What drives pharmaceutical growth?
8/3/20 Market Notes
by Akshata Bailkeri, Equity Analyst -
US equity markets ended last week on a mixed note with the S&P 500 up 1.7% and the Dow Jones Industrial Average down -0.2% with delays in the stimulus bill offsetting strong earnings news. The Nasdaq led markets higher; up 3.7% over the week, as technology giants Amazon, Apple, Facebook and Alphabet reported strength in sales and profits in the face of the pandemic. U.S. futures are up this morning as earnings and stimulus talks continue.
The week ahead will showcase updates on manufacturing PMI, construction spending, factory orders and trade before ending the week with the July jobs report. Among the companies scheduled to report their quarterly results this week are Walt Disney, Clorox, Tyson Foods, T-Mobile and Toyota.
We recently completed a deep-dive into the pharmaceutical sector to better understand company pipelines, patent expirations and growth drivers.
To do this, we analyzed 15 of the largest pharmaceutical companies in the US, Europe and Japan, looking to identify valuation drivers and to see areas of potential investment. Using regression and correlation data, we were able to extrapolate some interesting relationships between valuation multiples and variables like R&D spending and therapeutic areas of research focus.
What drives pharmaceutical growth? Research and development (R&D) spending was the primary factor contributing to revenues and valuation, followed by a focus in the Oncology therapeutic area.
Our analysis illustrated that R&D spending had strong positive correlations with revenue growth and P/E multiples. Investments in R&D translate into the development of new compounds for the company’s pipeline or into additional indications for their existing drugs and therapies. This influx propels revenues and offsets patent expirations (which is the largest threat to a pharmaceutical company’s growth). Companies with robust pipelines and high sales growth see a similar boost in their valuations, often through P/E ratios higher than those of their peers.
Pharmaceutical companies clearly understand the impact of the R&D on their bottom line. Of the companies that have reported so far, even ones that have reduced operating expenses, none have reduced allocation to R&D. Rather, R&D is a continued point of investment, especially for companies looking at vaccines and treatment options for the novel coronavirus.
Another key driver for pharmaceuticals is the exposure to the Oncology therapeutic area. Oncology has seen some recent blockbusters, most notably Merck's Keytruda and Bristol Myers Squibb's Opdivo, both of which expected to generate in excess of $26 billion of revenue next year (2021). Overall, we found that Oncology compounds had the fastest expected revenue growth versus the compounds in other therapeutic areas. Thus, companies that invested more in growing out their Oncology pipeline benefit from a higher valuation. We see that most of the global companies are already aware of and readily investing in this growing area, based upon their pipeline data.
Coupled with the fact that R&D spend and Oncology have a statistically significant relationship, we see the compounding of these two influences pay off in valuation and revenues. If a higher R&D spend leads to a higher P/E ratio, then it is understandable that the investment in some of the fastest growing therapeutic areas would further justify the premium. Pharmaceutical companies with a higher revenue mix in Oncology and higher R&D spend stand to benefit from both these factors considerably.
Why is this important? When investing in pharmaceutical companies, we believe in keeping an eye these significant drivers, while also assessing the fundamentals as a whole. Our disciplined approach in evaluating this sector helps us to better understand the existing pharmaceutical names in each of our strategies, and to identify any potential new investment ideas.
*Bloomberg and Goldman Sachs data used for analysis
Disclosures: This market commentary is written by the 1879 Advisors® and represents the views of 1879 Advisors®. This commentary is not investment advice and should not be used as a basis to make investment decisions. Please consult with your registered investment advisor before making any investment decisions.