Big Pharma: Navigating a Golden Age of Innovation

Transcript

A massive wave of innovation is taking place in drug development. We saw it in the rapid rollout of vaccines and therapeutics to treat COVID-19. There’s also been a corresponding proliferation of early-stage biotech companies in private and public markets in recent years.

But the need for constant innovation has always been a fact of life for big pharma. The patents on all drugs eventually expire, typically 10 to 15 years after they launch. Think of it as a treadmill that requires constant investment instead of running.

This reality underpins how I analyze the companies I cover. For all the complex science taking place, how management chooses to allocate capital is still critical to creating value.

I view large pharmaceutical companies as portfolios of assets that the market tends to value based on the duration and diversity of the underlying cash flows.

In my experience, the most appealing setups often occur when a company trades at a lower price-to-earnings multiple—and management is taking credible steps to transform the company’s product portfolio to diversify and extend the duration of its cash flows.

History is littered with examples of companies where management teams rest on their laurels after developing a blockbuster drug and failed to maintain an appropriate level of investment in advance of the inevitable patent cliff. I actively seek to avoid these situations.

I prefer to take a long-term view on how a company’s investments in research and development might affect the duration and diversity of its product portfolio. This approach, in my experience, is often a higher-probability exercise than trying to add value by trading around potential near-term catalysts.

Let’s explore some of the nuances behind the two main levers for pharmaceutical companies to replenish their product portfolios: research and development and mergers and acquisitions.

We’ll start with R&D. Understanding innovation is at the heart of my framework. Cutting-edge therapeutics tend to enjoy better pricing power, particularly when they exhibit superior efficacy to existing treatments or address areas of unmet need. For example, one of the highest-quality European pharma companies managed to avoid years of widespread government pricing pressure on therapeutics following the global financial crisis. Why? Because the company had three highly effective cancer drugs for which there were no alternatives.

But not every cutting-edge therapeutic is a clinical or commercial success.

Some areas where I see a strong overlap between innovation and potential commercialization include oncology and immunology. I also see promising drugs in the pipeline for patients with Alzheimer’s. The size of the market and limited competition suggest that, if approved, some of these therapies have the potential to be mega-blockbusters. Obesity is another area where significantly improved efficacy of recently developed drugs has driven favorable reimbursement trends and could create significant commercial opportunity.

M&A, along with partnerships and licensing, can help big pharma to build out its development pipeline.

In my view, roughly half of my coverage universe urgently needs to boost their growth profiles in the back half of the decade. That’s when a significant wave of patent expirations could pose a challenge if management teams do not address the issue proactively. I tend to take a cautious view of companies that likely need to pursue ambitious M&A programs.

I see the potential for deal flow to pick up, as early-stage companies need to raise capital in a market where liquidity may be more constrained than in recent years. However, the large number of recently formed companies, in my opinion, has lowered the overall quality of the small- to mid-cap universe. I think management teams will need to be very selective in their deal making to avoid negative returns on investment.

I am optimistic that we’re at the beginning of a golden age of drug discovery, fueled by the technological and scientific advances of the past few decades. Amid all this change, however, my framework for evaluating large-cap biopharma companies remains consistent. The key, I believe, is viewing these innovations through a commercial lens and focusing on trends in the duration and diversity of a company’s cash flows. To this end, I’ll continue to pay close attention to different management teams’ willingness to invest at an ever-increasing rate to support long-term growth.