Pharmas made less money but bought their own stock

by Daniel R. Hoffman, Ph.D.

Published May 13, 2013, 9:27 a.m. ET

Did anyone in Big Pharma post improved results for the first quarter? Pfizer, Merck, Bristol-Myers Squibb, AstraZeneca, GlaxoSmithKline, Sanofi and Novartis (the last two in their pharmaceutical operations) all generated lower sales this past quarter, compared to the same period last year.

Some companies (such as Roche, Novo Nordisk, and AbbVie) did post gains in their pharma units, but overall it was a dismal quarter for the branded drugs sector.

Throughout the year a number of observers wondered when investors would start to see a major disconnect between the soaring stock prices of Big Cap pharmas, most of which hit 52-week highs many times this past quarter, and some very shaky fundamentals. As it turns out, it may not take all that long.

The stock market's short-term focus doesn't permit an appreciation of the extent to which pharma's business model has broken down. Consider in that regard Merck, a company that was Big Cap pharma's crown jewel for many years.

Merck's total sales for the quarter just concluded were $10.671 billion, a 9% decline from the $11.731 the company sold during first quarter last year. Some of the company's diehard partisans claim this past quarter was uncharacteristically down because of a precipitous revenue fall following the patent expiration on Merck's top-selling product, Singulair. Their cheerleading ignores the fact that sales and non-GAAP net income at Merck have both remained sluggish during the past three years.

For the most part, pharmas have two ways of stimulating growth: developing new products through R&D, and buying other companies and/or products. Merck, it seems, isn't keen on doing either one. The company's R&D spending declined by more than 26% between 2010 and the end of last year. During the same period, while acquisition spending rose slightly in 2011 over the previous year, it fell back in 2012 to the 2010 level. Merck's combined R&D and acquisitions spending declined by almost 17% between 2010 and 2012.

One might reasonably think that drug discovery and development represent the heart and soul of branded pharma, but the CFOs that run the industry's operations these days disparage that part of the business. At least they don't feel it justifies the cost of capital for their own companies to do research.

If Merck's managers subscribe to that thinking, they could have taken a page from GlaxoSmithKline which recently placed half a billion dollars with a venture capital firm. Their partnership will look to uncover and fund startup pharmas that hope to discover auspicious target sites for drug action. It makes good sense for a pharma to supply the capital and the VC to make the deals, mainly because pharmas are too slow and hidebound to do that sort of thing on their own.

But if Merck's research budgets are going south and it trails its competitors in dealmaking, the company isn't just hoarding its cash. At the same time they announced the disappointing quarterly results, Merck's top brass also stated they would spend $15 billion to buy back company stock. That amount almost equals two full years worth of R&D spending. So instead of putting their money into the labs or the clinic, management decided to reduce the number of outstanding shares and, thereby, boost earnings per share.

Merck is also using its cash to pay dividends. In fact the company honchos claim they will continue to use operating cash, together with borrowed money, to repurchase stock and continue making hefty dividend payments. While these finance-directed moves have the effect of propping up Merck's stock price, they do so at the expense of starving its long-term growth prospects.

To recognize the folly of this course, one need only remember that pharma is an industry requiring, on average, ten years to develop a new drug. This basic fact obliges management to keep its eye on that decade-long horizon. So why would Merck compromise its long-term growth prospects to goose up its current stock price in an overheated market?

The answer comes from two sources. First, Factset showed at the end of April that health care companies, led by revenue-challenged manufacturers, bought back more of their own stock during the first quarter than any other sector except IT. In other words, when top line growth appears shaky, executives look to retain their hold on the company by buying back stock. This financial arithmetic inflates portfolios, thereby masking reality and distracting investors.

A second answer comes from another set of data. Three accounting professors found that the likelihood for accelerated share repurchases is greater at companies where executive compensations are based on earnings per share. In other words, Merck's top managers spent that $15 billion of the shareholders' money on stock buybacks to appease investors and keep themselves in their positions. That happens a lot in pharma.

The money spent on stock repurchases that could otherwise pay for R&D or fund many more backloaded, milestone-laden deals goes instead to boost the short-term gains of investors who reward executives for such generosity. As always, the company's mission and its prospects for extended survival take the hit because directors and C-suite members view everyone outside the boardroom as an enemy.

Anticipating a bleak earnings call, Merck's managers gave an anticipatory offering when they replaced their head of R&D. That was another effort to place a band-aid on investors' concerns amidst this year's darkening financial results. Such changes represent a CFO's version of taking a pill for today's intense pain, even though the medication takes two weeks to work. That's because the ten-year lead time for bringing new compounds to market means it will take several years before people can tell whether the man just installed atop R&D has made Merck more productive at developing new drugs. If the company does launch any important, big-selling drugs within the next three years, they will mainly be due to the previous guy's work.

Equity analysts typically scoff at such criticisms of their efforts to talk up a stock by invoking their standard line that there's a major difference between a good company and a good stock. In the short term they may be right, but eventually the company's stock price will catch up to its fundamental realities. Even then, the stock dealers don't really care because they make money when a stock goes up and when it goes down. So volatility is what the brokers and analysts crave. They sniff out signs of it the way a cat stalks rodents and if they can't smell even a whiff of it, they're not above some wildass exaggerating to move a stock. But the air is now legitimately fragrant because there's a case for seeing Merck as overvalued. As a result it has become one of the Dow's most shorted stocks (see here).

So what we have here is a fine object lesson in how the stock market's dynamics are often just peripherally connected to the underlying fundamentals of a particular sector. Equities resemble any other market in that it's possible to promote players up and to talk them down, regardless of the bases beneath such promotion. The problem comes when the company that analysts are talking up tries to support their undeserved praise by stinting on what's essential for maintaining growth. Therein lies the essence of pharma's current condition. It no longer exists as a research-driven, growth industry because it pumps earnings into dividends and stock buybacks.

Whether pharma can endure this way, as an asset play for widow/orphan investors, remains to be seen. Unlike utilities or some other value sectors, pharma must relentlessly develop new and better products or lose its business to low-cost generics. Some of the industry's top executives already know that and they see no workable solution. Instead they've decided to just ride the gravy train of eight-figure annual compensations while lobbying and political payoffs stick taxpayers with the fare. Stock buybacks and high dividends are the coal they use to keep that train rolling.