Stuart R. Gallant, MD, PhD
This two-part post looks at pharmaceutical companies and how they are financially structured to survive in a competitive market, to deliver value to their investors, and to manufacture quality pharmaceuticals for the patients they serve. I look at companies which fall in the categories of mature, diversified pharmaceutical companies, generic pharmaceutical companies, and pharmaceutical contract manufacturers. But, I leave out startups which are different enough to make a direct comparison difficult. I plan to return to the subject of startups in future posts.
Disclaimer: This series is not intended, nor is it in fact, an analysis of the appropriateness, superiority, or inferiority of any company as a financial investment. Please read PharmaTopo’s site disclaimer.
Data
For this survey, I selected the following companies as representative of three separate types of pharmaceutical companies:
| Company Type | Company |
| Mature Diversified Pharmaceutical | Johnson & Johnson (NYSE: JNJ) Merck (NYSE: MRK) Novartis (SIX: NOVN, NYSE: NVS) Roche (SIX: ROG) |
| Generic Pharmaceutical | Aurobindo (NSE: AUROPHARMA, BSE: 524804) Sun Pharma (BSE: 524715, NSE: SUNPHARMA) Teva (NYSE: TEVA) Viatris (Nasdaq: VTRS) |
| Pharmaceutical Contract Manufacturer | Catalent (NYSE: CTLT) Lonza (SIX: LONN) Siegfried (SIX: SFZN) WuXi AppTec (SSE: 603259) |
The selection of companies was somewhat arbitrary. Four per category represented a tractable number for discussion, but clearly such a small number is susceptible to the influence of outliers. Data used in this analysis was publicly available and current as of February 2022. I tabulated the data in a spreadsheet which is attached below.
Methodology
To give the financial metrics of these pharmaceutical companies meaning and context, I wanted to use data from outside the pharmaceutical sector. For this reason, I tabulated the quartiles of the S&P 500 companies as points of comparison for each financial metric. Clearly, most of the pharmaceutical companies discussed in these two posts are not members of the S&P 500; however, the S&P 500 quartiles are used as a reference point to think about whether the value of a particular metric is “high,” “medium,” or “low.” Take care to note that Q4 is always the “high” quartile, but not always the “best” quartile. For example, the “price” metrics (Price/Book, P/E, etc.)—if one takes the point of view of an investor, low values of the price metrics may indicate attractive investments. Also, there isn’t a correct value of dividend payout—investors often like to see 25% to 40% dividend payout but may find lower values acceptable if the company is funding growth from revenue.
Also, take care to note that the S&P 500 quartiles include “min” and “max” values. These values are often extreme values driven by unusual business cases. Better for the reader to focus on the Q1, Q2, and Q3 values which represent the partitions between the 4 quartiles.
Analysis
Financial metrics are a bit like the instruments in an airplane cockpit. Airspeed is a pretty important value, but I think we would all be a bit worried if we knew that our pilot only looked at the airspeed indicator. A good pilot regularly scans the instrument panel, and so will we. Below are some of the major financial metrics, starting with net margin which is an important metric focused on the income statement (appearing at the left of the attached spreadsheet), and proceeding through some of the price ratios (P/E and PEG) which attempt to capture key features of stock value (appearing at the right of the attached spreadsheet).
A. Income Statement
- Net Margin (net income/revenue) reflects the fraction of revenue not consumed by manufacturing costs, R&D costs, sales and marketing, administration, interest, and taxes. Net margin is all about value creation—how much does the market say a product is worth above the bits and pieces that went into its fabrication.
- Net margin is known to vary from industry to industry, reflecting the characteristics of the industry. (Is the business a commodity business, what are the sales volumes in relation to capital requirements, etc.?) Interestingly, the quartile breaks for the overall S&P 500 and for the healthcare portion of the S&P 500 were found to be quite similar:
| S&P 500 Net Margin TTM (Percent) | S&P 500 (Healthcare Only) Net Margin TTM (Percent) | |
| Maximum | 146.9 | 146.9 |
| 3rd Quartile | 20.9 | 22.7 |
| Median (2nd Quartile) | 12.9 | 15.5 |
| 1st Quartile | 8.1 | 8.4 |
| Min Value | -2158.8 | -11.2 |
This indicates that healthcare broadly speaking is not substantially different from the broader range of industrial companies with respect to net margin. However, as the categories of pharmaceutical companies are examined, there are some differences in the example companies in their net margins, compared to the S&P 500 companies as a group.
- The mature, diversified pharmaceutical companies (MDPCs) had the highest net margin—all 4 in this category appear in highest quartile (Q4). Generic pharmaceutical companies had lower net margins, appearing in Q1 and Q2, with the exception of Sun Pharma which appeared in Q3. This agrees with the general perception that generics have lower profit margin, compared to innovator companies. It is also interesting that Sun Pharma, the largest pharma company in India, was able to coax higher net margin and worth looking into its strategies.
- Interestingly, the contract manufacturers had similar net margin to the MDPCs. This last point deserves some consideration—does contract manufacturing offer a path to participation in relatively high net margins like MDPCs with perhaps lower risk? Certainly, an idea worth considering.
B. Balance Sheet
- Current Ratio (ratio of current assets to current liabilities) is a good way of appreciating the strength of a company’s balance sheet. S&P 500 companies generally have strong balance sheets with current ratios over 1.0 in most cases and over 2.0 in top quartile:
| S&P 500 Current Ratio (MRQ) | |
| Maximum | 7.9 |
| 3rd Quartile | 2.0 |
| Median (2nd Quartile) | 1.3 |
| 1st Quartile | 1.0 |
| Min Value | 0.3 |
- Looking at the three categories of pharmaceutical companies, the contract manufacturers hand the highest current ratios. Catalent, Lonza, and Siegfried all had current ratios in the top quartile. The MDPCs and generics companies had strong balance sheets also, though not quite as strong. All these companies had current ratios above 1.0, except Roche, and Roche’s was quite close to 1.0.
- This is only conjecture, but one is left to wonder if the billing structure of contract manufacturers is an advantage in this case. Contract manufacturers generally receive payment for work completed net 30 days, and they are not forced to carry any significant amount of inventory.
C. Cash Flow
- “Cash is king.” Free Cash Flow (i.e., cash from operations minus capital expenditures) offers a measure of a firm’s financial flexibility:
| S&P 500 Free Cash Flow (Millions of Dollars) | |
| Maximum | 101,853 |
| 3rd Quartile | 2,892 |
| Median (2nd Quartile) | 1,268 |
| 1st Quartile | 592 |
| Min Value | -14,726 |
- All of the MDPCs maintain sizable free cash flows in the Q4 range. The generic companies Teva and Viatris maintain strong positions in Q3, as does Lonza among the contract manufacturers.
- Catalent, Siegfried, and WuXi Apptec all fall in Q1. Looking back over several years, these three maintained a consistently near neutral or even negative free cash flow—this may reflect a strategy for financial efficiency shared by these CMOs.
E. Management
- Return on Equity (Net Income/Equity) and Return on Assets (Net Income/Assets) are a good measure of how the management team is running a company. Are the executives using the company in an efficient way? Return on equity and return on assets are normalized and also independent of stock price. Stock price, particularly in the short run can be pumped up artificially (and I can think of one or two particularly egregious examples of that—relating to executive teams positioning their shells of companies for acquisition):
| S&P 500 Return on Equity | S&P 500 Return on Assets | |
| Maximum | 251,634 | 49.5 |
| 3rd Quartile | 30.9 | 11.2 |
| Median (2nd Quartile) | 17.5 | 6.3 |
| 1st Quartile | 9.8 | 2.8 |
| Min Value | -1409 | -19.7 |
- The mature, diversified pharmaceutical companies (MDPCs) predictably were in the top quartile (Q4) for return on equity and return on assets (or just narrowly missing it, as was the case for Johnson & Johnson and return on equity).
- It wouldn’t be fair to compare the generics and contract manufacturers to the MDPCs in these metrics. In general, the generics companies and contract manufacturers did less well in terms of return on equity and return on assets, scoring in Q1 and Q2.
- It is worth noting that the Aurobindo team seems to be able to coax a better return from their company, compared to other generics companies, scoring Q3 for return on equity and Q4 for return on assets. For generic companies, ensuring an adequate return for their investors is perhaps a more delicate balancing act than for MDPCs—Aurobindo has had some negative interactions with the FDA in the past [1, 2]. Aurobindo may have been burned by pushing too hard for returns in the past; however, it seems to have been able to maintain high returns in the years since its unpleasant feedback from the FDA.
F. Finance
- Total Debt to Equity (ratio of liabilities to equity) is a measure of how leveraged a company is—and therefore how much risk the company is willing to live with:
| S&P 500 Debt to Equity | |
| Maximum | 693981.9 |
| 3rd Quartile | 151.1 |
| Median (2nd Quartile) | 79.9 |
| 1st Quartile | 42.2 |
| Min Value | -71579.5 |
- Most of the pharmaceutical companies take a very moderate approach to leverage. Three of the four MDPCs are in Q2 with respect to total debt to equity. Roche is in Q3. Of the generics companies, only Teva is in Q4, and that is somewhat of a famous case with that company carrying a substantial debt due to acquisitions. Teva had an even higher debt to equity ratio as recently as 2020 [3].
- Among the contract manufacturers, leverage is also low. Within these companies, the highest ratio is 94%, maintained by Catalent, which is still in the “safe” region below 100%.
In the second part of this two-part post, the topic of valuation will be discussed, followed by how some of these financial metrics affect and are affected by market strategy.
[1] www.fda.gov/inspections-compliance-enforcement-and-criminal-investigations/warning-letters/aurobindo-pharma-limited-577033-06202019
[2] www.businesstoday.in/markets/company-stock/story/aurobindo-pharma-share-crashes-20-to-hit-52week-low-usfda-observations-lupin-glenmark-fall-up-to-9-231848-2019-10-07
[3] ycharts.com/companies/TEVA/debt_equity_ratio; note this source records the data as ratio rather than percent.
Disclaimer: PharmaTopoTM provides commentary on topics related to drugs. The content on this website does not constitute technical, medical, legal, or financial advice. Consult an appropriately skilled professional, such as an engineer, doctor, lawyer, or investment counselor, prior to undertaking any action related to the topics discussed on PharmaTopo.com.