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Opportunity knocks for big pharmaceutical companies in the credit crunch

Posted on 16 October 2008

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Although the credit crunch has left non-financial services companies, including those in the biotechnology industry, without cheap debt, the pharmaceutical industry avoided relying on this resource and has remained cash-rich. As a result, pharmaceutical companies should weather the financial storm and be able to make significant acquisitions, unlike their biotechnology counterparts.

The key impact of the credit crunch on the corporate world is the abrupt loss of cheap debt. During the late 1990s and 2000s, companies across all industries have exploited easy access to cheap debt to amplify or "leverage" their return to investors. However, in the wake of the sub-prime crisis and the subsequent collapse of big name financial institutions, banks have no choice but to protect their own capital and stop lending, turning off this supply of cheap debt.

This leaves those companies that have taken on debt in the extremely uncomfortable position of having to either rapidly pay off their debts ("deleveraging") or re-secure new debt at much higher interest rates, potentially threatening the viability of the firm. Datamonitor believes that large pharmaceutical companies have wisely stayed out of the cheap debt game and, as a result, the credit crunch will actually play out as a net positive for an industry much in need of good news. Pharmaceutical companies are not only expected to weather the financial storm successfully, but also to use this period to exploit their unique cash strength by embarking on an acquisition spree.

Negative issues already priced into pharmaceutical valuations

Until very recently, the pharmaceutical industry's stock market performance has been faltering compared to other sectors. The reasons for its poor performance relative to other industry groups are well known and deep-seated. At its most fundamental level, the pharmaceutical industry as a whole has failed to discover and develop sufficient numbers of high-value and innovative products to replace the drugs facing patent expiry and maintain its historical growth rates.

Pharmaceutical companies are experiencing pressure from a wide variety of sources, with many facing unprecedented losses of drug sales to generic competition over the coming years. Datamonitor forecasts that, between 2007 and 2012, the top 50 pharmaceutical companies will face patent expiries on $115 billion worth of drugs.

Furthermore, in 2007 the FDA approved just 19 new products: the lowest level for over 20 years. At the same time, the cost of developing innovative therapies keeps rising, reaching an average of $800m to bring a drug to market: 15 times higher than that recorded in the 1970s and more than three times higher than in the 1980s. This lack of true innovation, coupled with recently increased regulatory scrutiny and tougher cost-containment measures from payers to drive down prices, has made the healthcare environment more difficult to operate in than ever before.

This array of negative long-term pressures has already been fully reflected in the pharmaceutical industry's stock market performance. Between January 2007 and May 2008, the Dow Jones US Pharmaceutical Index fell by 10%, while the Dow Jones Industrial Average (DJIA) remained broadly unchanged.

A cash-rich pharmaceutical industry

Today's credit crisis has separated companies into two camps: those that appear to have enough cash to cover their debts, and those that do not.

It is worth noting that average net debt as a proportion of capital employed for the top 20 pharmaceutical companies is just 6%, while the average net debt carried by financial institutions is 95%. This fact alone suggests that the fallout from the credit crisis will not be as significant in the pharmaceutical industry as in other more highly leveraged sectors.

When this is combined with the fact that the average top 20 pharmaceutical companies have access to $7.5 billion in cash, equivalents and short-term investments, the ability of large pharmaceutical companies to weather the credit storm is very clear.

The markets have evidently recognized the balance sheet strength of pharmaceuticals in the midst of the credit crunch and, as a result, there has been a recent reversal in the industry's stock market fortunes: from the end of June 2008 until the end of September 2008, the Dow Jones US Pharmaceutical Index rose by 2% while the DJIA fell by 5%. The major market declines of early October have seen a continuation of this theme, with pharmaceutical stocks outperforming the general indices.

Credit crunch shifts balance of power

While the credit crunch promises to strengthen the hand of large pharmaceutical companies, the outlook is far from positive for small biotechnology players. Over the last decade, the pharmaceutical industry has increasingly looked to its cousins in the biotechnology sector to help replenish its dwindling product pipelines. A symbiotic relationship was established: biotechnology companies provided innovative therapies and, in return, pharmaceutical companies brought funding and development "know-how". A natural balance was established in the pharmaceuticals-biotechnology relationship: risk and reward were shared.

In recent years, however, biotechnology companies' access to funding from other sources of capital became easier. Financing became cheaper, and the balance of power in the pharmaceuticals-biotechnology relationship shifted: pharmaceutical companies' need for access to biotechnology products increased significantly, while biotechnology's need for pharmaceuticals funding diminished.

Consequently, biotechnology companies could afford to either carry more risk themselves by taking their projects deeper into clinical development or demand more favorable terms from the increasingly desperate pharmaceutical industry. This shift in power towards biotechnology companies was reflected in the declining number of licensing deals between pharmaceutical and biotechnology companies; Datamonitor's analysis shows that there has been an average yearly decrease of almost 18% since the beginning of 2006.

The current credit crisis looks set to change again the balance of power in the pharmaceuticals-biotechnology relationship. Biotechnology companies' ready access to capital and funding has dried up almost overnight; while there are few that will struggle immediately, acquiring funding for their operations in the longer term looks more difficult. In terms of licensing deals, biotechnology companies will be forced to accept less favorable terms.

Most significantly, with the cheap debt supply turned off, the pharmaceutical industry's cash pile means that it is now the only serious buyer in the room: private equity has vanished and small players will lose their own sources of funding. There can be only one outcome. Under the cover of the credit crunch, large pharmaceutical companies will swoop repeatedly to acquire substantial biotechnology targets.

Perhaps the clearest example of this intent is that Pfizer currently holds well over $25 billion in cash and short-term investments. It may well be that the credit crunch provides large pharmaceutical companies with exactly the opportunity they need to rebuild their ailing pipelines.

Source: Datamonitor


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