmaceutical Companies
(PHOTO needs HERE)
This was more than five times the median profitability for all Fortune companies (3.1%) (See Figure 1); nearly seven times the ROA (2.1%) and two and one-half times the ROE (10.2%). The top 10 drug companies in the Fortune 500 topped two key measures of profitability in 2002.
Figure 1. Profitability of Fortune-500 Drug Companies vs. Profits for All, 2002.
Figure 2. Profitability of Fortune-500 Drug Companies vs. All, 1970-2002.
As shown in Figure 2, this gap has been widening almost every year for at least 20 years. Throughout the 1970s and 1980s, drug companies in the Fortune 500 achieved returns on revenue (profits) that were twice that of the median for all industries in the Fortune 500. In the 1990s, the drug industry’s profitability grew to almost four times the Fortune 500 median.
In contrast, all companies in the Fortune 500 suffered a combined decrease of 66.3% profits from 2001 to 2002. Although the pharmaceutical industry claims to be a high-riskbusiness, year after year, drug companies enjoy higher profitsthan most in the Fortune 500 list. In 2005, only Mining, Crude-Oil Production, Internet Services, Commercial Banks and Telecom had higher profits. Can a businessthat is consistently so profitable be consideredrisky?
Table 3. 2005 Fortune-500 Most Profitable Industries: Return on Revenues
|1||Mining, Crude-Oil Production||29.9|
|2||Internet Services and Retailing||23.8|
|4||Network and Other Communications Equipment||15.8|
|6||Medical Products & Equipment||13.2|
|11||Household and Personal Products||11.1|
|12||Insurance: Life, Health (stock)||10.3|
|14||Insurance: P & C (stock)||9.0|
|15||Oil and Gas Equipment, Services||8.7|
|17||Food Consumer Products||8.4|
|18||Electronics, Electrical Equipment||8.2|
|20||Computers, Office Equipment||7.5|
|21||Health Care: Insurance & Managed Care||7.1|
|22||Hotels, Casinos, Resorts||6.8|
|23||Industrial & Farm Equipment||6.6|
|26||Utilities: Gas & Electric||6.0|
|30||Information Technology Services||5.1|
|31||Aerospace and Defense||4.9|
Table 3. Continued
|32||Health Care: Medical Facilities||4.6|
|36||Semiconductors and Other Electronic Components||3.9|
|39||Health Care: Pharmacy and Other Services||2.8|
|42||Wholesalers: Food and Grocery||2.1|
|43||Food & Drug Stores||1.6|
|45||Wholesalers: Electronics and Office Equipment||1.4|
|46||Wholesalers: Health Care||1.3|
|47||Automotive Retailing, Services||1.1|
|48||Motor Vehicles & Parts||1.1|
Source: Fortune Magazine –April 17th, 2006
, the top 12 pharmaceutical companies on the Fortune 500 list generated combined revenues of $359 Billion with combined profits of $62 Billion. This is consistent with the 17.3% margins of 2002. By 2005 though, there had been some significant changes in the rankings. For example, Pfizer took the lead from Merck, rising from $35 billion to $51 billion in revenues due primarily to the success of such products as Lipitor, the most-prescribed drug in the world, the anti-depressant Zoloft and the allergy medicine Zyrtec. In 2002, Pfizer achieved 26 percent net profit margin ($9.1 billion), outperforming the Fortune 500 median by nearly eight and a half time. In 2003, Pfizer also gained ownership of the $3 billion arthritis drug Celebrex and the $928 million glaucoma treatment Xalatan when it absorbed Pharmacia, another Fortune 500 drug company that had $597 million in profits in 2002.
Due to some of these aggressive changes by Pfizer and its recall of Vioxx, Merck slipped from the number one position in 2002 to nine in 2005. That’s how quickly large scale changes are occurring and how vulnerable these companies can be both domestically and internationally.
Most of the profits derived by these companies are principally derived from (1) third party U.S. insurance companies, (2) monopoly pricing protected by U.S. patents, and (3) government payers (Medicare and Medicaid). Hundreds of highly paid pharmaceutical lobbyists have successfully prevented government agencies from negotiating for volume pricing (Medicare Reform Act of 2003), while other countries allow such practice. This excess pricing power has provided significant funding from the U.S. pharmaceutical industry to virtually subsidize the development of pharmaceuticals for the rest of the world.
Table 4. 2005 Fortune 500 Rankings, Revenues and Profits of Top 12 Pharmaceutical Companies
|Rank||Company||Global 500 rank||Revenues ($M)||Profits ($M)|
|2||Johnson & Johnson||104||50,514||10,411|
Source: Fortune Magazine – July 24, 2006
Table 5. Top 12 Pharmaceutical Company Profits as a Percentage of Revenues and Assets
|Rank||Company||Global 500 Rank||% of Revenue||% of Assets|
|2||Johnson & Johnson||104||21||18|
Source: Fortune Magazine: July 24, 2006 Issue
The U.S. is the only advanced country that does not limit pharmaceutical price increases in some way. In the U.S., uninsured patients (of which there are nearly 50 million) are charged more for drugs than those who have large insurance companies to bargain for them, and the prices of prescription drugs are generally much higher to start with than in other advanced countries. In fact, prices of top-selling drugs are routinely artificially increased in the U.S. at two to three times the general rate of inflation (Pattison & Warren 2003, Bouton 2003, Hensley, 2003).
II.B. Where Do All the Profits Go: R&D or Marketing and Sales?
Throughout the 1990s, the top 10 drug companies in the world consistently spent 11% to 14% of sales on R&D, but 30% to 35% on marketing and administration (The Henry J. Kaiser Family Foundation 2001). For that decade, the top 10 drug companies generated profits of 19% to 25% of sales. From Figure 3, one can see for the top 10 U.S. companies in 2002, expenditures for marketing and administration were 31% of sales, compared with only 14% for R&D (Pattison &Warren, 2003). That comes to an astonishing $67 billion for sales and marketing of their $217 billion in revenues.
This fact is not meant to discount the enormous industry costs of R&D. New products take an average of 17-20 years to develop from initial discovery to final FDA approval (DiMasi, 2001). According to a 2002 report by the Federal Trade Commission, between 1988 and 2001, the average time the FDA took to approve a new drug was approximately 20 months. Over the same time period, the cost of developing a new drug increased nearly four-fold from $231 million in 1987 to $802 million in 2000.
In 1990, R&D expenditures for U.S. pharmaceutical companies totaled $6.8 billion and grew to over $21.3 billion in 2000. As a percentage of sales, however, R&D expenditures from 1990 to 2001 remained at approximately 17%. They peaked at 20.4% of sales in 1997 and recorded at 14.1% in 2002 (Pharmaceutical Research and Manufacturers of America, 2002).
Figure 3. 2002 Revenues Dedicated to Research and Development vs. Profits and Marketing and Sales
Yet, financial reports show that the companies focus more on short term profits, marketing and administration than on long term R&D. As a whole, Fortune 500 drug companies channeled 17% of revenue into profits in 2002 and 2005 while spending just 14.1% of revenues on R&D. (Pattison& Warren 2002).
Figure 4. 2002 Profits vs. Research and Development at 10 Fortune 500 Pharmaceutical Companies
While pharmaceutical companies insist that the extraordinary profits generated through the U.S. market are necessary to fund the huge expense ($800 million) and 17 – 20 years of R&D to bring a drug to market, these companies actually spend at least twice the money on marketing and sales as on research for new product development.
II.C. Me-Too Drugs
From 1989 through 2000, the FDA approved 1,035 new drugs. Of those, only 248 (24 %) were given priority review by the FDA. Since the FDA’s priority review process identifies drugs that represent a significant improvement in treating or preventing disease, only 24% of the drug approvals over the 12-year-peiod were considered to be significant improvements over existing remedies (U.S. Food and Drug Administration 2004). Hence, 76% were not.
Rather than developing breakthrough remedies, much of the R&D expense is devoted to copying or modifying the latest blockbuster drug. Modifying these chemical compounds and piggy-backing on the FDA testing process does not require as much investment as discovering new chemical compounds. Since the competitor already invested in developing market awareness and acceptance, it has become a low-risk way to cash in on a “hot market.” Introductory marketing expense to gain consumer acceptance is lower because the originating company already invested in introducing it as a new drug class. Profit margins are, therefore, higher than investing in creating entirely new compounds.
As a good example of a Me-Too drug, the antacid Nexium was AstraZeneca’s virtually identical replacement for Prilosec when Prilosec went off exclusive patent protection. Thus, Nexium is a minor variation of highly profitable drug already on the market. Because of the overwhelming cost and risk involved in developing new compounds, many pharmaceutical companies have directed R&D efforts toward developing similar compounds that will extend monopoly rights on an older blockbuster.
Another example is when Pfizer developed Liptor as a copy of Merck’s blockbuster Mevacor. Mevacor was the first “statin” drug designed to reduce blood levels of cholesterol by inhibiting the rate-limiting enzyme in cholesterol synthesis. It proved to be astoundingly profitable and is now the #1 selling drug in the world. Novartis (formerly Ciba-Geigy) created a similar drug named Lescol. Warner-Lambert (now Pfizer) entered the market with Lipitor. Bristol-Myers Squibb produced Pravachol and Bayer created Baycol. To protect market share and profits, Merck itself added Zocor to cannibalize the competitors’ entrants.
These statins became the top revenue producing drugs for Merck, Pfizer and Bristol-Myers Squibb, and were responsible for close to $20 billion in annual sales. Lipitor topped the list within a few years, due primarily to its marketing and sales and slightly better efficacy. In 2002, Lipitor alone generated revenues of nearly $8 billion. Partly because of the success of Pfizer’s marketing efforts with Lipitor, Viagra ($1.7 billion sales in 2005) and the acquisition of Pharmacia, Pfizer conquered the #1 revenue position over Merck in 2005.
From 1998 through 2003, of the 487 drugs approved by the FDA, only 67 (14%) were new compounds that were considered likely to be improvements over older drugs. 379 (78%) of the drugs were classified by the agency as “appear[ing] to have therapeutic qualities similar to those of one or more already marketed drugs” (U.S. Food and Drug Administration Center, 2004). 333 (68%) weren’t even new compounds (what the FDA calls “new molecular entities”). Instead, they were new formulations or combinations of old ones (U.S. FDA 2004).
Me-too drugs rarely compete on price. Companies market them as differentiated than the originals. This marketing may be by touting the results of clinical trials in which the drug was used for a slightly different indication. These clinical studies consume about a quarter of the industry’s much-vaunted R&D expenditures. In the terms of the Boston Consulting Group, these Me-Too drugs become “cash cows” which support other R&D, marketing and lobbying efforts, and stock prices.
II.D. Marketing and Advertising
Excess Me-Too drugs are closely tied to excessive marketingexpenditures. According to a 2002 report by the PharmaceuticalResearch and Manufacturers of America (PhRMA), the industry’strade association, 35% of its members’ personnel in 2000 wasin marketing compared with 12% in administration. Marketingexpenditures include an item previously described as “education of medical professionals.”This is probably the biggest single component of marketing expenditures. Administration expenseincludes huge executive salaries often in the millions of dollars with additional stock, stock options and other perks, legal costs andthe overhead associated with running any large business.
Most of the marketing and physician educational expense is directed toward persuading doctors and patients to choose one Me-Too drug over another, usually without a scientific basis. Free samples are mainly newly patented Me-Too drugs. This Me-Too switching behavior can be expensive. For example, AstraZeneca spent $500 million in a year to convince patients and doctors to switch Prilosec users to Nexium (Harris, 2002). Meanwhile, a uniquely important drug requires little promotional expense.
Until the late 1990’s, most advertising and promotional dollars were spent on push marketing whereby detail personnel routinely visited physicians to promote products, offered educational perks, golf outings, trips and other inducements to persuade doctors to write prescriptions on their products over the competitor especially in the Me-Too products lines. Physicians would then determine which drug they would prescribe, effectively pushing the product on the patient with a third party employer or insurer paying for it. The patient has neither knowledge nor incentive to care which drug is better or more cost effective, nor the need to negotiate price, although this practice is likely to change in the coming years.
In 1997, the FDA relaxed its advertising rules allowing direct-to-consumer (i.e. pull market) advertising, usually found on television, magazines, newspapers, radio and other media. In 1996, direct-to consumer advertising topped $800 million. By 2001, it increased 145%, soaring to nearly $3 billion annually. Now, patients would come to physicians asking for certain prescriptions, thus “pulling” the prescription for what they wanted from the physician.
A Harvard-MIT study found a $4.20 return in sales for every dollar spent on direct-to-consumer ads. Some 8.5 million consumers a year ask for a drug after seeing it advertised on television (Arvida, 2003). In 2000, for instance, drug companies gave nearly $8 billion in free samples to doctors, according to the Kaiser Family Foundation. The result was that patients asked for more brand-name drugs, doctors began prescribing more brand-name drugs, and sales took off.
In 2002, Advertising Age magazine showed that Pfizer and Johnson & Johnson alone spent more on ads than did Coca-Cola, McDonald’s or Toyota and were listed as two of the top advertisers in the U.S. It is no wonder that 30.8 % of the average pharmaceutical company’s revenues are spent on marketing and administration, while less than half of that (14.1%) is spent on R&D of new drugs. As Money magazine stated, “It was an addictive formula: Offer a simple variation on an existing medicine, turn it over to the marketing machine and watch the money roll in” (Pattison and Warren, 2003).
Advertising expands the total market. Drug companies increasinglydevelop expensive advertising campaigns to promote diseases to fit drugs, thus expanding their direct to consumer markets and profits, rather than focusing on designing new drugs to treat existing diseases. Especially in affluent countries, companies focus on educating consumers about conditions that need long-term drug treatment such that millionsof normal people start to believe they have questionableailments such as generalized anxiety disorder, erectile dysfunction (ED),premenstrual dysphonic disorder and gastro esophagealreflux disease (GERD). They then justify high prices to cover their very high R&D costs, when more than twice that covers their marketing costs, and produce exorbitant profits.
II.E. The Pharmaceutical Lobby
A large portion of these profits goes to pay lobbyists to continue to push the industry’s agenda. The pharmaceutical industry now has the largest lobby in Washington, DC. There are more pharmaceutical lobbyists than members of Congress. In 2002, prior to the Congressional vote on the Medicare Reform Act of 2003, which created Medicare Part D to provide pharmaceutical coverage to 41 million Medicare recipients, the drug industry hired 675 different individual lobbyists from 138 firms. That’s nearly 7 lobbyists for each U.S. Senator. In that year, pharmaceutical companies spent a record $91.4 million on lobbying activities. This figure does not include spending on advertising and other public relations, direct mail and telemarketing efforts, or grants to advocacy groups and academics pushing the industry’s position. By doing so, the industry was able to derail efforts to include a prescription drug benefit as part of the traditional Medicare program. Instead, the industry has pushed to have Medicare drug coverage provided by private insurers and HMOs – fragmenting the collective bargaining power of the 41 million Medicare beneficiaries (and the Federal government) in negotiating for lower prices.
With all that lobbying money and copious political campaign donations paid for through Medicare, Medicaid and commercial insurers, the prescription drug legislation and policies that come out of Washington are usually “made to order” to favor the pharmaceutical companies. A few examples include:
- Passage of a series of laws that enabled drug companies to extend the exclusive marketing rights of brand-name drugs (including suing generic companies, sometimes repeatedly), to gain additional 30-month periods of exclusivity;
- Nearly free pharmaceutical company access to results and products developed using publicly funded research, with no requirement for reasonable pricing to consumers;
- Prohibitions on importing less expensive prescription drugs from other countries like Canada;
- No FDA requirements to test their new drugs against old ones for the same condition, even when several drugs of the same class are already on the market; and
- Passage of the Medicare Prescription Drug benefit as part of the 2003 Medicare reform act which explicitly prohibits the Federal Government (the largest purchaser of healthcare benefits in the nation) from negotiating prescription drug discounts on behalf of 41 million Medicare beneficiaries. Meanwhile, agencies such as the Veterans’ Affairs System and the Department of Defense, as well as other large insurers, do bargain with drug companies for lower prices or discounts. This makes prescription drugs unique in the Medicare program, which does regulate doctors’ fees and hospital reimbursement.
II.F. Influencing the Medical Profession
To influence prescribing physicians’ behavior, billions of dollars from pharmaceutical marketing budgets support most continuing medical education,medical conferences and meetings of professional associations (Relman, 2001). Meals, trips to exotic locations, and many other perks are provided to medical students, house officers and physicians as marketing and education.While medical and industry association guidelinesare designed to limit these gifts, they are entirelyvoluntary and specifically full of loopholes to take advantage of these extensive educational contributions.
It is somewhat ironic that contrary to most other industries and professions, the noble profession of medicine relies on the pharmaceutical companies to provide “objective” information about their own products. But continuing education credits required to maintain professional licensure, as well as free lunches and other perks, seem to be working. These costs are incorporated into the price of drugs.
Although outpatient prescriptions accounted for only 12% of the U.S. personal health care expenditures in 2002, they were its fastest growing component with an unsustainable increase rate of about 15% per year (Levit, et al. 2004). The excesses of the pharmaceutical industry are perhaps the clearest example of the folly of allowing health care expenditures and policies to be driven by largely–unregulated market forces and the profit-making imperatives of investor-owned businesses.
II.G. Drug Prices Outpace Inflation
The growing drug costs, rising profit and strength of the pharmaceutical lobby frustrate employers and insurers, and intimidate many consumers. In 2002, average drug prices increased by 4%. That was almost double the rate of inflation. The industry experienced 12% sales growth. Of that, 5% came from an increased volume of prescriptions and only 3% from the introduction of new drugs. Examples include:
- In 2002, Pfizer Inc. boosted the price of cholesterol-fighter Lipitor by 7% and then by an additional 4% in January 2003;
- Merck raised the price for Singulair, its asthma remedy by 6% and then by another 5% in the 1st Quarter of 2003;
- Wyeth raised the price for Premarin by more than 17%, even amongst mounting questions about the value of hormone-replacement therapy. As a result, Wyeth, ($4.4 billion in profits in 2002), increased profits by 95% over 2001, the greatest rate of increase of any drug company in the Fortune 500.
Wyeth, whose antidepressant Effexor achieved 2002 sales of $2.07 billion, also markets the acid-reflux disease drug Protonix, the anti-depressant Zoloft, and the allergy medicine Zyrtec. With 30% profit margins, Wyeth outperformed the median Fortune-500 company by tenfold. This is good for investors, but what about consumers?
III. Opportunities and Risks in Multinational Pharmaceutical Companies
Pharmaceutical companies have boasted gross margins of 80%, operating margins of 35%, and 15% annual earnings growth. These stocks have topped the S&P 500 by nearly 100% over the past 10 years (Aravind, 2003). Because of high sales growth rate and profit margin, pharmaceutical stocks have been one of the best and safest investments for the past decade or so.
As the population ages, managed-care programs (i.e., HMOs and PPOs) and insurers have pressured doctors to prescribe more cost-effective outpatient pharmaceutical regimens and to engage in preventive drug treatments to reduce the incidence of expensive hospital settings. With the baby boomers moving into their 50’s, 60’s and 70’s, there is increased demand for drugs to fight arthritis, and to lower cholesterol and triglyceride levels all aimed at preventing or reducing strokes, cardiac problems, depression, and minimizing the effects of Alzheimer’s.
Research breakthroughs by companies like Genentech and Amgen in genomics and biotechnology are creating new billion-dollar drugs. These new drugs support treating diseases with pharmaceuticals. Drug treatment for disease is far more cost-effective than surgery or other medical procedures. Since over 100,000 deaths each year are documented as due to hospital acquired infections, keeping people out of the hospital is also more cost effective and can add to longevity.
Investors, however, must also be cautious. In many cases, much of this past growth was due to only a handful of drugs treating a very narrow range of conditions. For example, one-half of Eli Lilly’s 2002 profits came from only 3 drugs. For Pfizer, 25% of 2002 profits came from Lipitor alone. For most of the top 10 drug companies, the majority of profits came from Me-Too drugs, which ignored development of a solid pipeline of new, innovative drugs.
Loss of Patent Protection will Hurt Profits and Stock Value
One of the problems drug companies now face is that dozens of blockbuster drugs like Claritin have started to come off patent protection. This is causing sales (and profits) to plummet as generic versions hit the market and are replaced by over-the-counter versions, which do not require a prescription. Of the 52 blockbuster drugs on the market in 2001, 42 will go off patent by 2007. In 2001, those 42 drugs accounted for an $82 billion in sales. For these companies there is potential for huge loss in profits if generics or Me-Too’s are introduced. By 2009, 12 of the top 35 drugs today will lose their patent protection. In the next five years, 28% of the global drugs industry’s $307 billion in sales will be exposed to off-patent generic challenge in America alone. Eli Lilly, for example, lost protection on Prozac in August 2001. After growing more than 20% in 1999 and 2000, Lilly’s profit growth rates turned negative: -8% in 2001 and -4% in 2002 (Aravind, 2003). In the meantime, few new drugs are coming along to replace the profits of those facing patent expiration.
III.A. Patent Process
There are two patent protections for pharmaceutical companies: Traditional and Regulatory Patents. Traditional patents are granted and processed by the U.S. Patent and Trademark Office (USPTO). In 1994, The Uruguay Round Agreements Act extended patent lengths from 17-years from the grant date to 20-years from the application filing date. Traditional patents can be filed anywhere along the development lifeline of a drug using a wide range of claims. Most pharmaceutical products have several patents attached to them to maintain protection options.
A Regulatory patent is an exclusive patent granted by the U.S. FDA upon approval of a new chemical entity (NCE). The patent can be concurrent with traditional patent protection and is typically granted for 5-years. This Exclusivity Provision was passed as part of the Drug Price Competition and Patent Term Act of 1984 (the Hatch–Waxman Act) and provides pharmaceutical companies 5-years of marketing protection. During that time, no other manufacturers can apply to the FDA to sell a generic product. However, this does not exclude other manufacturers from seeking approval for Me–Too drugs using the same therapeutic mechanism. For example, after Viagra™ came out and was successful, Levitra™ was approved on August 19, 2003 and Cialis™ was approved only 3-months later on November 21, 2003.
Companies can further extend the length of both their patent protection and exclusivity. Patent protection can be extended by applying to have half the time the drug spent in clinical trials (4-8 years), plus all of the time spent having the FDA review application (usually 2 years), added onto its patent length. However, the extension cannot be longer than 5 years; total patent length cannot exceed 14 years after the drug has been approved; companies must apply for the extension within 60 days of FDA approval (Congressional Budget Office, 1998); Only one patent is eligible for the Hatch–Waxman extension.
Exclusivity protection can be granted by the FDA for 3 more years for a supplemental NDA, if the application required additional clinical testing. This is commonly used for approval for new dosages of previously approved products. For example, when Claritin™ was going off patent, Schering used these provisions to extend patent protection by introducing Claritin-D™ and Claritin-D 24 Hour™.
Exclusivity is the exclusive regulatory marketing rights granted by the FDA under 21 C.F.R. 314.108. This prevents generic products from entering the market during the period of patent protection. In 1998, the pharmaceutical industry had a combined total of approximately 1,100-years of aggregate exclusivity protection remaining on existing drugs. Nonetheless, with the focus on Me-Too drugs and the smaller pipeline of new, innovative drugs, by 2001 (only 3 years later), the exclusivity horizon had fallen to just over 800 years and the rate of decline has been fairly rapid (Higgins and Rodriguez, 2006).
Most firms choose to extend the patent that covers the drug’s chemical compound or in the alternative, the patent that covers the use of the drug (Congressional Budget Office, 1998). In effect, brand-name manufacturers are able to tack on another 2 ½-years of exclusivity protection thereby increasing their effective exclusivity period to 7 ½-years to thwart generic competition (Federal Trade Commission, 2002).
III.B. Diminishing “Pipeline” of New Innovative Research Drugs Creates Risk
The boom of the 1990’s and early 2000’s was built on research done in the 1970s and 1980s that produced important new classes of drugs such as the statins, proton pump inhibitors (causes stomach ulcers; e.g., Prilosec), and selective serotonin re-up-take inhibitors (SSRIs) that alter brain chemistry to fight depression (e.g., Prozac). In truth, only six clinical areas formed the foundation of the drug boom:
- Cardiovascular problems (especially hypertension and high cholesterol);
- Inflammation (arthritis);
- Gastrointestinal diseases (ulcers);
- Infectious diseases (like respiratory infections); and
- Central nervous system conditions (depression and anxiety).
Having tackled the six big disease categories, the biggest untapped opportunity is in addressing the aging degenerative diseases like Alzheimer’s. However, researchers know neither what causes most chronic or degenerative diseases, nor exactly how to measure a drug’s efficacy for these conditions. While a simple blood test can easily measure the effectiveness of a cholesterol lowering medicine, it is much harder to quantitatively determine if a drug is slowing a person’s mental decay. This measurement problem poses difficulties in sourcing funding for new drug research.
Cost and Clinical Trials
In addition, the cost of developing, testing, achieving approval for a drug and bringing it to market has risen dramatically. In 1991, the average cost was roughly $231 million. As previously stated, it is now estimated at $802 million requiring 12 to 15 years to get from conception to the FDA approval process. FDA approval can easily take another 3-5 years. Due to some recent problems with Vioxx and other drugs, the FDA now often requires even more clinical trials than in previous years.
From the mid-1980s to the mid-1990s, the number of clinical trials required has almost doubled, from 36 to 60. The number of patients enrolled in the average trial almost tripled, to 3,521. That is often why it can be much more cost effective to wait for another company to develop a drug and then produce a Me-Too drug with a slight variation to speed through the process and focus on marketing and sales.
For these short term profit driven reasons, the large pharmaceutical companies have not developed a sufficient pipeline of replacement blockbusters for cancer, Alzheimer’s or Parkinson’s disease despite spending large sums on R&D. While some drugs were recently announced to treat previously unaddressed disease processes such as Alzheimer’s, drug makers have been reluctant to devote resources to diseases that affect relatively few people, with the exception of the development of monoclonal antibodies by the biotech firms combined with new nanotechnology based targeted anti-cancer drugs.
With the major disease categories covered in most cases, this often leaves diseases that affect a fewer number of people. These are the so called orphan drugs designed to treat conditions which affect fewer than 200,000 people. Only 28% of R&D for these drugs was spent by the larger, traditional pharmaceutical companies. Instead, some of the biotech firms have entered this smaller market. These firms have spent about 65% of the total research dollars for these important, but limited-use drugs. However, approvals are still few and far between. In 1996, the FDA approved 53 new drugs. In 2002, the FDA approved only 17 (Aravind, 2003).
Me-Too Strategy Caused Pipeline Vulnerability
With the very limited number of new drugs approved by the FDA and the multitude of cash cows coming off-patent, the Me-Too strategy has left many companies precariously vulnerable. As mentioned above, three drugs accounted for about half of Eli Lilly’s 2002 sales and 25% of Pfizer’s revenue, which makes hundreds of drugs and consumer products, is from one drug, Lipitor. That makes these huge companies extremely financially vulnerable and highly risky for investors.
In addition, due to a series of highly publicized cases in which recently approved Me-Too drugs produced dangerous side effects such as Bayer’s Baycol, the FDA has become more cautious in approving them. The FDA wants to see that any new drugs with potential side effects have clear advantages over current treatments. Vanlev, for example, is Bristol-Myers Squibbs’ new drug for congestive heart failure. It is considered one of the BMS’ next potential blockbusters. However, a March 2002 study demonstrated that Vanlev was only marginally more effective than a drug already on the market. BMS’s share price fell 15% in one day. Then, in July 2002, an FDA panel recommended the rejection of Vanlev. The FDA is requiring BMS to perform further expensive testing before Vanlev may be approved.
Risks to Investors
Investors are becoming more careful about which pharmaceutical company stocks they own. In addition to the low number of new drugs in the pipeline and the FDA’s slowdown on approving new Me-Too drugs, scandals over product safety, consumer anger about pricing and new consumer directed high deductible health plans could pose as serious challenges to the drug companies that can stem profit and revenue growth.
III.C. Mergers and Acquisitions Required to Boost Pipelines
To maintain cash flow and profit margins in the face of this shortage of new medications, drug companies are trying to merge with or acquire other companies. In 2000, Pfizer acquired Warner-Lambert for $90 billion. They then bought Pharmacia for $60 billion. Johnson & Johnson bought Alza for $10.5 billion in 2001. 2005 was an active year, especially for mid-sized acquisitions. 2006 is also active. To name a few, Bayer AG outbid Merck K GaA for Schering AG. Actavis, the Icelandic generic manufacturer, is purchasing Pliva, and Novartis making a play for Chiron (Young, 2006).
The market for acquisitions in the generic manufacturers is also hot. Teva’s acquisition of Miami-based IVAX made it the 16th largest pharmaceutical company and the largest generics firm in the world. Actavis’ purchase of Pliva and Alpharma is catapulting it to the 5th rank in the world. Actavis will then have more than 200 new products in its pipeline. At this point, M&As may be essential to long-term survival of many larger pharmaceutical companies. Future mergers are expected to come from central Europe and India or further East like China (Bremer, 2006).
With each deal, sales forces and administrative functions are combined, slashing billions in costs and raising earnings. But the consequent employee reductions in force and cost cutting may sometimes be unwise for the future. In the U.S. in particular, executive compensation packages are often tied to stock price and short term profitability is paramount. Therefore, U.S. executives are more concerned with short term profitability and stock price.
These mergers can also be dangerous to international profitability since each merger creates a higher revenue base and a larger debt service. For example, after absorbing Pharmacia, Pfizer achieved $52 billion in revenue. To maintain stock price and growth targets, analysts expect 10% annual sales growth and 16% earnings on revenues. However, on the larger revenue base and debt service, the company will have to add close to $6 billion each year to its top line. Without a solid pipeline of blockbusters, it is highly unlikely the company can achieve these results in the short term without sacrificing future stability. This poses risks to long term investors.
To keep profits up (to maintain stock price and executive compensation), the pharmaceutical companies often cut capital investments in manufacturing. As a result, the declining quality of their manufacturing plants has caused trouble with the FDA. In May 2002, the FDA found significant violations of regulations related to quality assurance, equipment, laboratories, packaging and labeling at four Schering-Plough facilities in New Jersey and Puerto Rico. Schering-Plough agreed to pay $500 million as part of a settlement. This poses another risk to investors.
III.D. Generic Manufacturers as Merger Targets
Statistics confirm that the U.S. consumer spends almost twice as much per capita on health as the rest of the world (See Figure 5). Meanwhile, Great Britain (not on the chart), with their socialized system of healthcare, is one of the least expensive pharmaceutical markets. With GlaxoSmithKline and AstraZeneca, however, Great Britain boasts some of the largest international drug companies. Companies in Great Britain actually own 60% of the generic
Figure 5. Americans Spend Nearly Twice as Much on Healthcare than Other Advanced Countries
market. Britain ranks alongside the U.S., Denmark, the Netherlands and Germany as the biggest generics market in both volume and market penetration.
Generics make up more than half (56 %) of the pharmaceutical volume sold in Great Britain. Generic market growth has been averaging 10% – 12.5% annually, over the last few years. 80% of prescriptions are written generically and 60% reimbursed generically. This may be a result of negotiations and purchasing power of Britain’s National Health System. That British experience may be the reason that pharmaceutical companies spend so much money on Washington lobbyists – primarily to maintain protectionism and prevent generic cannibalization of profits by British and upcoming Indian and Chinese generic manufacturers.
Unlike the branded manufacturers, generics do not need to create their own pipeline since they simply copy compounds coming off patent. With a small number of large companies dominating the market, generic manufacturers concentrate on sourcing ingredients and producing medicines at low cost. Actavis and Ranbaxy (India) are on the acquisition trail and the Chinese will eventually produce one of the five big dominant companies. Each company will probably further dominate their market by specializing in certain areas.
Rapid Growth in Generic Sales and Brands
Generic sales are growing at double-digit rates, twice as fast as the overall market. They constitute over half of volume sales in America and Britain. Because generics are much cheaper than branded drugs, their market share by value is estimated at 13% globally.
Due to the growing popularity and cannibalization of their revenues, big pharmaceutical firms are starting to launch their own generic brands. Merck, for instance, has joint ventured with an Indian firm, Dr. Reddy’s Laboratories, to produce generic versions of Zocor, its cholesterol-reducing drug. Similarly, Pfizer plans to produce Zoloft, its popular anti-depressant, through its Greenstone generics subsidiary.
To further avoid generic competition, firms sometimes cut the branded drug price. Merck, for example, before the launch of a generic, slashed the price of Zocor to a level so low that a U.S. Senator demanded an investigation of predatory pricing.
The Battle over Generic Drugs Heats Up
A widely publicized scandal over generics recently ended with the resignation of the CEO of Bristol-Myers Squibb. It revolved around a joint marketing agreement with France’s Sanofi-Aventis over Plavix, the world’s 2nd best-selling drug (after Lipitor). Plavix helps to prevent heart attacks and strokes by inhibiting blood platelets from sticking together to form clots. The patent expires in 2012, and with global sales of nearly $6 billion, BMS expected to squeeze out billions more dollars. However, Apotex, a generic manufacturer, thought that BMS’s patent protection was weak and launched a generic version of the drug, undercutting the branded version’s price. Sanofi and BMS filed suit demanding a halt to the shipments.
Apotex believed that the Plavix patent was unenforceable. Sanofi and BMS tried to negotiate, and struck a deal with Apotex to delay the generic launch until 2011, in return for a financial pay-off and the promise that the giants would not compete with Apotex by launching their own “authorized” generic. Then, Sanofi and BMS began undercutting Apotex’s generic with the price of branded Plavix. The state attorney-generals office began a criminal anti-trust and predatory pricing investigation which resulted in the BMS CEO resignation.
III.E. Patent Protectionism to Protect Profits
In addition to mergers, the large pharmaceuticals have attempted to use the legal system to protect their patented drugs from generic cannibalization of profits. To try to extend the life of existing patents and delay the onslaught of significantly lower generics, they often sue generic manufacturers claiming patent infringement. The law provides an automatic 30-month patent extension while the case is under review. It also allows multiple 30-month extensions for filing sequential claims against generic manufacturers.
For example, in March 1998, Apotex filed an application to make a generic version of Paxil, GlaxoSmithKline’s blockbuster antidepressant. Two months later, GSK sued Apotex, winning a 30-month extension until November 2000. GSK also listed nine additional patents on Paxil and brought suit against Apotex four more times between over the next 3 years (1998 -2001), each time gaining another 30-month extension to protect their Paxil profits. There is an obvious battle between generic manufacturers looking for new product and the brand manufacturers trying to protect profits and recoup R&D and marketing expense for shareholders. Who will win?
In November 2000, Bristol Myers Squibb sued generic manufacturer Mylan Laboratories for patent infringement on its anti-anxiety drug BuSpar just prior to losing patent protection. But this time, a group of states’ attorneys and consumers sued BMS, alleging anti-competitive practice to lock generic competitors out of the BuSpar market by filing frivolous secondary patents.
While admitting no wrongdoing, BMS settled the case for $535 million. Even the traditionally pharma-friendly Republican administration, saw the abuse going on and President Bush proposed limiting a pharmaceutical to a single 30-month extension on a patent. Obviously, with case law now on the books and the public screaming about excessive drug company profits, the generic manufacturers may be a better long term investment. However, that assumes that the branded manufactures will start to shift resources from marketing and sales to R&D. That may not happen quickly under the current executive compensation programs, which are tied to short-term stock price.
III.F. Pricing Pressure from Insurers and Canada
Health insurers typically: (1) Get significant volume-based discounts through Pharmacy Benefit Management firms, and (2) Structure benefits to promote the use of generics over brand prescriptions. To save more money, they are also moving to disallow whole classes of prescription drugs when one drug in the class is approved by the FDA for non-prescription sales (e.g., “over-the-counter). For example, since Claritin is now sold over the counter, Aetna, (the second-largest health insurer) will no longer cover non-sedating antihistamines like Aventis’ Allegra and Pfizer’s Zyrtec without a special request from the physician. Similarly, WellPoint Health Networks (which owns Blue Cross Blue Shield HMOs in 16 states including California) has been lobbying the FDA to move Allegra, Zyrtec and Clarinex from prescription to over-the-counter status. Since prices for a month’s supply of Claritin fell from $80 or so to about $30, this could significantly impact drug company profits.
Canadian Price Cutting
Big pharmaceutical firms have never much liked Canada. The country’s socialized medical system is less profitable for them than the American market, and “grey market” shipments of branded drugs from Canada have undercut the fat margins they are used to across the border. This has become a big issue and U.S. pharmaceutical companies are lobbying hard to keep Canadian supplies from reselling their products back to the U.S. at significantly reduced margins.
Just as every other industry sector the drug industry goes through its booms and busts. Given all the factors above, it will be difficult for pharmaceutical companies to maintain their extraordinary profitability and dominance in the stock market. The steep decline in innovation levels, combined with the threat from generics, has caused pharmaceutical companies across the world to collaborate with biotech companies, thus relying on external resources to boost their innovation and productivity levels.
It will likely take 7 to 10 years to turn back to a boom when “genomics,” also know as genetic re-engineering, could pay off, unleashing the next big wave of drugs. Meanwhile, a number of pharmaceutical companies will probably not survive to see the genomics-inspired boom. Instead, they are likely to be merged into or acquired by more innovative, capital intensive firms with good pipelines of drugs. These drugs are likely to achieve FDA approval sooner because of their unique contribution to the general health of the population.
Both Novartis and AstraZeneca have developed promising cancer drugs. Since there are few competitors for these drugs, these companies will be able to charge high prices. Eli Lilly may also be a survivor, since it has built up its expertise in biological cures for conditions like diabetes which affect a huge portion of the population. Some of Lilly’s other pipeline drugs are also likely to play a key role in the fight against cancer and rheumatoid arthritis.
Likely to survive are the ones that can profit from existing blockbusters until the next wave of big drugs hits the market. Pfizer, for example, recently increased its marketability of its antidepressant Zoloft when it was approved for social anxiety disorder as well, extending its use to new patients.
To stay competitive, companies need to leverage their sales forces and prestige to strike advantageous deals (like Pfizer and Merck) or have the ready cash to buy them out (like Johnson & Johnson). Pfizer has 110,000 employees and a $7 billion annual research budget, and had $51 billion in sales in 2004. But in the last five years, Pfizer has introduced only a handful of breakthrough drugs. Mergers and alliances with, or acquisition of biotech firms may be the key to maintaining its number one status (Berenson, 2006). While little known to the public, Pfizer is also using much of its excess cash to buy back at least $16 billion in stock in 2006 to increase its stock price for stock-based mergers.
In keeping with the trend of licensing deals, currently 70% of the industry’s drug pipeline is with biotech companies. Moreover, the industry is exhibiting significant changes as an increasing number of pharmaceutical companies are focusing their efforts on licensing early-stage compounds due to spiraling costs of late-stage compounds. However, while early-stage compounds are less expensive, they also possess a higher risk quotient (PR Newswire, 2006).
III.H. Stock Price
M&A activity is just one of the elements that make up the industry’s financial picture. Another is stock price. While most of the large multinational pharmaceutical companies are listed on the New York or other U.S. based exchanges, each company also measures itself with its own proprietary U.S. and European index, and the global generic market. In recent years, pharmaceutical company stock prices have been showing several puzzling trends. To minimize risk, successful investors need to identify the few first-tier players from the second-tier also-rans, especially with blockbuster drugs coming off patent, generic manufacturers gaining legal protections and biotech companies gaining ground. Smart investors need to look for undervalued companies that are possible takeover targets for the European giants eager to expand in the U.S.
Overall, investors will have to lower expectations. As a group, earnings are projected to increase by only 8% over the next 10 years–about 40% below Wall Street’s consensus estimates. Yet, the strong record of dividend payouts by the large pharmaceutical companies will continue to make them attractive for older investors on fixed incomes. The huge, record premiums of the past 10-15 years for the industry, however, are likely to vanish.
Lately, the Pharmaceutical Index has been continuously underperforming the S&P Index, with negative returns for the first time in 2004. Recent high-profile recalls of Vioxx and the impending patent expiration have created that downturn. In addition, generic drugs now represent nearly half (48%) of the total drug sales in the U.S. pharmaceutical market. Since the U.S. market is by far the world’s largest, brand pharmaceutical companies have some huge hurdles to overcome to maintain earnings targets (PR Newswire 2006).
Strategic Alliances are Forming
The pharmaceutical companies are trying to maintain market share and earnings potential through strategic alliances with biotech companies, generic manufacturers and self cannibalization of their own off-patent drugs to forestall revenue loss to foreign and domestic generic manufacturers. In the 5 years between 1997 and 2002, more than 1,500 alliances were formed. Their contribution of licensed products towards total sales is predicted to increase from 20% in 2002 to 40% in 2010. A recent research by Higgins and Rodriguez (2006) shows that establishing these alliances tends to result in fewer overpayments in eventual mergers/acquisitions and greater shareholder value.
A strategic alliance between Roche and Genentech in 1990, for example, provided Roche with access to Genentech’s innovations. This set an important precedent, and drove large pharmaceutical companies to focus on licensing and alliance deals with other companies. In addition, as pharmaceutical companies such as Merck, best known for their internal R&D efforts, are now pursuing feasible alliances and licensing deals, this trend is expected to continue.
The Human Genome Project (HGP)
The decoding process of the entire human DNA was recently completed, radically transforming beliefs related to disease and patient homogeneities. It has had a significant impact on the drug discovery industry and biotech companies are rushing in to reverse engineer drugs that will act directly on DNA – the genetic code, to diagnose, prevent and cure diseases through genetic replacement at the molecular level.
Advances in nanotechnology, using molecules targeting cancer cells through specific receptors, are also moving rapidly with products expected to be commercially available in the next few years. At the same time, significant advances are being made in genomics, proteomics and other allied areas, which are expected to encourage pharmaceutical companies to revise their R&D operations.
Savvy investors need to be aware of these changes and find companies promising to produce these new technologies in commercially viable products and distribution networks. Over the period of the next five years, pharmaceutical companies will need to increase efforts to strengthen their pipelines and foster alliances with the new companies in order to sustain the historic growth rates of sales revenues, stock price and dividend payouts (PR Newswire 2006).
III.I. Foreign Manufacturers and Direct Investments in the U.S.
Not only are U.S. based pharmaceutical companies aggressively entering foreign markets, but foreign drug manufacturers especially in generic manufacturing markets are aggressively entering U.S. markets with off-patent products. In addition to Japanese and Korean conglomerates which benefited from protection and big profits domestically before they took on the world, new contenders in many industries are from developing countries like Brazil, China, India, Russia, Egypt and South Africa. Most of these companies have prevailed in brutally competitive domestic markets as well as with rival western conglomerates. As a result, these champions must make profits at price levels unheard of in the U.S. and Europe. Indian pharmaceutical companies, for example, charge 1 – 2% of what people pay in the U.S. for the same drugs.
The Boston Consulting Group (BCG) recently published a study based on 3,000 companies in 12 developing nations and identified 100 emerging multinationals that appear positioned to “radically transform industries and markets around the world.” These companies had combined 2005 revenues of $715 billion, $145 billion in operating profits and $500 billion in assets. They are growing at 24% annually in the past four years. Indian generic pharmaceutical manufacturer, Ranbaxy is one of the companies on this list.
India has some of the lowest price pharmaceuticals in the world. For example, Indian producers produce 101 brands of generic Ciprofloxin (an antibiotic used to treat bacterial infections such as pneumonia and anthrax, costing an average of 6.3 cents for each 500 mg tablet, while the same generic drug in the U.S. for 5.10 dollars as much (Engardio, 2006). This demonstrates how the U.S. healthcare system, specifically taxpayer money (Medicare and Medicaid) and commercial employer monies are used by U.S. drug companies to subsidize R&D and sales and marketing for drugs sold throughout the world at much lower prices than those charged in the U.S.
Ranbaxy now ranks 14th in the $28 billion U.S. market for generic drugs, but it is the leader in other countries such as Nigeria and Brazil. It is one of the biggest suppliers of $1/day generic AIDS drug treatments (cost) and hopes to put a new malaria drug on the market by 2008. Ranbaxy snapped up smaller generic drug manufacturers from Belgium, Italy and Romania. When first selling to physicians and purchasing managers in Europe, Ranbaxy representatives were often kept waiting for hours. Now, they are one of the top suppliers in Europe and 80% of its $1.2 billion in revenues are from overseas. Ranbaxy now has manufacturing plants in 7 nations, marketing and sales staff in 49 countries and a staff of over 1,100 in New Delhi for R&D alone (Engardio, 2006).
Ranbaxy has the 2nd biggest generic drug “pipeline” with 58 generic medicines pending U.S. FDA approval, including a version of the anti-cholesterol drug, Lipitor. Ranbaxy hopes that all the R&D will allow it to get into the top 5 in the U.S. by 2012 and number one world wide, passing Teva Pharmaceutical Industries, Ltd., the current world leader in generic manufacturing from Israel.
According to the 2005 GlaxoSmithKline Annual Report, total worldwide pharmaceutical sales for 2005 were £ 302 billion. At a recent day’s spot rate of 1.90£/$ that is $574 billion. Average revenue growth (after conversions) was 6%. While 2005 growth in the U.S. market slowed to 3%, the U.S. still represents 44% of the global prescription pharmaceutical market compared with 30% 10 years ago.
Table 6. 2005 World Pharmaceutical Sales Statistics
|Geographic Region||Total Value
|% of Total||Growth (%)|
|USA||132.0 £bn/($250.9 bn)||44%||3%|
|Europe||86.8 £bn/($165.0 bn)||29%||8%|
|Germany||16.4 £bn/ ($31.2 bn)||5%||8%|
|France||15.9 £bn/ ($30.2 bn)||5%||9%|
|United Kingdom||10.5 £bn/ ($20.0 bn)||3%||0%|
|Italy||9.9 £bn/ ($18.8 bn)||3%||3%|
|Japan||32.5 £bn/ ($61.8 bn)||11%||4%|
|Asia Pacific||20.5£bn/ ($39.0 bn)||7%||13%|
|Latin America||13.7 £bn/ ($26.0 bn)||4%||15%|
|Middle East, Africa||9.8 £bn/ ($18.6 bn)||3%||17%|
|Canada||7.0 £bn/ ($13.3 bn)||2%||14%|
|Total||302.3 £bn/($574.6 bn)||100%||6% average|
Source: 2005 GlaxoSmithKline Annual Report ($US converted at $1.90/£ spot rate as of 9/24/06)
Table 7. 2005 World Pharmaceutical Sales Statistics By Class of Drugs
|Class||Value £bn ($bn)||Growth CER||Growth|
|Cardiovascular||50.7£bn ($96.4 bn)||17%||7%||6%|
|Central nervous system||49.7£bn ($94.5 bn)||16%||6%||4%|
|Alimentary tract and metabolic||36.6£bn ($70.0 bn)||12%||6%||5%|
|Anti-infectives (bacterial, viral & fungal) excluding vaccines||32.2£bn ($61.2 bn)||11%||7%||5%|
Source: 2005 GlaxoSmithKline Annual Report ($US converted at $1.90/£ spot rate as of 9/24/06).
(Note: data based on 12 months to 30th September 2005.)
III.J. International Manufacturing
Most of the multinational pharmaceutical companies manufacture different drugs and Over–The–Counter (OTC) cosmaceutical products in plants throughout the world. The choice of country may result from various international JVs, alliances, acquisitions, labor cost structures, favorable regulatory environment, tax incentives/structures and proximity to product distribution networks.
For example, GSK manufactures vaccines primarily in two Belgian locations, with three other sites in France, Germany and Hungary. In 2005, GSK strengthened its global production network in North America through three major acquisitions: (1) Corixa Corporation, which produces an important component in many of GSK’s vaccines under development, (2) a vaccine production site in Marietta, Pennsylvania, and (3) ID Biomedical with flu vaccine manufacturing facilities in Canada. In Asia, new vaccine production facilities are being built in India and Singapore. GSK’s vaccine division also has two JVs in China and Russia. During 2005, GSK opened a new $3 million manufacturing facility in Cape Town, South Africa to produce Albendazole. Table 8 gives an example of the international diversification which the GlaxoSmithKline maintains as part of daily business operations in a multitude of countries.
Table 8. GlaxoSmithKline Worldwide Principal Offices and Subsidiary Operations
Business Segment: (Ph) Pharmaceuticals, (CH) Consumer Healthcare
Business Activity: (d) development, (e) exporting, (f) finance, (h) holding company, (i) insurance, (m) marketing, (p) production, (r) research, (s) service
|England||Brentford||+GlaxoSmithKline Holdings (One) Limited||Ph,CH||h|
|Brentford||+GlaxoSmithKline Services Unlimited||Ph,CH||s|
|Brentford||+GlaxoSmithKline Finance plc||Ph,CH||f|
|Brentford||GlaxoSmithKline Capital plc||Ph||f|
|Brentford||SmithKline Beecham p.l.c.||Ph,CH||d e h m p r|
|Greenford||Glaxo Group Limited||Ph||h|
|Greenford||Glaxo Operations UK Limited||Ph||p|
|Brentford||Glaxo Wellcome International B.V.i||Ph,CH||h|
|Brentford||Glaxo Wellcome Investments B.V.i||Ph,CH||h|
|Stockley Park||Glaxo Wellcome UK Limited||Ph||h m p|
|Brentford||GlaxoSmithKline Export Limited||Ph||e|
|Brentford||GlaxoSmithKline Research & Development Ltd||Ph||d r|
|Brentford||GlaxoSmithKline UK Limited||Ph||m p|
|Brentford||SmithKline Beecham (Investments) Limited||Ph,CH||f|
|Brentford||SmithKline Beecham (SWG) Limited||CH||e m|
|Brentford||SmithKline Beecham Research Limited||Ph||m|
|Brentford||Stafford-Miller Limited||CH||m p|
|Greenford||The Wellcome Foundation Limited||Ph||p|
|Austria||Vienna||GlaxoSmithKline Pharma G.m.b.||Ph,CH||m|
Table 8. Continued.
|Rixensart||GlaxoSmithKline Biologicals S.A.||Ph||d e m p r|
|Rixensart||GlaxoSmithKline Biologicals Manufacturing S.A||Ph||h|
|Guernsey||St. Peter Port||SmithKline Beecham Limited||Ph,CH||i|
|Denmark||Ballerup||GlaxoSmithKline Consumer Healthcare A/S||CH||m|
|Brøndby||GlaxoSmithKline Pharma A/S||Ph||m|
|France||Marly le Roi||Groupe GlaxoSmithKline S.A.S.||Ph||h|
|Marly le Roi||Laboratoire GlaxoSmithKline S.A.S.||Ph||m|
|Marly le Roi||Glaxo Wellcome Production S.A.S.||Ph||m p|
|Marly le Roi||GlaxoSmithKline Sante Grand Public S.A.S.||CH||m|
|Germany||Buehl||GlaxoSmithKline Consumer Healthcare GmbH & Co KG||CH||d h m p r s|
|Munich||GlaxoSmithKline Pharma GmbH||Ph||h|
|Greece||Athens||GlaxoSmithKline A.E.B.E||Ph,CH||h m|
|Hungary||Budapest||GlaxoSmithKline Medicine & Healthcare Products Ltd||Ph,CH||e m|
|Italy||Verona||GlaxoSmithKline S.p.A.||Ph||d h m r|
|Milan||GlaxoSmithKline Consumer Healthcare S.p A.||CH||h m|
|Luxembourg||Mamer||GlaxoSmithKline International (Luxembourg) S.A.||Ph,CH||f h|
|Zeist||GlaxoSmithKline Consumer Healthcare B.V.||CH||m|
|Poland||Poznan||GlaxoSmithKline Pharmaceuticals S.A.||Ph||m p|
|Warsaw||GlaxoSmithKline Consumer Healthcare Sp.Zo.o.||CH||m e|
|Portugal||Lisbon||GlaxoSmithKline-Produtos Farmaceuticos, Limitada||Ph||m|
Table 8. Continued.
|Ireland||Dublin||GlaxoSmithKline Consumer Healthcare Ltdii||CH||m|
|Carrigaline||SmithKline Beecham (Cork) Limitedii||Ph||p|
|Carrigaline||SmithKline Beecham (Manufacturing) Ltdii||Ph||p|
|Spain||Tres Cantos||GlaxoSmithKline S.A.||Ph||m p|
|Alcala de Henares||SmithKline Beecham S.A.||Ph||p|
|Switzerland||Muenchenbuchsee||GlaxoSmithKline Investments-Switzerland GmbH||Ph,CH||h|
|Philadelphia||SmithKline Beecham Corporation||Ph,CH||d e h m p r s|
|Pittsburgh||GlaxoSmithKline Consumer Healthcare, L.P.||CH||m p|
|Pittsburgh||Block Drug Company, Inc.||CH||h m p|
|Wilmington||GlaxoSmithKline Financial Inc.||Ph||f|
|Wilmington||GlaxoSmithKline Holdings (Americas) Inc.||Ph,CH||h|
|Bermuda||Hamilton||GlaxoSmithKline Insurance Ltd||Ph,CH||i|
|Canada||Mississauga||GlaxoSmithKline Inc.||Ph,CH||m p r|
|Vancouver||ID Biomedical Corporation||Ph||d m p r|
|Australia||Boronia||Glaxo Wellcome Australia Pty Ltd||Ph,CH||d e m p r|
|China||Hong Kong||GlaxoSmithKline Limited||Ph,CH||m|
|Tianjin||Sino-American Tianjin Smith Kline & French Laboratories Ltd||Ph||d m p r|
|India||Mumbai||GlaxoSmithKline Pharmaceuticals Limited||Ph||m p|
|Nabha||GlaxoSmithKline Consumer Healthcare Ltdiii||CH||m p|
Table 8. Continued.
|Malaysia||Petaling Jaya||GlaxoSmithKline Pharmaceutical Sdn Bhd||Ph||m|
|New Zealand||Auckland||GlaxoSmithKline NZ Limited||Ph,CH||m|
|Pakistan||Karachi||GlaxoSmithKline Pakistan Limited||Ph,CH||m p e|
|Philippines||Makati||GlaxoSmithKline Philippines Inc||Ph,CH||m|
|Singapore||Singapore||Singapore Glaxo Wellcome Manufacturing Pte Ltd||Ph||p|
|Singapore||GlaxoSmithKline Pte Ltd||Ph||m|
|South Korea||Seoul||GlaxoSmithKline Korea||Ph||m p|
|Taiwan||Taipei||Glaxo Wellcome Taiwan Limited||Ph||m p|
|Japan||Tokyo||GlaxoSmithKline K.K.||Ph,CH||d m p r|
|Argentina||Buenos Aires||GlaxoSmithKline Argentina S.A.||Ph,CH||m p|
|Brazil||Rio de Janeiro||GlaxoSmithKline Brasil Ltda||Ph,CH||m p|
|Colombia||Bogota||GlaxoSmithKline Colombia S.A.||Ph,CH||m|
|Mexico||Delegacion Talpan||GlaxoSmithKline Mexico S.A. de C.V.||Ph,CH||e m p s|
|Puerto Rico||Guaynabo||GlaxoSmithKline Puerto Rico Inc.||Ph||m|
|San Juan||SB Pharmco Puerto Rico Inc.||Ph||p|
|Venezuela||Caracas||GlaxoSmithKline Venezuela C.A.||Ph,CH||m|
|Middle East & Africa|
|Egypt||Cairo||GlaxoSmithKline S.A.E||Ph||m p|
|South Africa||Bryanston||GlaxoSmithKline South Africa (Pty) Ltd||Ph,CH||m p|
|Turkey||Istanbul||GlaxoSmithKline Ilaclari Sanayi ve Ticaret A.S.||Ph||m p|
|Source:||GlaxoSmithKline Annual Report, 2005|
IV. Multinational Corporation Currency Issues, Risk Management and Hedging
Most large pharmaceutical companies are multinational corporations. As a result, they collect revenues and pay expenses in a multitude of currencies against a multitude of exchange rates. As mentioned previously, for example, GlaxoSmithKline (GSK) has 100,000 employees operating on 116 countries. GSK is a British based company and must convert all currencies into British Pound Sterling (£) for accounting purposes and tax payments. Pfizer has 110,000 employees operating in 180 countries. Pfizer is U.S. based and must convert all currencies into dollars, even though they may pay employees and suppliers in other currencies.
This poses enormous accounting challenges in determining fair market value for services. Currency values are constantly changing with changes in the world economies. It creates a tremendous need for expertise in financial derivatives to constantly swap currencies, hedge against unanticipated foreign exchange (FX) rate fluctuations, and purchase currency forwards to minimize risks and manage cash flow. Small errors in management of currency risks can lead to millions (or even billions) of dollars in lost profits, annually. Tax and other revenue recognition and repatriation incentives by domestic governments also play an important role in managing profitability and maximizing shareholder value.
In addition, since material costs for plant construction and product manufacturing is often done in a multiple countries, similar currency issues are faced when purchasing building products, pharmaceutical product ingredients (supplies), packaging and other materials. The cost can vary significantly with changes in FX rates, tax law changes, and with the instability of certain governments/economies. All these risks require hedging and careful use of derivative financial instruments. These will be discussed in the following sections.
IV.A. Effects of World Economy Changes on Exchange Rates
Given the international nature of the pharmaceutical business, the world economy plays an important role in a pharmaceutical company’s financial planning, currency swaps, futures and supply hedging. While gross domestic products (GDP) growth in most major countries improved in the first part of 2005, higher oil prices then caused leading indicators to turn downward and business confidence to weaken. This causes currency fluctuations.
U.S. GDP growth slowed in the fourth quarter of 2005 to 3.5% compared with 4.2% in 2004, reflecting a slow down in consumer spending and in federal government spending. Since the U.S. is the largest and highest margin consumer market for pharmaceuticals, changes in U.S. GDP affects worldwide sales. During 2005, U.S. interest rates increased from 2.25% to 4.25%. This also affects sales as well as the cost of capital for new projects (R&D, building and acquisitions, etc).
In 2005, the British pound sterling hit its highest level against the dollar for more than four years, climbing to $1.92 at the year-end. In 2004, the Euro gained 1% against the sterling and 8% against the dollar. This was the second consecutive year that the dollar has fallen against the Euro, due to the impact of continued unrest in Iraq, tension elsewhere in the world and concerns for the U.S. economy (GlaxoSmithKline, 2005).
IV.B. The Effect of Global Political and Economic Conditions
In 2005, global expansion was led by the U.S. and China, where momentum was maintained in contrast to most other regions, excluding Japan and India. GDP growth in China again exceeded expectations at 9.9% and was also robust in India, where continued expansion in services such as information technology, manufacturing and pharmaceuticals remained strong. These are all important factors in projecting stock price. Also in 2005, global trade arrangements were made between the European Union (EU) and China and between the U.S. and China on textile imports. World Trade Organization (WTO) ministerial talks in Hong Kong at the end of the year made modest progress towards agreement on the reduction of trade barriers. The Japanese economy expanded strongly, with the GDP rising by 5.5%, supported by a strengthening labor market which saw full-time employment expand for the first time in seven years (GlaxoSmithKline, 2005).
Oil prices and higher commodity prices slowed growth in the 12 European nations and economic forecasts for the EU were downgraded during the year. With increased concerns about rising inflation, the European Central Bank raised interest rates by 0.25% to 2.25%, the first change in rates since June 2003. Weak domestic demand and the Euro’s lack of resilience to external events were features of the Euro zone in 2005.
In the United Kingdom, GDP growth of 1.8% was recorded, with a rate of around 2% predicted for 2006. The Bank of England cut interest rates in the middle of the year to 4.5% on the grounds that economic growth was subdued, but predicted growth would pick up in 2006, reflecting a recovery in domestic demand and foreign trade (GlaxoSmithKline 2005). All of these changes require constant currency risk management.
IV.C. Financial Instruments for Currency Risk Management
In most cases, multinational pharmaceutical companies rely on sustained cash flows generated from foreign sources to support long-term commitments to R&D. To the extent the value of cash flows is diminished as a result of currency fluctuations, the ability to fund research and other strategic initiatives at a consistent level may be impaired. Therefore, most MNCs have established revenue hedging and balance sheet risk management programs to protect against volatility of foreign currency cash flows. Their objective is to reduce the potential for longer-term unfavorable changes from foreign currency denominated sales, primarily the U.S. Dollar ($), British pound Sterling (￡), the Euro (€) and Japanese Yen (￥).
Table 9. Common Exchange Rates
|Period end rates:|
GlaxoSmithKline Annual Report, 2005 (9/24/06 spot rate is $1.90/£, 1.46 Euro/£ and 221.58 Y/£)
To achieve this objective, these companies partially hedge anticipated third-party sales that are expected to occur over their planning cycles. These cycles are typically no more than three years into the future. Companies then layer in hedges over time, increasing the portion of sales hedged as they get closer to the expected date of the transaction, such that it is probable that the hedged transaction will occur. The portion of sales hedged is generally based on assessments of cost-benefit profiles that consider natural offsetting exposures, revenue and exchange rate volatilities and correlations, and the cost of hedging instruments. The hedged anticipated sales are a specified component of a portfolio of similarly denominated foreign currency-based sales transactions, each of which responds to the hedged risk in the same manner.
Merck, for example, manages its anticipated transaction exposure principally with long positions in local currency put options, which provide the Company with a right to sell foreign currencies in the future at a predetermined price. If US$ strengthens relative to the currency of the hedged anticipated sales, total changes in the options’ cash flows fully offset the decline in the expected future US$ cash flows of the hedged foreign currency sales (Merck, 2005).
Conversely, if the US$ weakens, the options’ value reduces to zero, but the company benefits from the increase in the value of the anticipated foreign currency cash flows. While a weaker US$ would result in a net benefit, the market value of the Merck’s hedges would have declined. Because Merck principally uses purchased local currency put options, a uniform weakening of the US$ will yield the largest overall potential loss in the market value of these options (Merck, 2005).
In 2005, for example, the US$ strengthened by over 10% against the BP￡, rising to $1.72 at the year-end following two years of weakness. Both EU€ and JP￥ year-end rates weakened against BP￡ by just over 3%. One then has to account for rebates, discounts and allowances which are common in the U.S. third party payer system to determine actual financial performance and predict stock price and valuation.
IV.D. Derivative Instruments and Hedging
To deal with these constantly changing economic forces, the multinational pharmaceutical corporations must employ financial hedging techniques to avoid significant currency and material cost fluctuations and smooth earnings. Therefore, derivative financial instruments are used to manage exposure to market risks from treasury operations.
The principal derivative instruments used by multinationals are foreign currency swaps, interest rate swaps and currency forward contracts. Among the many 2005 annual reports of the major pharmaceutical companies, the best descriptions about their use and methodologies related to financial derivatives and hedging came from those from GlaxoSmithKline and Merck.
“Derivative financial instruments are initially recognized in the balance sheet at cost and then re-measured at subsequent reporting dates to fair value. Hedging derivatives are classified as fair value hedges, cash flow hedges or net investment hedges. Changes in the fair value of derivatives designated as fair value hedges are recorded in the income statement, with the changes in the fair value of the hedged asset or liability. Derivative instruments no longer designated as hedges are restated at market value and any future changes in value are taken directly to the income statement.
Changes in the fair value of derivatives designated as cash flow hedges are recognized in equity. Amounts deferred in equity are transferred to the income statement in line with the hedged forecast transaction. Hedges of net investments in foreign entities are accounted for in a similar way to cash flow hedges. Changes in the fair value of any derivative instruments that do not qualify for hedge accounting are recognized immediately in the income statement.
Currency swaps and forward exchange contracts are used to fix the value of the related asset or liability in the contract currency. They are fixed at the contract rate and are accrued to the profit and loss account over the life of the contract. Gains and losses on foreign exchange contracts designated as hedges of forecast foreign exchange transactions are deferred and included in the measurement of the related foreign currency transactions in the period they occur.
Gains and losses on balance sheet hedges are accrued and are taken directly to reserves except that forward premiums/discounts are recognized as interest over the life of the contracts. Interest differentials under interest swap agreements are recognized in the profit and loss account by adjustment of interest expense over the life of the agreement” (Merck 2005).
This description is fairly explanatory and detailed. While most of the other multinationals did not go into such extensive detail, one can surmise that they tend to follow similar procedures.
Cash Flow Hedges
For GlaxoSmithKline, cross currency swaps are designated as a cash flow hedge converting fixed EU€ coupons, payable annually, to fixed JP￥ payments. The risk being hedged is the variability of cash flows arising from currency fluctuations.
For Merck, the cash flows from these contracts are reported as operating activities in the Consolidated Statement of Cash Flows. The primary objective of the balance sheet risk management program is to protect the US$ value of foreign currency denominated net monetary assets from the effects of FX volatility during conversion to US$. Merck principally utilizes forward contracts. These contracts enable the company to buy and sell foreign currencies in the future at fixed exchange rates. They, therefore, offset the consequences of changes in FX on the amount of US$ cash flows derived from the net assets (Merck, 2005).
Fair Value Hedges
FX contracts, designated as fair value hedges, are typically used to hedge the foreign currency risk associated with inter-company loans and deposits, commercial paper borrowings and other liabilities. Interest rate swaps and the interest element of cross currency swaps are considered fair value hedges. The risk being hedged is the variability of the fair value of the bonds arising from interest rate fluctuations (GlaxoSmithKline, 2005).
Net Investment Hedges
FX contracts and the currency element of cross currency swaps are designated as net investment hedges in respect of the foreign currency translation risk. This risk may occur during consolidation of net investments in the US$, EU€ and JP￥. The following Table from GSK’s Annual Report is an example of how these hedging techniques are used to set out the principal amount and fair values of derivative contracts which qualify for hedge accounting treatment.
Table 10. Principal Amount and Fair Values of Derivative Contracts which Qualify for Hedge Accounting Treatment
|Contract or underlying principal amount||Fair value of derivative contract|
|Cash flow hedges:||2005 (£m)||2005 (£m)|
|Cross currency swaps||342||10|
|Fair value hedges:|
|Foreign exchange contracts||2,151||74|
|Interest rate swaps||1,848||(42)|
|Cross currency swaps||500||3|
|Net investment hedges:|
|Foreign exchange contracts||(6,816)||(57)|
|Cross currency swaps||500||51|
IV.E. Interest Rate Risk Management
In addition to the revenue hedging and balance sheet risk management programs, the multinational pharmaceutical companies may use interest rate swap contracts on certain investing and borrowing transactions to manage its net exposure to interest rate changes and to reduce its overall cost of borrowing. They try not to use leveraged swaps or leveraged investment activities that would put principal capital at risk.
Changes in medium- to long-term US$ interest rates have a more significant impact on the market value of fixed-rate borrowings, which generally have longer maturities. Sensitivity analyses to measure potential changes in the market value of the Company’s investments, debt and related swap contracts from a change in interest rates are generally performed. For Merck, for example, a sensitivity analysis indicated that a 1% increase in interest rates at December 31, 2005 and 2004 would have positively impacted the net aggregate market value of these instruments by $236.2 million and $75.4 million, respectively. Similarly, a 1% decrease at December 31, 2005 and 2004 would have negatively impacted the net aggregate market value by $283.6 million and $115.4 million, respectively.
In Merck’s case, the increased sensitivity is attributable to a change in the mix of investments from long-term fixed rate to short-term variable rate as of December 31, 2005. The fair value of the Company’s debt was determined using pricing models reflecting one percentage point shifts in the appropriate yield curves. The fair value of the Merck’s investments was determined using a combination of pricing and duration models (Merck 2005).
Investments comprise non-current equity investments which are available-for-sale. They are recorded at fair value at each balance sheet date. For investments traded in an active market, the fair value is determined by reference to the relevant stock exchange quoted bid price. For other investments, the fair value is estimated by reference to the current market value of similar instruments or by reference to the discounted cash flows of the underlying net assets.
Most companies hold a number of equity investments, frequently in entities with research collaborations. Equity investments are recorded as non-current assets unless they are expected to be sold within one year, in which case they are recorded as current assets. Non-current equity investments offer the opportunity for return through dividend income and fair value gains.
On disposal investments fair value movements are reclassified from reserves to the income statement based on average cost. The impairment losses can be recognized in the income statement for the year within other operating income, together with amounts recycled from the fair value reserve on recognition of the impairments. These impairments initially result from prolonged or significant declines in the fair value of the equity investments below acquisition cost, subsequent to which any further declines in fair value are immediately taken to the income statement (Merck, 2005).
IV.G. International Revenue Recognition
Revenues from sales of products are generally recognized when title and risk of loss passes to the customer. Revenues for domestic pharmaceutical sales are usually recognized at the time of shipment, while for many foreign subsidiaries, as well as for vaccine sales, revenues are recognized at the time of delivery. International revenue is recognized in the income statement when goods or services are supplied or made available to external customers against orders received and when title and risk of loss passes to the customer.
Recognition of revenue also requires reasonable assurance of collection of sales proceeds and completion of all performance obligations. Domestically, sales discounts are issued to customers as direct discounts at the point-of-sale or indirectly through an intermediary wholesale purchaser, known as charge-backs, or indirectly in the form of rebates. Additionally, pharmaceutical sales are generally made with a limited right of return under certain conditions. Revenues are recorded net of provisions for sales discounts and returns, which are established at the time of sale (GlaxoSmithKline, 2005; Merck, 2005).
Turnover represents net invoice value after the deduction of discounts and allowances given and accruals for estimated future rebates and returns, which vary by product arrangements and buying groups. These arrangements with purchasing organizations are dependent upon the submission of claims some time after the initial recognition of the sale.
As GlaxoSmithKline (2005) describes their method,
“accruals are made at the time of sale for the estimated rebates, discounts or allowances payable or returns. The methodology and assumptions used to estimate rebates and returns are monitored and adjusted regularly in the light of contractual and historical information and past experience. Turnover also includes co-promotion income where the company records its share of the revenue but no related cost of sales. Value added tax and other sales taxes are excluded from revenue. Because the amounts are estimated they may not fully reflect the final outcome, and the amounts are subject to change dependent upon, amongst other things, the types of buying group and product sales mix. The level of accrual is reviewed and adjusted quarterly in the light of historical experience of actual rebates, discounts or allowances given and returns made and any changes in arrangements. Future events could cause the assumptions on which the accruals are based to change, which could affect the future results of the company”
IV.H. Credit Risk, Rebates and Prompt Payment Discounts
With all the cash and large purchases/trade credits, wholesale discounts and other sales/accounting techniques used to enhance product manufacture and distribution, pharmaceutical companies are exposed to a concentration of credit risks. With respect to wholesalers, for example, if one or more of them is affected by financial difficulty, it could materially and adversely affect the company’s financial results.
Where significant investments are with a single counterparty, the pharmaceutical manufacturers try to mitigate the risk by requiring collateralization. Otherwise, credit-related loss exposures in the event of non-performance by counterparties can be significant. These companies tend to apply Board-approved limits to the amount of credit exposure to any one counterparty and employs strict minimum credit worthiness criteria as to the choice of counterparty.
Rebates and Prompt Payment Discounts
Customer rebates are offered to key managed care and group purchasing organizations and other direct and indirect customers. These arrangements require the customer to achieve certain performance targets relating to value of product purchased, formulary status or pre-determined market shares relative to competitors. The accrual for these rebates is estimated based on the specific terms in each agreement, historical experience and product growth rates.
Cash discounts are offered to customers to encourage prompt payment. These are accrued for at the time of invoicing and adjusted subsequently to reflect actual experience. Where there is historical experience of customer returns, companies tend to record an accrual for estimated sales returns by applying historical experience of customer returns to the amounts invoiced, together with market related information such as stock levels at wholesalers, anticipated price increases and competitor activity.
Tax is usually the biggest expense most companies face. These multinational pharmaceutical companies conduct a substantial portion of their operations outside of their domestic country. Hence, tax laws, accounting standards and fluctuations in FX rates materially affect financial results.
In general, these companies have no control over changes in inflation and interest rates, FX rates or other economic factors affecting its businesses or the possibility of political unrest, legal and regulatory changes or nationalization in jurisdictions in which they operate. The effective tax rate on earnings may be beneficial in countries with more favorable jurisdictions outside the home country. Changes in tax laws or in their application with respect to matters, such as transfer pricing and the risk of double corporate taxation in the U.S., could increase the effective tax rate and adversely affect financial results.
Transfer Pricing and Taxation
The integrated nature of these company’s worldwide operations, involving significant investment in research and strategic manufacture at a limited number of locations, with consequential cross-border supply routes into numerous end-markets, gives rise to complexity and delay in negotiations with revenue authorities as to the profits on which individual subsidiaries may be liable to tax. Disagreements with, and between, revenue authorities as to intra-company transactions, in particular the price at which goods should be transferred between subsidiaries in different tax jurisdictions, can produce conflicting claims from revenue authorities as to the profits to be taxed in individual territories.
Transfer pricing methodology must be used appropriately to make adequate provision for the liabilities likely to arise from open assessments. However, there may be a wide difference of views between the company, the IRS, and other relevant taxation authorities where open issues exist. The ultimate liability for such matters may vary from the amounts provided and is dependent upon the outcome of litigation proceedings and negotiations with the relevant tax authorities.
Repatriation of Earnings
The American Jobs Creation Act (AJCA), signed in October 2004, created temporary incentives through December 31, 2005 for U.S. multinationals to repatriate accumulated income earned outside of the United States as of December 31, 2002. In connection with the AJCA, the Merck, for example, repatriated $15.9 billion during 2005, Pfizer repatriated nearly $37 billion in foreign earnings to strengthen its balance sheet and invest in the business.
To enable execution of the AJCA repatriation, the Merck changed its mix of investments from long-term to short-term, resulting in a significant increase in working capital. In 2005, Merck invested approximately $5.2 billion of the AJCA repatriation invested in fully collateralized overnight repurchase agreements. These are included in short-term investments in the Consolidated Balance Sheet. During the first quarter of 2006, Merck then began reinvesting its repurchase agreement balances into other short- and long-term investments. This all helps company growth in the U.S.
IV.J. Other Risks
In the U.S. it has become increasingly common that following an adverse outcome in prosecution of patent infringement actions, the defendants and direct and indirect purchasers and other payers initiate anti-trust actions as well. Claims by direct and indirect purchasers and other payers are typically filed as class actions and the relief sought may include treble damages and restitution claims. Damages in adverse anti-trust verdicts are subject to automatic trebling in the U.S.
Merck’s litigation around Vioxx, for example, continues to unfold and will go on for years. As of December 31, 2004, the Company had established a reserve of $675 million solely for its future Vioxx legal defense costs. During 2005, the Company spent $285 million in the aggregate in Vioxx legal defense costs worldwide. In the fourth quarter of 2005, the Company recorded a charge of $295 million to increase the reserve solely for its future legal defense costs related to Vioxx to $685 million at December 31, 2005.
Sales, Marketing and Regulation
The pharmaceutical industry operates globally in complex legal and regulatory environments that often vary among jurisdictions. Failure to comply with applicable laws, rules and regulations in these jurisdictions may result in civil and criminal legal proceedings. In the U.S., for example, a number of the pharmaceutical are responding to federal and state governmental investigations into pricing, marketing and reimbursement of prescription drug products. These investigations could result in related restitution or civil false claims act litigation on behalf of the federal or state governments, as well as related proceedings by or on behalf of consumers and private payers. Such proceedings may result in trebling of damages awarded or fines in respect of each violation of law. Criminal proceedings may also be initiated against group companies or individuals.
Human Resource Issues
With a number of these companies having 100,000 employees or more around the world, they are subject to laws and regulations concerning its employees that vary significantly amongst countries and jurisdictions. These can range from discrimination and harassment to personal privacy and labor relations. Failure to continue to maintain a culture of compliance could have a significant adverse affect on the company.
There has been an increasing amount of focus on privacy issues around the world, including the United States and Europe. These governments have pursued legislative and regulatory initiatives regarding privacy, including federal privacy regulations and recently enacted state privacy laws concerning health and other personal information.
Infractions may require additional legal costs to defend and internal costs associated with developing and maintaining expensive compliance programs. These all add cost that affect a company’s operations. Although no one can predict the outcome of these legislative, regulatory and advocacy initiatives, most of the companies appear well-positioned to respond to the evolving health care environment and market forces.
These companies operate globally, primarily through subsidiaries established in the local markets. Due to the nature of their businesses and subsidiaries with patent protection on many products, they may compete largely on product efficacy rather than on price. Selling margins need to be sufficient in international currencies to exceed operating costs. Operating cash flow is generally used to fund investment in the R&D of new products as well as routine outflows of capital expenditure, tax, dividends and repayment of maturing debt. There may also be additional demands for finance, such as for share purchases and acquisitions.
In addition to the strong positive cash flow from normal trading activities, additional liquidity may need to be available via commercial paper and short term investments. In most cases, liquidity is required to fully fund R&D, focus on external alliances, support in-line products and maximize upcoming launches while providing significant cash returns to shareholders. For most of these companies, cash provided by operating activities is the primary source of funds to finance capital expenditures, treasury stock purchases and dividends paid to stockholders.
Multinational pharmaceutical companies have been the darlings of Wall Street for the past decade. They have consistently produced high returns on equity, paid dividends, and substantially contributed to domestic and international economies. One way or another, the products of these companies are sold or distributed in almost every country in the world and are designed to improve the health and well being of the populations they serve.
Through clever use of profits to maintain U.S. Congressional protectionism and keep margins excessively high in the U.S., the multinational pharmaceutical companies have used the U.S. insurance system to effectively subsidize the pharmaceutical needs of the rest of the world. Their claims regarding the need for such protection to foster R&D are obviously unfounded as more than twice the percentage of revenues produced is put towards marketing and sales than R&D. Even after exorbitant executive compensation packages and perks are paid, there is still more money used for administrative salaries and profit to shareholders than for research into new and innovative products.
The Me-Too drug strategy has paid off well in the past decade, especially for companies like Pfizer. However, this short term, profit oriented strategy is starting to catch up with management. With the FDA cracking down on Me-Too drugs without substantial new benefits, and increased scrutiny of new drugs through enhanced clinical trial requirements the pipelines of these multinationals are starting to dry up. This will affect stock price and ultimately executive compensation/shareholder value. Global efforts toward health care cost containment continue to exert pressure on product pricing and access.
As a result, the multinationals will have to look toward JVs, alliances, and acquisitions of smaller companies with new products or better technologies to bolster their future pipelines. The biotechs are a good target. With the Human Genome Project now complete, venture-funded biotech companies are racing to develop genetically reverse-engineered products that can more cost effectively design drugs to attack the needed, but less common human ailments. These may be those in the mental health area or the metabolic and genetically based “orphan” markets.
Venture funded nano-technology companies may also be good targets. In many cases, these companies are developing carbon molecule based compounds designed to attach to specific receptor sites on cancer cells. They may carry with them a lethal dose of a cancer killing agent that doesn’t affect normal cells. Alternatively, they may carry a specific metal ion that can be attached to a cancer cell and then heated via external gamma radiation until the cancer cell explodes. Most of these treatments do not involve the systemic nausea and other cell killing effects typical of today’s more generalized anti-cancer treatments.
As Higgins and Rodriguez (2006) demonstrate, alliances and JVs with target companies ultimately seem to result in better acquisition valuations. This improves shareholder value and should be fostered. Investors should look for these types of companies for higher returns.
Other changes are occurring as well. In the U.S., the Medicare Prescription Drug Improvement and Modernization Act of 2003, has prevented the Center for Medicare and Medicaid Services (formerly the Health and Human Services division) from using its $500 billion in annual purchasing power from driving U.S. pharmaceutical pricing down to its marginal cost – as other national health services have done. However, the same Act opened the door to allowing consumers to do this through the implementation of Health Savings Accounts. While not advertised much right now, the large financial institutions (banks and mutual funds) and the HMOs are starting to work together to bring consumers the tools to allow them to understand their disease entity and negotiate for the price of drug treatments. This will drive demand for generics over branded products and reduce margins significantly.
Since over $2 trillion is spent on health care annually in the U.S., this buyer power will eventually be unleashed upon excessively priced products. As a result, the “hay day” for most of these pharmaceutical companies will be over in the next decade. Investors need to be aware of this when looking at long term stock purchasing strategies. Pharmaceutical companies need to build or acquire generic manufacturers and look for biotech and nanotech companies to purchase.
Outside the United States, in difficult environments encumbered by government cost-containment actions, pharmaceutical companies will attempt to work in partnership with payers on allocating scarce resources to optimize health care outcomes. They will need to limit the potentially detrimental effects of government policies on sales growth and access to innovative medicines and vaccines, and support the discovery and development of innovative products to benefit patients. Governments in many emerging markets in Eastern Europe, Latin America and Asia welcome new investments in improving their citizens’ access to medicines and will often provide funding or tax incentives to foster these developments. The European Union (EU) countries are recognizing the economic importance of the research-based pharmaceutical industry and the value of innovative medicines to society. As a result, they are working with industry representatives and the European Commission on proposals to complete the single market in pharmaceuticals. This will improve the competitive climate through a variety of means including market deregulation.
Finally, the multinationals must be well aware of the competitive pressures that are coming in the generic market from India, China, and Great Britain. Russia, Turkey and Hungary also have enormous market potential as do third world countries such as Mexico, Iran and Iraq where oil money and favorable population banding will make these countries either large potential target markets, or eventually significant competitors.
While the pharmaceutical companies are looking for international profit protection, one of their most-persistent challenges is that of national health systems, such as the European Union, using their sole buyer status to pay artificially low prices for innovative treatments. “We believe that nations that can afford innovative medicines should pay their fair share for the research that went into their development” (Pfizer Annual Report, 2005). However, the opposite is likely to happen. In Europe, for example, where an aging population is stretching healthcare budgets, the governments are actively negotiating sole buyer programs that emphasize to minimize drug costs and focus prevention, early diagnosis and healthy lifestyles. At the same time, the pharmaceutical companies are urging governments to invest in innovation to help patients lead better lives and reduce the overall burden of disease to society. This ultimately leads to buying more pharmaceutical products as populations live longer. In many cases, though, this may be good, since pharmaceuticals tend to be more efficacious and considerably less costly to society than hospitalization.
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* Phone: 954) 701-9505
** E-mail address: email@example.com. Phone: 954) 262-5103. Fax: 954) 252-4455. (Contact author.)
 Teva, incidentally, recently purchased Miami-based IVAX, one of its largest U.S. competitors, for $7 billion. Some of that money has been donated by Phillip Frost to his Alma Mater, the University of Miami.