Pharmaceutical actions – what to look for

One of the most important aspects of investing is understanding what a business does and the risks to its business. Profits and cash flow are key metrics to watch for any business, but there are often industry-specific metrics as well. This can be especially tricky when it comes to pharmaceutical companies. In addition to medical jargon, it is often difficult to decipher the value of a group’s drug portfolio.

Cash flow – what is it and why is it important?

Every investment carries a certain degree of risk and pharmaceutical stocks are no exception. However, we believe that the information below should help in the decision making process.

This article is not personal advice. If you are unsure whether an investment is right for you, seek advice. Ratios and metrics shouldn’t be seen in isolation, you need to see the big picture. All investments and the income they generate may fall as well as rise, so that you may get back less than what you invested. Past performance is no guarantee for the future.

Size matters

It’s expensive to be a drug maker. Enormous research and development costs go into every new therapy, and many never make it to drugstore shelves.

Only about 10% of newly developed drugs will pass the rigorous testing process. Even in the later stages of the approval process, there is a better chance that a drug will be thrown in the trash than made available. Just over 58% of drugs in phase three (final stage) clinical trials will be rejected.

One bird in the hand is worth three in the bush, as they say, and in the case of drug makers, this certainly applies. Having drugs already on the market generating the money to support the expensive development process is a big bonus. For this reason, the biggest and best-funded players in the industry tend to be more secure than some of the nascent biotech stocks that often make headlines.

In the United States, Johnson & Johnson (JNJ) is an example of such a juggernaut. In the last quarter alone, the group’s pharmaceutical division brought in $ 13 billion. JNJ already offers several patented and cash-generating treatments, which represent around 20% of the group’s overall sales. For these drugs, competition is limited and revenues are relatively secure.

Overall, its pharmaceutical arm generates just over half of its revenue. The rest comes from a host of other products like medical devices and consumer products, adding a layer of diversification. The group plans to split its consumer goods business, which will shift the portfolio more towards pharmaceuticals. But the fact remains that JNJ is more diverse than some of its smaller peers.

Johnson & Johnson revenue breakdown

Johnson & Johnson Pharmaceutical revenue breakdown

Source: Johnson & Johnson Annual Report 2020.

From a safety standpoint, this can be a good thing because a failed drug will not sink the ship. But on the other side of the coin, a new treatment won’t move the needle much either. It’s clear when you look at JNJ’s price / earnings ratio.

While there have been several big developments for JNJ, like the Covid-19 vaccine and subsequent boosters, investors are willing to pay $ 16 for every $ 1 of expected profit – roughly in line with the 10-year average of the group.

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Patent protection

The size of a drug manufacturer helps mitigate the ups and downs that come with the drug approval process. But patent protection is what keeps their current arsenal of treatments profitable while they work on new therapies. When a new drug is created, it gets patented, preventing the low-cost generic versions from taking hold and starting a price war.

But the rights to a particular drug don’t last forever. For the most part, after 20 years, they will expire. With the exception of a few brief expansions, you can expect generics to hit the market soon after, drastically reducing profitability.

With that in mind, patent expiration is another key way to gauge income. If a significant percentage of a company’s sales are at risk over the next few years, it’s important that its pipeline is relatively advanced with several drugs in the process of being approved.

Take AstraZeneca, for example. Sales in the United States represent approximately one-third of overall revenue. From 2029, a significant portion of that revenue is likely to decline as its patents begin to expire.

Percentage of AZN US revenue at risk due to patent expiration

Scroll down to see the full graph.

Source: AstraZeneca 2020 annual report.

However, the group has 171 projects in its pipeline. Of these, more than half are in the final stages of the approval process. This does not guarantee that the income will be replaced. But that does mean there is a better chance of having new sources of income in place before the old ones dry up.

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Dividend potential

The big drug companies are generally well known for dividend payments. While it is always nice to have the added benefits of a dividend payment, there are some things to consider.

The first is the budget. A pharmaceutical company that earns too much for its shareholders will find it difficult to invest in its pipeline. This could expose them to the expiration of their existing patents.

On the other hand, investors will expect some compensation if they are to remain in the uncertain approval process. With most of the biggest names in the business handing over money to shareholders, that’s an important consideration.

Just because a business pays dividends today doesn’t mean it will pay dividends tomorrow. We suggest that you look at dividend coverage to get an idea of ​​the safety of a dividend payment – but remember that dividend yields are variable and no dividend is guaranteed. They are not a reliable indicator of future income.

GlaxoSmithKline, for example, recently reduced its dividend and is now expected to offer a potential return of 3.5%. This represents nearly 70% of the group’s income, leaving behind 30% to invest in growth and repay debt. While not a huge cushion, it is enough to suggest that there is no immediate need for further cuts.

However, a single metric rarely tells the whole story and that’s why it’s important to look at the big picture. Many companies choose to divert investor cash to pay off debts if they start to get expensive. With a potential rise in interest rates on the horizon, heavily indebted companies may begin to prioritize their financial obligations.

GSK is in such a position. The group plans to proceed with a split that will see its debt flow to its consumption branch in the coming year. But if that doesn’t go as planned, the dividend could be on the chopping block.

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The bottom line

Demystifying drug portfolios and understanding how drug companies run their businesses takes time and effort, but all of this information can be found in their annual reports. If browsing through a mountain of drug data isn’t your cup of tea, we’ve got research updates on over 100 stocks, including a few in the pharmaceutical industry.

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Unless otherwise stated, estimates, including potential returns, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Returns are variable and not guaranteed. Past performance is no guarantee for the future. The value of investments goes up and down, so investors could suffer a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No opinion is given on the current or future value or price of an investment, and investors should form their own opinion on any proposed investment. This article has not been prepared in accordance with legal requirements to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting pre-research transactions, but HL has controls (including transaction restrictions, physical and information barriers) in place to manage the transactions. potential conflicts of interest presented by such a transaction. Please see our full disclosure of non-independent research for more information.

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