14th September 2012
The pharmaceutical sector has endured a torrid decade across several fronts – patent expirations, anaemic pipelines, pricing and political pressure. The sector enjoyed great success in the last two decades of the twentieth century, when burgeoning pipelines were bringing blockbuster drugs to the market with remarkable frequency, at 90%+ margins. Drugs like Prozac and Viagra have come to define an era, when cash flows generated by the sector in the 1990s, in particular, rivalled the tobacco sector.
During the first decade of the current century, the sector has been largely unloved and frequently ignored, no longer seen as a growth sector, with many rushing to write its obituary. These years led so called "big pharma" to turn to M&A to protect market share and prop up the diminishing R&D returns – $500bn spent since 1980 on 50 deals. Several household names – American Home Products, Hoechst, Pharmacia, Beecham, Warner-Lambert – disappeared during this time, when company management spent hundreds of billions on buying up rivals at inflated prices, further compounded by overpaying for early stage biotech assets, which often added little or nothing to the bottom line in the long run. The top 10 companies account for nearly 50% of the global pharmaceutical market.
The sector has become more in vogue during the financial crisis, with its defensive characteristics coming to the fore. The larger players have maintained healthy balance sheets, with little leverage, high cash generation, and a growing dividend stream, all of which is being offered on a relatively cheap valuation. The long term drivers augur well for the sector, with an increasing and ageing population, underpinned by a burgeoning middle class in emerging markets who are developing lifestyle disorders such as obesity, diabetes and cardiac diseases.
The re-rating of the sector has produced clear geographical winners and losers, with the US large cap players outperforming over the past three years. However, looking ahead, the European large cap companies are better positioned. They have a smaller patent cliff, greater revenue diversification via consumer, healthcare and biotech assets, and a larger presence in emerging markets. This bias plays out in terms of sales and margin growth. In terms of valuation, European large cap companies are on average cheaper, offering a higher level of dividends, both in term of yield and growth. For example, Roche has delivered dividend growth of 15% per annum over the past 5 years.
The US companies still offer compelling value in the American market, offering yield of nearly 4%, solid balance sheets and good cash flow generation, but from a global perspective, the European companies are well positioned to offer better value in the medium to long-term. The greater level of diversification, fuller pipelines, more robust balance sheets and greater exposure to the fast growing emerging markets should lead to a greater competitive advantage.
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