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February 6, 2011 5:14 pm
The announcement last week that the US drug company Pfizer is to shut its UK research centre provoked much soul-searching, to do with the alleged death of British science and so forth. The real message is rather different, though not necessarily more cheerful.
Big pharma is a shrinking business. The clearest evidence for this is the continuing wave of mergers among drug companies worldwide. That is what shrinking industries do: think of UK textiles after the second world war, or global brewing in the past two decades.
Pfizer has led the consolidation, having become the world’s biggest drug company by swallowing up Warner Lambert, Pharmacia, Wyeth and others. In the decade 2000-2010, it spent some $230bn on acquisitions. The result is a business with a market value today of $154bn.
One obvious reason for the industry’s contraction is the failure of its old hugely expensive research and development model to come up with the goods.
This is not the place to discuss the reasons. But note that Pfizer, which expects group sales to fall about 5 per cent in the course of the next two years, also plans to cut worldwide R&D by about 30 per cent in the period.
Another reason may be less obvious. For decades, the global pharmaceutical industry focused its attention on the US market – not just because it was the world’s biggest, but because the margins were higher than anywhere else.
That was always a doubtful proposition. Americans are not known for paying more than other people; compare the prices of most goods and services in the US and Europe. Relying on the US paying over the odds for medicines was not a sustainable strategy.
And so it has proved. The combination of US healthcare reform and the march of generic competition – itself the direct result of the R&D failure – has had dire results for the industry.
Consider the case of UK-based GlaxoSmithKline (GSK). In 2006, the company had slightly more than half its sales of prescription drugs in the US and rather more of its profit. But since then its US sales have fallen by more than a quarter.
Meanwhile, its sales to emerging markets have doubled. As a result, they are almost half the size of its US sales, compared with less than a fifth in 2006.
That might seem a benign case of evolution – the new world coming to the rescue of the old. The snag lies in the margins.
GSK’s emerging world margins have been rising as US margins have dropped. But in the year just finished, they were still only 36 per cent (before R&D costs), compared with the US figure of 66 per cent.
We must not exaggerate all this. The decline of big pharma is a slow process, and would be much less noticeable were it not in stark contrast with the explosive growth of 20 years ago.
The more interesting question is how the industry evolves from here. Consolidation will no doubt continue, in the usual way. And then there is the question of R&D.
Pfizer is thus far unusual in the scale of its planned cuts. GSK and Merck, both of which reported full-year earnings last week, are more cautious.
But the sums on the table are still enormous. Pfizer spent $9.4bn last year – 13.9 per cent of sales – and GSK £4.0bn, or 14.0 per cent. In Pfizer’s case, this represented a drop from earlier peaks – 16.7 per cent in 2003, for instance – while GSK is in the middle of its long-run range.
The scope for cuts should not be exaggerated, though. A large chunk of R&D cost is that of drug development – the essential task of formulating and testing drugs in order to satisfy regulators on their safety and efficacy.
But the assumption is that drug companies will throw off more cash. Pfizer has bumped up its stock buy-back programme by $5bn and GSK plans to buy £1bn-£2bn worth this year while raising its dividend by 7 per cent.
The equity markets have, of course, been alive to this trend for some time. Both companies yield about twice the average for their respective markets – GSK 5.5 per cent, Pfizer 3.9 per cent.
Meanwhile, both stocks have done wretchedly over the past decade – GSK underperforming its domestic market by more than 40 per cent and Pfizer by over 50 per cent.
Just the thing for the contrarian investor, in fact. Drug companies look like what Benjamin Graham called “cigar butt” stocks – thrown away, but still with a puff in them.
As for UK politicians and commentators, less hand-wringing is called for. Certainly, we need a strong scientific base. But big pharma R&D looks increasingly like yesterday’s place to find it.
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