Big Pharma's Big Decision: Diversify Or Focus?

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buy, sell or hold?by Centinent Management

The pharma business is a risky undertaking, even for monster companies such as Pfizer (PFE). That was once again clearly demonstrated when Pfizer lost $20 billion in market capitalization last week, after it decided to withdraw its new compound torceptrapib. It is rumored that Pfizer lost an additional $1 billion in development costs on the drug, and the company spent almost 15 years focused on it. Other pharmas the size of Pfizer, the ones that have continued to operate consumer or generic divisions, rarely take hits this size.

The Pfizer case is by no means unique, however. Other big pharmaceutical companies have suffered similar setbacks when one of their key pipeline products failed in trials or showed signs of trouble. The torceptrapib case shows how even a few deaths can cause a company to abandon a promising drug. That is because a tainted drug is unlikely to become a blockbuster.

Like Hollywood movie studios, pharmaceutical giants live or die by the blockbusters they produce. Average performers are lost in the noise, and as a rule more than 60% of a pharma's sales comes from blockbusters. Some companies derive more than three-fourths of their income from star performers. The only reason why such companies have average performers at all is because some drugs did not live up to their potential and that was discovered after they were already on the market.

Drugs that show they will not live up to this star potential are canned or sold to smaller companies, even if those drugs may have significant benefits for the majority of patients. As far as pharmaceutical executives and investors are concerned, the earlier these underperformers can be taken out, the better. But as the Pfizer case shows, companies will not think twice about removing a drug that is close to approval if they think it will be a dud.

Not surprisingly, the pharma business is also one where rewards can be very high. Blockbuster drugs routinely hit yearly sales of $3-5 billion, and some very successful ones may bring in double that amount. Pfizer's Lipitor, the most successful prescription drug, sells $12 billion a year. Nearly all of that is pure profit and thanks to strong IP protection, this scenario may last for as long as 10-15 years. In some cases, easy follow-on products, such as sustained release formulations, can extend the reward period for another 10-20 years. In other cases, a patent extension may add 3-5 years. One blockbuster can take a company from obscurity into the major leagues.

Generics companies such as Teva (TEVA), Ranbaxy, and Dr. Reddy's have made a living out of challenging patent protection. They have become more aggressive at doing so and winning patent cases. In response, many major pharmas have set up or acquired their own generics business. Others have signed pre-emptive deals with the generic producers in order to maintain some extended market exclusivity without a threat of lawsuits.

Wall Street likes high stakes, so it always pushes pharma company executives to focus on their risky core business and shed all distractions. These distractions include related health care and consumer businesses that do not exhibit the same risk/reward profile. Because most of these divisions are steady performers that bring in income no matter what, they can be a great buffer in times of turmoil. They are entirely predictable and while they never lose big, they never gain big either.

These distractions are there because most pharma businesses developed out of related business segments, such as chemistry, medical devices, diagnostics, and others. Many companies also struggled for years before they became household names. In the process, they merged and acquired other businesses. For example, Warner-Lambert, the maker of Lipitor that was acquired by Pfizer, had a razor business and a tropical fish and aquarium business in its portfolio. To Wall Street, razors and fish are distractions. Even the generics and over-the-counter business is seen as unproductive by some.

But lately, as more blockbusters are coming off patent - record numbers of blockbusters will lose IP protection between now and the end of the decade - pharmas have learned that they may be able to hold on to significant sales if they produce a generic version of their own drug. Loss of IP protection typically causes branded sales to drop precipitously and become insignificant within a few years. Producing its own generic allows a company to benefit from its work past the IP protection date.

So today, even a pure-play pharma such as Pfizer has its own generics division, in this case called Greenstone Ltd. It is the seventh-largest generics business in the US with $722 million in sales in 2005. Nearly every pharma has its own generics business. Nevertheless, Pfizer is still considered one of the best examples of pure-play.

Other pharmas, like Johnson & Johnson (JNJ) or Abbott (ABT) are diversified by choice. J&J is in every health-related sector, from prescription to generic to over-the-counter. It has a big consumer business, a formidable diagnostics division, and several device businesses. J&J is a competitor in hot medical device areas such as stents, and hip and knee replacements. It is a force in diagnostics. Abbott is a major player in diagnostics, hospital products, and nutrition.

While the pure plays dominated the market and racked up huge profits in the late 90s and early 00s, the diversified models have outperformed them recently. Many have seen this as a vindication of the diversified model. But the final decision is by no means in. Diversified player Novartis (NVS) clearly showed this when rumors appeared last week that it is trying to sell its baby food unit, Gerber, and other nutrition businesses to Nestle. The sale is likely to net Novartis $5 billion, which it pledged to reinvest in its branded business.

Still Novartis is not becoming a pure play. The company pledged its commitment to the diversified model and claims it will keep branded drugs, generics, and vaccines as part of its core business. Medical nutrition however, is considered a non-core area. It is interesting to note that Novartis' prescriptions, generics, and vaccines units grew at 5, 10, and 15 respectively, while nutrition was flat in 2005.

Last year, Novartis purchased Bristol-Myers’ (BMY) consumer business including the Maalox, Exedrin and Triamic brands. NVS's consumer business generated nearly $2 billion in sales last quarter, much of it from OTC products. That is more than its generics business at $1.4 billion and it dwarfs vaccines at $375 million. In many ways, it looks as if Novartis is trying to play it right down the middle.

Its Swiss competitor, F. Hoffmann-La Roche Ltd, ("Roche" RHHBY), is pursuing a similar middle-of-the road model. Although Roche sold its consumer business to Bayer for 3.6 billion CHF in 2004, it has kept its diagnostics units. It has also surrounded itself with a network of other businesses where it has equity or other licensing arrangements. Best known among those is Genentech (DNA) of South San Francisco. But Roche also holds a major stake in Japan's Chugai. All in all, Roche is a partner to more than 60 companies worldwide, 24 in the US alone. Germany's Bayer (BAY) is another example of a diversified company that is doing very well.

Pfizer, on the other hand, is staying the course, despite recent setbacks in its share price. It just sold its consumer brands to J&J for $17 billion, receiving wide-spread praise from analysts at the time, not in the least because many thought J&J overpaid for the unit. Now that torceptrapib is out of the picture, many of these same analysts probably have second thoughts about the move.

There is no doubt that big pharma is under heavy pressure right now. As mentioned, record numbers of blockbusters are losing patent protection. For the first time, there will be a key drug in every major therapeutic area that is available as a generic. That has emboldened health care plans and insurers to force doctors and hospitals to prescribe generics whenever possible. But they don't stop there. Many insurers are taking the battle to the consumer, with some thinking about withdrawing benefits for branded medications altogether. Generics manufacturers are also increasingly challenging patents. Plavix is a good case in point.

Added to that that, pipelines are pretty dry and the crop of new candidates is quite thin. Ironically enough, some of the more diversified companies, like Novartis, may very well have the best pipelines. Perhaps that is a reason why Novartis is moving more to the middle? Unload a bit of the ballast to better ride the upcoming wave.

Disclosure: Centient management holds a position in Genentech shares and does consulting work for Genentech.

source - seeking alpha