Background: Business Dynamics Unique To Branded Pharma Companies

We generally view the business model for branded pharmaceutical companies favorably because they share many strengths. The model has uniquely high barriers to competition stemming from patent protection and regulatory exclusivity, stringent manufacturing standards, substantial capital requirements to fund research, and the lengthy regulatory approval process. In addition, the consumable and nondiscretionary nature of life-extending or life-enhancing drugs results in revenues and profits relatively insulated from the business cycle. The companies we rate in this sector have very high profitability, averaging about 30%-40% EBITDA margins (after R&D costs), better than any other industrial sector. This is supported by drugmakers' strong pricing power stemming from the societal benefits they provide. Less frequent defaults than even the broader noncyclical health care sector empirically support our favorable perspective on branded pharma companies.

Branded pharma companies also have unique risks. Revenues and EBITDA margins can be quite volatile when key products lose patent protection or face reimbursement or substitution risk (absent offsetting growth from other products), especially with the high product concentration found among speculative-grade companies (the median top product represents 37% of 2020 revenue). This can lead to multiple years of double-digit percent revenue declines, negative EBITDA, or even insolvency. Thus, evaluating the sustainability and stability of revenues longer term is a key part of our assessment of business strength.

How Speculative-Grade Pharma Credits Differ From Investment-Grade Pharma Credits

Table 1 highlights differences between the business of investment-grade and speculative-grade pharma companies.

Table 1

Strength Of Businesses Varies Materially Among Peers

Notwithstanding their shared characteristics, speculative-grade branded pharma companies vary significantly in business strength. The most prominent considerations include the relative strength of the pipeline (which reflects the sustainability of the competitive advantage and longer-term growth prospects) and product concentration. Our assessment of business strength is also well correlated with scale. Other key considerations include profitability (EBITDA margins), diversification beyond branded drug products, therapeutic diversity, geographic diversity, and where appropriate a forward-looking extrapolation from the history of revenue and earnings volatility. Collectively these factors capture most of the differences in business strength, as we discuss below.

Chart 1

Scale

There is a strong correlation between scale (annual revenues) and our assessment of business strength (Charts 1 and 2). Although greater scale may provide economies of scale and greater negotiating power, we believe this correlation primarily reflects greater diversification (product, therapeutic, customer, geographic) and competitive position (market share) associated with the larger scale.

Chart 2

Product and therapeutic diversity

Although we consider the concentration of revenues from both the top product and top three products, we typically view single product concentration (Chart 3) as more important because the probability of revenue from more than one product falling significantly short of expectations is usually low, especially when the products are not well correlated.

We also consider therapeutic diversity in both disease (such as diabetes) and a broader therapeutic category (endocrine related). We look at concentration by therapeutic category because we view products within a given therapy as subject to some shared risk of a new competing technology harming revenues of multiple products. We take diversification by disease and therapeutic area into context with the degree of competition, size of that market, market share, and prevalence of the disease. That said, given the substantial revenue concentration from the top product for most speculative-grade pharma companies, disease and therapeutic concentrations tend to be less important considerations. Information on therapeutic diversity can be found in the Appendix.

Chart 3

The imperfect correlation between product diversity and business risk category reflects the multiple factors involved in our assessment of business strength and our forward-looking perspective. For example, our assessment of Almirall S.A. as weak, despite very good product diversity, reflects the significant concentration in dermatology (40% of 2020 revenues), which is highly competitive with relatively low acuity. Conversely, our assessment of Jazz Pharmaceuticals Inc. as fair despite its high product concentration reflects our expectations that the company's product concentration will decline significantly over the next few years as we expect revenues from its oncology and antiepilepsy products to increase.

Geographic diversification

In contrast to investment-grade peers, speculative-grade branded pharma companies tend to focus and rely primarily on the U.S. market, where drug prices are most lucrative. The speculative-grade companies in this report on average generated 74% of revenue (median 81%) in the U.S., compared to about 50% for investment-grade pharma peers (Chart 4). The exception is Almirall, which is based in Spain. The incremental differences in geographic concentration between most of these companies is not that meaningful analytically, limiting the correlation between geographic concentration and business risk category. Moreover, we expect the concentration of revenue in the U.S. to rise for Bausch Health Cos. Inc. following the planned spin-off of the eye-care business. (See the footnote to Chart 4 as it relates to information limitations and simplifying assumptions.)

We believe the high concentration in U.S. revenues reflects more lucrative pricing in the U.S. and exposure to smaller product markets that are not attractive opportunities outside the U.S. While this supports high margins, it exacerbates risks from adverse regulatory or reimbursement changes in the U.S.

Some of these companies such as Horizon Therapeutics USA Inc., Jazz, and Lantheus Holdings Inc., focus heavily on orphan drugs in the U.S., where very high prices are tolerated given the limited patient base (for indications that typically affect less than 200,000 individuals). Orphan drugs also have an advantage of requiring significantly smaller (and less expensive) clinical trials because of the small patient base. Orphan drugs attract less criticism in the media and from legislators, despite extraordinarily high prices per patient, likely due to their more limited cost to the health care system. The orphan drug designation itself was established to encourage research into rare diseases. We believe it's premature to conclude whether those products are more insulated from drug price reform than those prescribed more widely.

Chart 4

Revenue declines

Most of the nine speculative-grade pharma companies recorded at least one year of 8% or greater revenue declines in 2015-2020. Two had an annual revenue decline of more than 20% (Chart 5). Moreover, for many companies such as Indivior PLC, Bausch Health Cos. Inc., and Endo International PLC, their worst year of revenue decline was adjacent to other years of decline such that the cumulative decline over multiple years was greater than shown. This phenomenon is also fairly common among investment-grade pharma issuers. The volatility of revenues is well correlated with the business risk category and demonstrates the challenges of maintaining consistent revenue growth in this industry.

Chart 5

R&D and M&A

The branded pharma business model requires significant investment in R&D and late-stage M&A that can be expensive and risky. To measure the companies' investment in growth, we looked at how much each spent on R&D and M&A as a share of total revenues. In this analysis, the R&D amount only includes internal investment and usually excludes spending to acquire in-process R&D, collaborations, and milestone type payments. However, over this period, there were not meaningful in-process R&D adjustments. The median R&D margin from 2015 through 2020 for these companies was 7%, substantially below the approximately 18% average for investment-grade pharma companies over the same period. We view this as low and generally insufficient to support revenue growth without M&A. Accordingly, we view the EBITDA margins as superficially inflated (by about 1,000 basis points, on average) given that they don't include the full burden of reinvestment needed to sustain the business.

The median reinvestment in growth via M&A for speculative-grade branded pharma companies was about 12% of revenue (average of 16%), which is like that for investment-grade pharma companies. Altogether, the lower reinvestment by speculative-grade branded pharma companies resulted in smaller development pipelines, lower organic growth expectations, and inflated profitability due to lower R&D spending. For this reason, we generally have heightened concerns about the sustainability of these businesses and often significantly burden our forecasts with an assumption of substantial acquisition spending to compensate for gaps in the pipeline.

R&D spending varies significantly by company. Most speculative-grade companies seek pipeline growth primarily through M&A (Chart 6). In addition, businesses we categorize as vulnerable had particularly low reinvestment over this period. Finally, the companies with the highest reinvestment are sometimes those with the greatest need to replace lost revenues, though in many cases they expect the investment to support not just replacement revenues but substantial revenue growth.

Chart 6

Profitability is adjusted for unusually high or low R&D

Various factors affect margins, among them aggressiveness in pricing, willingness to cut development programs when prospects justify it, the intensity of internal R&D spending, and variations in marketing efforts that address that particular portfolio. For example, companies that market drugs prescribed by a narrow group of specialists can typically be served by a smaller (and more efficient) sales force than those with drugs prescribed more broadly by primary care doctors.

In measuring profitability (EBITDA margins), we often focus on consolidated results (including revenues from non-pharma segments) given the difficulty in allocating costs across shared segments. EBITDA margins are burdened with R&D expenses (including spending on acquired pipeline assets and certain contingent payments), but not M&A expenditures. Companies that pursue an M&A growth strategy (as a substitute for investment in R&D) benefit from artificially higher margins. For this reason, we also look at EBITDA margins adjusted for unusually high or low R&D intensity, relative to the median of 7% for speculative-grade peers (though we view that as insufficient to sustain revenue over the long term). Also notice the positive correlation between profitability and businesses risk category.

Chart 7 also highlights the volatility of EBITDA margins by showing the strongest and weakest margins over the last six years. EBITDA margins can fluctuate significantly based on pricing pressures; competition; selling, general, and administrative expenses; and R&D fluctuations.

Chart 7

Chart 8 provides additional detail on differences in cost structure and margins vary across companies through a common-size income statement.

Chart 8

Revenue durability and growth: pipeline prospects and patent expirations

Pipeline prospects and patent expirations are key drivers of revenue growth and declines (Chart 9). Though the durability of a company's revenue-generating drugs also depends on marketing efforts to support higher volumes, patent management, life cycle management (through changes in dosing, delivery method, or extending the indication to pediatric patients), pricing trends, formulary status, and other factors.

Chart 9

We note that the new molecular entities (NME) we reference here may reflect some shared in partnership or collaboration among different companies, as well as those with only a royalty interest in an NME.

Although the primary focus of this article is on business strength, differences in financial measures (credit ratios) have an equally important influence on credit ratings. Chart 10 shows the ratings for each of the discussed issuers after combining the business risk profile with the financial risk profile, and considering any additional factors not captured by these two scores.

Chart 10

The Appendix provides a more detailed summary of how we combine our assessment of the business risk and financial risk in our rating analysis. Our report, "Key Credit Factors For The Pharmaceutical Industry," published April 8, 2014, gives further details on how we incorporate these considerations into our assessment of business risk.

Drug Price Reform

We believe business strength for branded pharmaceutical companies has eroded 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 drug price reform legislation that aims to cut spending growth on health care and address affordability. This has constrained revenue growth for branded pharma companies, and we expect drug price reform to lead to moderate pressure on margins in coming years. Although the media, payers, and legislators primarily focus drug price conversations on the large-capitalization, investment-grade pharma companies and their blockbuster products, we view speculative-grade issuers as particularly at risk. Many have a relatively high proportion of revenues concentrated in the U.S., high leverage, and charge very high prices per dose. For example, as of February 2021, Horizon had two of the five most expensive prescription drugs by list price in the U.S., according to GoodRx Inc. That said, the economics of rare diseases, such as for orphan drugs, often requires the ability to set price at a premium to allow for a meaningful return on R&D investment.

For details on our outlook on the pharmaceutical sector, see "Pharma Outlook: Eighth Straight Year Of Credit Deterioration In 2021,"published Feb. 23, 2021.

Appendix

Table 2

Overview of our analytical framework

Our assessment of business strength is a key driver of ratings on pharmaceutical companies. This and our view of financial risk are the primary elements in our analysis for issuer credit ratings. A business risk profile reflects our view of the strength, stability, and long-term durability of a company's profits. Although our assessment is qualitative, we use various quantitative metrics within that process. We also find it valuable to compare these metrics among peers to highlight their relative strengths and weaknesses. We look at these measures holistically and at the interplay among them rather than just viewing each element in isolation. Moreover, these factors constantly evolve with the ebb and flow of product life cycles, so we consider their variability longer term rather than at a single point in time.

This article summarizes the key quantitative measures we use in assessing the businesses of the speculative-grade branded pharmaceutical companies we rate, how those metrics vary across peers, and how this influences our view of these firms. For a similar publication on investment-grade branded pharmaceutical companies, see "How Business Strength Varies Across The Top Pharma Companies", published Aug. 27, 2020.

Business 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 EBITDA margins and their stability, 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. We incorporate various analytical adjustments (including for operating leases and pension obligations, and stock-based compensation). We usually place more emphasis on our projections and ratios in future years than on ratios from previous years. See Chart 8 to see combined business and financial risk profiles for speculative-grade branded specialty pharma issuers, with fiscal 2020 adjusted leverage.