The end for the Pharmaceutical Bull Cycle?

The denouement of a sectoral investment trend is characteristically well telegraphed.

A cable transmission is received. Typically terse, it notes either the demise of, or the malfeasance by, a much admired and widely held company and is generally read in utter disbelief. In some cases, investors refuse to acknowledge the existence of the wire; denial is a strong salve applied on all manner of pernicious investment choices.

Such repudiation appears to be the mantra, for an investment case, in the pharmaceutical sector today.

There have been three drivers of investment returns in the current pharmaceutical cycle; large pharma and small biotechs alike are part of this virtuous loop.

The first driver has been the “develop-and-sell” model. Small companies develop quasi-beneficial products and quickly sell out to a large pharma in possession of a sales channel and marketing expertise. This creates a frenzy of interest by investors looking for the next drug to reach FDA approval. Efficacy and ultimate profitability of such drugs are of secondary importance to those investing in this model; they are simply banking upon the hope that a larger pharmaceutical company will be the greater fool.

The second driver is traditional, but with a tax twist. Large pharma merges with other large pharma to cross-sell each other’s compounds. Many head to Ireland or even to Canada, for tax inversions, where corporate accounting can be charitably described as Byzantine and regulatory oversight is next to nil. These lower tax brackets and wider loopholes enable companies to post abnormally large increases in profits, for a time.

The third driver is novel and somewhat unique to this sector and cycle. More recently, a new-and-improved pharmaceutical business model has appeared; the M&A rollup. Certain companies, led not by scientists, but instead by investment bankers (many formerly of McKinsey & Co.), engage in serial acquisitions of anything and everything, with actual sales, that isn’t bolted down. Upon consummation of an acquisition, purchase accounting quirks are used to maximum advantage and R&D spending is slashed or eliminated altogether; this immediately benefits the bottom line and enables firms to boast of improvements in operating margins.

Investors swoon at the hard-nosed approach and praise the rollup executives as being astute and visionary. Less widely discussed are predatory price increases of the acquired company’s product list which pay off the acquisition debts and MA& fees. Almost unknown, but likely to be talked about in the year ahead, is the “sharing” of a portion of the shocking price increases, in the form of rebates, to ensure silence, with middlemen and Pharmacy Benefit Managers, wherever permitted by law. Possibly it will determined that some of the inducements were in fact, suborned.

The M&A fueled double whammy of outsized pricing changes and reduced R&D expenses does lead to rapid profit changes; it is a siren song. Such earnings momentum, of course, can only be sustained with further acquisitions.

Perversely, and in sharp contrast, industry class acts, those firms that refuse to participate in the shenanigans, appear dowdy and out of step. The adage, “no good deed goes unpunished”, applies at frothy tops; for it is the principled businesses that are discounted down to low valuations, while the M&A dross represents the froth that is adored.

Pharmaceutical rollups are also loved by Wall Street, who earn massive M&A fees, bond placement fees and occasional equity underwriting fees in exchange for explicit support of the model. It is rare indeed to find a firm with anything negative to say about the M&A rollups. Why would they? Disbelief is readily suspended by deliveries of boatloads of cash to your front step. Wall Street has no interest in killing the golden goose.

Despite Wall Street’s reticence to carefully scrutinize their clientele, the combinations of predatory pricing and some outright dodgy practices for pushing products are coming to light. This would be bad enough in its own right; compounding the risk is the backdrop of the current US presidential cycle. A catalyst is needed to rally public support for one candidate or another. If I was a policy advisor, I could not think of a better call to arms, to sway public opinion in favor of my candidate’s platform, than to attack pharmaceutical companies.

I suggest that an outcry against egregious pricing by pharmaceutical companies is gathering steam. What may ensue could be a series of public lynchings, increased legislative and/or regulatory oversight, or, at the very minimum, an equity-capping pillory of the industry. Every US election is fought over something; the public and the politicians require a villain in any economic cycle. In the 2008 downturn, it was the banks. In the early 2000’s, it was the dotcoms. I suspect that this time, the “evildoers” will be the pharmaceutical companies.

Lest we all forget, it was not so long ago, during the tenure of President William Jefferson Clinton, that legislation was passed which resulted in the bankrupting of almost EVERY single publicly traded nursing home chain in America. As with the pharma rollups of today, the nursing home industry at that time had been rolled up by a number of firms. That industry was also subject to scrutiny for above above average pricing increases, bad service, legal lapses and employed shoddy accounting practices.

It is a possibility that the new US President will also be a Clinton; such a development could bode ill for foreign pharma rollups; that business sector has, apparently, played fast and loose with rules of the game. Companies domiciled in foreign jurisdictions should be the first likely targets of particularly harrowing scrutiny. For a US legislator, there is absolutely no downside to driving a “bad-apple” foreign company out of business with punitive fines.

In my view, pharmaceutical investors are in the denial stage of the cycle. Predatory practices appear to have gone on; suspect accounting has propped up bad acquisition decisions. The rising tide of rampant price increases for branded products has even permitted marginal players, that being the generic pharmaceutical manufacturers, to engage in some healthy price hikes of their own. Good companies and bad alike have been buoyed by the rising tide.

Even if the sector survives a period of enhanced scrutiny, I surmise that two, of the sector’s three, stool legs have been effectively sawn off. M&A rollups only succeed when price increases can be achieved to support high valuations. If drug pricing for branded products cannot be increased, mergers will abate. A cessation of merger activity caps valuations and investors are wholly unaccustomed to valuation compression in the sector. And, if mergers cease, the investment case for the “develop-and-sell model” in the smallest companies also ends. An end to the pharmaceutical bull market will bring to an end the inexpensive funding to serve as a greater fool; funding to carry marginal drugs through the FDA filing process will also become impossible to source.

When an entire industry becomes tainted, I have seen, time and time again, that an integral part of the tarring is as a result of investment bankers enmeshing themselves in the running of firms. It appears that seeds have been sown for the demise of the pharmaceutical sector; the “smartest guys in the room” have taken over the pharmaceutical boardrooms and are milking it for everything they can. Now, I believe that momentum has clearly shifted. Sentiment has definitely changed. The tide has likely turned.