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For four years Chris Viehbacher has been bracing himself for a nasty turn. Since being appointed Sanofi’s chief executive in 2008, he has been diversifying the French drugmaker to prepare for the moment it loses US patent protection on one of its most lucrative products.
“It’s T-minus 3 weeks,” Mr Viehbacher says. Along with its US partner Bristol-Myers Squibb – Sanofi is set to see sales of Plavix, the blood-thinner that is the world’s top selling medicine, drop sharply this year from nearly €7bn in 2011.
Along with many of his peers in the pharmaceutical industry, he faces a “patent cliff” of expiries that has pushed companies to adopt widely divergent responses and helps explain a recent flurry of licensing deals and acquisitions.
Les Funtleyder, analyst and fund manager at Miller Tabak, says: “The cost of capital is pretty cheap and may not be forever. If you don’t have a good R&D engine, you have to find other ways to support the engine you do have.”
Pfizer this week was among the companies to report a drop in first-quarter sales and earnings as generic rivals diluted its sales of Lipitor, the cholesterol-lowering drug that was itself the world’s top seller until patent expiries began to bite.
Late last month, similar gloomy forecasts at AstraZeneca on sales and earnings weighed heavily in the abrupt resignation of David Brennan as its chief executive amid growing investor pressure for change.
The industry has faced expiries before, but Tim Anderson, pharmaceutical analyst with Bernstein, says: “Nothing like this has ever been seen before. A series of products are near simultaneously going off patent. In years past, the rates of erosion were substantially less.”
Other sectors, such as software and consumer goods, have patents. But they rely on rapid innovation to maintain sales. In pharmaceuticals, stringent regulations on authorisation and marketing impose tighter controls, higher costs and longer lead times, making drug developers more reliant on patent monopolies to recoup their costs.
That model is under threat. Mr Anderson argues that “the patent system is working more efficiently.” In the US, and increasingly in Europe, generic drug companies are ever more aggressive in launching their own deeply discounted versions, eroding margins as soon as patents expire.
Teva of Israel, the world’s largest generic company, is among those going still further, challenging the validity of patents in the courts, and sometimes – as it did in the UK last year with Lipitor – launching “at risk” even before a judge has ruled.
The strong headwinds facing big pharmaceutical groups are due in part to pressure from the rise of generic rivals. But many of these off-patent counterparts are having an equally tough time as they feel the squeeze from a harsh economic climate, writes Andrew Jack.
Intensifying competition from even lower-cost rivals in India, and price pressure from western healthcare systems seeking to save money on medicines via tenders and discounts, are cutting into margins.
Claudio Albrecht, chief executive of Actavis, the Swiss-based generic group that amassed large debts as it bought up smaller European rivals over the past decade, says generic producers face two choices.
“You can become bigger and benefit from scale and then fight on price and the best cost of goods, or you can become more non-generic,” he says.
If his company’s €4.5bn purchase last week by Watson of the US signalled the former approach, Teva’s partnership unveiled last year with Procter & Gamble and its $6.8bn purchase of Cephalon pointed to the latter.
Yet innovative pharmaceutical companies are also interested in generic companies, notably to diversify into emerging markets or into higher margin products. For instance, Amgen late last month bought MN of Turkey for $700m, and Novartis this week paid $1.5bn for Fougera, a generic dermatology products group.
Frances Cloud, a consultant to the generics industry, warns that innovative pharmaceutical groups recent in-roads will be short-lived, given the modest scale and lower margins of the niche.
But she predicts further consolidation among mid-size generic companies, such as the takeover of Stada of Germany. “We are running out of chunky sized targets and buyers, although there will still be lots of people hoovering up small assets for access to new geographies and technologies.”
Sir Andrew Witty, chief executive of GlaxoSmithKline, which has recently ridden through a series of patent expiries, says: “There has been intensifying competition between companies”. Newer but more effective or safer patented medicines for the same diseases often displace existing treatments long before patents expire, he explains.
Pressure on health systems also means that insurers and governments are imposing price cuts on existing drugs, or – as in the case of the UK’s decision on GSK’s Benlysta for lupus last month – refusing to buy new ones, claiming they are not cost effective.
Another problem compared with previous patent expiry cycles in large companies is their very scale. Sales from a single new drug are insufficient to compensate for a series of existing ones expiring.
That raises a final factor: the rising costs and falling productivity of innovation means returns on research and development have been falling. Shareholders are increasingly sceptical that investing fresh money will deliver good returns, pushing instead for dividends and share buybacks.
“R&D in pharma and biotech is a very risky exercise,” says Clint Gartin, Morgan Stanley vice-chairman of investment banking and head of healthcare banking. “Most projects that are started end in failure.”
The result is that companies trading on the lowest multiples in the sector include AstraZeneca and Eli Lilly, which have remained focused on searching for the next blockbuster in patented drugs. While they may be able to generate fresh products, they face difficulties retaining and recruiting the best staff – and new money – during the down cycle.
Investors have instead rewarded companies that have diversified to de-risk future income streams – such as into consumer and animal health, medical devices or even generic drugs. Examples include GSK, Johnson & Johnson, Sanofi and Novartis, which diversified further this week with the $1.5bn purchase of Fougera, a dermatology generics company.
Nevertheless, there is still sharp disagreement on how far large-scale acquisitions have delivered good returns. There are also doubts on how far companies still focused on patented drugs can diversify and deliver the best returns in other niches, such as consumer health, where they have less expertise.
“Cash gives you strategic options,” says Mr Viehbacher at Sanofi, who remains sanguine. “When I joined this industry in 1988, everybody was predicting doom and gloom. But it has proved more resilient, with consolidation and diversification. We do adapt.” For now, many investors are showing little tolerance to sit out the cycle and hope for improvement.
Additional reporting by Alan Rappeport and David Gelles in New York
Drugmakers see $33bn bout of M&A activity
A recent spate of takeovers in healthcare, as drugmakers seek to replace expiring drug patents, has made it the busiest sector in April with acquisitions around the world worth more than $33bn, according to Dealogic, write David Gelles and Andrew Jack
Completed transactions included AstraZeneca’s $1.3bn purchase of Ardea, which has an experimental drug for gout, while other companies of similar size named as potential takeover bids include Onyx and Amylin.
Several have even turned hostile. GlaxoSmithKline has an outstanding unsolicited $2.6bn bid for Human Genome Science, joint developer of Benlysta for lupus; and Roche recently withdrew a $7bn bid for Illumina, a US diagnostics company which spurned the offer.
“We’re in an attractive M&A market as big cap pharma companies are looking to acquire innovation to address their patent cliffs,” says Rick Leaman, managing partner at Moelis & Co, the New York investment bank.
Clint Gartin, Morgan Stanley vice-chairman of investment banking and head of healthcare banking, says the heavy deal flow illustrates the fast pace of change in the sector. “In healthcare, a new drug can change the environment overnight. It can make some products not competitive, and move others to the front row.”
Borrowing is cheap, helping acquirers to boost earnings rapidly after completing takeovers. The large pharmaceutical companies also remain highly cash generative from existing products, while sales of divisions – such as Pfizer
’s $12bn nutrition disposal to Nestlé
– provide more funds. Bayer and Johnson & Johnson are among those that have indicated they are interested in new transactions.
While the appetite for “mega mergers” has dulled, several midsize companies including Shire and Biogen Idec are regularly cited as potential targets. Even Bristol-Myers Squibb, Eli Lilly, AbbVie and AstraZeneca are periodically cited as takeover candidates should they fail to replenish their own pipelines.
Drew Burch, head of healthcare M&A at Barclays, says: “The nature of the business is that the revenues are dependent on patent protections. That means at some point you face a decline in that revenue stream. The replacement has either got to come from your own labs or from outside.”