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)

Reckitt's Becht earns close to £100 million in 2009

Reckitt Benckiser (RB) Chief Executive, Bart Becht, earned £93m in 2009 making him one of the best paid business leaders in the world. Having grown earnings per share from 92p to 195p over the last few years it could be said that Becht deserves this payout which is largely a share based compensation package. However, is any CE really worth close to £100 million a year despite being credited with making Reckitt the P&G of Europe? At least Becht will donate three million Reckitt shares, worth £110 million, to his charitable trust.

SSL rises on Reckitt's takeover rumour

From today's Telegraph "On Tuesday, Royal Bank of Scotland told clients that last week they had an "interesting" meeting with Reckitt Benckiser's management. "There were a couple of off-the-cuff comments on 'attractive opportunities' that sounded interesting. Suffice to say, one brief comment was with regards to the condom business and how it would fit into their acquisition template," said the RBS salesman. He concluded: "The whole SSL/Scholl North America dynamic, the stumbling block last time around, has changed a bit and could make the takeout story more intriguing now." SSL gained 20½ to 841p."

SSL shares are up another 29p this morning to 871p. I am sceptical because SSL's Scholl brand is owned by Schering Plough in the U.S. under the Dr Scholl umbrella. Also RB will be reluctant to over pay. Assuming a takeover price of £10.00 and earnings per share of 35p in 2010 this puts it on a forward p/e of 29. Finally it would be surprising if RB would be able to accelerate the growth of Durex too much faster than SSL itself. The contrary argument is that cash rich Reckitt needs a big acquisition to fuel further earnings growth. Could be an interesting couple of days for RB and SSL but the likelihood is its yet another false rumour. Shorts placed between 875p and 880p this morning.

FIVE U.K. STOCKS WITH POTENTIAL FOR SHORTING

Contrarian Investor UK have been looking for stocks on the U.K. market which look overvalued and are candidates for a shorting strategy and here is my top 5 watch list. The FTSE All share is now up nearly 10% in the last month and 53% for the last 12 months and has tracked the move upwards on the U.S. Dow and S&P 500 (the S&P is up 10.5% in the last month). The strength in the overall market and generally bullish tone makes picking some overbought shares a tempting proposition as I feel that there is scope for a set back, albeit minor, in the next few weeks. Contrarian Investor UK uses Contracts for Difference (CFDs) through Igmarkets to enable stocks to be shorted i.e. with a hope that the price of a stock will go down in the future. However, spread betting using platforms such as IG index is also another easy potential online platform which allows buying as well as selling of individual shares and indices.

1. SSL International (SSL)
At £7.75 (52 week range £4.26- £7.89), health and personal care company, SSL trades on a price/earnings of 24 (based on earnings to year end March 2010) and a forward p/e for 2011 of 19 (based on earning of 40p per share in 2011). Garry Watts, its chief executive, has set a goal of increasing its earnings per share by 50pc over the three years to March 2012.

SSL's share price has been premium priced for years because of persistent rumours that Reckitt Benckiser will acquire the company to get its hands on its Durex and Scholl brands. But Reckitt's CEO Bart Becht is known for his prudence when its comes to acquisitions. Although Reckitt's paid a full price for both the Boots Healthcare International and Adams Therapeutics businesses, a takover of SSL for £9-10 would be difficult to justify given 1)it is unlikely that RB could accelerate the growth of SSL power brands too much faster given SSL has done a good job in delivering strong growth over the last 5 years 2) there is a portfolio of second line brands which were acquired during the 1990's particularly in Over the Counter (OTC) medicines which add significant complexity to the business and limited earnings e.g. Meltus, Cuprofen. Though these could be sold on, why pay a premium price for these brands? 3) SSL's organisation is relatively lean and therefore unlike the Boots acquisition, cost saving measures would not come as easily.

SSL has been busy beefing up its East European presence and now has strong growth prospects in Russia and other markets. It increased its presence in the Russian condom market by raising its stake in its BLBV joint venture in February. The company now generates about 85pc of its revenues from outside the UK. However, there are still significant risks in these markets as economic growth is still muted. The share price does not have the benefit of a good dividend, currently SSL yields 1.3%.

Although SSL's management has been doing a lot of the rights things over the last 5 years e.g. focusing growth on brands like Durex, emerging markets expansion, the high expectations for earnings growth in 2011 and 2011 and takeover rumours which justify the premium rating can easily fall apart if there is a glitch in any of its key markets. Investor's Chronicle featured SSL as a sell this week, and I agree with their assessment.

2. Reckitt Benckiser Group (RB.)
I have covered my reservations about healthcare and household company, Reckitt on a previous Contrarian Investor UK article published on Sunday 14th February (http://contrarianinvestoruk.blogspot.com/2010/02/reckitt-benckiser-certainly-not-good.html). At £35.11 (52 week range £24.96-35.45), the p/e is relatively undemanding at 18 and has a 2.9% dividend yield but my key concern remains the earnings impact of a generic competitor to opoid abuse drug, Subuxone in the U.S.. Suboxone accounts for 18% of group operating profits and around 10 percent of group profits. In the U.S. the drug accounts for half of the pharmaceutical divisions earnings and the North American operation represents two-thirds of total pharma sales.

3. ARM Holdings (ARM)
Chip designer, ARM (ARM or NASDAQ ARMH) currently trades at £2.27 (52 week range £0.98-2.32), rising from £1.95 over the last month alone as rumours have swirled around that Qualcomm (QCOM) is considering a bid. The company trades on a demanding 2010 p/e of 32.7 and 2011 of 27.5 as the company is seen to be geared to the huge growth in smart phone demand. The Cambridge-based firm had at least one of its chips in 90pc of all smartphones sold last year.

But directors have recently been selling the stock. For example, Tudor Brown (Chief Technical Officer and one of the founders) sold over £1 million of stock on March 9th. On March 11, RBS downgraded the stock despite the positive outllook for semiconductor stocks on valuation grounds and the Qualcomm rumours seem unlikely given competition concerns and a negative reaction from mobile manufacturers. Despite the positive fundamentals of the business, the share price seems to have gone a little over board and ARM therefore represents a good short at anything close to £2.30.

4. Rightmove 
Online estate agency, Rightmove (RMV) has had a tremendous share price move, rising from a low of £2.25 in March 2009 to its current £6.58, a rise of nearly 300% and not far from its 52 week high of £6.77. A renewed positive sentiment in the U.K. housing market has helped lift the shares and driven revenues back up as properties come onto the market for sale and hence Estate agents to use Rightmove as an advertising vehicle. It trades on a forward p/e of 19.7 and yields about 2%. Underlying operating profit for the 12 months to 31 December rose 2% to £41.9m on revenue down 6% to £69.4m. Pre-tax profit fell 1% to £37.8m from £38.2m.
Revenues for the second half of 2009 were 7% higher than in the first half and, by the end of 2009, monthly revenues had moved back toward their pre-crash peak. Costs were slashed by 17% to £27.5m as the company cut 16% of its admin staff during 2009. Broker Numis has upgraded full-year 2010 profit estimate to £52m from £50m and 2011 forecasts rise to £60m from £55m. Giving a 2011 forward p/e of around 16.

Of course these earnings estimates are dependent on a continued turn around in the U.K. housing market.The number of first-time buyers who expect to enter the housing market in 2010 has declined, which is concerning. The company's Q1 2010 Consumer Confidence Survey, which measures the public's property market views, revealed that the number of projected first-time buyers for the 12 months ahead has dropped for the third consecutive quarter. Only 26% of those who expect to buy in the next 12 months will be first-time buyers, a drop from 28% in Q4 2009 and 31% in Q3 2009. 

5. Astra Zeneca (AZN)
I have written about my negative stance on Astra Zeneca back in January (http://contrarianinvestoruk.blogspot.com/2010/01/astra-zeneca-azn-cheap-or-not.html) and my thoughts have not turned for the better after the failure of Recentin (cediranib) to reach its primary end point in the Horizon III clinical trial. Eight patents on drugs that represent 60 percent of Astra Zeneca's current sales are due to expire by 2016 and drugs like Recentin are desperately needed to fill the whole left by major patent losses on drugs such as Crestor and Pulmicort. Altough Astra trades on a forward p/e of only 7 and has a 5% dividend yield, patent expiries make earnings in 2011 and beyond hazy and the company has said as much. Heavyweight cost cutting is being done to try and stem the tide but success in the laboratory is needed and unfortunately Astra has been plagued by clinical trial failures on promising new molecules over the last 10 years. If AZN moves much beyond £30 (currently £29.22), this represents a good short opportunity and a move back towards its highs of £31 would make it an excellent shorting trade.

Reckitt Benckiser - certainly not a good time to rush into buying!

Background 
U.K. based Reckitt Benckiser (RB.) was formed from the merger of British company Reckitt and Colman and Dutch Benckiser in December 1999. Bart Becht became CEO of this new company and has been credited for its transformation, focusing on core brands and margin enhancement. He adopted a consumer marketing mindset and increased spend in advertising, focused investment on 17 global power brands (e.g. Finish, Airwick, Nurofen, Gaviscon) and product innovation. 40% of Reckitt Benckiser's 2007 revenues came from products launched within the previous three years. Although traditionally known as a household products company because of brands like dishwasher detergent, Finish, the company now has a relatively large over-the-counter (OTC) medicines business (including brands such as Lemsip, Gaviscon and Senokot) as well as a small, but profitable prescription pharmaceutical division.

In October 2005, Reckitt’s bought the OTC business of Boots Healthcare International (part of the Boots Group), for close to £2 billion, beating of competition from other companies such as GlaxoSmithkline and Novartis. Boots Healthcare International’s portfolio included some strong brands, notably the pain killer Nurofen, Strepsils sore throat lozenges; and the anti-acne brand Clearasil. In January 2008, the company acquired Adams Respiratory Therapeutics, Inc., a U.S. company, for $2.3bn: predominantly for its Mucinex cough business which the company now plans to expand beyond the U.S. where it has a significant share of the market.

Results
Since the formation of Reckitt Benckiser, the financial results delivered have been tremendous. Reckitt’s share’s have risen consistently since 1999 from around £4 to close to £34. Becht’s focus on delivering strong share holder returns have made him one of the best paid CEO’s in the World. The Boots OTC acquisition in 2005 proved to be a master stroke since the company has managed to drive significant growth in the core brands such as Nurofen through innovation e.g. Nurofen Express, cost cutting and a focus on superior marketing.

Reckitt Benckiser continued to deliver strong results last year with underlying sales for 2009 rising 8% year on year. Operating margins rose 1% point to 24.4%. However, the European business only delivered 1% growth to £867 million whilst emerging markets grew 19% to £388 million. The company has set targets in 2010 for net revenue growth of 5% and for operating profit growth of 10%. The company had net cash of £220 million.

Bear Points
Generic competition for Suboxone
In 2009, Reckitt Benckiser's pharmaceutical business grew 66% to £194 million but Becht declined to give 2010 guidance for the division at last week's results due to the uncertain timing of generic competition for its high growth Suboxone (buprenorphine and naloxone) heroin substitute in the US. The product lost “orphan drug” protection in the U.S. in October 2009, although it has recently gained protection in Europe for another 6 years.. In Europe sales are driven by Subutex (buprenorphine) a similar product but lacking the overdose protection of Suboxone. Suboxone in the US now accounts for 18% of group operating profits and around 10 percent of group profits. In the U.S. the drug accounts for half of the pharmaceutical divisions earnings and the North American operation represents two-thirds of total pharma sales.

If a generic version of Suboxone launches in the U.S. sales are expected to decline 80-90% as pricing pressure intensifies. A generic version of Subutex was launched in October 2009 in the U.S. by Roxane (part of Boehringer pharmaceuticals) but this has had relatively limited impact because Suboxone constitutes the majority of U.S. sales currently. The threat of generic Subuxone remains a significant driver of Reckitt’s earnings uncertainty in 2010. To date there has been no application to the Food and Drug Administration (FDA) for a generic copy and the indication for the drug is relatively niche for many generics companies to get involved with. In addition, Reckitt’s may decide to strike a deal with a generic manufacturer to exclusively licence the drug,keeping others competitors at bay for up to a year and holding up prices. The if and when of generic competition remain the $64,000 questions for the company. If generics can be held off then the highly profitable Suboxone business can be kept afloat. The fact that pharmaceuticals account for 10% of group earnings should not be underestimated if generic Suboxone becomes an unwelcome reality for Reckitt Benckiser. It should be noted that other similar companies in the consumer good sector do not have this uncertainty to contend with since they do not have this prescription market exposure.

Retail environment and private label 
The global recession of the last 18 months has tempted consumers to buy cheaper private or own label products as finances have been stretched in many households. Up to this recession there was an intrinsic fear for many shoppers of being seen with cheaper “copies” in their shopping trolleys but the allure of expensive retail brands seem to have diminished and it is not expected that this trend will reverse as private label has shown strong growth. Supermarkets such as Tesco in the U.K. and Walmart in the U.S. have worked hard to improve the quality of their own offerings. A trend in consumers trading down to cheaper products is likely to curtail the growth of Reckitt’s products and this was certainly seen in Europe in 2009 where growth was limited despite significant product innovation.


Pressure from retailers to increase their margins is also intensifying. Large mass market retailers are "encouraging" further investment in in-store brand support or squeezing additional trade margin out of suppliers. Although Reckitt's has strong brands and the customer infrastructure to resist these pressures, maintaining margin is increasingly difficult if the competition decide to capitulate to these demands.

Reducing scope for cost cutting
Reckitt’s “Project Squeeze” to drive gross margin on its product has been effective in driving profitability over the last decade. However the scope for further margin improvement seems unlikely given pressures on raw material costs and the evaporation of further savings from the integration of both Adams and Boots Healthcare International.

Likelihood of acquisition
Reckitt’s healthy cash position and decelerating growth in developed markets makes an acqisition for the company more likely than ever. The company has publicly stated it has an appetite to build its presence in healthcare. However, obvious candidates apart from UK based SSL International (owners of Scholl and Durex) are thin on the ground, particularly in the over-the-counter market. An acquisition of SSL is likely to be expensive and therefore it is felt unlikely to be a target, especially as it has a fragmented portfolio of many brands acquired during the 1990’s. Other targets in the healthcare space are owned by multinationals such as Novartis, J&J and GSK who have not announced intentions to divest assets. A consumer products or household company may be an easier buy but again assets for sale will be premium priced. Given the growth outlook, it seems likely that Reckitt’s will acquire but perhaps at an unpalatable price for investors.

Bull points
Reckitt Benckiser remains a well run company with senior management objectives aligned behind investor’s objectives – namely strong earnings per share growth over the short and long term. Its focus on investing heavily behind their core brands have paid dividends and the emerging markets remain a significant target for future growth. It has a culture of innovation and differentiation and this remains core to the company’s future momentum. The company has a strong balance sheet, cash flow generation and has yield of around 3% which is likely to increase.

The forward price/earnings of Reckitt’s is undemanding at around 16 times 2010 earnings. This is in line with competitors like Procter and Gamble and Unilever.

Summary
Following the 2009 results, several analysts upgraded Reckitt Benckiser and the consensus amongst brokers is either buy or strong buy. Thus expectations are high for continued delivery of strong growth. For Contrarian Investor this gives an opportunity since when expectations are so consistently high, any slip up at all by the company will hit the shares hard. The entry of a generic competitor to Subuxone in the U.S. potentially gives the catalyst for a downward re-rating of this share. At £33.13, there may be still some upward momentum to go if the markets continue to rally especially given the undemanding rating assuming that generic Suboxone competition does not hit in 2010 . However, a short position looks tempting if the shares move beyond £35 in the near future. Watching and waiting for an opportunity to take advantage of a fall. Reckitt Benckiser is an extremely well run business but the environment in which it is operating is getting tougher and the company's healthcare exposure gives it access to a high margin market but with it regulatory and generic risks.