Our assessment of business strength is a key factor for our ratings on pharmaceutical companies. This, along with our view of financial risk, are the two primary elements in our analysis for all of our corporate ratings.

The 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. It's also valuable to compare and contrast these metrics among peers, to highlight relative strengths and weaknesses. We look at these measures holistically, including the interplay among them rather than viewing each element in isolation.

Moreover, these factors constantly evolve with the ebb and flow of product life cycles, so we consider their variability over time rather than at a single point in time.

We summarize here the key quantitative measures we consider when assessing the businesses strength of the largest pharmaceutical companies we rate, how those metrics varied across these peers in 2023, and how this influences our view.

Business Dynamics Are Still Broadly Positive For Big Pharma

We generally view the business models for branded pharmaceutical companies quite favorably, because these companies share many positive characteristics. The 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 lengthy regulatory approval process. In addition, the consumable and nondiscretionary nature of life-extending or life-enhancing drugs keeps revenues and profits relatively insulated from the business cycle.

Moreover, the industry is moderately consolidated. The leading companies have unique expertise and capabilities in the development, marketing, and manufacturing of branded drugs and navigating diverse regulatory requirements across the globe. The companies we rate in this sector have very high profitability, averaging 30%-40% EBITDA margins--after research and development (R&D) costs--which is better than any other industrial sector. Supporting margins is the pricing power granted to the industry in return for the societal benefits it provides. Relatively infrequent defaults even compared to the broader noncyclical health care sector empirically support our favorable perspective on well-established companies.

Branded pharma companies, however, are not without weaknesses.   Their revenues and EBITDA margins can decline materially 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 declines for even leading global pharma companies. In turn, it can lead companies to pursue large debt-financed acquisitions to support revenue growth, which can weigh on leverage.

In addition, the process of drug development is fraught with high uncertainty, even in the later stages of clinical trials.

Current Industry Dynamics And Outlook

We believe business strength for branded pharmaceutical companies operating in the U.S. has modestly eroded in recent years due to industry and regulatory developments. For example, the industry is less able to annually increase net prices in the U.S. than in the past. In addition, they face pressure from various initiatives to reform drug prices in the U.S., where prices and profits are highest. We expect this may lead to moderate pressure on growth and margins in coming years. (For our latest views on the industry and more details on drug price reform initiatives, see "Pharmaceutical Industry 2024 Credit Outlook Is Stable As Revenue Growth Mitigates Pressures", published Jan. 24, 2024.)

We also expect the blossoming market for biosimilars (generic-like alternatives to branded biologic drugs) to increase competition and pricing pressure on high-price and high-margin biologic drugs, once those lose exclusivity. (For further details on the biosimilar market in the U.S. see "Biosimilar Adoption In The U.S. Will Challenge Some Of Pharma's Biggest Names", published March 3, 2020).

Business Strength Varies Materially Among Peers

Notwithstanding their shared characteristics, major branded pharma companies vary in scale (annual revenues), diversity (product, therapeutic, and geographic), competitive position (market share and level of innovation within a therapeutic area), and level and volatility of profitability. They also differ in reinvestment strategy (including the reinvestment and mix between internal R&D-based innovation and acquiring drug innovation externally via mergers and acquisitions, M&A), sustainability of revenues and revenue growth, and degree of operational risk.

Our business risk assessments range down from excellent (the strongest of six categories) and strong (second strongest) to satisfactory (third strongest). We generally group companies in each category together throughout this report (Table 1). We typically assign speculative-grade ratings to other branded pharma companies that score weaker in our assessment.

We place the greatest focus and weight on competitive advantage (derived from meaningful innovations) that is sustainable over the long term, reflecting the potential for premium pricing and product differentiation. We often base this evaluation on the amount of investment in R&D, track record of the R&D organization, strength of the pipeline and marketing products, and ability to sustain long-term revenue growth (even in the face of products losing exclusivity) and strong margins. Diversification and scale follow closely in importance.

Competitive strengths and weaknesses

We compare companies against peers within the same business risk category and look at how they measure broadly across the group (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 include revenues from royalties, contract manufacturing, consumer health, generics, and animal health businesses.

Table 1

Recent Transactions And Developments Affect Business Strength

Over the last several years, some larger companies and more diversified big pharma companies divested noncore assets including consumer health, generic drug, and animal health businesses. This includes GSK PLC (A/Stable) and Pfizer Inc. (A/Stable), divesting their consumer health business (Haleon PLC; BBB+/Stable) in 2022, and Johnson & Johnson (AAA/Negative) divesting its consumer health business (Kenvue Inc.; A/Stable) in 2023.

In addition, some companies divested a portfolio of products that had lost exclusivity, including Pfizer in 2020 (contributing to the formation of a new company, Viatris Inc.; BBB-/Negative) and Merck & Co. Inc. (A+/Stable) in 2021 (which it formed into a new company, Organon & Co.; BB/Stable). Also, substantial revenues relating to COVID-19 products (including vaccines) have subsided, significantly reducing revenues at Pfizer and Regeneron Pharmaceuticals Inc. (BBB+/Stable).

Following this convergence in terms of scale, seven of these 17 companies have annual revenues of $40 billion-$60 billion.

Moreover, we expect GLP-1 based products approved for obesity will further this convergence in scale. We expect industry leading annual revenue growth, in the low- to mid-teens percent range (well above that of peers), for Eli Lilly & Co. (A+/Stable) and Novo Nordisk A/S (AA-/Stable) in coming years (each about $34 billion of annual revenues in 2023).

Scale

While we believe greater scale can confer certain competitive advantages (such as greater economies of scale, capabilities, and negotiating power of larger companies), we believe the correlation with our assessment of business risk (Chart 1) also reflects the greater diversification and competitive position (market leadership and market share) associated with larger scale.

The lack of a perfect correlation between scale (as well as most of the other factors individually) and our business risk categories reflects the multiple factors involved in our assessment of business strength as well as our forward-looking perspective.

Chart 1

Product diversity

Although we consider both the concentration of revenues from a company's top product and top three products, we often view single-product concentration as more important. The probability of the top three products all falling materially short of expectations is usually low, assuming they are not well correlated.

We also consider qualitative differences within product concentration. For example, Merck's leading product, Keytruda, is approved for many oncology indications, which reduces the downside risk from competing products. It still exposes the company to significant pressure when patents expire. Although GLP-1 based products have shown benefits beyond obesity and type-2 diabetes, we don't currently view them as having the same qualitative diversity because it's not yet clear whether these potential benefits accrue independent of or because of the weight loss they provide, and because we don't view GLP-1 products as having as strong a competitive advantage as Keytruda. Conversely, many of Gilead Sciences Inc.'s (BBB+/Positive) products are effectively substitutes, with the newer generation expected to cannibalize revenues from earlier generation products over time. This increases product concentration.

For both Merck and Novo Nordisk, revenue concentration from the top product (above 40% of revenue) is materially higher than the average of peers with business risk profiles of strong. These products also contribute an outsize portion of the companies' revenue growth. We view this as a material weakness in their credit profiles relative to peers.

Chart 2

Therapeutic diversity

We consider therapeutic diversification at both a disease level (e.g., diabetes) and a broader therapeutic category (e.g., endocrine related). (For a summary of therapeutic categories and the three largest diseases within each category, see Appendix.)

We look at this concentration 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. Within oncology, for example, many distinct indications seem to require differing pharmacological strategies and products.

Although we generally view greater diversification across therapeutic area as a credit positive, the caveat is that we also view a company's competitive position as stronger when it has a leading position (often measured in market share) within a specific disease or therapeutic market, even as it usually corresponds to a higher concentration within the given therapeutic area.

In considering the trade-off between therapeutic diversity and a leading market position, we consider the size of the market, number of competitors and intensity of competition, extent of market position (market share) and therapeutic concentration, and growth prospects for drugs within that area. For example, oncology and immunology have relatively attractive growth prospects on the heels of medical advances in understanding the immune system.

Both Eli Lilly and Novo Nordisk have higher focus in products for a single disease (diabetes) than similar peers. We expect this will decline, helped by strong revenue growth in GLP-1 based products approved for obesity.

Chart 3

Diversification by therapeutic category

Chart 4

Geographic diversification

Given industry pressures and risks of drug price reform in the U.S., we view geographic concentration in the country as more of a risk than in the past, notwithstanding more favorable margins. In Chart 5, note that some companies don't break out results from Europe, the Middle East, and Africa, in which case we include those regions in "other".

Chart 5

Volatility of revenue

In 2009-2023, annual revenue declined in double-digit percents for eight of the 17 top pharma companies. 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. This data is measured in the reported currency, excludes declines associated with subsiding sales of COVID-19 products and significant divestitures, and thus primarily reflects revenue declines stemming from patent expirations.

Chart 6

Investment in R&D and M&A

Given the limited life of branded pharmaceutical products, companies need to invest significantly in a combination of R&D and M&A to offset revenue declines. Moreover, even with this reinvestment revenue growth is mostly modest, in the low- to mid-single-digit percentage range annually. Thus, we believe they need a significant portion of not just R&D but also M&A spending to maintain revenues, which should be considered when evaluating profitability and return on capital in this industry.

Indeed, big pharma companies view these as complementary sources of innovation for their pipelines of new products, even as U.S. generally accepted accounting principles treat these differently. They require R&D, as well as acquired in-process R&D (IPR&D), to be expensed immediately, reducing taxable income, whereas the cost of other acquisitions is capitalized and amortized.

As such, we look at how much big pharma companies reinvest via R&D and M&A, as a proportion of both total revenues and EBIT-plus-R&D (i.e., the profits available to split among R&D, M&A, and other uses). The median investment from 2009-2023 for these companies:

• R&D as a percentage of revenue was about 18% (compared with 21% for 2023);
• M&A as a percentage of revenue was about 12%;
• R&D as a share of EBIT-plus-R&D was 41%; and
• M&A as a share of EBIT-plus-R&D was about 28%.

Stated another way, big pharma companies typically reinvest about 70% of available profits before R&D in future innovation (via a combination of R&D and M&A), which is significantly higher than often appreciated. We break down the level of investment for each company individually (Chart 7).

Chart 7

Revenue durability: Patent expirations versus pipelines and other growth drivers

Pipeline prospects and patent expirations are key variables in the durability of revenue (Chart 8). But the durability of a company's revenue-generating drugs also depends on marketing efforts to support and increase 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. Thus we focus on the trajectory of revenue growth overall, which incorporates all of these individual dynamics.

Chart 8

Profitability is adjusted for unusually high or low R&D

The difference in accounting treatment between R&D (which is expensed) and M&A (which is capitalized and amortized) can materially inflate the margins of pharma companies that pursue an M&A-oriented growth strategy (as a substitute for investment in R&D). Thus, we also look at S&P Global Ratings-adjusted EBITDA margins, adjusted for unusually high or low R&D intensity (relative to the median company that invests about 20% of revenue in R&D).

More broadly, we also view companies with materially below-average investment in R&D as reliant on M&A to support long-term growth, and as having a weaker competitive advantage than companies that have the capabilities to drive revenue growth from internal innovation.

We look at S&P Global Ratings-adjusted EBITDA margins (Chart 9) as well as EBITDA margins reduced (or increased) for R&D margins that are below average (or above average). This exercise reflects profitability, if the company's reinvestment in R&D was in line with peers.

Chart 9

Interestingly, there seems to be a correlation between higher concentration and profitability (companies farther to the right on Chart 9, with higher concentrations, have higher profitability). It likely stems in part from greater efficiencies in marketing efforts that focus on a narrower group of products or prescribing specialists.

Conclusion

Although the leading branded pharmaceutical companies share many common characteristics--including a strong competitive advantage reflecting differentiated products with premium pricing and limited sensitivity to the business cycle--we see meaningful variation in business strength across the sector. The key areas are scale, diversification, pipeline strength, and prospects for sustainable revenue growth.

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 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 the ratio of funds from operations to debt, which we refer to as the core ratios. In assessing them, 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 ratios in future years than on ratios from previous years.

Table 3

Table 4

Finally, we sometimes adjust the anchor score slightly (rarely more than one notch in this sector) to arrive at the 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 most often the comparable ratings analysis modifier. We can apply it in various circumstances, including when a company is at the extreme end of the spectrum within its business risk and/or financial risk category.

Chart 10

Chart 11

Related Research

• Pharmaceutical Industry 2024 Credit Outlook Is Stable As Revenue Growth Mitigates Pressures, Jan. 24, 2024
• Mortality In Health Care: What Factors Lead To Default For Pharmaceutical Companies, Feb. 14, 2022
• How Business Strength Varies Across Speculative-Grade Branded Pharma Companies, Jan. 24, 2022
• How Business Strength Varies Across The Top Pharma Companies, Aug. 27, 2020
• COVID-19 May Accelerate Disruption In The Global Vaccine Market, Aug. 3, 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
• Lessons Learned: What Leads To Rating Changes For Investment-Grade Pharmaceutical Companies, Jan. 22, 2019
• Criteria - Corporates - Industrials: Key Credit Factors For The Pharmaceutical Industry, April 8, 2014