Pipeline or pipe dream? Pfizer/Astra Zeneca and crumbs for ants

On May 6 2014 Astra Zeneca (AZ) 'opened its kimono' and gave us all a revealing peek into the riches of its pipeline. This was a direct response to Pfizer's audacious takeover bid, offering $106 billion for the UK-based company whose recent stock market performance has been underwhelming.

From its disclosures, it seems that AZ is sitting on an embarrassment of riches whose combined value is expected to increase sales by more than twofold to $45 billion in the next decade, with peak sales forecast at $63 billion. This mind-blowing forecast was derived from the predicted sales of 11 pipeline assets and has highlighted one of the idiosyncrasies of Wall Street valuations of pharmaceutical companies – the minimal value attributed to pipeline assets that have not yet generated sales.  Who is right: the company or the analysts?

Both Pfizer and AZ have been badly hurt by the expiry of key patents during the past few years. Pfizer has been affected the most, losing almost $30 billion in annual revenues since 2009 (notably through the loss of Lipitor, which earned more than $12.5 billion in 2009); while AZ has lost more than $7 billion a year.

In fact, the loss of key patents and the inability to replace them has meant that the market performance of a representative sample of top pharma companies since 1997 would have underperformed the Dow Jones Industrial Average. This is not what we expect of so-called 'defensive industries'.

Much has been written about the decline in R&D productivity in big pharma and an industry structure that generates historically almost half of all global sales from just 10 therapeutic areas. The 'medical industrial complex', as it may be referred to, has developed in tandem with the regulatory agencies that patrol it and the government agencies and insurance companies that are its customers. It has become intellectually sclerotic and self-reverential. However, increasingly powerful generic companies, longtail economics and big genomics are ushering in a bipolar world of commoditised drugs and personalised medicine – and big pharma is caught in the middle. This is what is driving mergers and acquisitions.

To put this in perspective, acquisitions have accounted for two-thirds of all sales growth in big pharma since 1995. Consolidation is the name of the game. But what next? Big pharma is ripe for disruption in the Clayton Christiensen sense of the word.

Which brings me back to the refreshing part of AZ’s defence against Pfizer’s embrace. AZ is one of the most transparent pharmaceutical companies in the world when it comes to showing investors what it is working on. Like its UK cousin GlaxoSmithKline (GSK), its pipeline is discussed quite openly on its website and its progress in trials is revealed. In contrast, Pfizer is not so open, particularly with regard to mechanism of action explanations; and at the other end of the spectrum, industry giant Johnson & Johson is impenetrable.

By revealing and putting numbers on its pipeline, AZ has done something extraordinarily risky. It has made itself a hostage to fortune and has asked analysts to do something that they have not done to date – to stop discounting the pipeline and to value intellectual property more equitably with cash flow.  Valuing pipelines is hard for analysts, and thus they tend to err on the side of caution. Many analysts’ pipeline value discount factors reflect a venture capital mentality to risk analysis, reflecting the high probability (even in phase 3) of disappointment. AZ is exposed in this regard as it has quite a small portfolio, certainly in comparison to GSK (or even Pfizer), and 'short the launch' is Wall Street's default position – reflecting the failure rate of drugs even after they make it through the Food and Drug Administration Hunger Games.

The Pfizer/AZ deal is partly an IP story and partly an old-fashioned Barbarians at the Gates trade. In just over a decade Pfizer has acquired Warner Lambert (WL), Pharmacia and Wyeth (the former for $112 billion), and each deal has been driven by strategic considerations. In the case of WL it was the co-promotion of Lipitor, and in the case of AZ it may be tax management echoing the Elan/Perrigo merger and on trend with the 'inversion' play that is the latest Wall Street wheeze for relocating drug companies into tax-efficient domiciles.

Ultimately, however this dramatic story plays out, the reality of the industry is that the bigger the beast, the hungrier it gets. In IP terms, this means that as the balance sheet gets bigger, the minimum sales target for new drugs grows, R&D budgets get proportionately smaller and in-licensing increases, interrupted by periodic significant acquisitions.

For vertically integrating generics companies, venture capitalists and opportunistic private equity investors, the scraps from the table of this ongoing feast will make a very good meal. Or, as a good friend is always telling me, “The crumbs from an elephant's table are a feast for an ant.”