PFE decides to shrink; HHS ends AWP; Drug pricing hits a speedtrap

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PFE’s R&D / sales will fall to 10.5% in 2012, down from 13.9% last year.  Strictly speaking, with R&D returns < WACC, the only ‘right’ R&D / sales ratio is zero.  Assuming R&D returns can be >= WACC (we believe they can), companies need R&D / sales ratios of 15% simply to hold the real value of sales constant.  All else equal, and assuming R&D equal to WACC, PFE’s reduction in its R&D / sales ratio shrinks the present value of the company’s long-term earnings by roughly one-third

On February 3rd, HHS Secretary Sebelius announced plans to publish a survey of drug acquisition costs by the end of this year.  This obviates the need for AWP, which is the benchmark used by commercial contracts; presumably these contracts now must be re-written.  HHS-provided acquisition cost data would give plan sponsors the details on pharmacies’ generic acquisition costs that they’ve been lacking; we expect 2012 generic dispensing margins to fall as a result.  PBMs (MHS, CVS, ESRX) are most negatively affected, followed by drug retailers (WAG, RAD), then drug wholesalers (CAH, ABC, MCK)

List price increases for US drugs tend to decelerate in presidential election years, especially when prices are growing rapidly in the year pre-election, as is presently the case.  This is particularly important in light of the fact that real pricing is now a more dominant component of revenue growth than it’s ever been, making its potential loss all the more impactful.  Manufacturers with weak volume / mix trends are most at risk, e.g. GSK, PFE, JNJ, SNY, and MRK. Wholesalers (CAH, ABC, MCK) also are at risk as the buying margin benefits of large real price gains may be lost abruptly

We provide an updated drug stock selection screen, adding specialty pharma and biotech to our existing screen of large caps.  We select for low sales-weighted average product age, high percentage of sales attributable to biologics, and high ratios of phase III or filed products to current sales.  Predictably large caps fare poorly, which argues in favor of more actively managed portfolios of small – mid cap names

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