The Big Pharma Edition
Roche, Pfizer, J&J, Merck, Bayer
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With the S&P 500 making new highs, I have been rummaging through the dustbin of the 52-week-lows list. I found not one but several Big Pharma names in there. Besides, it is earnings season and 2 of the companies have reported and 2 are reporting next week. A great time to take a look.
On the chart above, you can see my top-of-mind selection of Big Pharma companies. Roche, Pfizer, and Bayer's drop from the top is of the level experienced only during the GFC and the COVID-19 meltdown. So, I naturally asked myself, why are things so grim for these pharma giants?
Big Pharma's Big Issues
Big Pharma has big issues as well.
The quite obvious short-term hurdle is that revenues from COVID-19 vaccines and tests are drying up. Pfizer (and Moderna) was the big winner in this category and is now seeing the expected reversion to business as usual. Its total revenue doubled in 2021 to $80B, almost entirely thanks to the Comirnaty vaccine and the antiviral pill, Paxlovid. The duo brought in over $50B in 2022. Merck, J&J, and Roche saw much more modest bumps in sales.
Merck is a heavyweight in vaccines, second only to GSK in vaccine revenue. The company has over a century of traditions in the field, and it is behind some of the key vaccines in use today (e.g., Ebola, HPV, measles, mumps, rubella, and varicella). Ironically, it failed to develop a COVID-19 vaccine. Its then-CEO Kenneth Frazier called for caution, especially with the new mRNA vaccines, which have completely different mechanics compared to traditional vaccines. Unfortunately, his call was misappropriated by COVID conspiracy theorists that bombarded me with facts and authoritative opinions at the time. In any case, Merck came back in 2021 with molnupiravir, an antiviral pill, which added $1B in just the last Q of 2021.
J&J was also a latecomer to COVID-19 vaccines, but it managed to rack up $2.4B in 2021 and over $2B in 2022.
Roche generated some CHF 1.6B (out of 65B) in 2021 from its aptly-named Ronapreve, before it started losing steam against Omicron. The latest investor presentation shows that COVID-19-related revenues have all but dried up.
The second, or first depending on the product mix, most mentioned cause for poor performance in pharma company annual reports is biosimilar erosion. As the name suggests, biosimilars are essentially generic versions of the original. This ailment is a natural part of the lifecycle of patented biologics.
The patent expiration is just the beginning of the end. For one, there is some time between the patent expiration and the wide availability of generics. I am no pharma expert, so correct me if I am wrong, but to my understanding, the way the process works is that patent expiration only removes the patent barrier, but then there is regulatory data exclusivity of the original clinical trial data. Biosimilars rely on the original's clinical trial data primarily because conducting full clinical trials for biosimilars would be unethical, costly, and duplicative. Unethical and duplicative, because the original molecule has already proven that it works. No need to repeat it and let the control group go without treatment to satisfy the bureaucracy. Costly, because clinical trials cost tens or hundreds of millions, while a major benefit of biosimilars is that they offer a cheaper alternative to the original. Since biosimilars are similar versions of approved biologics, regulators allow abbreviated pathways leaning on original clinical data, with selective Phase 1 and 3 trials for critical safety/efficacy aspects.
Moreover, revenue doesn't just disappear the moment patent protection is gone. I am sure you know people buying Bayer's Aspirin, even though generic acetylsalicylic acid is widely available. Whether it is a force of habit, nostalgia, better marketing, or a mix of the above, the original continues to sell, albeit in volumes and at price points much lower than during the patent-protected period. Wikipedia has side-by-side examples from the US and Canada. A 33-37% premium for the same molecule.
In Roche's case, biosimilar erosion is after its top 3 cancer drugs, which generate CHF 3.7B revenue (11% of Pharma and ) globally and have been the core drivers of growth in the recent past.
Avastin - generated CHF 1.21B in the first 9 months of 2023
Herceptin - CHF 1.26B
Rituxan/MabThera - CHF 1.26B
The young part of the portfolio, consisting of all launches since 2016, has been growing steadily and accounted for 50% of Pharma division sales in the first 3 Qs of 2023.
The young portfolio contains six CHF 1B+ products, which together account for CHF 14.5B of sales or 43% of total Pharma sales. Ocrevus, multiple sclerosis medicine, is the top performer (CHF 4.8B) in this group followed by hemophilia drug Hemlibra (CHF 3.1B), and PD-L1 inhibitor Tecentriq (CHF 2.8B). Vabysmo (CHF 1.6B), which treats age-related macular degeneration, was added to the lineup only in 2022 and is showing a lot of promise. It is expected to surpass CHF 2B in FY23.
At the bottom of this chart, you can see biosimilar-eroded Herceptin and Avastin down 17% and 20%, respectively.
Below are the top 20 products in the Pharma division. They account for 91% of total Pharma sales for the period. In the mid-section of the table, you can see the declining but still significant share of the legacy top products - Herceptin, MabThera, and Avastin - making up 11% of Pharma sales.
Related to the biosimilar erosion problem covered above, M&A is one place pharma companies are looking for answers. The lucky, or skillful, ones are able to pick the winners, even after accounting for the heady deal prices. The unlucky ones, because failure is not something CEOs like being accountable for, end up looking like Bayer, which by the way was the most valuable German company just before the following happened.
The company paid the top price of $63B all-cash (most of it the bank's) for Monsanto, which came hooked up with a trailer of Roundup litigation festering. Part of the reason for the acquisition were the expiring patents on top-selling drugs, Xarelto and Eylea. Not a year had passed since the deal closed and it was proclaimed among the worst corporate deals ever - in the ranks of AOL-Time Warner and BoA-Countrywide. Bayer optimized the synergy function to 1+1=0.5. Now the combined entity is worth less than each of the components pre-merger, with litigation liabilities over $11B and counting (still 40K claims remain pending). The latest $1.5B verdict was on November 23, 2023.
The Monstanto debacle aside, Bayer's pharma division is doing pretty well. Its drug portfolio is on the upswing. Its best-sellers are growing by healthy 7-10%. In an extremely rare bout of shareholder revolt, former CEO Werner Baumann was ousted shortly, less than 5 years, after the acquisition was completed. But from the country that gave us Wirecard, this qualifies as expedite action. This good news for Bayer, however, was bad news for Roche as they lost the head of Pharma, Bill Anderson, who became the new CEO of Bayer. Anderson's extensive experience in the pharmaceutical industry includes leadership roles at Genentech and Roche, where he played a key role in various aspects of the companies' operations and product development.
This brings us to Genentech, one of the top producers of cancer treatments in the world. Genentech is known for its unique company culture, which is often described as "casual intensity." This culture is characterized by a focus on innovation, collaboration, and a commitment to solving complex health challenges. This is why they have developed and commercialized numerous products, including the first targeted antibody for cancer and the first monoclonal antibody for rheumatoid arthritis.
In 2009, Roche acquired the remaining 44% of Genentech for $46.8B in cash ($95 per share). The reason was, of course, synergies. I am joking. It was partly the IP portfolio and partly Genentech's unique research-focused culture - something that Big Pharma struggles to maintain or deliberately kills and then needs to replenish periodically from outside. It was a bit of a forced marriage as Genentech rejected Roche's initial bid in July 2008, after which Roche went straight to Genentech's shareholders.
It was a period of significant activity by Big Pharma, driven once again by the pharma arch-nemesis Patent Cliff, also known as Biosimilar Erosion. Merck acquired Schering-Plough and Pfizer acquired Wyeth. The price tags for all three deals were around $40B and $70B, respectively.
I remember I was looking at Pfizer back in 2010. It was about to lose patent protection on its blockbuster drug Lipitor (also acquired, in the Warner-Lambert deal) in 2011, which necessitated the acquisition of Wyeth. The stock fell from $20 to $17 in early 2010, and proceeded to drop all the way to $14, losing about a third of its value. By mid 2011, it was back to $20. Now, Pfizer is down over 50%. However, this time around it is even larger than before and the universe of potential deals that would move the needle has shrunk. The most recent acquisitions were Array Biopharma (in 2019 for $11.2B) and Trillium Therapeutics (in 2021 for $2.2B) - both oncology focused.
However, let's get back to Roche's acquisition of Genentech. This bet paid off handsomely. Roche's 3 core products that I mentioned - Avastin, Herceptin, and Rituxan - are actually Genentech products. The promising young portfolio products that are now filling the gaps from the shrinking core are also to a large extent Genentech products.
Roche's most recent acquisitions are Carmot Therapeutics ($2.7B), expected to close in Q1 2024, and Telavant Holdings ($7.1B). The former is a bet on new obesity and diabetes products, while the latter is working on drugs for people suffering from inflammatory and fibrotic diseases. These are small, bolt-on additions to strengthen the product portfolio, not large pipelines or blockbuster drugs like the Genentech acquisition.
The last resort - coming up with new molecules the hard way, in your own lab. It takes a long time, costs a lot of money, and is not something that huge corporate structures are particularly supportive of or fit to do. I am a cautious optimist on this one, mostly because of the positive things I have read about Genentech.
Moreover, I am a cautious optimist about the benefit to pharma R&D that can come from the dynamic field of AI. These new models hold promise of accelerating the R&D process massively. They can generate and test promising new molecules entirely in their simulations, completely bypassing the slow and burdensome chemistry that researchers do, and instead allowing them to focus their efforts only on a preselected subset of molecules holding the most promise. I don't see a good reason why pharma wouldn't benefit in the way the chip industry has, where the latest chip designs would have been impossible without the help of AI tools.
The 5 pharma companies I have been mentioning are quite similar in terms of margins, except Bayer, the sick man of Big Pharma.
Roche stands out with the most consistent performance in the group, similar to J&J. How does that relate to the asset base?
Roche shines here, both in absolute terms and in consistency. Looking at their ROA and ROE over 5, 10, and 20-year periods, it is remarkably stable around 14% and 40%, respectively. JNJ is second, but with significantly lower numbers, averaging 9% ROA and 23% ROE. Prizer and Merck are quite close on average (6-7% ROA and 15-20% ROE) and they have also tracked each other closely over the past 20 years. Needless to say, Bayer is the outlier again. It's returns are dismal.
Below I have averaged the LTM EV/EBIT ratio to illustrate the historical movement of these companies' valuations. Roche and Pfizer are trading at a discount to historical averages, optically at least.
Pfizer is a special case, because the LTM EBIT of $17.7B is still quite elevated compared to the pre-COVID level of $10B. If it were to revert, EV/EBIT would go up to 18x or very roughly from almost 30% under the long-term average to 30% over. I see it going somewhere in the middle, meaning reverting to the 20-year average, because of inflation and high-margin, COVID-product revenue continuing to trickle down.
Roche was not a big COVID-beneficiary and its EBIT is around the CHF 20B mark, where it was pre-COVID. The young portfolio is so far making up for the losses from the 3 core products. With 6 new products selling over CHF 1B and growing fast, I am inclined to think that they will do a good job of filling in the shoes of the old trio.
J&J is trading right at its long-term average - a great business at an OK price.
Merck looks expensive.
Bayer is a mess. Did I say this already? Its EBIT is where it was 20 years ago and the litigation is not even over yet. Herr Baumann nuked that company. Of course, such disasters hold the grains of explosive, value-unlocking potential. This is the reason I sort of like it - in the way value investors like cigar butts.
The good thing with pharma companies is that they are cash-rich and they pay good dividends while you wait good things to happen. So, let's look at the three components of shareholder yield.
Dividend yields are quite generous for the group as whole. Of course, the ones with the higher prices offer the more modest 2.5% and 2.9%. Respectively, the more beaten-down the stock, the better the dividend yield. This is where Bayer shines, followed by Pfizer and Roche.
Pfizer has been quite the cannibal - retiring 30% of its shares over the past decade. However, since 2020, it has been moving a bit in the other direction. Still, impressive performance by Pfizer.
Roche has bought back only 7% over the past decade. Merck - lose to 19%. J&J - around 12%. And Bayer, Bayer diluted shareholders by some 30%.
Finally, debt payback hasn't been a large component of shareholder yield. Debt has circulated around the average level for each of these companies, except Bayer again which went form €15B to over €50B overnight to finance the Monsanto deal.
All in all, I like Roche and Pfizer at these levels, and Bayer as the wildcard. I have all 3 in my portfolio.
By the way, for those of you who would like to learn more about the world of pharma, I highly recommend Fierce Biotech. These guys know pharma.