Shifts in Pharma Capital Agendas

The long-awaited patent cliff that has loomed in the pharmaceutical industry for years has arrived in earnest in 2012, with more than $40 billion in 2011 brand sales facing loss of exclusivity (LOE). Although this year's LOEs were well-anticipated, a confluence of unexpected financial events and negative conditions in key global markets are creating additional challenges for a pharmaceutical industry seeking sustainable growth.

Declining first-half sales for top pharma

Among the leading (top 10 in global revenues) multinational pharmaceutical companies, first-half 2012 sales fell by $8 billion, or 3%, globally from the year-ago period. The Eurozone crisis contributed to this decline as European aggregate sales fell 6% in the first half of 2012, reflecting a weaker pricing environment for branded drugs as well as increased generic-drug substitution.

Emerging markets have been a growth driver for pharma in the last several years, with aggregate sales rising 12% in 2011. It is a different picture for 2012, however, as first-half sales growth for emerging markets decelerated to approximately 7%, principally due to slower growth in gross domestic product and declining transaction volume, particularly mergers and acquisitions. Although pharma's appetite for inorganic growth in emerging markets remains strong, those markets have become increasingly competitive, creating challenges to getting deals done. Also, government policies intended to support local industry are affecting market share and pressuring prices, albeit volume growth generally has remained strong. As a result, some pharmaceutical companies may be concluding that growth could be better realized in markets where uncertainty appears to be decreasing. For all the concerns about the United States, the "known unknowns" in the US may be better than the "unknown unknowns" that characterize some emerging market countries.

US bolt-on deals back in vogue?

Following the US Supreme Court's decision in June to uphold the Affordable Care Act and the US Federal Reserve reaffirming its stance to keep interest rates low through 2014, the US life-sciences industry could be moving into a new phase of heightened domestic deal activity. In the third quarter of 2012 in the US, there were several noteworthy mergers and acquisitions featuring Big Pharma: almost all were under $10 billion in value. These bolt-on deals are likely to continue as a core strategy given that overall industry growth is projected to remain anemic over the next several years.

Dividends and buybacks on the rise

As the pharmaceutical industry faces negative revenue growth, profit growth has waned even after waves of cost-cutting. Companies have responded to shareholders' demands by increasing dividends and buying back stock. The pharmaceutical industry's historic relatively unlevered balance sheets may be changing as debt-to-equity ratios rise to an estimated 18% this year versus 9% in 2007. Also, with payout ratios for many top life-sciences companies hovering around 40% and with less willingness to lever up, this constraints on financial resources mean that megamergers appear increasingly unlikely. For certain multinationals, the answer has been to "grow smaller," by optimizing growth by divesting noncore or underperforming operations. With most of the top pharmas facing similar strategic challenges—modest near-term growth prospects with increased investor scrutiny of capital allocation—we could see a continuation of the recent wave of divestitures.

Hopeful signs emerging

This year is likely to be remembered by new lows in growth rates. Although 2013 appears challenging, too, there are three reasons to view the glass as half-full:

• Several recent FDA approvals in obesity, cardiovascular, and oncology, after a dearth in brand pipeline approvals could revive domestic growth.

• The implementation of healthcare reform in the US could jumpstart growth in 2014.

• Restructuring and diversification into businesses with less exposure to patent cliffs (e.g., consumer, animal-health) are beginning to pay off. For the past several years, the industry has made difficult strategic decisions, cut costs, and expanded into more promising markets while exploring new business models with a goal of achieving more growth with less risk.

Most optimistically, pharmaceutical stocks have recently outperformed the major averages, and for 2012, have pulled even in performance after years of lagging. Forward-looking, investors may be signaling that the worst days are likely behind us.

Andrew Forman, Transaction Advisory Services, Ernst & Young. The views expressed herein are those of the author and do not necessarily reflect those of Ernst & Young LLP.