The Risk of Doubling Down on Pharma
Examining the divestment risks, as more large companies look to spin off consumer health and other business units to focus on branded pharmaceuticals
The decisions of big pharma companies GlaxoSmithKline and Johnson & Johnson to spin off their respective consumer health businesses reflect concerted efforts to double down on brand-name prescription drugs. The two drugmakers are not alone when it comes to narrowing their focus, since Pfizer, Abbott Laboratories and other organizations have embraced the risk of developing pharmaceuticals while divesting themselves of over-the-counter (OTC), generics and other businesses with lower profit margins but more predictable cash flows.
Spinoffs are an attempt to maximize value for investors by separating businesses that have divergent priorities.
J&J and GSK’s planned spinoffs of their consumer health businesses reflect a reality that OTC medicines and hygiene products have more in common with Procter & Gamble, Unilever, Colgate-Palmolive and other brands in the front of the pharmacy and at mass merchants rather than making complex proteins, detailing their clinical benefit to doctors and negotiating reimbursement with payers.
Adam Koppel, MD, PhD, managing director at Bain Capital Life Sciences, says the market dynamics of these businesses also demand different management skills and lead to varied investor preferences.
Some investors have appetite for 10%-to-20% annual returns by investing in pharmaceutical manufacturers, knowing that a safety issue or setback during clinical trials could hurt the value of the business. An investor in a consumer product company is likely to seek 5%-to-6% annual returns and a predictable dividend with far less risk. Also, some pure-play drugmakers may opt to reinvest in product development with expectations of larger returns in the future rather than rewarding shareholders with dividends at the present.
“Investors are getting greater value from pure-play pharmaceutical companies rather than diversified businesses,” says Jeffrey Stoll, US life sciences strategy leader, KPMG.
Many of the largest drug companies originated in the chemicals business but then focused on medicines as that segment became more profitable. Some pharma organizations have amalgamated diverse businesses over the decades to grow and manage risk. Much like the industrial conglomerates that started breaking themselves up to maximize shareholder value, many drugmakers are following suit by focusing on new, brand-name products, mostly biologics.
The approach runs counter to the idea of creating synergies by having a portfolio of businesses under one umbrella to mitigate risk and share certain functions to create efficiencies. The mindset is hoping that “one + one equals three” to building value from acquisitions. In the case of divestitures, executives are hoping that investors will see greater returns from the market assessing the value of these businesses separately or that a business that is valued at $3 per share can be worth $2 + $2 if the business is split into two companies.
According to Koppel, the notion of doubling down on newer brand name drugs is that investors capture significantly more upside with successes. However, share prices also take a bigger hit when something goes wrong, he notes. Diversification can offer some safety for investors, but it also dampens the upside for the biggest successes.
The risk-return profile for a drug business is much different than more predictable consumer health, generics or animal care businesses. Developing new brand-name pharmaceuticals takes time and is costly, and they have a limited amount of exclusivity in the market before patent expirations. In a market that increasingly rewards innovation, drugmakers are also looking to gain additional indications for products once they reach the market. The Pharmaceutical Research and Manufacturers of America (PhRMA), the industry trade group, says more than 500 medicines have been approved since 2000. In the oncology category alone, 1,300 medications and vaccines are under development, according to PhRMA, including more than 500 different compounds targeting solid tumors and 141 different prospective lung cancer treatments.
With this deep pipeline, competition could be the biggest risk from this effort to double down on brand-name drugs, Stoll believes, noting there may be opportunities for two or three treatments that could satisfy each indication. Assumptions that might have been made about an individual drug’s prospects could change rapidly, given the emergence of new therapies. A drug might have had expectations to generate $2 billion a year in sales, but new entrants with greater efficacy or more benign side-effect profiles could dampen those expectations, Stoll says. The need for pharma companies is to “have enough shots on goal” to ensure that one miss in the pipeline doesn’t set back the company if a compound fails or if a medicine’s sales fail to meet expectations, he adds.
“Over the last eight to 10 years, biopharma has largely recognized that the payer environment won’t reimburse ‘me-too’ drugs or drugs that have marginal impact on clinical outcomes over and above the standard of care,” Stoll says.
Legislation or regulatory risk can also change the investment thesis for the pharma sector. Focusing specifically on pharmaceuticals does have some exposure to regulatory and policy risk if there are attempts to regulate drug prices in the US. Despite the predictability of the non-pharma businesses, Koppel sees a weakness among consumer health businesses versus brand-name pharma: “You never had the pricing power,” he says. “For example, consumer businesses selling toothpaste and mouthwash don’t have the pricing power of an effective cancer drug.”
If price controls are set on new drugs, Stoll says attempts to cap prices for drugs could be harmful to development of treatments for rare and ultra-rare conditions. These treatments can run into the hundreds of thousands of dollars annually, largely because the development cost is spread across a limited number of patients.
In the past 10 to 15 years, drug development has shifted to more exotic proteins, antibodies, nucleic acids and cell and gene therapies. Drugmakers have shifted away from broad treatment categories to specific targeted diseases, where you can show a benefit to a much smaller population with more serious diseases. While drug development costs are extremely high, there is a higher probability of successfully bringing the drug to market from this narrow focus.
Meanwhile, data and analytics are accelerating clinical trial site selection, structure and data collection to help increase the odds of success, industry executives believe. Economics may have had as much of a bearing on the need to double down on newer drugs.
J&J, GSK’s divestitures
J&J and GSK’s spinoff plans are the latest and among the most significant efforts to separate businesses that are behind the pharmacy counter and those that fill the aisles of drugstores, supermarkets and mass merchandisers.
J&J announced plans in November to spin off its consumer health business,1 an enterprise expected to generate $15 billion in revenue from Neutrogena, Aveeno, Tylenol, Listerine, J&J’s Band-Aid bandages and a variety of products in the personal care aisles of retailers and pharmacies around the world. The spinoff is anticipated to occur 18-to-24 months after the announcement, or approximately the latter half of 2023.
“Our goal is to accelerate the growth, enhance innovation and improve execution across all of our businesses following this separation,” J&J Executive Chairman Alex Gorsky said in November’s investor call announcing the spinoff. “We believe that this move will allow us to even accelerate further the progress that you’ve seen in our pharmaceutical and medical device space.”
Complexity of healthcare and consumer markets has required innovation and agility, making the timing appropriate for a spinoff, and both businesses will be “well capitalized with significant cash flow,” according to Gorsky.
J&J’s spinoff decision comes after GSK had announced its own divestment of its consumer health business,2 which features Advil and Excedrin pain relievers, Nexium and Tums heartburn drugs, Centrum vitamins, Aquafresh toothpaste and other products. The move is expected to occur in the middle of this year.
GSK said it anticipates to receive an 8-billion-pound dividend—approximately $10.8 billion based on early January’s exchange rate GBP1=US$1.35—from the consumer health business. As far as J&J’s dividend, the company, citing the still-early stages of the spinoff plan, said: “there are many details to be worked out and decisions still to be made. We are committed to communicating with all our valued stakeholders and keeping them informed as we move through this process.”
“J&J’s consumer healthcare divestment follows a path similar to GlaxoSmithKline’s divestment of its consumer group,” Damien Conover, Morningstar analyst, wrote in a research note.3 “However, with J&J trading at a higher valuation multiple versus Glaxo, we see less potential for it to create value with its consumer healthcare divestment, even with the strong comparable valuations of stand-alone consumer health companies.” Conover added that he saw little synergy between J&J’s consumer health and the pharma division and he “wouldn’t be surprised” if the medical devices business was eventually separated from the company.
“Given the market focus on higher-margin, higher-growth businesses, we believe the removal of the consumer business should be viewed positively, as it could unlock greater returns from more concentrated investments for the pharma business,” Morgan Stanley analyst Matthew Harrison wrote in a research note shortly after J&J’s announcement.
At the pharma giant’s conference call related to its consumer health spinoff, CFO Joseph Wolk said the “dis-synergies” related to the spinoff could be $500 million to $1 billion.
While GSK announced its spinoff in 2020, the company is facing criticism for its underperformance by activist investors. In July, Elliott Advisors Ltd sent a letter to GSK’s board criticizing its leadership, citing how it dropped from being the third-largest drug company to the 11th, and its share of total R&D spending dropped 30% during the last 15 years.4 Elliott Advisors, which acquired a multi-billion-pound stake in GSK, urged the drugmaker to double down further.
“From a broader capital allocation perspective, GSK chose to maintain a dividend in excess of what it could afford,” Elliott Advisors said in its letter to the board. “This shifted funds away from investments in business development and R&D.”
GSK, however, maintains that the company has substantially strengthened its R&D performance and productivity with 11 major product approvals since 2017, and it has doubled the number of assets in Phase III clinical trials and registration to 22.5 Over the next five-year period, GSK said its pharma business expects to annually deliver sales growth and adjusted operating profit growth of more than 5% and more than 10%, respectively.
Pfizer, Merck, Abbott and others sharpen pharma focus
As noted, other large drugmakers have opted to sell and spin off non-core businesses to get higher returns and reinvest proceeds into developing new medications.
Merck & Co. spun off Organon & Co. in June 2021,6 and as part of that spinoff, Merck received a $9 billion distribution as it focuses upon faster growing product lines. Organon is concentrating on women’s health, biosimilars and “established medicines” across a range of therapeutic areas.
Since 2011, Pfizer has divested its animal health business (Zoetis), its generics business (Upjohn), OTC medicines and infant nutrition and capsule manufacturing businesses. Meanwhile, the company has been “refining and focusing its approach to R&D,” Pfizer spokesperson Pam Eisele said. Pfizer’s consumer health brands were sold to GSK as part of its efforts to focus on pharmaceuticals.
Abbott Laboratories spun off AbbVie, the maker of Humira, as a stand-alone biotech company in 2013, and its stock performance has outpaced the S&P 500 since then, even as the index was increasingly driven by technology giants, such as Apple, Alphabet, Facebook and Netflix.
There are some exceptions to this trend. Germany’s Bayer AG and Merck KGaA, Darmstadt, Germany are among the companies that have maintained significant non-pharma businesses. Bayer has branched into diagnostics and agriculture, while Merck KGaA has a flourishing chemicals business that has grown significantly and its American Depository Receipts (ADRs), which are traded “over-the-counter,” have outperformed the S&P 500.
More R&D implications
While pharma manufacturers have opted to focus on newer brand-name drugs, the conditions in researching and developing drugs are evolving. The success rates of drugmakers in getting a treatment to market have changed, reflecting a willingness to set a higher bar in early-stage trials to prevent expensive failures in later-stage trials.
Beyond that, the sector has showed great discipline in allowing experimental medicines to fail quickly in earlier stage trials rather than enduring high costs to push compounds to Phase III studies. Stoll says the industry’s probability of technical and regulatory success has improved between 2011 and 2018, meaning the drugs in the latter stages of development are more likely to succeed in reaching the market than a decade ago.
Drugmakers themselves point to their own development programs and the role that data and analytics and a more disciplined approach to development has served in increasing the odds of success.
Pfizer said its end-to-end clinical success rate of new molecular entities is 21%, versus an industry average of 11%, and by the time the compounds reach Phase III trials, the success rate is 85% versus 72%.
At a November investor day, Najat Khan, chief data science officer and global head of R&D strategy at J&J’s Janssen Pharmaceuticals division, said the company’s data and analytics capabilities have enhanced clinical trial design, leading to faster and more efficient studies. For example, artificial intelligence and machine learning helped cut the development time of the J&J Covid-19 vaccine by six weeks, according to Khan.
Where does M&A fit in the pharma focus?
As drugmakers double down on new products, R&D becomes increasingly paramount for the business. Executives are often at a crossroads about the “build-versus-buy” approach to filling a product pipeline.
The majority of pharmaceutical companies aggressively reinvest in developing next-generation drugs or acquiring smaller biotechs that are pursuing innovative new drugs to broaden a product portfolio, Stoll says.
The biggest and most common risk of mergers and acquisitions across industries is overpaying.
With valuations at high levels for pre-revenue companies, even the best due diligence cannot cut through the vagaries of clinical trials and regulatory approvals. Meanwhile, doubling down with a big deal to buy another drug company poses integration risks beyond getting products to market.
Gorsky noted during the November investor call that the post-spinoff J&J will have some “consistency about capital allocation” with investments in its own programs, and that the company’s appetite for M&A has largely been about smaller acquisitions.
Koppel reminds that this has been the approach among many pharma manufacturers—to focus on smaller companies for acquisitions. Proceeds from divestitures of lower-growth operations among the big pharma companies are helping to fund these acquisitions.
“There is more value in buying several smaller biotech companies while avoiding some of the integration headaches that come with acquiring one big company,” Koppel says.
About the Author
William Borden is a freelance journalist covering the pharmaceutical industry. He is based in New Jersey.
References
3. https://www.morningstar.com/articles/1067756/jj-announces-divestment-of-consumer-group
4. https://www.prnewswire.com/news-releases/elliott-publishes-letter-on-glaxosmithkline-301323833.html
6. https://www.merck.com/news/merck-announces-completion-of-organon-co-spinoff/
