The “Biopharma” Industry
The lines between the “pharmaceuticals” and “biotechnology” sectors are becoming increasingly blurred. With 35-40% of the earnings of global large cap pharmaceuticals companies coming from biologics, it is probably more accurate to refer to these companies as operating in the “biopharma” industry.
Corporate governance has played a key role in the emergence of biopharma. The “old” business model of large cap pharmaceuticals companies, which was in place from about the 1990s to the mid-2000s, was comprised of five elements:
• Strategy: A focus on primary care areas.
• Drug development: A focus on “small molecule” drugs (i.e., non-biologics taken orally). As their patents expired, these drugs faced intense competition from the manufacturers of generics.
• Research & Development: A “shotgun” approach to R&D, with many projects underway at a given point in time with a goal of developing a handful of “blockbusters.”
• Mergers & Acquisitions: Mega deals e.g., Pfizer/Wyeth and Merck/Schering-Plough.
• Business model: A diversified healthcare model.
The “new” business model, which emerged in the late 2000s, modified those elements as follows:
• Strategy: A focus on specialty care areas, which offer relatively high margins.
• Drug development: A focus on “large molecule” drugs i.e., biologics.
• Research & Development: More targeted R&D focused on specialty care areas.
• Mergers & Acquisitions: Bolt-on M&A deals typically involving smaller biotech companies e.g., Bristol-Myers Squibb / Medarex, Eli Lilly/Imclone, Novartis/Chiron.
• Business model: A pure drugs business model. One consequence of a less-diversified structure has been a large number of divestments lately e.g. Abbott Laboratories split in two and spun off its research pharmaceuticals business as a new entity (AbbVie); GlaxoSmithKline sold its Ribena and Lucozade drinks businesses; Novartis sold its blood transfusion diagnostics unit.
The ongoing shift to biologics in the biopharma sector is likely positive for secular earnings growth for a number of reasons:
• Longer product lives: Product cycles are relatively long in biotech, typically greater than ten years. Given the technical complexities involved, biologics are not easily replicated by generic manufacturers.
• New product areas: In large part because of the growth of biologics, the FDA has approved a significant number of new drugs in recent years─ 27 New Molecular Entities were approved in 2013 and 39 in 2012 contrasted by only 17 in 2002. In terms of new product areas, immunotherapy is a new way of treating cancer, which involves turning the body’s immune system against the cancer cells. Some analysts see immunotherapy doing to cancer what new therapies did to HIV i.e., dramatically transforming life expectancies.
• A better pricing environment: Although biotech products are typically very expensive, the level of innovation being delivered by many new biotech therapies likely justifies the cost. That said, as discussed below, the price of biologics is a growing issue for buyers of drugs, including employers and governments, as well as for health insurers.
Biopharma from an ESG Perspective: “S”
Bristol-Myers’ Yervoy drug has shown very promising results for the treatment of melanoma. However, the price of Yervoy is $30,000 per injection, which translates to a cost of $120,000 for a course of therapy. Similarly, Gilead Science’s Sovaldi drug for hepatitis C is $84,000 per 12-week treatment course.
By the estimates of IMS Health, biologics will account for 20% of total drugs by 2017, suggesting that biologic pricing will become an increasingly important issue. At some point, insurance companies and governments worldwide will not be able to handle these costs. In fact, some PBMs and corporations are already removing certain biologics from formularies in an attempt to control costs.
Some observers speculate that health insurance will eventually evolve into a two-tier system: a “cheap” option that provides access to small molecule drugs and an “expensive” option that provides access to large molecule drugs.
Biopharma Valuation and Accounting Issues
When accountants think of the pharmaceuticals industry, two things typically come to mind: intangibles and taxes.
Intangibles are an issue because a large part of the valuation of pharmaceutical companies is derived from their products and pipeline. But this highlights one shortcoming with U.S. GAAP balance sheets – they are based on historical cost. Therefore, the intangibles that companies create are not recorded on the balance sheet (except in limited circumstances, such as with software.) There have been proposals through the years to require all intangibles to be recorded and, also, for the amounts to be updated periodically.
The concerns about such requirements (including possible biases by companies in valuations and, also, having gains and losses from changes in valuation flow through earnings) have outweighed the benefits. Many investors would be in favor of having better disclosure about intangibles, so they can assess the potential risks and rewards on their own.
So, any intangibles that do show up on balance sheets are the result of acquisitions. Let’s take a quick refresher on acquisition accounting. The fair value of the acquisition price is allocated to the assets and liabilities. First tangible assets – things we can touch – are recorded at fair value. Then we move to identifiable assets – things we can’t touch but can name. Accountants break these down into two categories.
• First is finite-lived intangibles: those that have a determinable life; they are amortized over that life.
• Next come indefinite-lived intangibles – those whose life extends beyond the foreseeable future. These are not amortized until their life becomes determinate. Included in this category is typically regarded as the largest intangible in pharmaceutical acquisitions – in process research and development (IPR&D). In a quick review of pharmaceutical filings, it is easy to find acquisitions where 75% or more of the purchase price was allocated to IPR&D.
After the purchase price is allocated to tangible and identifiable intangible assets, any remaining consideration is recorded as goodwill (or potentially negative goodwill.)
After some valuation abuses in the past, the American Institute of Certified Public Accountants issued guidance on valuing IPR&D. That guidance was recently updated in a December 2013 guide, “Assets to Be Used in Research and Development Activities.”
There are three basic valuation techniques for IPR&D:
• The first is the cost method, which looks to the cost to replace an asset. Given the variable nature of the cost-to-benefit ratio for IPR&D, this metric is rarely used.
• Second is a market approach, where recent transactions of similar assets are analyzed. Because of the unique nature of IPR&D and infrequency of transactions, again, this factor is rarely used.
• Most valuations of IPR&D are calculated using an income approach. Under the income approach, the cash flows from the asset – both inflows (revenues) and outflows (expenses) – are analyzed, usually under different scenarios with probabilities assigned. They are then discounted using a risk-adjusted discount rate. Again, looking at a small sample of pharmaceutical financial reports, disclosed discount rates have been in the 12% to 17.5% range.
Under U.S. GAAP, costs to complete the research are expensed as research and development expense. The recorded asset is tested at least annually for potential impairment, and written down, if necessary. If and when a successful product is produced, the asset now has a finite life, and any recorded amount is amortized.
So recorded IPR&D has some serious limitations: it only includes acquired IPR&D, and is not revalued (except downward if impaired.) But it does give us some insight into the amount of value in the pharmaceutical or biopharmaceutical industries that is related to the pipeline.
Turning now to taxes, there are at least three issues that have to be considered when analyzing the Pharmaceutical industry.
• In the March Journal of Sustainable Finance & Banking we wrote about the R&D credit, which expired at the end of 2013. Although it is highly likely to be extended retroactively, U.S. GAAP does not allow any anticipated earnings to be included in first quarter earnings. This will continue a multi-year distortion of first quarter earnings for impacted companies.
• In addition, concerns about taxation of foreign income continues to be a hot topic in Washington. There are numerous proposals to reform the U.S. international tax system – focusing on the U.S. taxation of non-U.S. subsidiaries. And closely related to this are concerns about use and abuse of tax havens by U.S. companies.
• The third tax issue comes not from Washington, but from Norwalk, Conn., where the FASB headquarters are located. There are occasional calls to amend an exception from U.S. GAAP’s treatment of the earnings of non-U.S. subsidiaries. Currently if those earnings are deemed to be indefinitely reinvested overseas, the U.S. parent does not accrue deferred taxes on any potential repatriation. If this exception is removed, earnings of multinational companies would decrease due to higher tax accruals.
Biopharma from an ESG Perspective: “G”
Financial accounting (as just discussed) has been in use for around 150 years. But “ESG” accounting is relatively new, having come into focus in the last 20 years or so. Reflecting this, Novo Nordisk is one of the few big cap pharma companies to employ a full-time ESG Data Manager, Cora Olsen.
At the same time that some observers complain of “reporting fatigue” (i.e., companies spending a lot of time and effort to fill out ESG questionnaires) it seems that there is still a lot of work to be done, especially in the area of data quality. Reflecting the tremendous variability in terms of how companies report CO2 emissions, water usage etc., the Sustainable Accounting Standards Board (SASB) is working on the issue of ESG data standards.
Then, too, ESG data is not of much use if they are gathered but not used by managements to address corporate governance issues. Corporations that actively incorporate ESG data in their decision making process, such as Novo Nordisk, believe it gives them a competitive advantage over other companies that don’t have a similar focus.
From the perspective of investors, it seems that ESG data are not widely used by the mainstream investment community. That said, there is a case to be made that investment managers focused on sustainable investing have consistently performed relatively well. In fact, some investors believe that their focus on ESG data gives them an edge over other investors that are solely focused on traditional financial accounting metrics. To be sure, not all investors agree on the “right” ESG metrics but many investors who choose to focus on one or two metrics believe that these are “value-added” data points in the investment decision process.
For more on tangible and intangible assets, see Janet Pegg’s article in the Cornerstone Journal of Sustainable Finance & Banking, October 2013 “Things We Can Kick… And Things Which Are Precious.”
For more on R&D tax credit, see Janet Pegg’s article in the March edition of the Cornerstone Journal of Sustainable Finance & Banking “Lack of R&D Tax Credit Will Complicate First Quarter Earnings.”