AstraZeneca PLC and Pfizer Inc.
Mr Charles Pfizer (1824-1906), courtesy Wikipedia
Pfizer's Offer for AstraZeneca
Big pharmaceutical companies have been buying each other or merging for many years.
AstraZeneca (AZN) is itself the product of a merger between large British and Swedish companies. And Pfizer and AZN are serial acquirers. The reasons for this merger and acquisition activity in 'Big Pharma' are well known. As patents expire and generic competition drives down the price of drugs and as the return on research and development has declined, a sector that was once associated with steady organic growth fell into decline. Between 2011 and 2013 revenues fell at both Pfizer and AZN. One of the ways these companies can respond is to buy or merge with others and then reduce costs by, essentially, reducing staff.
So Pfizer's offer to buy AZN is par for the course. Pfizer is the largest company by pharmaceutical revenues and the fourth by R&D spend in the world. By the same measure, AZN is the sixth largest by pharmaceutical revenue and the ninth by R&D spend in the world.
But Pfizer has a further consideration - US corporation tax. Last month Pfizer reported that it had $69 billion cash outside the USA. If it were to repatriate this amount, Pfizer would have to pay US corporation tax at 35% on the $69 billion less the tax it had paid internationally. In the last three years, Pfizer has paid an average of 14.6% to non-US jurisdictions on its international earnings. This suggests that Pfizer would have to pay around $16.5 billion on its international cash pile if it chose to repatriate all the funds to the USA. (This is calculated by grossing up the $69 billion for the overseas tax and applying a tax rate of 20.4% - 35% less the 14.6% satisfied in other jurisdictions).
This hypothetical charge of $16.5 billion compares to the company's average annual ordinary pre-tax profit of $12.8 billion between 2011 and 2013. If, instead, Pfizer uses these funds to make an overseas purchase, such as AZN, then it will escape this charge for US corporation tax.
Further, given the large difference between UK corporation tax at 20% (from 2015) and US corporation tax at 35%, Pfizer would move its tax domicile from the USA to the UK. This follows in the footsteps of the US company SmithKline Beckman (SKB) which merged with Beechams of the UK in 1989 and then moved to London. The difference is that in 1989 the respective corporation tax rates were 35% in the UK and 38.7% in the USA . Also, SKB moved its HQ and listing to London, which Pfizer does not plan to do.
No one questions the legality of Pfizer's proposals. But Pfizer has declared losses of $9 billion in the USA in the past 3 years, while reporting $43 billion profit internationally - and yet America accounts for about 40% of the world's market for pharmaceutical products. In recent years tax avoidance has become much more of an ethical issue for the public, politicians and the media and, as a consequence, for company directors. And both the UK and Swedish authorities are worried about the reduction in staff, including those engaged on research and development, that will inevitably follow any AZN acquisition.
The industrial logic for the proposed merger, at least at 50 pounds a share for AZN, is not supported by Pfizer shareholders (Pfizer share price in blue, AZN share price in red):
Graph courtesy Yahoo, click to enlarge
The individual investor will consider, in the short term:
Ø Does the current share price of 48.23 pounds (or the proposed purchase price of 50 pounds a share or whatever is the final offer) exceed the value he or she places on AZN?
Ø Would it make sense to invest some or all of the proceeds from a sale in the new enlarged company?
AstraZeneca R&D facilities, in Mölndal, Sweden, courtesy Wikipedia
AstraZeneca (AZN), unlike many other large pharmaceutical companies, relies entirely on the sale of medicines for its survival. The company divides its activity into four therapeutic areas: cardiovascular and diabetes; cancer; respiration, inflammation and autoimmunity; and infection, neuroscience and gastrointestinal.
While trading results have been generally disappointing, AZN continues to be cash generating. Taking 2006 as a base year:
· Revenues in 2013 were 3% below 2006 and 24% below 2011.
· AZN bought back 20% of its shares in this period at an average cost of $48 per share. As a result, earnings per share have increased by 2% since 2006, once large impairment and restructuring charges are excluded from the 2013 results. However, 2013 EPS are 37% below the level of 2011.
· In 2006 the company held net cash of $5.9 billion compared to $0.4 billion net debt in 2013.
· AZN has increased its annual dividend by an average of 7% per annum. 2013 was the first year that saw no increase in its dividend.
· Return on equity, which was 40% in 2006 has declined to 22% in 2013. While this is still an excellent return, the return on retained earnings (new equity) over this period has fallen to 7%. If this poor return on new capital continues, AZN's profitability and cash generation will suffer.
· Over the last 5 years, net operating cash flow has covered the dividend by 1.9 times, leaving almost $16 billion for share buy backs and acquisitions.
In the past five years, AZN shares (in blue) have underperformed the FTSE 100 (in red) until Pfizer came along with its offer:
Graph courtesy Yahoo, click to enlarge
At the current price of 48.23 pounds, AZN shares trade on an adjusted PE ratio of 20 and yield 3.5%. The two main adjustments in 2013 are a $1.8 billion impairment charge for sales of a new drug, which are "below commercial expectations", and a $1.4 billion charge for restructuring. Include these charges and AZN's historical PE ratio rises to 40.
The Chairman gives a sobering account of the state of his industry in the 2013 Annual Report: "The world pharmaceutical market is still growing and underlying demographic trends remain favourable to long-term industry growth. However, many of the drivers of demand and supply in the industry are under pressure. On the demand side, we face increased competition from generic drugs as some of the world’s most successful medicines come off patent. In addition, securing recognition (through reimbursement approval) and reward for innovation (through favourable pricing and sales) is becoming more difficult in the face of intense pricing pressures, particularly in Established Markets facing rising healthcare costs. On the supply side, the industry faces an ongoing R&D productivity challenge. R&D costs have risen significantly over the past decade, while industry-wide probability of success of new medicines, though showing some recent signs of improvement, has not kept pace."
Against this background, the outlook for AZN is not good. Consider:
1. The company's three largest selling drugs, Symbicort for asthma, Nexium for acid-reflux and Crestor for managing cholesterol levels, account for over half of AZN's sales. The first two will lose patent protection in 2014 and Crestor's main patents expire in 2016. Sales will fall dramatically. AZN has not been able to develop or acquire new drugs to replace these three 'blockbusters'.
2. World pharmaceutical sales increased by 2.7% in 2012 and by 2.5% in 2013. The company cites the projections for world drug sales by the consultancy IMS Health. IMS expects global sales to increase by 8.6% per annum from now to 2017. AZN might be disappointed.
3. AZN's new CEO expects core earnings per share to decline by the mid-teens, in percentage points, in 2014. His objective is that, by 2017, the company will have recovered the level of sales it reached in 2013, which was 24% below 2011's sales.
As it can take ten years to develop, test and receive the final approval of the regulators for a drug before it can be marketed, the traditional pharmaceutical business is only affordable for large companies willing to take the long view of their business.
AZN appointed a new CEO in October 2012. He has set three strategic priorities:
Ø Achieve Scientific Leadership
The company will focus on cardiovascular diseases and diabetes; cancer; and respiration, inflammation and autoimmunity. It believes it has the best opportunities of developing new drugs in these three areas and it will support them via two autonomous biotech units and 'novel' science. It has set goals for Phase II trials. AZN is moving its corporate headquarters and global science centre to the Biomedical Campus in Cambridge. Here it will have direct access to academic scientists, which the CEO believes can contribute in the early stages of R&D.
Ø Return to Growth
New goals for specific drugs that it believes offer the best opportunities in certain specific markets. It is seeking to accelerate growth through larger scale product in-licensing and partnerships, and with bolt-on acquisitions.
Ø Be a Great Place to Work.
The failure of many of AZN's new drugs to get beyond Phase III - the last testing phase - prior to regulatory approval has sapped the enthusiasm of its staff. And, despite acquiring many new businesses, the number of employees has fallen by almost a quarter since 2006. By flattening the organizational chart, simplifying procedures, communicating directly with staff and focussing on 'talent and leadership', the hope is that staff morale and productivity will improve.
However, AZN will, over four years, cut 10% of its staff at a cost of $2.5 billion to realise an annual cost saving of $800 million.
Assuming that revenues and earnings recover to 2013 levels by 2017, my model values AZN shares at less than 30 pounds. No doubt AZN is worth more to an industrial buyer which is also aiming to save large sums in tax.
AZN shareholders should also consider the risks attached to AZN as an independent company:
1. The new CEO's plans look positive but they cannot be valued by an outsider. The essence of the business, as outlined above by the Chairman, is not going to change and this must cause any investor to wonder whether the CEO's seemingly modest objectives are realisable.
2. Net sales have declined from 55.6% of gross sales in 2011 to 45.4% in 2013. The huge and widening difference between the two reflect the increasing burden of chargebacks (from wholesalers) and rebates (from managed care and group purchasing organisations). This loss of pricing power reflects the difficult market that drug companies now face.
3. Capitalised product marketing and distribution rights have risen from $9.7 billion to $14.6 billion in three years. 2013 results were hit with a $1.8 billion impairment charge and further impairment charges could be in the offing.
4. Moody's downgraded AZN's credit rating for long-term unsecured debt from A1 to A2 in April 2012. The credit rating agency cited the loss of patent protection as its main concern.
5. The company's defined benefit pension schemes are in deficit to the value of $2.2 billion. While the schemes have been closed to new entrants since 2000, they will most likely require further funding.