The pharmaceutical industry, part of the healthcare sector, deals with the development, manufacturing and distribution of pharmaceutical products. Some of the largest pharmaceutical companies worldwide include Pfizer, Merck & Co, Johnson & Johnson and AbbVie. According to the Global Use of Medicines report from the IQVIA Institute for Human Data Science, the global market for pharmaceuticals reached $1.2 trillion in 2018 and was expected to grow to $1.5 trillion by 2023. In 2018, U.S. alone spent $485 billion, a staggering 40% of total global spending.

With the global search for vaccines against COVID-19, pharmaceutical companies were thrown into the spotlight. Some companies are directly involved in the development of COVID-19 vaccines, such as Johnson and Johnson and GlaxoSmithKline, while others are indirectly riding along with the trend. If you are looking to invest in a pharmaceutical company, the following can serve as a simple guide on the 5 key factors you may consider looking out for.

1. Liquidity Ratios

In the pharmaceutical industry, it takes money to make money. Pharmaceutical companies, on average, spend 17% of revenue on research and development (R&D). Such huge spending is necessary as these companies constantly rely on the development of new drugs for their growth. Even after the successful development of a drug, huge marketing expenses will be spent on generating awareness. Marketing is mainly done by sending paid representatives to persuade healthcare professionals and direct-to-consumers sales. As a case study, in 2019, Eli Lilly spent 25.1% of total revenue on R&D and 27.8% of total revenue on marketing, selling and administrative expenses.

As such, cash is vital to sustain the business. Investors may look out for the quick ratio which measures a company’s short-term liquidity to cover its day-to-day operating expenses. It is calculated by taking the sum of current assets minus inventories and dividing by total current liabilities. For more conservative investors, they may look out for the cash ratio which takes the total reserves of cash and cash-equivalents and dividing by total current liabilities. A high quick ratio or cash ratio gives the company the leeway to increase its spending when the need arises, for example, pushing its marketing for newly developed drugs. Below is a table of comparison of the 5 largest pharmaceutical companies listed in the U.S.

2. Debt Headroom/Debt Ratios

Other than depending on organic growth, large pharmaceutical companies may turn to acquisitions to boost their product portfolio and pipelines. Over the years, Eli Lilly has acquired a total of 23 various pharmaceutical companies. In 2007, the company acquired ICOS Corporation, gaining full control over the erectile dysfunction drug, Cialis. More recently in 2019, Pfizer acquired Array BioPharma Inc which gave it access to Array’s approved drugs for skin cancer and targeted cancer medicines.

Therefore, it is a common practice for companies to perform acquisitions to gain direct access to proven products. Other than having a huge cash pile to support these acquisitions, having sufficient debt headroom will ease some pressure off its short-term liquidity. The current low interest rate creates an ideal situation for these companies to have access to funds at cheap rates.

Investors can look out for the debt-to-equity ratio as a gauge of how the company is financing its operations through debt versus wholly-owned funds. The ratio is calculated by dividing a company’s total liabilities by its shareholder equity. Investors can also look out for the interest coverage ratio which measures the capacity of a company to pay their interest expenses on outstanding debt. The ratio is calculated by taking earnings before interest and taxes (EBIT) and dividing it by interest expense. Investors can take note that companies may choose to finance their acquisitions through cash and equity offering, and not necessarily through debt. However, with the debt headroom, it gives the company more financing options, especially if the cost of debt is significantly lower than the cost of equity. Below is a table of comparison of the 5 largest pharmaceutical companies listed in the U.S.

3. Profitability of R&D spending

Despite huge R&D spending by pharmaceutical companies, R&D spending by itself does not necessarily guarantee results. For example, in 2016, Eli Lilly’s experimental drug for Alzheimer’s disease failed to produce positive results during its trial. This led to the company’s shares falling 13% in premarket trading on the announcement date. The bearish sentiments eventually spilled over onto other companies in the industry – Shares of Biogen Inc, which was developing a similar drug, tumbled 11% at that time.

Profitability of R&D spending is important because there is a huge opportunity cost involved when pharmaceutical companies allocate funds for R&D. The funds could potentially be spent on tangible assets or capital improvements, where results are clearly more visible. To have a gauge of profitability of R&D spending for a company, investors may look out for the return on research capital (RORC). It tells us how much gross profit is generated for every dollar of R&D spent. The ratio is calculated by taking the current year’s gross profit and dividing it by the previous year’s R&D expense. Investors may include this factor when doing peer comparison, to see which company is more efficient in terms of its R&D spending. Below is a table of comparison of the 5 largest pharmaceutical companies listed in the U.S.

4. Pipelines of Products

Before new drugs hit the market, they have to be assessed by the FDA’s Centre for Drug Evaluation and Research (CDER) to ensure that it works as intended and the health benefits far outweigh the known risks. It involves a stringent process with a series of laboratory and human testing. Companies with only a few drugs in their pipelines may run the risk of hitting a brick wall if their drug applications are not approved. Having a full pipeline of drug spreads out risk and increases the chances of getting some approved. With that, investors may also look for pharmaceutical companies with a strong track record of passing FDA scrutiny and successfully taking drugs to the market.

Usually, most of the developed drugs will be protected under a patent. The patent protection will provide the company with a steady stream of cashflow until it eventually expires. Thereafter, the company may see competitors producing imitations. For example, in 2018, Teva Pharmaceuticals launched a copycat version of popular-selling erectile dysfunction drug, Cialis. This directly led to Eli Lilly’s sales for Cialis plunging 17%. Therefore, having a strong pipeline of products will ensure consistent growth of the company in the event that some patents expire near-term. Some companies may even come up with an improved version of the drug and protect it with a new patent, so as to ensure that they still have a competitive advantage of these products over their competitors.

5. Market Potential/Market Share

It is also important for investors to assess the market potential of the drugs owned by the pharmaceutical company. They can look at whether the condition treated by the drug affects a significant proportion of the population and if the product is essential. Pharmaceutical companies rely heavily on blockbuster drugs to bring in profits. These drugs are usually used to treat chronic medical problems, as opposed to acute or short-term conditions. Some examples are medications for diabetes, cholesterol, high blood pressure, and cancer. If a condition is long-lasting, consumers will have to depend on it for a prolonged period of time. This provides a form of recurring income for the pharmaceutical company.

Investors may also assess the market share that a company’s drug possesses. Having a high market share can be an indicator that the company’s drug has an edge over its competitors. It also shows how well the product is performing in relation to the industry as a whole. For example, Eli Lilly has been the market leader in several diabetes products. Its diabetes medication, Trulicity, has dominated 45% of market share in Q12020 and shows little sign of being dampened by any competition or pricing. Below is a table showing the top-selling drugs for the 5 largest pharmaceutical companies listed in the U.S.

Generally, these are several key factors which you can consider when looking at a pharmaceutical company. There are definitely other factors that may come into play. For further analysis, one may consider conducting peer comparison and valuation measures to make a better-informed investing decision.

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