Large Pharma’s ‘Established’ & ‘Growth’ NEWCOs: A Solomonic Path to More Efficient R&D?

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Richard Evans / Scott Hinds / Ryan Baum

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@SSRHealth

June 10, 2014

Large Pharma’s ‘Established’ & ‘Growth’ NEWCOs: A Solomonic Path to More Efficient R&D?

  • We divided the large cap pharmaceutical companies into ‘established’ and ‘growth’ NEWCOs; we then compared the combined value of the ‘established’ and ‘growth’ NEWCOs to the legacy parent companies, and found no compelling evidence to believe the combined NEWCO values are any higher than the market values of their respective ‘legacy’ parents
  • The growth NEWCOs are dramatically smaller (average 32 percent of legacy revenues) than their parents. For the growth NEWCOs to have R&D / sales ratios on par with comparable existing biopharma growth companies, the average growth NEWCO would have to reduce its absolute R&D spending to a level 53% below that of its legacy parent. The negative implications for research tools and services companies (e.g. CRL, CVD, ICLR, LIFE, PLL, PRXL, QGEN, TECH, TMO, WAT) are obvious
  • The growth NEWCOs are much more reliant on US real pricing power than comparable existing biopharma growth companies … that is to say the ‘quality’ of the growth NEWCOs’ growth arguably is less than that of the comparables. This raises the question of whether the growth NEWCOs would be valued at par with the comparables, and challenges the core value-creation logic of proposed splits
  • The only benefits we see from breaking legacy companies into ‘established’ and ‘growth’ NEWCOs derive from the impact this has on R&D spending. Simplistically, because economic returns to R&D spending are on average negative, as long as this is true less R&D spending obviously is (economically) better. And, because economic returns to R&D spending are negatively correlated with scale, the significant rescaling of R&D implied by splitting legacy companies into ‘established’ and ‘growth’ NEWCOs might reasonably be expected to raise the productivity of the R&D spending that remains
  • Splitting legacy companies into ‘established’ and ‘growth’ NEWCOs is not the only path to lower R&D spending, and lower R&D spending is not the only path to better R&D productivity. We prefer the more ambitious approach of tackling R&D productivity by alternative means that do not require sacrificing non-R&D scale advantages

How we divided ‘legacy’ companies into ‘established’ and ‘growth’ NEWCOs

Products designated as ‘established’ include those with either no remaining marketing exclusivity or global consensus sales forecasts of less than 1% growth for 2015 and 2016; all products with consensus sales growth above this threshold are (generously) considered ‘growth’

We then assume the ‘established’ NEWCOs do not invest in future growth (i.e. no R&D, and no acquisition of product lines or businesses); and that the established NEWCOs have dividend payout ratios of 100%. We further assume that the established NEWCOs have margin structures that reflect brand-level gross margins, generic-level SG&A to sales ratios, and of course no R&D; this yields an assumed net margin of 32.7%. In all cases aggregate sales for products falling into the established NEWCOs are declining; we assume that after the period for which we have consensus forecasts (2020), these products will continue to decline at the average rate of decline consensus forecasts for 2014 – 2020

We assume the ‘growth’ NEWCOs operate with net margins on par with those of comparable biopharma companies (Exhibit 1) whose consensus revenue growth rates are on par with the revenue growth expectations we calculated for the growth NEWCOs

How we value the ‘established’ and ‘growth’ NEWCOs

To value the established NEWCOs, we discount the resulting dividends back to a present value using a discount rate of 6.8%[1]

To value the growth NEWCOs, we first apply the average of price to sales (Exhibit 1a) and price to earnings (Exhibit 1b) ratios taken from biopharma companies with similar rates of forecasted revenue growth through 2016

As a second step, we estimate the market value of the ‘excess’ innovation inherited by the growth NEWCOs from their parents. Because the growth NEWCOs’ total revenues are much smaller than their legacy parents’, and because we’re assuming the growth NEWCOs have cost structures (including R&D) on par with comparable growth companies, the R&D spending of the growth NEWCOs is greatly reduced as compared to that of their parents. The average growth company comparable has an R&D to sales ratio of 17.7% (Exhibit 1). By comparison, if the average growth NEWCO maintained its 2013 absolute R&D dollar spend, this would result in a much higher average R&D to sales ratio of 42.3% (Exhibit 2), ranging from a low of 28% (SNY) to a high of 53% (PFE). Plainly the growth NEWCOs would have to reduce R&D spending to normal (presumably on par with the comparables) R&D to sales ratios; this would result in an average drop in absolute R&D spending of 53.3% (Exhibit 3), ranging from a high of 64% (PFE) to a low of 35% (SNY). This implies that the growth NEWCOs inherit a ‘stock’ of discoveries from their legacy parent that is much larger than the stock of innovation carried by the growth comparables. To adjust for this difference, we add our estimate of the market value[2] of this excess inherited innovation stock to the growth NEWCOs’ estimated market values

Fundamental results: percent of legacy sales falling into either the ‘established’ or ‘growth’ NEWCOs, and growth rates for the NEWCOs

On average, only 32% of 2014 sales fall into the growth NEWCOs; PFE is the low at 18% and LLY the high at 56% (Exhibit 4) … thus in all cases the growth NEWCOs are dramatically smaller companies than their legacy parents. The average rate of consensus growth forecast through 2020 for the growth NEWCOs is 14%; BMY’s growth NEWCO has the highest rate of forecast revenue growth at 21%, SNY’s growth NEWCO has the lowest rate at 9% (Exhibit 5, ‘scenario 1’)

As we’ve emphasized elsewhere[3], US real pricing gains explain more than 100% of global growth for most of the larger pharmaceutical companies, and we believe these real pricing gains will soon come under pressure. In the right two columns of Exhibit 5 (‘scenario 2’), we’ve adjusted consensus forecasts by assuming US rates of real pricing growth for brand pharmaceuticals fall to zero over a five year period beginning in 2015. This would reduce the average global sales growth of the growth NEWCOs to 10.5%, with BMY still in the lead at 15% and SNY still the slowest at 4%

In all cases the ‘established’ NEWCOs have declining sales. Under consensus pricing assumptions the average rate of decline is -8.5% (Exhibit 5, ‘scenario 1’), under our modified pricing assumption (Exhibit 5, ‘scenario 2’) the average rate of decline is -10.7%. Under both pricing assumptions LLY’s established NEWCO has the most rapid sales declines (-16% and -19%, respectively); SNY’s established NEWCO has the least rapid sales declines (-5% and -8%, respectively)

Valuation results: comparing combined ‘established’ and ‘growth’ NEWCO values to ‘legacy’ values

Exhibit 6a compares the combined valuations of the ‘established’ and ‘growth’ NEWCOs to their corresponding legacy parents, under the general assumption that consensus sales forecasts are unaffected by a decline in US real pricing. Columns ‘a’, ‘b’, and ‘c’ provide current market caps for the entire legacy company, any non-Rx lines of business, and the legacy Rx business respectively. Column ‘d’ provides our estimate of market value for the ‘established’ NEWCO, and column ‘e’ provides our estimate of growth NEWCO value calculated using the average of current-market P/E and P/S values for the comparable growth companies in Exhibit 1. Column ‘f’ provides our estimate of the ‘excess’ innovation stock the growth NEWCO inherits from its parent. Column ‘g’ compares the combined value of the established and growth NEWCOs to the market cap of the corresponding legacy Rx business, without adjusting the growth NEWCO value for the excess innovation it inherits from its legacy parent. Column ‘h’ makes the same comparison, but adds the value of excess innovation inherited from the parent to the growth NEWCO valuation. Exhibit 6b is identical to 6a, except that we assume that US real pricing power falls to zero over the five year period from 2015 – 2019

Our fundamental beliefs notwithstanding, we seriously doubt the current market prices in a deceleration of US real pricing power, so Exhibit 6a is the better framework for deciding whether breaking companies into growth and established NEWCOs is likely to raise near-term equity values. If the market makes no adjustment for the fact that the growth NEWCOs will inherit larger stocks of innovation than are held by the comparable growth companies, the combined established and growth NEWCO estimated values would account for an average of 96 percent of current legacy company market values (Exhibit 6a, col ‘g’). Conversely, if the market gave the growth NEWCOs full credit for the excess innovation they would inherit from their legacy parents, the combined estimated value of the established and growth NEWCOs would be on average about 118 percent of the legacy parent market values (Exhibit 6a, col ‘h’). Realistically, because the market is inefficient at valuing early- to mid-stage research pipelines, the growth NEWCOs are unlikely to receive full value for their excess inherited innovation, meaning the likely valuation result is somewhere between columns ‘g’ and ‘h’. Simply stated, the combined values of the growth and established NEWCOs would be about the same as the legacy companies’ current values. And, because the growth NEWCOs are more reliant on US real pricing power than most of the growth comparables, for a given rate of revenue and earnings growth the market might apply lower P/E and P/S multiples to the growth NEWCOs

  1. The decision to use a figure lower than the companies’ current costs of equity reflects our belief that the cash flows of the established NEWCOs are more certain than the cash flows of the legacy (i.e. parent) companies. Companies with higher legacy costs of equity as a starting point arguably benefit from this assumption; however the benefit is marginal and does not affect the conclusions of our analysis
  2. For details on how we estimate mid- to early-stage pipeline values, please see: “Relative Price & Value of pre-Phase III Pipelines for the 23 Largest Drug & Biotech Companies – Updated View”, SSR Health LLC, May 7, 2014
  3. See most recently: “BIG Monkeys & a Looming Intervention: Pharma’s US Pricing Addiction”, SSR Health LLC, May 9, 2014; “Co-Pay Cards & the Stalling of Drug Rebate Growth Part II – The HIE ‘Test Case’” SSR Health LLC, May 8, 2014; “Drug Benefit Chicken: An Analysis of Benefit Designs on the Health Insurance Exchanges” SSR Health LLC, January 19, 2014;
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