Our assessment of business strength is a key driver of pharmaceutical company ratings. This assessment, along with our assessment of financial risk are the two primary elements in our rating analysis for pharmaceutical companies (as well as for other corporate sectors). This assessment of the business reflects our view of the strength, stability, and long-term durability of the company's profits. Although this assessment is qualitative in nature, we utilize various quantitative statistics within that process. We also find it valuable to compare and contrast these statistics among peers because doing so highlights the relative strengths and weaknesses of companies. We look at these measures holistically to see the interplay among them rather than just viewing each element in isolation. Moreover, these factors are constantly evolving with the ebb and flow of product lifecycles, so we consider their variability over time rather than at a single point in time.

This article summarizes the key quantitative measures we look at in assessing the businesses of the 15 largest rated pharmaceutical companies, how those metrics vary across these peers, and how this influences our assessment of these businesses. Our focus on pure play companies excludes Johnson & Johnson (which is diversified well beyond pharmaceutical products) as well as a number of other smaller investment-grade pharmaceutical companies.

Business Dynamics Are Broadly Positive

We generally view the business model for branded pharmaceutical companies quite favorably, as these companies share many positive characteristics. More specifically, the pharmaceutical business model has uniquely high barriers to competition stemming from patent protection and regulatory exclusivity, stringent manufacturing standards, and substantial capital requirements to fund the research and the lengthy regulatory approval process. In addition, the consumable and non-discretionary nature of life-extending or life-enhancing drugs results in revenues and profits that are relatively insulated from the business cycle. The rated companies in this sector have very high profitability, averaging 30%-40% EBITDA margins (after research and development costs), which is better than any other industrial sector, and are supported by the pricing power granted to the industry in return for the strong societal benefits it provides. Our favorable perspective on well-established branded pharma companies is also supported empirically by relatively infrequent defaults even compared to the broader non-cyclical healthcare sector.

Branded pharma companies, however, are not without weaknesses. Their revenues and EBITDA margins can be quite volatile when key products lose patent protection (absent offsetting growth from other products). This can lead to several years of stagnant revenue or double digit percent revenue declines even for leading global pharma companies. Thus the sustainability, stability, and growth of revenues over the medium term is a significant focus in our assessment of the business. We consider the patent expiration dates on revenue generating products (including exposure to potential patent challenges and generic competition) and conversely, the prospects for revenue growth from the pipeline of drugs under development. In assessing durability of revenues from marketed products we also consider competition from substitute products, clinical data, degree of side effects, risks to formulary status, the number and nature of patents, the number and nature of indications (e.g. chronic versus episodic, acuity of medical condition), and other factors that may lead to a deviation from the base case. In assessing the prospects for revenue growth from the pipeline of drugs under development, we consider the clinical data, whether the company has a history of successful new drug introductions, its record of innovation in a given therapy, available and potential future substitutes, and time to market relative to competitive products, among other considerations.

We believe business strength for branded pharmaceutical companies has been eroding in recent years due to industry developments in the U.S. For example, the industry now has less ability to implement annual increases in net price in the U.S. In addition, branded pharma companies are also facing the prospect of legislative-driven drug price reform that aims to cut spending growth on healthcare and address affordability issues with prescription drugs. This is already slowing revenue growth for branded pharma companies, and we expect drug price reform to lead to moderate pressure on margins in coming years. As a result, we may now consider a high geographic concentration in the U.S. as a negative, in some respects, whereas when drug companies were able to more easily institute annual price increases we generally viewed even high geographic exposure to the U.S. as favorable. Moreover, we expect these headwinds to increase the appetite for debt-financed mergers and acquisition (M&A) to support the level of revenue and earnings growth equity investors demand.

The Strength of the Businesses Varies Materially Among Peers

Notwithstanding their shared characteristics, the major branded pharma companies vary in terms of scale, diversity (product, therapeutic, and geographic), competitive position, level of profitability, and volatility of profitability. Companies also differ in their reinvestment strategy (including the trade-off between internal R&D and acquisitions), the sustainability of revenues and revenue growth, and the degree of operational risk, among other considerations.

Our business risk assessment on the leading global pharma companies discussed in this article range from excellent (the strongest category of six possible categories for business risk) and strong (2nd strongest), to satisfactory (3rd strongest) and we have grouped these categories together in the graphs below. Other pharma companies, including those with non-investment grade ratings, generally score weaker in our assessment of business risk.

We place the greatest focus and weight on the presence of a competitive advantage that is sustainable over the long term, reflecting the potential for premium pricing and product differentiation (derived from meaningful innovation), which is often demonstrated by leading pharma companies. Diversification and scale follow closely in importance.

Competitive strengths and weaknesses

The first six columns in the table below compare companies against peers within the same business risk category. The latter four columns are measured broadly across the group. These factors, however, are not all of equal importance and do not fully reflect the many nuanced distinctions between companies, some of which we highlight in the text below. These figures exclude material revenues from royalties, contract manufacturing, consumer health, generics, and animal health businesses.

Table 1

We take special notice of Gilead Sciences Inc., which has several generations of HIV products that are blockbusters. We view these drugs as highly correlated and expect some of them to cannibalize each other. We thus don't view them as favorably as might be implied by product-level diversity statistics. Gilead's business risk, however, is also supported by substantial cash balances and the capacity and appetite for merger and acquisition activity, which we expect to support growth.

Scale and number of blockbuster drugs

As highlighted in Chart 1 below, we view Merck & Co. Inc. and Gilead as particularly strong in terms of scale relative to their respective business category medians. We view Novartis AG as being particularly strong in terms of the number of blockbusters drugs (those with more than $1 billion in annual sales), while Sanofi, GlaxoSmithKline PLC (GSK), and AbbVie Inc. are weak on this measure. That said, Sanofi and GSK have large vaccine businesses, and GSK also has a large over-the-counter (OTC) business, which provides more diversification than shown. In addition, AbbVie's blockbuster, Humira, covers multiple indications (providing an element of diversification not reflected in the chart). Moreover, Humira is uniquely positioned as the highest revenue generating drug in the world.

Note also, that while we only included revenues from branded-pharma in the charts below, for the purposes of comparability, the non-pharma revenues have an important influence in our rating analysis.

Chart 1

Product diversity

Although we consider both the concentration of revenues from the top product and the top three products, we often view single product concentration as more important, because the probability of the top three all falling materially short of expectations is lower when they are not well correlated. As highlighted in chart 2 below, we view AstraZeneca PLC as uniquely strong, and AbbVie and Celgene Corp. as uniquely weak in terms of product concentration, relative to their respective category medians—although in the case of AbbVie, for example, the top product Humira covers many indications including rheumatoid arthritis, plaque psoriasis, Crohn's disease and other immune diseases. Although product concentration increases potential downside risk, it may also reflect a strength, such as a market leadership position, as in the case of AbbVie's Humira, or support sustained revenue growth, as in the case of Merck's Keytruda.

We also view Gilead as substantially weaker on this front than shown in this chart because several of its products are different generations of HIV products that we expect will ultimately cannibalize each other.

Chart 2

Diversification by disease

Although we consider both the concentration of revenues from the top therapeutic area and the top three therapeutic areas, we often view single greatest therapy concentration as more important, because the risk that the top three will all fall short of expectations is lower when they are not well correlated.

We consider this both at a disease level (e.g. diabetes) as well as at a broader therapeutic category (e.g. endocrine related). For a summary of therapeutic categories and the three largest diseases in each category, please see appendix 1. We consider concentration by therapeutic category because we consider products within a given therapy as being subject to some shared risk of a new competing technology harming revenues of multiple products in that therapeutic category. Some therapeutic categories are more diverse than others. For example, in oncology, there is a large number of distinct indications, which seem to require differing pharmacological strategies and solutions. In immunology there seems to substantial commonality, pointing to drugs, such as Abvie's Humira, that address several indications. Diversification by disease and therapeutic area is taken in context with the degree of competition, the size of that market, the company's market position (market share), and the prevalence of the disease.

We view Eli Lilly & Co. and Novo Nordisk as uniquely weak relative to peers in terms of concentration by disease, relative to the median for the strong category.

Chart 3

Diversification by therapeutic category

We view Pfizer Inc. and Sanofi as uniquely strong, and Roche Holding AG, GlaxoSmithKline PLC (GSK), and Novo Nordisk A/S as uniquely weak in terms of therapeutic concentration, relative to their respective category medians. For Gilead and Celgene, the weakness in therapeutic concentration is a key constraint driving the business risk category. For Roche, we view the high exposure to oncology as partially mitigated by the diversity of indications and unique solutions needed. For GSK, the non-branded-pharma revenues are a mitigating consideration, and for AbbVie, the fact that its largest product, Humira, serves patients with multiple indications is a mitigating consideration to that concentration.

Chart 3a

Geographic diversification

In determining geographic concentration, some companies don't break out EMEA (Europe, Middle East, and Africa), in which case we included those regions in "other". Amgen and, to a lesser degree AbbVie, are substantially more concentrated in the U.S. than the median for category peers. As noted above, we view geographic concentration in the U.S. as more of a risk, than we had in the past.

Chart 4

Revenue declines

Six of the 15 top pharma companies experienced double-digit percent revenue declines of the 2008 - 2018 period, with four seeing an annual decline in excess of 15%. Moreover, for many companies, the worst year of revenue decline was adjacent to other years of revenue decline such that the cumulative decline over multiple years was greater than shown. This data is measured in U.S. dollars, and may reflect currency fluctuations, but it excludes divestitures, and primarily reflects revenue declines stemming from patent expirations.

Chart 5

Research and development, mergers and acquisitions

The chart below details how much each of the 15 companies spent on R&D and M&A, either as a share of total revenues or as a share of EBIT-plus-R&D. In this analysis, R&D only includes internal investment, and excludes spending to acquire in-process R&D (IPR&D), collaborations, and milestone type payments.

Overall, the average R&D margin from 2008 through 2018 for these companies was 17.6% (compared with 19% for 2018). The average reinvestment in growth via M&A was about 10% of revenue and the average total reinvestment—R&D and M&A) as a share of revenues—was 28%.

Another way to think about the conventional level of reinvestment, and the level of reinvestment required to sustain the business, is by measuring that as a percentage of operating-profit-before-spending-on-R&D, i.e. the profits available to split among R&D, M&A, and other uses. The average R&D as share of EBIT-plus-R&D was 41%, the average reinvestment via M&A was about 23%, and the average total reinvestment (R&D and M&A) as a share of EBIT-plus-R&D totaled 63%--which is significantly higher than often acknowledged.

This highlights that the level of profitability (after acknowledging the M&A often needed to support the current level of revenue) is often below the reported levels, and that profit margins which exclude spending on M&A, are not a reliable measure of return on capital in this industry.

Chart 6

Durability of revenues; patent expirations and pipelines

Although the chart below highlights the pipeline prospects and patent expirations, which are key variables in the durability of revenue, the durability of the current revenue generating drugs also depend on marketing efforts to support higher volumes, patent management, lifecycle management (through changes in dosing, delivery method, or extending the indication to pediatric patients), pricing trends, formulary status, and other factors.

This data suggest that Gilead and Biogen Inc. may not have enough of a pipeline to replace lost revenue from patent expirations, over the next three years. In contrast, Celgene, AstraZeneca, and Novo Nordisk, are primed for strong growth, over that same period. That said, Celgene has substantial risk to patent exposure shortly following this 3-year period. In addition, Novo Nordisk's prospects for strong revenue growth, is reliant on only a couple of new molecular entities (NMEs) in the pipeline, which implies more risk of a substantial shortfall from these expectations. It's worth highlighting that the NMEs referenced here may reflect some that are shared in partnership or collaboration among different companies, as well those where a company has only a royalty interest in an NME.

Chart 7

Profitability adjusted for unusually high or low R&D

There are various factors that drive margins aside from innovation, including aggressiveness in pricing, willingness to cut development programs when prospects become less certain, the intensity of R&D spending, and variations in the marketing efforts needed to address that particular portfolio of drugs.

For example, drugs prescribed by a narrow group of specialists can be served by a smaller sales force than drugs that are prescribed by many primary care doctors. Indeed, this is at least part of the reason AstraZeneca's margins are below peers. Interestingly, the chart below seems to suggest an element of negative correlation between therapeutic concentration and level of profitability (as companies further to the right have higher profitability), likely stemming in part from greater efficiencies in marketing efforts that focus on a narrower group of prescribing specialists.

In measuring profitability (EBITDA margins) we used consolidated results (including revenues from non-pharma segments), given the difficulty in accurately discerning EBITDA profitability at a segment level.

EBITDA margins are burdened with R&D expenses (including R&D spending on acquired pipeline assets) but not M&A expenditures, so companies that pursue an M&A growth strategy (as a substitute for investment in R&D) benefit from artificially higher margins. This is why we also look at EBITDA margins adjusted for unusually high or low R&D intensity.

The chart below shows the average EBITDA margins as well as average EBITDA margins reduced (or increased) for R&D margins (R&D/Revenue) that are below-average (or above-average). This reflects margins, assuming the company's R&D expenditures were in line with peers.

Chart 8

In conclusion, although the leading pharmaceutical companies share many common characteristics including the strong competitive advantage reflecting differentiated products with premium pricing, we see substantial variation in business strength across these companies. The primary points of differentiation are scale, diversification, pipeline strength and prospects for sustainable revenue growth. At the weaker end of this group, are companies with substantial concentration within one or few narrow niches.

Appendix: 1: Therapeutic Landscape

Table 2

Appendix 2: Overview Of Our Analytical Framework

Business risk and financial risk are the two primary elements of our rating analysis. We assess each on a scale of 1 (strongest) to 6 (weakest). Our business risk score is based on our assessment of competitive advantage (including market position, degree of competition, and barriers to entry); scale, scope, and diversification (including by product, therapy, geographic region, payor, and customer); and operating efficiency. We also assess the level and stability of EBITDA margins, among other qualitative considerations.

The financial risk assessment is based purely on credit ratios. We tend to place the most emphasis on debt to EBITDA and funds from operations to debt, which we refer to as the "core" ratios. In assessing these ratios, we incorporate various analytical adjustments (including for operating leases, pension obligations, and stock-based compensation, among others). We usually place more emphasis on our projections and the ratios in future years than on ratios from previous years.

Table 3

We combine the business risk assessment and financial risk assessment into the anchor score (a preliminary rating).

Table 4

Finally, we sometimes adjust the anchor score slightly (rarely by more than one notch in this sector) to arrive at the final issuer credit rating. We refer to the end-stage adjustments from the anchor score as "modifiers."

Within the corporate health care sector, we use these modifiers in about 10% to 20% of our ratings, and the comparable ratings analysis modifier is the modifier we use most often. That modifier can be applied in various circumstances, including when a company is at the extreme end of the spectrum within its business risk and/or financial risk category.

Table 5

Table 6

Related Research

• Health Care Washington Watch: Which Government Proposals May Affect Ratings? April 18, 2019
• The Pharma Industry Outlook Is Negative On M&A, Pricing Pressure, Regulatory Scrutiny, And Opioid Litigation, March 11, 2019
• Lessons Learned: What Leads To Rating Changes For Investment-Grade Pharmaceutical Companies, Jan. 22, 2019
• Which Pharma Company Ratings Could Be At Risk If U.S. Drug Pricing Reforms Become Law?, Oct. 31, 2018
• The Opioid Crisis: Growing Litigation Concerns For The Health Care Industry, Oct. 2, 2018
• Criteria - Corporates - Industrials: Key Credit Factors For The Pharmaceutical Industry, April 8, 2014