Pharma – Does It Earn Excessive Returns?

The discussion in yesterday’s blog reminded me of an over-lunch debate between Terry Sullivan, Bloodhound’s CEO, and myself regarding the U.S. pharmaceutical industry.

Terry’s belief is based in fact similar to that of the Zero Hedge author of yesterday’s post. His thesis is that the drug companies hold the U.S. taxpayers hostage with their lobbying efforts and in turn gouge the U.S. consumer with inflated prices. Medicare is handcuffed and could solve a large portion of the problem by negotiating volume discounts. Much of his basis rests on the fact that the same drugs sold here are sold elsewhere in the world at a massive discount. As an example, he notes the availability of cheap drugs in Canada, and believes price parity could be achieved by allowing the re-importation of branded drugs back into the United States.

In my investing days, I covered a number of biotech and early-stage pharmaceutical companies. I saw the dollars thrown into drug development and their low aggregate ROIs first hand. As seen in the chart by the site FDAreview.org, the lifespan of drug development is a 7- to 13-year FDA review process after the drug has gone through as many as six years of early clinical trials.

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Take note that the cumulative probability of successfully developing a drug into an approvable process is only 8%. In other words, for every drug that makes it to market, there are 12 others that failed to get there. Six out of ten don’t get to the Investigational NDA stage at all. Additionally, the product brought to market has a limited shelf life (the period protected by patent) to earn a proper return. Unlike Kleenex, which faces generic competition but carries a first-to-market brand reputation, a branded drug’s profits are mostly wiped out when other companies have the ability to copy the formula and produce a generic.

My belief is that the problem isn’t that the U.S. industry gouges citizens on drug costs, but rather the rest of the world free rides off our development initiatives. Canada, as an example, produces almost no major pharma products – they import them. However, since Canada has price controls, those imports are sold at less MSPR than here.

Why do the drug companies allow it? Like an economy seat on an airplane, the companies make incremental revenue albeit at a lesser profit from Canada and elsewhere. However, the benefit from the allowance of Canadian re-importation is a fallacy. Drug companies will just stop selling to Canada. Sales to Canada are a rounding error for them. You can’t re-import enough Canadian drugs today to service beyond the marginal internet buyer. If the U.S. allowed Canadian pharmacies to sell directly to the US, they would stop getting the drug – because there is too much money at stake.

Europe’s dynamic is not materially different. This 2004 Economist article does a good job at explaining the free ridership issue of European drug companies. Although many worldwide entities are now based in Europe, much of their drug development is done here through U.S. subsidiaries.

American drug firms spend two times the amount of R&D that Europeans do (and I don’t know if that even counts U.S. subs of European entities) – a complete reversal from a few years ago when Europe once produced double the amount of new compounds of the U.S. I can’t even recall the last blockbuster drug that was developed in Europe and then sought approval here.

So, who is right? As in most cases, the likely answer is probably somewhere in the middle. We went to the data. Since Bloodhound has a database of over 26+ years of fundamental data on every company, we are able to analyze the aggregate profits on the pharmaceutical companies with no survivorship bias. Our point-in-time database includes companies that are no longer listed including all the biotech companies that either failed or were acquired by larger entities. GAAP accounting rules prohibit the capitalization of drug development costs but allow firms to capitalize acquired development costs, so net profits are a true reflection of the investment in the industry. We analyzed the cumulative profits of four SIC codes:

• Medicinal Chemicals and Botanical Products (2833),
• Pharmaceutical Preparations (2834),
• In-vitro and In-vivo Diagnostic Substances (2835), and
• Biological Products except Diagnostic Substances (2836).

In total, the four combined sub-industries generated $865 billion in profits between 1987 and 2011, and in that time, profits have grown at a compound annual rate of 10.8%. Additionally, it should be noted that more than 50% of those total profits were generated by four companies – Pfizer (PFE), Merck (MRK), Glaxo Smith Kline (GSK) and Novartis (NVS), and almost 65% when the profits of those with which they eventually merged. Those are the winners. However, during that period, 15 companies lost over $1 billion each, and almost 300 companies lost more than $100 million since 1987. Including the super-giants, only 89 companies made at least $100 million cumulatively.

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Why is there such a proclivity toward losses? Our database has no survivorship bias in a technical sense, yet there is a bias of survivorship in the industry. Although there are numerous development companies that try and fail, there are many companies that never reached profitability, but did valuable work. Their eventual gain comes not from future profits, but the ability to sell themselves. The largest pharmaceutical companies have a finite R&D capacity. They have finite investment dollars, finite set of scientists, and finite share of mind. As such, the big ones acquire companies that have already developed promising drug candidates. Those losses essentially act as bulk R&D payments. Investor X, you bore the losses for N years, now Eli Lilly (LLY) will (hopefully for Investor X) pay you for those losses plus a rate of return.

Disparity amongst the SIC groups demonstrates a lot about the profitability of the industry as a whole. Among the Biological Products group, they generated an aggregate profit of $19 billion. However, excluding one giant, Amgen (AMGN), the group lost $18.4 billion. Similarly, the Diagnostic Substances group lost an aggregate of $5 billion. The Medicinal Chemicals group made $5 billion, but $4.5 billion of that profit was generated by one company, Biogen (BIIB). With the exception of the two named entities, the other 247 companies in those three groups are or were essentially development arms for the industry as a whole.

The largest and most obvious pharma category is the Pharmaceutical Preparations SIC with a total of 539 companies spanning those 26 years. In that period, less than 21% were profitable, and 296 of those companies no longer trade. The numbers aren’t much better for just the last fully reportable fiscal year. In 2011, there were 243 companies covered under that SIC code, and only 28% of them were profitable, and 100% of the profits were generated at the top 12 firms.

The players may change over the years, but the group has shown considerable consistency. Whether it be 1990, 1998, or 2011, approximately one third of the companies are profitable, and roughly two thirds of the profits are generated by the largest five companies. Based on such consistency, it would validate that smaller companies have been development ventures for the industry by design.

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Does that design work? Working on the very broad assumption that the rest of the industry is designed to benefit the largest 10-20 conglomerates, we can evaluate the returns of the industry as a whole. We isolated the most recent year and aggregated the equity of the ten largest pharmaceutical companies as our denominator. As the numerator, we take the aggregate profits of the industry. The result equates to a return on equity of 17.8%. Expanding the universe to further oligopoly, the ROE using the shared equity of the top 20 would be approximately 16%.

In comparison, for most of the last hundred years, S&P 500 companies average between 10 to 15% ROEs, running in excess of 20% during the 1990’s. In today’s environment, the current P/E ratio of the S&P is slightly under 18x. The price to earnings ratio can mathematically be rewritten into P/B divided by ROE. Book value per share of the S&P at September 30, 2013 was $661.93. At a level of 1550, the S&P’s resulting P/B is 2.34x. Therefore, the combined ROE of the 500 companies in the index is currently 13%.

Consequently, one could suggest that the pharmaceutical business is receiving an above average return on their equity investment. 16% is certainly a fair, if not generous return. However, it hardly seems egregious or monopolistic. It appears relatively fair for a highly development enterprise with exposure to large tail risks including wide litigation exposure and government intervention. I don’t hear anyone complaining about Apple’s (AAPL) 35% ROE.

Looking at one individual company can get complicated given the wide spread acquisition activity. However, Pfizer holds the title for largest cumulative profit for the group. Pfizer’s ROE has fluctuated over the last 26 years. Much like the S&P, it rose significantly in the late 1990s, peaking in the years after it acquired Warner Lambert in 2000. However, since the integration of its $60 billion stock-for-stock acquisition of Pharmacia in 2003, Pfizer has seen a consistent decline in ROE despite significant stock repurchases between 2003 and 2007.

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In spite of its acquisition of competitors Wyeth and King Pharmaceuticals (or a consequence of it) and increasing leverage, Pfizer’s ROE of the last three years (plus the last 12 months) are the three lowest in at least 1973. At 11.8% in 2011, it would be hard to accuse the giant of gouging anyone, but that’s just my opinion.

Although $2.6 billion over 13 years in lobbying fees is a great stirring headline (even though it’s half the amount of the actual headline), it is a drop in the bucket of pharmaceutical profits which totaled over $700 billion during that same horizon. Although not perfectly cut and dry, I think the data suggests that the pharmaceutical industry is earning a elevated, but fair return on its equity. Since I’m the one writing the article, I also get to be the judge on the discussion. Prices of drugs around the world will always be a hot topic. However, if the U.S. were to attempt to rig the system to join in on the free-ride enjoyed by the rest of the world, the ride would not be free, but rather over.

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