A Few Words About Diversification

Guest blog by Dr Brian White, an analyst at Shore Capital.

As a result of the feared impact of the patent expiry cliff, the decimation of branded sales by multi-sourced generics and the obstacles erected, especially by managed care in the US, to slow the uptake of branded pharmaceuticals where a generic in the same class is available, industry players have responded by diluting their reliance on the “small white pill” to embrace a hybrid model combining pharmaceuticals with diagnostics, a consumer health business, animal health and even generics.

This strategy at the very least diversifies revenue sources away from pure pharmaceuticals. While animal health and diagnostics should be relatively defensive, we suspect that consumer health and nutritionals could ultimately be even less immune from the economic cycle than pharmaceuticals. Diagnostics is also benefiting from strong product innovation with new components of growth in areas such as in vitro and molecular diagnostics.

In Europe, Novartis is the best diversified company with interests across all of the above segments including generics (Sandoz), followed by Sanofi-Aventis. Arguably this is the most defensive strategy if the historic research driven branded pharmaceutical model is broken.

GSK’s strategy however has been to build the consumer health business through acquisition and investment in generating a differentiated clinical package for existing brands. More recently GSK has further diversified its product offering with the acquisition of private dermatology company Stiefel for $2.9bn, generating a new dermatology business operating under the Stiefel brand with total GSK derived dermatology sales post merger of around $1.5bn per annum.

Further on this theme, the acquisition of Schering-Plough has provided Merck & Co with a strong consumer health business. Similarly the acquisition of Wyeth by Pfizer bolsters the Animal Health business of Pfizer and added Consumer and Nutritionals businesses as well as vaccines. By 2012, this newfound emphasis is expected to dilute the enlarged company’s exposure to small molecule R&D from 90% (at end 2008) to 70% (by 2012), post the impact of the Lipitor expiry.

Overall, it would appear that those companies which have faced some of the biggest challenges to their branded Rx business have chosen to diversify. That said each of these companies has invested heavily in an effort to strengthen their investment in branded pharmaceutical R&D. Of the pharmaceutical majors, only AstraZeneca and Lilly offer a pure play branded ethical pharmaceutical investment, although BMS has recently IPO’ed its Mead Johnson consumer health business to focus more on branded Rx opportunities.

Nevertheless, even AstraZeneca, one of the key remaining proponents of the pharmaceutical research based model, has chosen to accelerate its diversification within ethical pharmaceuticals by acquiring Medimmune and CaT. Longer term these acquisitions should increase the contribution of sales from vaccines and biologics, which are less exposed to rapid genericization.

Looking to long-term profitability, it is clear that, with significantly higher operating margins associated with branded pharmaceuticals(~ 65% in the USA for example excluding R&D) compared to consumer health and generics, the pure play pharma companies will disproportionately benefit from successful R&D. That these companies largely suffer from lower ratings than their more diversified peers suggests that the market needs more evidence that high attrition rates in R&D can be reversed.

Dr Brian White