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In the face of the patent cliff, many big pharmaceutical companies are in a position to do serious damage to their shareholders. In the face of such patent expirations, declining sales, and plummeting profits, many management teams will double-down on research & development spending or overbid for acquisitions. This is very, very dangerous for shareholders.

Large pharmaceutical companies were reviewed based on free cash flows after adjustment for acquisition expenditures. Numbers for adjusted free cash flow to investors were 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. Long and short candidates were produced from this analysis.

Acquisitions vs. Internal R&D

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 keep report higher earnings with reduced R&D expense relative to their peers that internally develop their brands and technology.

There is concern that big pharmaceutical companies will be tempted to make value-destroying acquisitions:

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

Sales Growth

The best defense against the temptation of acquisition expenditure is the sales growth of an existing pipeline. Evaluatepharma.com's projections for compound average growth rates for sales by 2018 are provided below

Ticker

Company

2011

2018

% CAGR

(NYSE:NVO)

Novo Nordisk

12.4

20.3

7%

(NYSE:GSK)

GlaxoSmithKline

34.9

44.9

4

(NYSE:SNY)

Sanofi

39.3

48.2

3%

(NYSE:JNJ)

Johnson & Johnson

22.3

27

3%

(NYSE:BMY)

Bristol-Myers Squibb

16.9

21.4

3%

(NYSE:TEVA)

Teva Pharmaceutical

15.7

19.2

3%

(NYSE:NVS)

Novartis

46.7

51.3

1%

(NYSE:MRK)

Merck & Co

41.9

40.6

0%

(NYSE:ABT)

Abbott Laboratories

22.4

23.1

0%

(NYSE:PFE)

Pfizer

53.5

48.2

-1%

(NASDAQ:AMGN)

Amgen

15.3

14.5

-1%

(NYSE:AZN)

AstraZeneca

32.4

21.9

-5%

(NYSE:LLY)

Eli Lilly

20.4

13.7

-6%

Firms which are expected to see stagnant or declining revenues will have a motive to engage in acquisitions which often destroy shareholder wealth. Next, we will see which of these firms have histories of acquisition cash flows which have rivaled their free cash flows.

Screening for Cash Inflows

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 shielded 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

Novartis AG

13.68

7.45

9.46

11.84

11.92

10.87

Merck & Co.

5.99

5.27

1.93

9.14

10.66

6.60

Abbott Laboratories

3.53

5.71

6.19

7.72

7.48

6.12

Pfizer

11.36

16.54

15.38

9.94

18.58

14.36

Amgen

4.13

5.32

5.81

5.21

4.55

5.00

AstraZeneca PLC

5.83

4.70

10.15

8.50

6.52

7.14

Eli Lilly & Co.

4.07

6.23

3.48

5.67

5.54

5.00

Acquisition Cash Flow, Net ($B)

2007

2008

2009

2010

2011

Average

Novo Nordisk

-0.06

0.00

0.00

1.16

0.00

0.22

GlaxoSmithKline

-1.02

-0.45

-2.79

-0.35

-0.26

-0.98

Sanofi

-0.21

-0.66

-5.56

-1.66

-13.59

-4.34

Johnson & Johnson

-1.39

-1.21

-2.47

-1.27

-2.80

-1.83

Bristol-Myers Squibb

-0.16

-0.19

-2.23

-0.76

-0.21

-0.71

Teva Pharmaceutical

-0.02

-4.75

0.00

-4.95

-6.56

-3.26

Novartis AG

-0.05

-11.53

-0.93

-26.67

-0.58

-7.95

Merck & Co.

-1.14

0.00

-8.97

-0.26

-0.05

-2.08

Abbott Laboratories

0.00

-0.25

-2.37

-9.43

-0.67

-2.55

Pfizer

-0.44

-1.18

-43.12

-0.27

-0.91

-9.19

Amgen

-0.70

-0.06

0.00

0.00

-0.70

-0.29

AstraZeneca PLC

-14.89

0.00

0.00

-0.35

1.77

-2.69

Eli Lilly & Co.

-2.67

-6.08

0.00

-0.61

-0.31

-1.93

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

Novartis AG

13.62

-4.07

8.53

-14.83

11.34

2.92

Merck & Co.

4.85

5.27

-7.04

8.89

10.61

4.52

Abbott Laboratories

3.53

5.46

3.82

-1.71

6.81

3.58

Pfizer

10.92

15.35

-27.74

9.67

17.67

5.18

Amgen

3.44

5.26

5.81

5.21

3.85

4.71

AstraZeneca PLC

-9.06

4.70

10.15

8.15

8.30

4.45

Eli Lilly & Co.

1.40

0.14

3.48

5.06

5.23

3.06

Checking Valuations

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).

Company

Enterprise Value ($B)

EV/Avg FCF

EV/Avg Adj FCF

% CAGR

Novo Nordisk

84.9

6.58

6.47

7%

GlaxoSmithKline

129.67

25.73

31.93

4%

Sanofi

123.83

17.75

46.94

3%

Johnson & Johnson

175.43

13.79

16.11

3%

Bristol-Myers Squibb

55.21

16.29

20.61

3%

Teva Pharmaceutical

47.27

18.21

N/A

3%

Novartis AG

159.16

14.64

54.53

1%

Merck & Co.

136.88

20.74

30.31

0%

Abbott Laboratories

111.89

18.27

31.27

0%

Pfizer

197

13.72

38.07

-1%

Amgen

65.12

13.02

13.82

-1%

AstraZeneca PLC

60.82

8.52

13.67

-5%

Eli Lilly & Co.

49.64

9.93

16.20

-6%

A plot of enterprise value to cash flow multiples versus anticipated future sales growth visualizes this:

EV to Average Cash Flow Multiples

Novo Nordisk (NVO) and Johnson & Johnson (JNJ) dominate Novartis (NVS), Pfizer (PFE), and Eli Lilly (LLY) based on higher sales growth expectations and lower enterprise value to adjusted free cash flow multiples.

Conclusion

Novo Nordisk and Johnson & Johnson are attractive Buy candidates which trade at reasonable valuations and do not need to source acquisitions for future sales growth. Investments in these firms could be hedged by buying LLY puts, PFE puts, and NVS puts. Puts on these firms would benefit from the convergence of NVS share prices to those of its peers or from price declines in LLY or PFE shares following the announcement of acquisitions.

Please read the article disclaimer.

Source: Big Pharma Long-Short Portfolio