Saturday 31st January 2015
NEWS TICKER FRIDAY, JANUARY 30TH: Morningstar has moved the Morningstar Analyst Rating™ of the Fidelity Japan fund to Neutral. The fund was previously Under Review due to a change in management. Prior to being placed Under Review, the fund was rated Neutral. Management of the fund has passed to Hiroyuki Ito - a proven Japanese equity manager, says Morningstar. Ito recently joined Fidelity from Goldman Sachs, where he successfully ran a Japanese equity fund which was positively rated by Morningstar. “At Fidelity, the manager is backed by a large and reasonably experienced analyst team, who enjoy excellent access to senior company management. While we value Mr Ito’s long experience, we are mindful that he may need some further time to establish effective working relationships with the large team of analysts and develop a suitable way of utilising this valuable resource,” says the Morningstar release - The Federal Deposit Insurance Corporation (FDIC) today released a list of orders of administrative enforcement actions taken against banks and individuals in December. No administrative hearings are scheduled for February 2015. The FDIC issued a total of 53 orders and one notice. The orders included: five consent orders; 13 removal and prohibition orders; 11 section 19 orders; 15 civil money penalty; nine orders terminating consent orders and cease and desist orders; and one notice. More details are available on its website - Moody's Investors Service has completed a performance review of the UK non-conforming Residential Mortgage Backed Securities (RMBS) portfolio. The review shows that the performance of the portfolio has improved as a result of domestic recovery, increasing house prices and continued low interest-rates. Post-2009, the low interest rate environment has benefitted non-conforming borrowers, a market segment resilient to the moderate interest rate rise. Moody's also notes that UK non-conforming RMBS exposure to interest-only (IO) loans has recently diminished as the majority of such loans repaid or refinanced ahead of their maturity date - The London office of Deutsche Bank is being investigated by the Financial Conduct Authority (FCA), according to The Times newspaper. Allegedly, the bank has been placed under ‘enhanced supervision’ by the FCA amid concerns about governance and regulatory controls at the bank. The enhanced supervision order was taken out some months ago, says the report, however it has only just been made public - According to Reuters, London Stock Exchange Group will put Russell Investments on the block next month, after purchasing it last year. LSE reportedly wants $1.4bn - Legg Mason, Inc. has reported net income of $77m for Q3 fiscal 2014, compared with $4.9m in the previous quarter, and net income of $81.7m over the period. In the prior quarter, Legg Mason completed a debt refinancing that resulted in a $107.1m pre-tax charge. Adjusted income for Q3 fiscal was $113.1m compared to $40.6m in the previous quarter and $124.6m in Q3 fiscal. For the current quarter, operating revenues were $719.0m, up 2% from $703.9m in the prior quarter, and were relatively flat compared to $720.1m in Q3 fiscal. Operating expenses were $599.6m, up 5% from $573.5m in the prior quarter, and were relatively flat compared to $598.4min Q3 of fiscal 2014. Assets under management were $709.1bn as the end of December, up 4% from $679.5bn as of December 31, 2013. The Legg Mason board of directors says it has approved a new share repurchase authorisation for up to $1bn of common stock and declared a quarterly cash dividend on its common stock in the amount of $0.16 per share. - The EUR faces a couple of major releases today, says Clear Treasury LLP, and while the single currency has traded higher through the week, the prospect of €60bn per month in QE will likely keep the euro at a low ebb. The bigger picture hasn’t changed, yesterday’s run of German data was worse than expected with year on year inflation declining to -.5% (EU harmonised level). Despite the weak reading the EUR was unperturbed - The Singapore Exchange (SGX) is providing more information to companies and investors in a new comprehensive disclosure guide. Companies wanting clarity on specific principles and guidelines on corporate governance can look to the guide, which has been laid out in a question-and-answer format. SGX said listed companies are encouraged to include the new disclosure guide in their annual reports and comply with the 2012 Code of Corporate Governance, and will have to explain any deviations in their reporting collateral. - Cordea Savills on behalf of its European Commercial Fund has sold Camomile Court, 23 Camomile Street, London for £47.97mto a French pension fund, which has entrusted a real estate mandate to AXA Real Estate. The European Commercial Fund completed its initial investment phase in 2014 at total investment volume of more than €750m invested in 20 properties. Active Asset Management in order to secure a stable distribution of circa 5% a year. which has been achieved since inception of the fund is the main focus of the Fund Management now. Gerhard Lehner, head of portfolio management, Germany, at Cordea Savills says “With the sale of this property the fund is realising a value gain of more than 40%. This is the fruit of active Asset Management but does also anticipate future rental growth perspectives. For the reinvestment of the returned equity we have already identified suitable core office properties.” Meantime, Kiran Patel, chief investment officer at Cordea Savills adds: “The sale of Camomile Court adds to the £370m portfolio disposal early in the year. Together with a number of other asset sales, our total UK transaction activity since January stands at £450m. At this stage of the cycle, we believe there is merit in banking performance and taking advantage of some of the strong demand for assets in the market.” - US bourses closed higher last night thanks to much stronger Jobless Claims data (14yr low) which outweighed mixed earnings results. Overnight, Asian bourses taken positive lead from US, even as Bank of Japan data shows that inflation is still falling, consumption in shrinking and manufacturing output is just under expectations. According to Michael van Dulken at Accendo Markets, “Japan’s Nikkei [has been] helped by existing stimulus and weaker JPY. In Australia, the ASX higher as the AUD weakened following producer price inflation adding to expectations of an interest rate cut by the RBA, following other central banks recently reacting to low inflation. Chinese shares down again ahead of a manufacturing report.” - Natixis has just announced the closing of the debt financing for Seabras-1, a new subsea fiber optic cable system between the commercial and financial centers of Brazil and the United States. The global amount of debt at approximately $270m was provided on a fully-underwritten basis by Natixis -

Discontinuous Change

Thursday, 27 August 2009
Discontinuous Change The pharmaceutical industry faces a critical five years ahead. After its spectacular bull run which lasted from 1994 to 2001 and which saw the market valuations of big US and European companies in the sector soar by more than 400% – share prices have stagnated or fallen over the past four years as investor confidence has ebbed away. While profits remain high, there is little incentive to change. Is there a new approach in the offing? Andrew Cavenagh reports. http://www.ftseglobalmarkets.com/

The pharmaceutical industry faces a critical five years ahead. After its spectacular bull run which lasted from 1994 to 2001 and which saw the market valuations of big US and European companies in the sector soar by more than 400% – share prices have stagnated or fallen over the past four years as investor confidence has ebbed away. While profits remain high, there is little incentive to change. Is there a new approach in the offing? Andrew Cavenagh reports.

Investors fear established drug manufacturers are poorly positioned to cope with the pressures of a changing world, in which the demand for wider access to an acceptable level of healthcare is growing year on year. A continuing supply of innovative, life-enhancing – and affordable – prescription drugs is clearly vital to realising this goal. If the industry fails to deliver them, more government intervention is inevitable. Last year a group of 15 private-sector industry ‘stakeholders’ undertook a detailed investigation into the challenges that confront the sector and its likely future direction. The Pharma Futures group was set up and sponsored by three of the world's largest pension funds – Algemeen Burgerlijk Pensioenfonds (ABP) of the Netherlands, the Ohio Public Employees Retirement System, and the UK's Universities Superannuation Scheme, which – as long-term owners of pharmaceutical stocks – have a substantial interest in the sector's continuing profitability.       The findings of the Pharma Futures report, published in December last year, made uncomfortable reading for everyone involved in the business. The report finds that fundamental change for the industry is inevitable since “muddling through” on the basis of the current business model will mean increasingly unsuccessful fire-fighting on a growing number of fronts. The report also highlights ways that the sector can manage this change and emerge profitable and successful. Critically, the report shows that these challenges will only be met if both the sector and its institutional investors change their thinking and adapt to the new circumstances.

It concluded that unless the companies manage to bring innovative treatments to the market more quickly, the decline in the sector’s value will continue – as will the growing pressure from a broader society to see it overhauled. As well, the report said investor confidence in the sector’s ability to deliver sustainable shareholder value had eroded. Perhaps most worryingly – the report added that “trust is a key issue for this highly regulated sector and is under serious threat”.



“People really are going through a crisis of confidence with this sector,” says Stewart Adkins, senior pharmaceuticals analyst at Lehman Brothers and one of the 15 members of the Pharma Futures panel. “In a global context, I think it is going down.” He suggests that annual growth rates in the sector will drop from 10% to 6-7%, unless the big companies make drastic changes to their business models.

The companies are all too aware that a watershed looms. As Hank McKinnell, chairman and chief executive officer (CEO) of the US world-leader Pfizer, told his shareholders in February at the presentation of the company's 2004 results, “there can be no doubt that Pfizer, along with other research-based pharmaceutical companies, is facing the headwinds of an operating environment quite unlike any we have ever seen.” McKinnell explained that “We face severe pricing pressures, a contentious political atmosphere, and a maze of new regulatory demands. We are in a period of ‘discontinuous change’ – where many of the assumptions of the last half century no longer hold true”.

Bizarrely, the sector’s current financial performance gives no inclination of such impending crisis. Pfizer and the other three US and European giants – GlaxoSmithKline, AstraZeneca, and Merck – collectively made profits of over US$30bn in 2004 on a combined turnover of more than US$130bn [see table]. Furthermore, Pfizer’s net income of US$11.36bn came from sales of US$52.5bn – double the level of just five years ago – and the sector continues to command high credit ratings. “The highly rated US pharmaceutical industry reflects strong credit profiles due to healthy balance sheets, superior margins, excellent liquidity and solid cash-flow generation,” Fitch concluded in a report on the sector at the end of last year. “Even the more troubled credits are still in the single-A category,” adds Michael Zbinovec, the Fitch analyst in Chicago who wrote the report.

So why does this performance fail so utterly to impress the investment community? Despite its figures for 2004, Pfizer’s share price dropped 24% over the year. According to Adkins at Lehman Brothers, the disparity between the sector’s financial performance and investor sentiment reflects the difference between its last 10 years and future prospects. “They’ve got huge legacy balance sheets and huge legacy cash flows from the glory years,” he explains.

Looking forward, by contrast, investors see mounting pressures on drug company revenues and profits from a number of sources – the fast-approaching expiry of patents of a number of ‘blockbuster’ drugs, increasing pressure to regulate prices in the US and a proliferation of expensive lawsuits – arising from both civil litigation and regulatory investigations. “Longer term, I do not have a positive view in pharmaceuticals,” says Martin Eijgenhuijsen, the senior portfolio manager at ABP Investments who is responsible for the fund’s equity investments in healthcare (about 4% of ?156bn) and was another member of the Pharma Futures panel. “I think it is a lot more attractive than a couple of years ago, but I don’t see real signs that the industry is recovering.”

The big concern on the near horizon is the expiry of patents, which undoubtedly represent a clear and present danger to companies’ earnings. The loss of revenue on an ‘expired’ drug is now estimated to be between 70% and 80% within a matter of months, as opposed to the figure of around 50% that was generally assumed a few years ago. “Investors and analysts consistently underestimate the impact this can have on earnings,” maintains Adkins at Lehman Brothers. He adds that there has been no “meaningful pick-up” in new patent approvals to replace the revenue streams that are about to be lost. Zbinovec at Fitch, on the other hand, says expirations will not be too much of an industry-wide issue this year. The loss of patent protection for Abbott Laboratories’ immediate-release form of Biaxin and Johnson & Johnson’s Duragesic are likely to be the two largest instances. However, he acknowledges, there will be a large number of significant expiries in 2006. “That concerns me quite a bit,” comments Eijgenhuijsen at ABP. Affected companies will include Merck, Bristol-Myers Squibb and Pfizer. McKinnell warned his shareholders in February that the company would “lose patent protection on several of its best-selling medicines between this year and the end of 2007”.

The impact of expirations will not be uniform across the sector, however, and Zbinovec at Fitch says: “You almost have to look at it on a company-by-company basis.”

At the same time, the companies will have to face up to a big change in the drug-purchasing arrangements in the US. This is significant. The US alone accounts for 48% of the industry’s global sales and probably nearer two thirds of its profits. Further, it is the only significant market that is not subject to price controls

The Medicare Drug Improvement and Modernisation Act (MMA) will offer senior citizens – who are incurring increasing out-of-pocket expense for their medications – a comprehensive drug benefits package for a premium from the beginning of 2006 and is expected to lead millions of retired people to abandon the private pension plans that presently meet part of their requirements.   This will, in effect, turn the Federal government into the drug companies’ biggest customer in the US. "The Government will become the largest funder [sic] of drugs from 2006," says Adkins. “That changes the outlook for the market quite considerably.”

Although the Bush Administration is not in favour of the government setting drug prices and believes the task is better left to the private sector – and the MMA restricts government interference in pricing decisions – it does seem inconceivable that the government will hand over tens of billions of dollars to the industry without some scrutiny of costs.

Adkins says the federal authorities are unlikely, for example, to pay the prices needed to support the massive sales operations that the drug companies currently maintain – the sector spends twice as much on marketing as it does on research and development. “It will define corporate strategy [going forwards],” he says. “I think the industry has backed itself into a corner."

While the pricing model for the MMA has yet to be determined, Fitch suggests that the pressure for price cuts should be offset in part by the greater volumes of drugs that will be distributed through the programme. However, it concedes that the overall effect on earnings remains “uncertain”. Meanwhile, product liability claims against drug manufacturers continue to rise and the trend shows no sign of abating. The litigation industry received a big boost from Merck’s decision to withdraw its Vioxx COX-2 selective inhibitor for arthritis and pain in September 2004, after studies showed that the remedy increased risk of heart attacks and strokes. The company is now facing more than 800 individual law suits over Vioxx, and the number of claims could expand exponentially. Allegedly officials at the US Food and Drug Administration (FDA) estimate that up to 55,000 deaths may be attributable to the drug. Testimony by the FDA’s deputy director, Dr Sandra Kweder, to a US Senate panel on March 2 seems unlikely to help the company’s cause. Kweder reportedly indicated that it had taken over a year for warnings about the increased risk to appear on Vioxx labels because of protracted negotiations with the company over the wording. Zbinovec at Fitch observes that product liability awareness in the industry had already been heightened in 2004 – by Wyeth’s ongoing litigation of its diet drug, Bayer’s continuing liability for Baycol, and Pfizer’s agreement in July to pay US$60m to settle a class action for the diabetes drug Rezulin (which it inherited when it acquired Warner-Lambert in 2000). Further says Zbinovec, the overall level of litigation is now at record levels. “I would say it far exceeds the norm for the industry.” In terms of its financial impact on the sector, however, Zbinovec says one encouraging sign is that the drug companies are adopting a tougher stance to such claims. “Now the industry is fighting these cases tooth and nail.” Official investigations into industry practices are also rising sharply. Through 2003 and 2004 the US government secured penalties and fines totalling US$2.5bn from the sector. Elsewhere, it is a similar story. In the last week of March, for example, police in London arrested Ajit and Kirti Patel, respectively chief executive and chief executive officer of the Goldshields Group. Their arrest and release on police bail was the latest development in an investigation the Serious Fraud Office began in 2002 into suspected price fixing of generic medicines by companies supplying the National Health Service.

Zbinovec says the increasing number of investigations (the US Attorney’s office is currently looking into claims against Pfizer, Schering-Plough, Bristol-Myers Squibb, Eli Lilly, Johnson & Johnson and Wyeth) will inevitably raise the industry’s exposure to fines. But he adds that the impact of an adverse ruling on the companies’ credit rating would be minimal in most cases.

The only way the industry can sustain its long-term profitability in the face of these internal and external pressures is to develop – and secure approval for – new patented drugs. However, there has been a marked decline in applications and approvals over recent years. The number of new molecular entities (NMEs) approved by the FDA fell from 35 in 1999 to 21 in 2003, while the total of new active substances (NAS) sanctioned by the European Agency for the Evaluation of Medicinal Products dropped from 27 to 17 over the same period.

The trend led the European Commission last year to investigate whether there was a “worldwide crisis” in innovation in the pharmaceutical sector. It commissioned a study from Charles River Associates, which concluded that the downturn was cyclical rather than permanent and that the level of authorisations was likely to pick up in 2005.    However, investors still have reservations about the market value of the drugs that companies are currently developing. Eijgenhuijsen at ABP Investments worries that most are “product-line extensions” that will not provide the sort of returns that companies look for. “If I look at the potential profitability of the pipeline, that may be an issue going forward,” he says. “The industry really has to be innovative.”

Adkins at Lehman Brothers says another problem is that the research is now going into new areas, where the failure or “redundancy” rate is much higher. He points to genomics as an example where it is taking much longer than first thought to develop treatments because there are so many “blind alleys” for researchers to follow. “Has the low-hanging fruit been plucked?” he asks. “Getting a biologically valid target for a drug is getting very difficult these days.” In the shorter to medium term, the drug companies also need to reduce their costs. Part of this will involve reducing overheads, and several companies – including Merck, Eli Lilly, Bristol-Myers Squibb and Schering-Plough – have embarked on restructuring exercises that include scaling back the large sales forces in primary care. Pfizer announced a big restructuring plan at the beginning of April, and Fitch’s Zbinovec says he expects more to follow throughout this year. “It’s moving in the right direction,” agrees Eijgenhuijsen at ABP. “All the others are following as well.”

The other way for the industry to make meaningful savings will be to outsource more of its operations to low-cost, but fast-developing pharmaceutical jurisdictions such as China, India and Eastern Europe. The huge cost differentials have led most of the big companies to set up manufacturing operations in these countries – Adkins points to the example of a Czech generic drug producer that can manufacture products for 20% of the price of a German counterpart yet still make a 60% gross margin – but there is scope to farm out a lot more.

Adkins says, for example it would be quite feasible for US companies to conduct the Phase I and II clinical trials in Asia – and achieve an overall saving of around 3% of ultimate sales. “You could still probably do 25% of your research and development in India at 20% of the cost.”

If the short-term horizon looks bleak for the sector, however, long-term demographics are certainly in its favour as a continually ageing global population should ensure a growing demand for a vast range of existing and new treatments.

As Pfizer’s chief McKinnell observes: “Widespread chronic conditions such as hypertension, depression, and lipid imbalances remain largely undiagnosed and untreated. People are beginning to realise that it makes far more sense to invest in disease prevention and early treatment rather than to accept the human misery and high cost of events such as heart attacks and strokes.”

This has led some analysts to take a bullish view of the sector in the longer-term. “I think the demographics really look good for the pharma companies,” says David Schwartz, the independent stock market historian who wrote a strong recommendation for the sector on the London Stock Exchange’s web site in February.

“I think these things go in cycles,” Schwartz says. “Pharmaceuticals were riding high for a long time and then they hit a bad patch, but all the reasons for these companies to fly as they did in the 1990s are still with us. I think for a long-term player this is a great place to be.”

For an experienced investor like Eijgenhuijsen, however, the key to success in the sector will depend on the development on innovative – and more sophisticated – treatments that will be able to maintain attractive profit margins for a considerable length of time. “If you look at specific cancer drugs, if the industry develops a diagnostic tool with the drug then I think there will not be price pressure on the product.”

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