Is the big pharma drug model broken for good?

Is the traditional "big pharma"pharmaceutical company model broken? Certainly in terms of shareholder returns excluding dividends, their share price performance has been woeful. 

GlaxoSmithkline (GSK) (formed from the merger of Glaxo Wellcome of the U.K. and Smithkline Beecham of the U.S. in 2000) has seen its share price fall from around £21 at its inception to its current £11.43 (a decline of 46%).  U.S. giant Pfizer (PFE) which has been on an acquisition spree over the last 10 years or so with the purchase of Warner Lambert in 2000, Pharmacia in 2003 and more recently Wyeth in 2009 has also had a torrid time. Prior to the acquisition of the Warner Lambert business (owner of the cholesterol blockbuster Lipitor (atorvastatin) in 2000 its shares were over $46, they now stand at $18.15 ( a decline of 61%). Astra Zeneca (AZN) (formed from the merger of U.K. Zeneca and Sweden's Astra in 1999) has seen its shares oscillate between £29 and £35 for the last decade, and they now sell for £30.42, £5 less than in 2001.

AstraZeneca illustrates the problems faced by the big pharmaceutical players which have been formed from the merger of smaller players over the last 20 years. AZN is feeling the pain of generic competition as patents expire on some of its key drugs. Despite heavy R&D investment and acquisitions (e.g. MedImmune in 2007 for $15 billion), numerous failures in clinical trials have meant the company is increasingly reliant on some big bets in late stage clinical trials or regulatory approvals. Unfortunately the U.S. drug regulator, the FDA (the Food and Drug Administration), is becoming increasingly demanding of drug applications. Astra's anti clot drug, Brillianta, has been held up as the FDA has requested additional analysis of data.

Astra's 2010 revenue was flat at $33.6 billion and earnings per share (EPS) rose by 5% to $6.71 driven by cost cutting. But Quarter four revenue was down 3%. Growth in emerging markets is helping to offset patent expiry issues in the short term but there is more to come and cost cutting in areas such as sales has helped to drive profitability. To keep shareholders happy, the company increased the dividend by 11%,
and having bought back $2.2 billion of its shares in 2010 the company is targeting $4bn of share repurchases in 2011 to help drive the earnings per share growth into positive territory.

Pfizer has not had much better luck. Its acquisition of Pharmacia UpJohn (formed from the merger of U.S. Upjohn and Swedish Pharmacia in 1995) for $60 billion in an all share deal went badly wrong when two of its key blockbuster arthritis drugs called COX2 inhibitors were found to be associated with potentially serious side effects relating to increaed risk of heart attack and stroke. After an FDA review in 2005, Celebrex (celecoxib) had its labelling amended and second generation COX2 Bextra (valdecoxib) was withdrawn from sale. Bextra sales were expected to be in excess of $2 billon per year. In mid 2006, Pfizer made the decision to increase its reliance on the riskier prescription pharmaceutical business by selling its over-the-counter medicine business (including Listerine, Benylin, Sudafed) to Johnson & Johnson (McNeil). On a positive note it achieved a good price of $16 billion compared with sales of $3.7 billion as it was the one of the last crown jewel over-the-counter global businesses. J&J triumphed against other bidders such as GSK, Novartis and Reckitt Benckiser. The purchase (merger) with fellow U.S group, Wyeth (formerly American Home products which was due to merge with Warner Lambert in 2000 before Pfizer acquired Warner Lambert) is seen predominantly as a cost saving marriage, although Wyeth's vaccine and consumer health business help to diversify the group back from traditional prescription products.

Investors in pharmaceuticals have traditionally been income seeking through the high dividend yields they offer e.g. Astra 5.5%, Pfizer 4.3%, GSK 5.8%. As has been illustrated by the commentary, capital growth has certainly not been delivered. The series of mega-mergers has clearly failed to deliver shareholder value despite all the promises of increased R&D productivity and cost cutting. Tougher regulation and increasing R&D costs have not helped the sector as has increased pressure from ever more nimble generics companies e.g. Teva, Sandoz (owned by Swiss Pharma Novartis). Despite spending more and more on research, pipelines look anaemic. 

Part of the reason for the R&D problems is that centralisation has stifled creativity and innovation. Also easier molecular drug targets have been found and exploited. Biotechnology looks more fruitful but this is not without its problems and traditional pharmaceuticals companies have had to resort to takeovers to exploit this area in general e.g. Roche's takeover of Genentech in 2009. Although science continues to advance at an incredible pace, for example, the Human Genome project (HGP) was completed in 2003 after 13 years of work, the profit potential of these developments has yet to be truly felt by the pharmaceutical companies. New areas of science are themselves beset with issues such as how to test these new molecules on human subjects, particularly those that change the human gene to prevent or cure disease such as cancer. No doubt these problems and challenges will be solved but they will take time, maybe even decades before we see biological drugs which can prevent an at risk individual contracting a certain disease. If it could be cracked, the profit potential is incredible.

Big pharma needs to change to really deliver shareholder value. Forget the mega mergers (which have destroyed value in most cases). Companies like Novartis and GSK are ahead of the game with derisking their prescription businesses by moving into emerging markets, developing generic or over the counter divisions i.e. diversification. But even they are not going far enough. Development of a true biotechnology focus seems key in the new world. Reorganising R&D to drive true innovation rather than me-too's is also vital. I wonder how many CEO's in big pharma would be around if they were measured and remunerated on earnings per share growth (excluding share buy backs)? It is interesting that if you compare shareholder returns for an industry at polar opposite end of the spectrum such as tobacco but with similar high dividend yields, the differentials are astonishing. For example, British American Tobacco (BAT) has grown its share price from £3 to £23 since 2000. Household products company, Reckitt Benckiser (RB.) has grown its price from £8 in 2000 to £34. Enough said.

(NB. Historical earnings per share is not available but share price is used for illustrative purposes)