[Ed. This is the twelfth part in Wayne's series. You can access the whole thing by clicking here. Please leave comments or questions on the blog and Wayne will address them in future posts in this series.]
Brand, human prescription drugs is the core business of the pharmaceutical industry. Risk can be diversified and potential reward can be increased by having drugs in multiple therapeutic areas. Expansion and diversification could also involve other types of drug products and healthcare activities. The best current example of healthcare diversification is Johnson & Johnson. If you look at the longer term stock chart (NYSE:JNJ), you will see that the share price continued to climb from 1999 to 2005 and has since been in a volatile trading range.
This post will look at expansion and diversification into generics, vaccines, consumer products, diagnostics, medical devices, animal health and pharmacy benefits management.
I was a lobbyist for the Canadian generic drug industry group about twenty years ago and it was a great way to learn how the pharmaceutical industry works. Thirty years ago most brand pharma companies had a generic drug division. Very few major drugs were losing patent protection in the 1980s and growth in these divisions was much lower than for the brand products. As the blockbuster era emerged, the brand companies sold, shut down or spun out their generic drug divisions, with one major exception – Novartis, which was created in 1996 through the merger of Ciba-Geigy and Sandoz.
Brand and generic pharmaceutical companies may sell the same products made with the same chemicals on the same equipment but the similarities end there. Success in the generic industry is based on low cost of goods and getting space on pharmacy shelves. Pharmacies only need to stock one generic equivalent of each brand drug and, in Canada, there can be up to ten generic versions of some drugs all fighting for market share primarily on the basis of price.
The value of a generic division to a brand pharma company is stable revenue and overhead coverage in manufacturing facilities. It does not help in the marketing of brand products in the U.S. and E.U. It may help in countries where generics are branded, the price discounts are not as great and the population which can afford healthcare is growing. [Ed. for developments along these lines, see this post.]
Many countries and the larger U.S. states had their own vaccine manufacturers and human plasma processors until about 1980. The human plasma processors had to respond to cost concerns from inefficient small facilities, product competition (recombinant clotting factors) and developing new processes to deal with potential contamination by infectious diseases (HIV, hepatitis B and C). The result is an industry dominated by several large international commercial plasma processors.
The pharma industry almost abandoned vaccines in the 1980s due to small or non-existent margins on volume sales to W.H.O. (World Health Organization), lack of new products and vaccine-related damage lawsuits in the U.S. The U.S. solved the latter problem with the National Childhood Vaccine Injury Act of 1986 and the creation in 1988 of the National Vaccine Injury Compensation Program. There has also been a steady flow of new vaccines for infections such as hepatitis B, HiB (Haemophilus influenzae type B), Japanese encephalitis, rotavirus, bacterial meningitis and HPV (human papilloma virus).
Several things have triggered renewed interest in vaccines. First, some new vaccines are commercially attractive with more freedom on pricing and usually less competition. Second, the U.S. and other governments want effective vaccines and treatments for infectious diseases which can potentially be used in terrorist activities. Third, a potential flu vaccine shortage and pandemic outbreak caused governments to fund new manufacturing technologies and capabilities. However, stock market interest in new flu vaccines declined when the flu season was not as bad as expected.
There is almost no synergy between most pharma and vaccine products – they use completely different technologies and generally address different markets. There are exceptions such as the HPV vaccines which are marketed to GPs. If a pharma company already has a vaccine division which it can grow, or can acquire one, it is a potential expansion and diversification strategy.
Consumer healthcare products can provide a stable revenue and earnings base. However, reputations and sales can be severely damaged by minor manufacturing problems, a situation which Johnson & Johnson suffered recently.
Although marketing to consumers is completely different than marketing to physicians, a strong consumer brand could have an impact on prescription drug sales. Prescription drug advertising to consumers is allowed in the U.S. and consumers will ask physicians about certain types of drugs. If a pharma company has strong consumer name recognition, it may help in certain prescription drug classes. In countries where there is brand generic drug competition, strong consumer name recognition could also be useful.
Acquiring an established consumer healthcare products business would probably be very expensive and I am not sure any pharma company would put theirs up for sale. However, any pharma company which has a consumer drug franchise would probably consider growing that franchise through acquisitions.
In 1991, Roche acquired worldwide rights to polymerase chain reaction (PCR) technology, which it previously had licensed to develop innovative molecular tests for HIV and other diseases. At that time, PCR was a research lab tool and was not a platform for a high-volume diagnostics laboratory. In 1998, The Roche Group acquired Corange, the umbrella company for Boehringer Mannheim, and became a market leader in laboratory diagnostics.
Blockbuster diagnostics are fewer in number and peak sales are an order of magnitude smaller than for blockbuster drugs. Renewed interest in diagnostics was triggered by the need for biomarkers to use in stratifying or selecting patient populations. In clinical trials, this approach is expected to increase development success rates and should translate into improved patient outcomes in clinical practice. However, licensing biomarkers is sufficient and there is no need to establish new diagnostic divisions within pharma companies.
There are large pure-play medical device companies, including Medtronic, St. Jude Medical and Boston Scientific. There are medical imaging divisions within larger companies, including G.E., Philips, Siemens and Hitachi. These companies are facing revenue and profitability pressures not because of patent expirations but because the healthcare system is facing financial pressures.
Large company mergers primarily increase profitability by rationalizing the structure and expenses. It is difficult to see how this could happen from the merger of a pharma and a medical device company.
There is no synergy in the marketing of human and animal health products although there may be some overlap in development and manufacturing. Even in the animal health field, there is a distinction between products for food and companion animals. Some human drugs are not approved to treat companion animals but are widely used, such as anti-cancer drugs. There are other drugs which are unique to animal diseases and medical conditions.
Pfizer is currently considering whether to sell or spin off its animal health business. It is difficult to sell to another pharma with an animal health division because there are so few large competitors and any combination creates competition concerns. It is unlikely that any pharma is considering acquiring an animal health division as a diversification or expansion strategy.
Pharmacy benefits management (PBM)
Medco was a wholly owned subsidiary of Merck & Co., Inc., a global pharmaceutical company, from 1993 until Medco was spun-off as an independent publicly traded entity in August 2003. Other companies such as Eli Lilly & Co. and SmithKline Beecham also acquired and later sold pharmacy benefits management firms. Acquiring a PBM is not currently a diversification strategy for pharma.
There is no agreement amongst the major pharma companies on the correct strategy to survive or succeed, except for an industry wide reduction in staffing. There probably is no single correct strategy as each company is starting from a unique set of strengths and weaknesses.
What does this have to do with valuation of biotech companies?
- The future of most biotech companies involves either licensing or M&A deals with a pharma company.
- The expansion and diversification strategies chosen by each pharma company, and their relative success, will impact their interest in and the valuation they will assign to a product or company.
- A practical valuation has to move beyond the theoretical valuation on the spreadsheet.
- A practical valuation should consider the unique situation of the potential buyer or partner and how a licensing deal or acquisition would impact their profitability.
In the next post, I will move on to potential rewards for successful drug development.