Friday 29th April 2016
NEWS TICKER: Central bank policy is still dominating the trading agenda, even though most analysts believe that the Fed will, if it does move, move only once this year and will raise rates by a quarter of a percent. The statement of the US FOMC was terse and most likely signals extreme caution on its part, though there is a belief that hawkish voices are rising in the committee. The reality is though that the US economic growth story is slowing. Many think the June meeting will spark the uplift. Let’s see. The US dollar is continuing to lose ground across the board after data showed the US economy expanded at its slowest pace since the second quarter of 2009, according to the BEA, which FTSE Global Markets reported on last Friday. GDP increased at a 0.5% annualised rate - versus an expected 0.7% - after rising 1.4% in the fourth quarter of 2015 as personal consumption failed to boost growth in spite of low gasoline prices. Central bank caution makes sense in that context, however timing will be sensitive. If the central bank moves in the autumn it threatens to unbutton the presidential elections; but the reality is that mixed data will emanate from the US over this quarter which will make a June decision difficult. It’s tough being an FOMC member right now. The Bank of Japan meanwhile signalled its intention to stay the course this week with current policy, which discombobulated the markets. The Japanese markets were closed today for a public holiday, so it won’t be entirely clear if the market will suffer for the central bank’s decision. Certainly if fell 3.61% yesterday and is down 5% on the week. so the omens aren’t great. Of course, the pattern that is well established of late is that as the market falls, the yen appreciates. The yen was trading at 107.14 against the dollar last time we looked, compared with 108 earlier in the session, having at times touched 111/$1 yesterday (the lowest point for more than 18 months) The month to date has seen a rise in both the short term and long term volatility gauges. Coinciding with the rise, Nikkei 225 Index Structured Warrant activity has also significantly picked up. Nikkei 225 Structured Warrants showed increased activity with daily averaged traded value up 33% month-on-month. The Nikkei 225 Index Structured Warrants had significant increase in trading activity year-on-year with total turnover up by 6.8 times. – ASIAN TRADING SESSION - Australia's ASX 200 reversed early losses to close up 26.77 points, or 0.51%, at 5,252.20, adding 0.3% for the week. The uptick today was driven by gains in the heavily-weighted financials sub-index, as well as the energy and materials sub-indexes. In South Korea, the Kospi finished down 6.78 points, or 0.34%, at 1,994.15, while in Hong Kong, the Hang Seng index fell 1.37%. Chinese mainland markets were mixed, with the Shanghai composite dropping 7.13 points, or 0.24 percent, at 2,938.45, while the Shenzhen composite finished nearly flat. The Straits Times Index (STI) ended 12.42 points or 0.43% lower to 2862.3, taking the year-to-date performance to -0.71%. The top active stocks today were SingTel, which gained 0.26%, DBS, which declined 1.03%, NOL, which gained closed unchanged, OCBC Bank, which declined 1.00% and CapitaLand, with a 0.63% fall. The FTSE ST Mid Cap Index gained 0.60%, while the FTSE ST Small Cap Index rose 0.49%. Structured warrants on Asian Indices have continued to be active in April. YTD, the STI has generated a total return of 1.3%. This compares to a decline of 4.9% for the Nikkei 225 Index and a decline of 6.3% of the Hang Seng Index. Of the structured warrants available on Asian Indices, the Hang Seng Index Structured Warrants have remained the most active in the year to date with Structured Warrants on the Nikkei 225 Index and STI Index the next most active – FUND FLOWS – BAML reports that commodity fund flows went back to positive territory after taking a breather last week, supported again by inflows into gold funds. “The asset class is currently the best performer, with year to date % of AUM inflow at 15%, far ahead of all other asset classes. Global EM debt flows reflected the bullish turn of the market on EMs, recording the tenth consecutive week of positive flows. On the duration front, short-term funds recorded a marginal inflow, keeping a positive sign for the last four weeks. The mid-term IG funds continue to record strong inflows for a ninth week. But it looks like investors have started to embrace duration to reach for yield, as inflows into longer-term funds have recorded a cumulative 0.8% inflow in the past two weeks,” says the BofA Merrill Lynch Global Research team – GREEN BONDS - Banco Nacional de Costa Rica is the latest issuer with a $500m bond to finance wind, solar, hydro and wastewater projects. The bond has a coupon of 5.875% and matures on April 25th 2021. Banco Nacional will rely on Costa Rican environmental protection regulations to determine eligible projects. This is the fourth green bond issuance in Latin America, according to the Climate Bonds Initiative (CBI). Actually, Costa Rica is one of the global leaders in terms of renewable energy use. In the first quarter of 2016 it sourced 97.14% of its power from renewables. Hydro's share alone was 65.62%. – SOVEREIGN DEBT - After coming to market with a 100 year bond last week, the Kingdom of Belgium (rated Aa3/AA/AA) has opened books on a dual tranche bond; the first maturing in seven years; the second in 50 years, in a deal managed by Barclays, Credit Agricole, JP Morgan, Morgan Stanley, Natixis and Société Générale. Managers have marketed the October 22nd 2023 tranche at 11 basis points (bps) through mid-swaps and the June 22nd 2066 tranche in the high teens over the mid of the 1.75% 2066 French OAT – LONGEVITY REINSURANCE - Prudential Retirement Insurance and Annuity Company (PRIAC) and U.K. insurer Legal & General say they have just completed their third longevity reinsurance transaction together, further evidence that longevity reinsurance continues to be a vehicle for UK insurers seeking relief from pension liabilities exposed to longevity risk. “This latest transaction builds on our relationship with Legal & General and solidifies the platform from which future business can be written,” explains Bill McCloskey, vice president, Longevity Risk Transfer at Prudential Retirement. “It's also a testament to our experience in the reinsurance space and our capacity to support the growth of the U.K. longevity risk transfer market.” Under the terms of the new agreement, PRIAC will issue reinsurance for a portion of Legal & General's bulk annuity business, providing benefit security for thousands of retirees in the UK. PRIAC has completed three reinsurance transactions with Legal & General since October 2014 – VIETNAM - Standard & Poor's Ratings Services has affirmed its 'BB-' long-term and 'B' short-term sovereign credit ratings on Vietnam. The outlook is stable. At the same time, we affirmed our 'axBB+/axB' ASEAN regional scale rating on Vietnam. The ratings, says S&P, reflect the country's lower middle-income, rising debt burden, banking sector weakness, and the country's emerging institutional settings that hamper policy responsiveness. Even so, the ratings agency acknowledges these strengths are offset by Vietnam's sound external settings that feature adequate foreign exchange reserves and a modest external debt burden. The country has a lower middle income but comparatively diversified economy. S&P estimates GDP per capita at about US$2,200 in 2016. “Recent improvements in macroeconomic stability have supported strong performance in the sizable foreign-owned and export-focused manufacturing sector (electronics, telephones, and clothing). This strength will likely be offset by weaker domestic activity as the impetus to growth stemming from low household and company sector leverage is hampered by weak banks and government enterprises, and shortfalls in infrastructure. We expect real GDP per capita growth to rise by 5.3% in 2016 (2015: 5.6%) and average 5.2% over 2016-2019, reflecting modest outlooks for Vietnam's trading partners. Uncertain conditions in export markets and the slow pace in addressing government enterprise reforms, fiscal consolidation, and banking sector resolution add downside risks to this growth outlook – RUSSIA - Russia's central bank held interest rates steady at 11% today, in line with expectations, although it hinted that if inflation kept on falling it would cut soon. Last month, the bank held rates steady, warning that inflation risks remained "high" and that the then oil price rise could be "unsustainable." However, the decision came at a time of renewed hope for Russia's beleaguered economy and the country's oil industry with commodity prices showing tentative signs of recovery. The central bank noted that it "sees the positive processes of inflation slowdown and inflation expectations decline, as well as shifts in the economy which anticipate the beginning of its recovery growth. At the same time, inflation risks remain elevated." Yann Quelenn, market analyst at Swissquote explains: "The ruble has continued to appreciate ever since it reached its all-time low against the dollar in early January. At that time, more than 82 ruble could be exchanged for a single dollar note. Now, the USDRUB has weakened below 65 and even more upside pressures on the currency continue as the rebound in oil prices persists. The outlook for Russian oil revenues is more positive despite the global supply glut. Expectations for increased oil demand over the coming years and the fear of peak oil are driving the black commodity’s prices higher – MARKET DATA RELEASES TODAY - Other data that analysts will be looking out for today include Turkey’s trade balance; GDP from Spain; the unemployment rate from Norway; mortgage approvals from UK; CPI and GDP from the eurozone; CPI from Italy; and South Africa’s trade balance – FTSE GLOBAL MARKETS – Our offices will be closed on Monday, May 2ndt. We wish our readers and clients a happy and restful May bank holiday and we look forward to reconnecting on Tuesday May 3rd. Happy Holidays!

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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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