Our assessment of business strength is a key driver of pharmaceutical company ratings. This assessment, along with our view of financial risk are the two primary elements in our rating analysis for all of our corporate ratings. The business risk profile reflects our view of the strength, stability, and long-term durability of the company's profits. Although our assessment is qualitative in nature, we use various quantitative metrics within that process. We also find it valuable to compare and contrast these metrics 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.

We've looked at key quantitative measures in assessing the businesses of the largest pharmaceutical companies we rate, how those metrics vary across these peers, and how this influences our view 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, such as CSL Ltd.

S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The consensus among health experts is that the pandemic may now be at, or near, its peak in some regions but will remain a threat until a vaccine or effective treatment is widely available, which may not occur until the second half of 2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

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 companies we rate 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 supported empirically by relatively infrequent defaults even compared to the broader non-cyclical health care 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 we focus on the sustainability, stability, and growth of revenues over the medium term (over a two- to three-year period) 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 look at 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 revenue growth prospects 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.

Current Industry Dynamics And Outlook

We believe business strength for branded pharmaceutical companies has been eroding in recent years due to industry and regulatory 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 face the prospect of legislative-driven drug price reform that aims to cut spending growth on health care 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. Further, the growing momentum of biosimilars has increased pressure in the high-price and high-margin biologic drug market. For further details, "Biosimilar Adoption In The U.S. Will Challenge Some Of Pharma's Biggest Names," published March 3, 2020, provides further detail on rising biosimilar market in the U.S. 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.

Indeed, in the year since our prior report on the industry published June 10, 2019, three transformative M&A transactions occurred: AbbVie Inc.'s acquisition of Allergan, Bristol-Myers Squibb Co. acquisition of Celgene, and Pfizer Inc.'s pending divestiture of Upjohn. We are including Takeda Pharmaceutical Co. Ltd. in this report to replace Celgene on our list and Regeneron Pharmaceuticals Inc., a newly rated entity. (See "Regeneron Pharmaceuticals Inc. Assigned ‘BBB+’ Issuer Credit Rating; Outlook Stable," published Aug 5, 2020).

For more details on our outlook on the sector, please see "Outlook 2020: Pharmaceuticals Negative On M&A, Opioid Litigation," published Feb. 18, 2020, "Pharma Industry Only Moderately Affected While Helping Mitigate COVID-19 Pandemic Impact," published March 16, 2020, and "What Does Pharma’s Quest For A COVID-19 Vaccine Mean For Its Credit Quality And ESG Profile?" published July 8, 2020.

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.

Our business risk assessment on the leading global pharma companies we're discussing range from excellent (the strongest category of six possible categories for business risk) and strong (second strongest), to satisfactory (third strongest), and we have grouped these categories together (see table 1). Other pharma companies, especially 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 (and frequently reflected in the strength of the pipeline and track record of the R&D organization). Diversification and scale follow closely in importance.

Competitive strengths and weaknesses

We've compared companies against peers within the same business risk category as well as looked at how they measure broadly across the group (see table 1). These factors, however, are not all of equal importance and do not fully reflect the many nuanced distinctions between companies, some of which we discuss below. These figures exclude material revenues from royalties, contract manufacturing, consumer health, generics, and animal health businesses.

Table 1

Large Recent M&A Transactions Have Affected Business Strength

AbbVie, Bristol-Myers Squibb Co., and Pfizer have undertaken large M&A transactions, after which we slightly revised our assessment of their business strength. However we have not changed our overall business risk score for these companies. The transactions presented a mix of positives and negatives. We think overall business profiles of AbbVie and Bristol-Myers have improved. In the case of Pfizer's divestiture, we view the business profile as slightly weakened. These three transactions represent a convergence in terms of scale among leading industry participants, with seven companies having scale between $35 billion and $45 billion. We're also seeing improvements in the industry pipeline relative to last year, helped by R&D and smaller M&A transactions, while companies have been looking to divest non-core businesses such as consumer products, generic drugs, and animal health assets. Material changes to financial metrics and polices have also contributed more significantly to rating actions.

AbbVie Inc.

AbbVie Inc.'s acquisition of Allergan materially increases the company's scale and meaningfully improves product and therapeutic diversification, with its top revenue-generating product, Humira, an immunosuppressive drug, now representing about 40% of revenues, rather than 60% previously, and gave the company a Medical Aesthetics and Ophthalmology business. This transaction also supports revenue growth, especially as Humira patents expire in 2023. That said we view demand for Medical Aesthetics products (e.g., Botox) as subject to greater volatility in a cyclical downturn.

Bristol-Myers Squibb Co.

Bristol-Myers' acquisition of Celgene materially increased the company's scale, level of profitability, and pace of revenue growth and strengthened its position as a leader in oncology. However, the company retained relatively high product concentration, given Celgene's blockbuster Revlimid, and high therapeutic concentration in oncology. Its geographic concentration in the U.S. also increased.

Pfizer Inc.

Pfizer's divestiture of the Upjohn business will materially reduce the company's scale, increase product concentration, and increase revenue concentration in the U.S., but offers an opportunity for higher revenue growth and a greater focus on the innovative side of the business.

Biogen Inc.

Biogen is another company having undergone significant change. Although its product concentration has not materially changed since last year, a court judgement against its patent on its top product, Tecfidera, is why we view high product concentration as a key rating consideration. This is not fully offset by strong revenue growth from its second-largest product, Sprinraza (a treatment for spinal muscular atrophy, SMA). The abandonment and subsequent reversal of Biogen's bid for regulatory approval of aducanumab for Alzheimer's, were key developments, which meaningfully influence the company's future prospects.

Although 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. This is because the probability of the top three all falling materially short of expectations is lower when the products 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 look at concentration by therapeutic category because we view 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 categories are more diverse than others. In oncology, for example, a large number of distinct indications seem to require differing pharmacological strategies and solutions. In immunology substantial commonality exists given that to drugs, such as AbbVie's Humira, 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.

Chart 2

Chart 3

Diversification by therapeutic category

Chart 4

Geographic diversification

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

Chart 5

Revenue declines

Six of the 16 top pharma companies experienced double-digit percent revenue declines in the 2009-2019 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 6

R&D and M&A

We've looked at how much each of the 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, the R&D amount only includes internal investment, and usually excludes spending to acquire in-process R&D (IPR&D), collaborations, and milestone type payments.

Overall, the median R&D margin from 2009 through 2019 for these companies was 17.2% (compared with 17.9% for 2019). The average reinvestment in growth via M&A was about 12% of revenue and the average total reinvestment—R&D and M&A as a share of revenues—was 29%. Another way to measure that is 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 therefore totaled 64%--which is significantly higher than often acknowledged.

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

Chart 7

Revenue durability, patent expirations, and pipelines

Pipeline prospects and patent expirations are key variables in the durability of revenue (see chart 8). But the durability of a company's current revenue-generating drugs also depends 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.

We note that the new molecular entities (NMEs) we reference 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 8

Profitability is adjusted for unusually high or low R&D

Various factors affect margins aside from innovation, among them 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 that 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 PLC's margins are below peers. This seems to suggest an element of correlation between higher therapeutic concentration and higher level of profitability (as companies further to the right on Chart 9 have higher profitability), likely stemming in part from greater efficiencies in marketing efforts that focus on a narrower group of prescribing specialists (see chart 9).

In measuring profitability (EBITDA margins) we use 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 and certain contingent payments) 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.

We've looked at average EBITDA margins as well as average EBITDA margins reduced (or increased) for R&D margins (R&D to revenues) that are below average (or above average) (see chart 9). These margins assume the company's R&D expenditures were in line with peers.

Chart 9

We note that although the leading pharmaceutical companies share many common characteristics including having a strong competitive advantage reflecting differentiated products with premium pricing, we see meaningful variation in business strength across the sector. The big differences are of scale, diversification, pipeline strength, and prospects for sustainable revenue growth.

The weaker end of this group consists of companies with substantial concentration within one or few narrow niches.

Appendix 1: Therapeutic Landscape

Table 2

Appendix 2: Income Statement 2019

Chart 10

Appendix 3: 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.

We base the financial risk assessment 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

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%-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

• COVID-19 May Accelerate Disruption In The Global Vaccine Market, Aug. 3, 2020
• What Does Pharma’s Quest For A COVID-19 Vaccine Mean For Its Credit Quality And ESG Profile?, July 8, 2020
• Pharma Industry Only Moderately Affected While Helping Mitigate COVID-19 Pandemic Impact, March 16, 2020
• Biosimilar Adoption In The U.S. Will Challenge Some Of Pharma's Biggest Names, March 3, 2020
• Outlook 2020: Pharmaceuticals Negative On M&A, Opioid Litigation, Feb. 18, 2020
• Opioid Litigation Developments Point To Increased Liability And Downgrades For Global Drug Manufacturers, Sept. 23, 2019
• Health Care Washington Watch: Which Government Proposals May Affect Ratings? April 18, 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
• Criteria - Corporates - Industrials: Key Credit Factors For The Pharmaceutical Industry, April 8, 2014