Large, and largely profitable: Banking on the Future
We advise several pharmaceutical firms as part of our business transformation consulting services practice. We decided to start a continuing review of the financial performance of firms in our practice areas. Our objective is to explore the relationship between Business Transformation and financial performance. We are operating under the belief that business transformation has a positive correlation with increasing enterprise valuation, stronger competitive performance, and correspondingly higher stock performance. We will explore these ideas in this and subsequent articles.
Every company has its own story, and certain trends tend to vary by industry. So, our research data are summarized by industry, as are these articles. We hope that readers will find it easier to relate to the summary conclusions if they are influenced or driven by industry-specific data. This article and series will be focused on the Pharmaceutical Industry, as defined by how companies identify themselves to NAICS industry codes.
Pharma is a BIG industry segment: in excess of $1T in Total Assets, over $500B in annual Revenue, $72B in industry Net Income, and $76B in annual capital investments. We found that the 2nd and 3rd quartiles contain some of the largest industry participants and on average they have significant competitive room for improvement in enterprise valuation, asset turn overs, and Return on Assets compared to 1st quartile performers. Pharma is a highly regulated industry, with well-defined and lengthy procedural steps to get new products approved and into the market. Given these long lead cycles, it is imperative to achieve competitive operating margins AND return on assets – or pay the price by trading at a discount to higher performing peers for an extended period of time. We will explore these topics in more detail in the next blog posting.
Pharma: Bigger is Not Necessarily Better
Our database includes 203 pharmaceutical companies who publicly report quarterly and annual financial data in the United States. We subscribe to the ValueSource data service, and we update our data on a quarterly basis. Our analysis was based on annual financial data, as reported and captured by ValueSource for the most recent annual financial reporting period for each company. We further grouped the firms into four quartiles, and compared their performance to the other quartiles as well as the average for the industry.
We used a statistic called the Z-score to assess and rank companies based on their financial health. The statistical measure includes income statement and balance sheet ratios to develop a composite measure for each company, which is known as the Z-score. It was originally developed by Dr. Edward Altman of New York University, and has been refined over time to become the ‘gold standard’ of financial risk assessment. While most firms in the pharmaceutical industry are well above the parameters which indicate cause for concern, it is a helpful technique to rank firms into four quartiles for comparative purposes.
We will go into much more detail analyzing the relative performance of the Pharma four quartile composite parameters in the next several sections. You will discover that some of the market segment participants are in the 2nd and 3rd quartiles, so absolute size is not a guarantor of financial success.
In the next sections we will summarize and contrast the performance of the industry in the areas of revenue and margins, asset utilization and returns, impact of prior investments and asset efficiency, and market returns and the relationship of debt.
Revenue & Margins
We analyzed data for the 203 companies included in SIC 2834 (Pharmaceuticals), for their most recently reported annual financial results. The Pharmaceutical industry has some of the largest companies in the private sector, including Pfizer, Johnson & Johnson, Novartis, Merck, and GlaxoSmithKline. Twelve firms in the industry had annual revenues in excess of $10B, with total assets between $12B and $195B. There are a number of smaller firms in the industry, with 115 firms each reporting revenues less than $50M annually. Average revenue per firm in the industry was $2.5B, with a relatively tight range across the four quartiles for gross margins (76%) and operating profit margins (29%).
Asset Utilization and Returns
Financial performance varied more widely when factoring in balance sheet performance. Asset Turnover (Sales/Total Assets) and Return on Assets showed greater variation across the four quartiles compared to the average firm as contrasted to their operating margin variation. Asset Turnover ranged between 0.49 and 0.91 for the four quartiles, with an average turnover of 0.51 for the prior 12-month period. Essentially, it took 24 months of revenue to reach the equivalent level of Total Assets for the average firm. Top quartile firms by comparison only required 13 months of revenue to equal their asset investment, almost a full year more quickly.
Return on Assets (Net Income/Total Assets) also showed significant differences across the four quartiles when compared to each other and the industry average. The Return on Asset performance ranged from -18.2% for the 4th quartile to 11.6% in the 1st quartile, with an industry average of 6.6%. The 3rd quartile, with some of the largest firms, had an average ROA of 5.9% — roughly half the performance of the top quartile.
Impact of Prior Investments on Asset Efficiency
The relative higher levels of Depreciation & Amortization incurred by the larger firms, thereby reducing their Net Income Margin % or bottom-line performance, explain much of the difference in the ROA performance of the 3rd quartile. In summary, some of the larger firms in the industry are able to achieve competitive operating profit margins, before accounting for prior asset investments which are being depreciated and amortized over time. Until they are able to bring new drugs on line to generate new revenue streams with competitive margins, they will continue to need to address inefficiencies in asset utilization. And, Pharma will continue to suffer in their relative stock price performance versus their 1st and 2nd quartile competitors.
Market Value and relationship to Debt
We also looked at the market value of firms compared to their total debt book value, and found an even more divergent trend. The market value of pharmaceutical firms to total debt book value ranged from 0.99 to 25.31 across the four quartiles, with an average value of 8.95. Said another way, a higher value suggests the enterprise has a stronger balance sheet compared to lower values, presuming the firm can access the public equity markets to translate some of the ‘paper’ value into equivalent asset value.
At this point, we have taken a fairly in-depth look at the Pharma industry’s performance from top to bottom, next we will move on to an assessment of risk levels and summarize our findings.
A Z-score (a relative financial health assessment score developed at NYU) value of 0.99 in the 4th quartile suggests the market value of a firm’s public equity is about equal to the level of debt of that firm – very risky and represented by their Z-score of -1.54. Firms with a Z-score less than 1.81 are perceived to be distressed, with a high risk of bankruptcy (or acquisition targets with discounted valuations) in the next 12-18 months. The 3rd quartile had an average Z-score of 2.78, which is considered to be close to the top of the ‘Grey’ risk zone. These firms have some elevated credit risk, however their market value to debt is approximately 3X so they do have some room for additional equity if necessary. Also, many of these firms have rather large cash balances as part of their total assets, so they should play through this somewhat fragile financial period presuming their sizable investment in new drugs successfully moves through the approval pipeline in a timely manner.
The table below summarizes the data and you can see some interesting patterns in the second and third quartile metrics as we have discussed.
As you can see, the second and third quartile contained some of the largest firms in the industry. While their income statement measures of efficient performance, Gross Margin % and Operating Income Margin %, were statistically quite close to the industry average, they tended to be significantly less efficient in the use of assets. Driven by relatively high levels of ongoing depreciation & amortization of prior investment in these quartiles, they suffer with lower net income margins with correspondingly low return on assets — and lower relative public equity valuations versus their higher performing peers.
Betting on New Drugs and the FDA, how to take Unnecessary Risk out of the Future
Up to this point we provided a quantitative view of the Pharma industry’s performance across the four quartiles. Taking a more strategic view of performance, we will turn to why and how Business Transformation is the strategic management tool to improve performance reliably.
C-level executives are increasingly turning to Business Process Management (BPM) to take unnecessary risk out of their business and to create more sustainable and agile business models across the enterprise. Why do we say so?
Cap Gemini recently completed a survey of C-level executives and the survey reported 45% of the respondents they now place more emphasis on BPM within their organizations. The research highlighted functional impediments to BPM adoption, and some concerns that BPM is viewed strictly as an IT matter. 48% of those responding identified IT as a barrier to more effective process improvement. In addition to IT being perceived as a possible barrier to BPM initiatives, 46% of the respondents identified a lack of change readiness or change willingness at their organizations.
We know, based on our own consulting practice, that many prominent pharmaceutical firms have some business process improvement initiatives underway. We also know these initiatives tend to be funded from IT, and while some non-IT functional areas are involved, there has yet to emerge a strategic commitment to BPM as a way of life across all functions and organizational levels at most firms. We believe a top-to-bottom commitment to continuous Business Transformation across all functions is a strategic imperative, and in addition to improving enterprise valuations it will also reduce risk.
Value of BT to ROI and Enterprise Value
We introduced a new term in the last section: Business Transformation. We view Business Process Management as just one element of a comprehensive set of tools, methodologies, technologies, and training needs which collectively fall into the larger category of Business Transformation. We employ our Confiance Transformation Framework℠ (CTF) to advise and assist clients with their Business Transformation Initiatives. Using the CTF at a Pharma client, we worked with them to identify and implement process changes within 4 months in excess of 100% Return on Investment. Also, we recently launched Confiance University, (www.confianceuniversity.com) our cloud-based content platform we are building out with our partners to bring all relevant content together for our clients and professionals who are committed to Business Transformation. We believe this will accelerate the acceptance and adoption of Business Transformation by private and public sector organizations, and we intend to provide testing and certification so individuals with different roles and responsibilities may mutually learn and use common approaches to improve performance.
We know organizations that are embracing Business Transformation and are expanding BPM initiatives across more than their IT organizations. They are experiencing positive ROI outcomes – both within the pharmaceutical industry and in other industry verticals. Again, let’s look at the Cap Gemini study for some additional insights. 98% of their respondents reported a positive ROI outcome on their BPM initiatives, and 55% reported returns of at least 2X their initial investment. BPM makes sense, and cents!
Confiance Transformation Framework & Business Transformation
Previously we referenced the Confiance Transformation Framework℠ and the powerful business improvements results achieved at one of our clients in excess of 100% ROI’s.
To learn more about Business Transformation and how to get started, please view our webinar on the Confiance Transformation Framework℠. See how the Confiance Transformation Framework can help your organization with an in-depth discussion and case study.
Confiance is a global provider of business transformation solutions for commercial and government organizations. The company provides a comprehensive approach to Business Process Management, Enterprise Architecture and Service Oriented Architecture through a combination of consulting, education and technology that allows organizations to be more efficient, agile and improve service to customers and citizens. Confiance is recognized by its Global 500 and government agency customers as a trusted partner that helps implement change in order to achieve business results. Confiance’s customers include Alcoa, Bank of America, Bose, GE Commercial Finance, Kraft, State of New York, U.S. Army, Vodafone and Wyeth. For more information visit: www.confiancegroup.com.