Big pharmaceutical companies are in a position to do serious damage to their shareholders. The industry is enduring the expiration of patent protection on several blockbuster drugs, which leads to sales decline and profit destruction. In the face of such a bleak future, many management teams will double-down on research & development spending or overbid for acquisitions. This is very, very dangerous for shareholders in these acquiring firms.
The big pharmaceutical companies with projections of growing revenues were reviewed based on free cash flows after adjustment for acquisition expenditures. This adjusted free cash flow to investors was used to create an enterprise value-to-adjusted free cash flow multiple, which provides a way to judge whether the company is cheap or rich.
Acquisitions vs. Internal R&D
Recently, legendary short-seller Jim Chanos warned how acquisitions are a means for companies to double-up on research & development spending without recognizing it in the company's earnings. R&D spending is immediately expensed according to US GAAP (Generally Accepted Accounting Principles), but is largely capitalized in an acquisition. This difference allows acquiring firms to report higher earnings with reduced R&D expense relative to their peers that internally develop their brands and technology.
I utilized this insight to analyze the cost of acquisitions to big pharmaceutical companies, many of which are losing patent protection for their prescription drug products. Despite enticing dividends, investors should look elsewhere. I am not alone in this concern:
The patent cliff in its own right may not be the problem: more the reactions of management to it. For a company facing a patent cliff, a declining share price could even be seen as a sign of a successfully run company - if excess cash is being returned to shareholders via dividends. If a drug company were simply to collect the cash flows and put the money in the bank the share price would remain stable …But because most managers do not follow this business model, they start spending the surplus cash, thereby creating a riskier company, with the assumption that revenues and earnings can be smoothed." - Evaluatepharma.com World Preview 2018
Positive Sales Growth
The best defense against acquisition expenditure is the sales growth of an existing pipeline. According to Evaluatepharma.com, the following five firms have the highest compound average growth rates for prescription drug sales by 2018:
Ticker | Company | 2011 Sales ($B) | 2018 Sales ($B) | % CAGR |
(NVO) | Novo Nordisk | 12.4 | 20.3 | 7% |
(GSK) | GlaxoSmithKline | 34.9 | 44.9 | 4% |
(SNY) | Sanofi | 39.3 | 48.2 | 3% |
(JNJ) | Johnson & Johnson | 22.3 | 27 | 3% |
(BMY) | Bristol-Myers Squibb | 16.9 | 21.4 | 3% |
We next need to see if any of these firms are addicted to acquisitions.
Screening for Cash Inflows
Mr. Chanos warned how acquisitions are back-door way to double-up on research & development spending. R&D spending is immediately expensed according to US GAAP (Generally Accepted Accounting Principles) but is largely capitalized in an acquisition. This distinction allows firms which engage in acquisitions to keep earnings free from R&D expense. Their peers that internally develop their brands and technology would be at a disadvantage vis-à-vis accounting rules, since their earnings would be lower after expensing research and development costs.
This means that investors should pay careful attention to acquisition expenditures and free cash flow adjusted for acquisition payments. Net acquisition cash flows were subtracted from free cash flow below:
Free Cash Flow ($B) | 2007 | 2008 | 2009 | 2010 | 2011 | Average |
Novo Nordisk | 7.55 | 10.86 | 12.31 | 15.78 | 18.04 | 12.91 |
GlaxoSmithKline | 4.01 | 5.14 | 5.97 | 5.16 | 4.92 | 5.04 |
Sanofi | 5.496 | 6.917 | 6.73 | 8.197 | 7.537 | 6.98 |
Johnson & Johnson | 12.08 | 11.91 | 14.21 | 14.00 | 11.41 | 12.72 |
Bristol-Myers Squibb | 2.31 | 2.766 | 3.335 | 4.067 | 4.473 | 3.39 |
Teva Pharmaceutical | 1.271 | 2.55 | 2.654 | 3.426 | 3.081 | 2.60 |
Acquisition Cash Flow, Net ($B) | 2007 | 2008 | 2009 | 2010 | 2011 | Average |
Novo Nordisk | -0.06 | 1.16 | 0.55 | |||
GlaxoSmithKline | -1.02 | -0.45 | -2.79 | -0.35 | -0.26 | -0.98 |
Sanofi | -0.214 | -0.661 | -5.563 | -1.659 | -13.59 | -4.34 |
Johnson & Johnson | -1.39 | -1.21 | -2.47 | -1.27 | -2.80 | -1.83 |
Bristol-Myers Squibb | -0.159 | -0.191 | -2.232 | -0.762 | -0.211 | -0.71 |
Teva Pharmaceutical | -0.018 | -4.749 | 0 | -4.951 | -6.561 | -3.26 |
Adjusted Free Cash Flow ($B) | 2007 | 2008 | 2009 | 2010 | 2011 | Average |
Novo Nordisk | 7.49 | 10.86 | 12.31 | 16.94 | 18.04 | 13.13 |
GlaxoSmithKline | 2.98 | 4.68 | 3.18 | 4.81 | 4.66 | 4.06 |
Sanofi | 5.28 | 6.26 | 1.17 | 6.54 | -6.05 | 2.64 |
Johnson & Johnson | 10.69 | 10.69 | 11.74 | 12.73 | 8.61 | 10.89 |
Bristol-Myers Squibb | 2.15 | 2.58 | 1.10 | 3.31 | 4.26 | 2.68 |
Teva Pharmaceutical | 1.25 | -2.20 | 2.65 | -1.53 | -3.48 | -0.66 |
These numbers for adjusted free cash flow after acquisitions reveal how Novo Nordisk, GlaxoSmithKline, and Johnson & Johnson do not rely heavily on outside acquisitions
Checking Valuations
Company | Enterprise Value ($B) | EV/Avg FCF | EV/Avg Adj FCF |
Novo Nordisk | 83.34 | 6.46 | 6.35 |
GlaxoSmithKline | 128.2 | 25.44 | 31.57 |
Sanofi | 120.57 | 17.29 | 45.71 |
Johnson & Johnson | 176.34 | 13.86 | 16.19 |
Bristol-Myers Squibb | 60.23 | 17.77 | 22.48 |
Teva Pharmaceutical | 49.36 | 19.01 | NA |
Novo Nordisk, and to a lesser extent Johnson & Johnson, are attractively priced because their enterprise values are small multiples of cash flows to investors (debt and equity investors).
Conclusion
Novo Nordisk is a slam dunk investment at current price levels. It has no need for enormous acquisitions because of the forecasted sales growth of its current projects, nor has it engaged in them. It also trades at a very attractive valuation multiple. Johnson & Johnson is also attractive, though to a lesser extent. Both are recommendable at current price levels.
Please read the article disclaimer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
