As the curtain rises on the drug industry's latest act, the
scene is ominous. Executives must choose a strategic course in the
face of shifting industry economics. This will not be easy.
Revenues are declining as the blockbuster drugs that have driven
growth reach the end of their life-cycles, and R&D departments
haven't produced enough new products to replace the fading
blockbusters. When new drugs do make it out of the clinic, they
face increasingly stringent regulatory review. All this threatens
to permanently erode profits.
For pharma executives, the question is, do they continue to
invest heavily in research despite the recent slump in
productivity? If so, should they reinvigorate their internal
research departments, or do they pursue acquisitions and
partnerships?
The first of the two prior acts, which began in the mid-1990s,
was a happy one. A wave of products to treat conditions such as
depression, high cholesterol and schizophrenia hit the market. They
were cheap to make, easy to market and most importantly, largely
maintenance medications - consumers took them every day, for
life.
Between the end of 1994 and the end of 2000, the Dow Jones World
Pharmaceutical index rose almost 2.5 times, trouncing the S&P
500 index, which rose 1.9 times.
The second act was gloomy. Eli Lilly's (LLY) Prozac and
Schering-Plough's (SGP) Claritin lost exclusivity in the early
2000s, and investor attention turned to the even bigger patent
expirations on the horizon: Lipitor, Zyprexa, Plavix, Diovan and
their peers would not live forever. It became apparent that by the
middle of the new century's second decade, the party would be
over.
Things got worse. Safety issues, notably with Merck's (MRK)
Vioxx and GlaxoSmithKline's (GSK) Avandia, led to product
withdrawals or sales declines. Companies spent billions developing
drugs, like Sanofi-Aventis's (SNY) obesity treatment rimonabant,
which U.S. regulators refused to approve because of side
effects.
The generic-drug manufacturers smelled blood and began
aggressively challenging patents. Merck's multi-billion-dollar drug
Fosamax, for example, lost years of patent protection when the U.S.
drug giant lost a court decision to Israel's Teva Pharmaceutical
(TEVA) in 2005. As the curtain fell on the second act, a new U.S.
administration signaled its determination to cut health-care
costs.
With the Pharma index down by nearly half from its peak, what
direction must the industry take in the third act? At least one
option should be discarded at the outset: diversification.
In discussing the acquisition of Wyeth (WYE), Pfizer (PFE) CEO
Jeff Kindler emphasized how the tie-up would create a leader not
only in pharma-biotech, but also animal health, consumer health and
nutritionals. Similarly, Merck CEO Richard Clark noted that the
Schering-Plough acquisition brings with it leading nutritionals and
animal-health businesses.
Part of the appeal for diversifying in this way may be that
stocks of diversified firms, such as Johnson & Johnson (JNJ),
have shown more resilience in the recent downturn than pure-play
pharmas. Rightly or wrongly, consistent and predictable earnings
get a premium during a crisis.
But investors can diversify by simply buying stocks from
different sectors or owning exchange-traded funds. There's little
need for diversification within a single company. What investors
need instead are companies with competitive advantages, adequate
capitalization and the ability to execute.
To be sure, diversification makes sense for companies with
assets that can be leveraged, at low incremental cost, into new
product lines. This is true for small-molecule pharmaceuticals and
biologic drugs or generics, where there is overlap in scientific,
marketing and regulatory expertise. But medical devices?
Over-the-counter remedies? Baby food? It is hard to see what these
provide besides smooth cash flows.
Pharma executives and their advisors in the capital markets
should understand: diversifying into areas where there is not true
operational leverage with the drug business is nothing but taking
cash generated by the drugs and investing in an unrelated area. If
that is the best available course, return the capital to investors
and let them make their own reinvestment choices.
One Big Pharma chief executive grasps this point: Bristol-Myers
Squibb (BMY) CEO James Cornelius.
"We couldn't be a mini-J&J" he was quoted as saying in The
Wall Street Journal.
He's right. Bristol has recently sold or spun off several
non-drug businesses. It sold its medical-imaging business in
December 2007 for $525 million to Avista Capital Partners. Its
wound care business went to Avista and Nordic Capital in August of
2008, for $4.1 billion. Most recently, it spun off 17% of its Mead
Johnson (MJN) infant nutritionals business in a stock offering that
raised nearly $800 million.
The company now has a $1.5 billion net cash position, before the
proceeds of the Mead Johnson spin-off, and plans to pursue a
strategy of acquisitions and partnerships to rebuild its pipeline.
There is no shortage of places for them to invest - there are
roughly 500 pharma and biotech firms with market values under a
billion dollars, not to mention all the privately held companies
across the world. The economic climate will make many of these
eager for a partner with deep pockets.
Bristol is building a drug company that focuses on selling
drugs. Perhaps that is why the stock has outperformed most of its
peers over the last year.
This is not to say the drugs that Bristol purchases will
ultimately succeed. Science, which will play a decisive role, is
impossible to predict. And it may be that those companies that
invest internally will be more productive than those that acquire
and partner. But at least Cornelius is not hiding from the
long-term issues the industry faces.
(Robert Armstrong is a senior columnist with Dow Jones
Newswires. He can be reached at 201-938-2319 or by email at
robert.armstrong@dowjones.com. Dow Jones Newswires is enhancing its
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