Financial Metrics of Pharmaceutical Companies (2 of 2)

Stuart R. Gallant, MD, PhD

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.

G. Valuation

Dividend Payout Percent (dividend/net income) is a traditional measure of value. In the past few decades, investors changed their perspective on dividend payout. Traditionally, investors like to see 25% to 40% dividend payout percent. However, some attractive stocks do not pay a dividend [1], choosing to plow money back into expansion of their business.

	S&P 500 Dividend Payout Percent
Maximum	651.6
3^rd Quartile	44.9
Median (2^nd Quartile)	24.7
1^st Quartile	0.0
Min Value	-5500.0

Examining the S&P 500 companies, half of them fall below the traditional 25% to 40% band on dividend payout. Presumably, investors are begin compensated through growth—either through acquisitions or through internal growth funded by revenue.
Of the MDPCs, Merck, Novartis, and Roche all paid healthy dividends. Sun and Viatris, among the generics, and Lonza of the CMOs paid large traditional dividends.
Price Ratios are one of the most common tools investors use to make sense of stock value over time, as management philosophies evolve and as business conditions change:

	S&P 500 Price/Book	S&P 500 P/E (TTM)	S&P 500 PEG
Maximum	355.3	1128.6	165.3
3^rd Quartile	7.9	36.9	3.0
Median (2^nd Quartile)	3.9	24.2	2.0
1^st Quartile	2.1	16.0	1.1
Min Value	0.6	3.9	-20.3

Low price/book stocks are categorized as “value” stocks, and high price/book stocks are categorized as “growth” stocks. The median of the S&P 500 for price to book has edged upward in the last decade (from around 2 in 2010 to 3.9 currently). However, in spite of its recent inflation, price/book is still a nice metric because it factors in debt.
If we use the median of the S&P 500 to divide “value” from “growth,” 3 of the 4 MDPCs are growth stocks, with only Novartis categorized as value. In contrast, only 1 of the generic stocks qualifies as a growth stock (Sun Pharma). All of the contract manufacturers fall in Q3 (“growth”), except Siegfried which falls in Q2 and narrowly misses Q3. The bottom line is that all 12 of these companies fall toward the middle of the distribution (nether very strongly value, nor very strongly growth), except Teva which is at the bottom of Q1—strongly value.
It makes sense to look at P/E and PEG together:
- Since the late 1980s, average price/earnings has oscillated around 24. Some value investors look for stocks with P/E less than 15.
- Factoring in growth (PE Ratio/5 year EBITDA growth rate), the PEG takes into account that some companies value stock growth over dividends.
All of the MDPCs paint a similar picture in terms of P/E and PEG. They are low quartile (Q1 and Q2) in terms of P/E, indicating good value if only dividend is considered. However, they increase in quartile for PEG, indicating that slow growth makes them less attractive long term investments.
Two of the generics companies paint an attractive picture for P/E and PEG. Aurobindo and Teva are lower quartile for P/E (Q1 and Q2) and Q1 in terms of PEG, indicating good expected growth. Sun and Viatris both expect negative growth.
The contract manufacturers are high quartile (Q3 and Q4) in terms of P/E but fall in quartile when growth is taken into account, indicating they may be more attractive long term investments—particularly Siegfried which appears in Q1 for PEG.

Conclusions

We began this two-part series thinking about how a good pilot scans the instrument panel. The pilot looks at speed, altitude, heading, fuel level, and other instruments to ensure that the plane is safe and headed in the correct direction. Let’s consider how the different categories of pharmaceutical companies manage their financial metrics:

The average quartile for each metric is included in the table, and the “best” performers are highlighted in green. Clearly, MDPCs have some significant advantages (high net margins, large free cash flow, high return on equity and return on assets, lower debt to equity). Some of these advantages are shared by contract manufacturers.

However, if you look at these companies as investments, generic companies have some significant value that they provide to investors with P/E comparable to MDPCs and superior PEG. Although, that last statement needs a significant caveat applied—two of the generics had negative growth and were not included in the PEG average. The generic business is extremely cutthroat at the current time, and it is very possible for a company to contract (or to grow).

Certainly, there is no indication from this table that innovative drugs are overpriced (from an investment perspective). If anything, it shows that significant investments are required to maintain returns for investors.

Epilogue: Teva, Novartis, Biosimilars, and Startups

I categorized Teva as a generics company which is to a certain extent true. However, Teva also generates innovative medications (for example Copaxone). Given that the preceding table demonstrates that there are some significant differences between the innovative drug and the generics businesses, companies like Teva that attempt to maintain both aspects to their business are pulled in some interesting directions. Similarly, Novartis is an MDPC with a substantial interest in the generics business which, no doubt, creates some challenges for the Novartis executive team in balancing investment in innovative versus generics projects.

In the last decade, biosimilars (which are something of a hybrid of innovative and generic pharmaceuticals) have become a growing trend in the pharmaceutical sector. Now, any sizable pharmaceutical company has a group of balls that it needs to keep in the air:

Innovative drugs being developed in-house
Innovative drugs being developed through partnerships with startups
Portfolio growth through acquisition
Generics
Biosimilars

In that sense, pharmaceutical companies start to look more like venture capital firms housing a range of related enterprises—constantly hedging risk and vying for new markets, as well as increased shares of existing markets.

[1] www.dividend.com/how-to-invest/why-google-goog-doesnt-pay-a-dividend/

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